The EU ETS and CBAM Connection
Why this lesson matters
CBAM was not designed as a standalone trade measure. It is the external-facing complement to the EU Emissions Trading System. Understanding how the two systems interact - and especially how the phase-out of free allowances connects to the phase-in of CBAM - is essential for understanding the compliance calendar and the financial stakes for both EU producers and importers.
The EU ETS: A Brief Refresher
The EU Emissions Trading System, established in 2005, is the world's first large-scale greenhouse gas cap-and-trade system. It covers approximately 10,000 installations across the EU and European Economic Area - power plants, energy-intensive industries, and aviation within Europe. Together, these installations account for roughly 40% of EU greenhouse gas emissions.
The system works through a declining cap on total allowable emissions. Each year, the aggregate number of EU ETS allowances (EUAs) - each representing one tonne of CO₂ equivalent - decreases according to a legislated trajectory. Installations must surrender allowances equal to their actual verified emissions each year. They can obtain allowances through the auction market, secondary trading, or, in limited cases, free allocation.
ETS as a Carbon Budget
Think of the EU ETS as a shared bank account for carbon. The total balance (the cap) decreases each year - there is less and less to spend. Each installation gets a limited number of credits (allowances). If it emits more than its credits, it must buy more from the market. If it emits less, it can sell its surplus. CBAM then ensures that imported goods must pay an equivalent "entry fee" based on their carbon cost, as if they too were drawing from that same shrinking account.
Free Allocation: The Bridge Between ETS and CBAM
Since the EU ETS's earliest phases, sectors deemed at significant risk of carbon leakage have received a portion of their allowances for free, rather than having to purchase them at auction. This free allocation was the primary mechanism for maintaining the competitiveness of EU industry in the absence of any border measure.
Article 10a of the EU ETS Directive governs free allocation. Under Phase 4 of the ETS (2021-2030), free allocation is being reduced over time, but sectors on the carbon leakage list (Annex I of the ETS Directive) still receive substantial free shares. With the introduction of CBAM, the rationale for free allocation to CBAM-covered sectors diminishes: if imports must now pay a carbon cost equivalent to the EU ETS price, then EU producers no longer need the same degree of protection through free allowances.
| Period | Free Allocation (CBAM Sectors) | CBAM Status |
|---|---|---|
| 2021-2025 | Maintained at high levels (up to 100% benchmark-based) | Transitional phase (reporting only, no certificates) |
| 2026 | Begins phasing down for CBAM sectors | Definitive period begins; certificates required |
| 2027 | Further reduction | Full certificate surrender obligations apply |
| 2028 | Further reduction | Ongoing |
| 2029 | Further reduction | Ongoing |
| 2030 | Zero free allocation for CBAM-covered goods | CBAM fully operational |
| 2034 | Transition complete for all ETS sectors | CBAM review and possible scope expansion |
This phased structure is critical. It means that from 2026 to 2034, both systems operate simultaneously: EU producers still receive some free allowances (though declining), while importers must surrender CBAM certificates. To avoid over-compensation of EU producers, CBAM Article 31 provides that the number of CBAM certificates that importers must surrender is adjusted downward to reflect the share of free allowances that a comparable EU producer would still receive. As free allocation falls, the CBAM surrender obligation rises proportionally.
How the CBAM Certificate Price Is Set
Unlike a fixed tariff, the CBAM certificate price is not set by legislators. It is derived from the EU ETS market itself, maintaining the equivalence between the cost facing domestic producers and the cost facing importers.
Under Article 21 of the CBAM Regulation, the price of CBAM certificates is calculated as the average price of EU ETS allowances at auction in a given reference period - quarterly in 2026, and weekly from 2027 onwards. The European Commission publishes these prices, and importers purchase CBAM certificates at the current price when they submit their annual CBAM declaration.
Calculating the CBAM Liability
An EU importer brings in 500 tonnes of cement clinker from Turkey. The verified embedded emissions for this shipment are 0.83 tCO₂ per tonne of clinker, giving total embedded emissions of 415 tCO₂. The EU ETS quarterly average auction price for the relevant period is €72/tonne CO₂. The Turkish producer operated under no domestic carbon pricing mechanism. The importer's CBAM liability is therefore:
415 tCO₂ × €72/tCO₂ = €29,880 in CBAM certificates to surrender
If Turkey had a domestic carbon price of €20/tonne, the liability would be reduced to 415 × (€72 - €20) = €21,580.
What CBAM Means for EU Producers
From the perspective of an EU producer in a CBAM-covered sector, the introduction of the mechanism represents a long-term structural shift. During the transitional period (2023-2025), nothing changes in their ETS compliance - they continue to receive free allowances and surrender EUAs as before. From 2026, however, two parallel processes begin:
- Their free allocation begins to decline, meaning they must purchase a growing share of their EUAs at auction. Their carbon cost exposure increases each year.
- At the same time, the competitive pressure from carbon-free imports diminishes as those imports must now carry CBAM costs. The playing field levels progressively as free allocation falls and CBAM rises in tandem.
EU producers will also face new administrative demands: they will need to provide data on their production benchmarks to national authorities, so that the "free allocation adjustment" to CBAM can be calculated correctly. This creates a data linkage between the ETS registry and the CBAM registry.
Article 31 of the CBAM Regulation specifies that the number of CBAM certificates an importer must surrender must be reduced by a factor reflecting the free allocation that a comparable EU installation in the same sector would receive during that compliance year. This prevents EU producers from being subsidised (through free allowances) while importers pay full CBAM costs.
In practical terms, as free allocation for, say, cement is reduced from 100% to 90% to 80% and so on through the phase-out schedule, the CBAM certificates required from importers increase correspondingly - from 0% to 10% to 20% of the full liability. The two curves mirror each other, creating a smooth transition from a leakage-protection system based on free allocation to one based on border adjustment.
Key Takeaways
- 1The EU ETS is a declining-cap carbon market covering roughly 40% of EU emissions; installations must surrender allowances equal to their verified emissions each year
- 2Free allocation of ETS allowances to carbon-leakage-risk sectors was the previous leakage protection tool, but it is being phased out as CBAM phases in
- 3From 2026, EU producers in CBAM sectors will see their free allocation decline each year until it reaches zero by 2034, while CBAM obligations on importers rise in parallel
- 4CBAM certificate prices track EU ETS auction prices dynamically, maintaining exact equivalence between the carbon cost facing domestic producers and importers
- 5CBAM Article 31 adjusts importer surrender obligations downward to reflect residual free allocation, preventing over-compensation of EU producers during the transition