Interaction with EU ETS Free Allowances
What you will learn
The transition from a free-allocation-based leakage protection system to a CBAM-based one is not a sudden switch. It is a carefully engineered phase-out and phase-in that runs in parallel from 2026 to 2034. Understanding exactly how these two systems interact determines the actual net cost of imports and the competitive reality facing EU producers.
The Policy Problem: Why You Cannot Have Both
Free allocation and CBAM serve the same purpose: protecting EU producers from unfair competition with carbon-free imports. If both operate simultaneously at full strength, EU producers receive double protection - their own carbon costs are subsidised through free allowances, while their import competitors face a CBAM cost. This would over-compensate EU producers and potentially amount to a subsidy incompatible with both WTO rules and the internal logic of the EU ETS.
The CBAM Regulation therefore establishes a strict linkage: as CBAM capacity expands, free allocation to CBAM-covered sectors must be phased down proportionally. The two curves are designed to sum to 100% throughout the transition - full leakage protection is maintained, but gradually transferred from one instrument to the other.
The Relay Race Baton
Imagine free allocation and CBAM as two runners in a relay race. Free allocation runs the first leg and holds the baton (leakage protection). As it tires, it passes the baton incrementally to CBAM. At no point is the baton dropped - leakage protection is continuous - but by the time the race is complete (around 2034), CBAM is running with the baton entirely, and free allocation has left the track.
The CBAM Adjustment Factor
Article 31 of the CBAM Regulation operationalises this balance through a mechanism called the CBAM adjustment factor. Rather than imposing full certificate surrender from day one, the number of certificates an importer must surrender is reduced by a factor reflecting the proportion of free allocation that a comparable EU producer in the same sector would still receive during the same reporting year.
In concrete terms: if in 2026 a comparable EU cement producer still receives 90% of its benchmark-based allowances as free allocation, then the CBAM importer only needs to surrender certificates covering 10% of their embedded emissions. If in 2030 that free allocation has fallen to 50%, the CBAM surrender obligation rises to 50% of embedded emissions. By 2034, when free allocation reaches zero, the CBAM surrender obligation covers 100% of embedded emissions.
| Year | Free Allocation Share (Indicative) | CBAM Adjustment Factor | CBAM Surrender Obligation |
|---|---|---|---|
| 2026 | ~97.5% | ~2.5% | ~2.5% of embedded emissions |
| 2027 | ~95% | ~5% | ~5% of embedded emissions |
| 2028 | ~87.5% | ~12.5% | ~12.5% of embedded emissions |
| 2029 | ~75% | ~25% | ~25% of embedded emissions |
| 2030 | ~62.5% | ~37.5% | ~37.5% of embedded emissions |
| 2031 | ~50% | ~50% | ~50% of embedded emissions |
| 2032 | ~25% | ~75% | ~75% of embedded emissions |
| 2033 | ~12.5% | ~87.5% | ~87.5% of embedded emissions |
| 2034 | 0% | 100% | 100% of embedded emissions |
Note: The exact phase-out schedule for each sector is defined through delegated acts under the ETS Directive. The figures above are indicative of the general trajectory; actual values vary by sector and are calculated annually based on the benchmark-based free allocation methodology.
How the Adjustment Is Applied in Practice
The European Commission calculates and publishes the adjustment factor annually for each sector covered by CBAM. For a given reporting year, the factor represents the proportion of free allocation that would have been allocated to a comparable EU installation - expressed as a fraction of the total benchmark-based allocation that sector would have received without any free allocation phase-out.
From the importer's perspective, the annual CBAM declaration must include a calculation of adjusted embedded emissions (the total embedded emissions multiplied by the CBAM adjustment factor). It is this adjusted figure - not the gross embedded emissions - that determines the number of certificates to be surrendered.
The Adjustment Calculation in 2028
A Spanish importer declares 1,000 tCO₂ of embedded emissions in steel imports for the 2028 reporting year. The CBAM adjustment factor for steel in 2028 is 0.20 (meaning comparable EU producers still receive 80% free allocation). The adjusted embedded emissions are:
1,000 tCO₂ × 0.20 = 200 tCO₂ adjusted embedded emissions
The importer must surrender certificates equivalent to 200 tCO₂, not 1,000 tCO₂. The EU ETS price is €80/tCO₂, so the cost is 200 × €80 = €16,000 rather than €80,000 for the full gross liability. As free allocation falls in subsequent years, the effective CBAM cost will rise substantially.
Implications for EU Producers
For EU producers, the phase-out of free allocation is a phased increase in their unsubsidised carbon cost. The rate at which they lose free allowances is matched by the rate at which their import competitors face rising CBAM costs - so the relative competitive position is designed to remain constant during the transition.
However, EU producers must plan carefully for the increasing absolute carbon cost they will face as free allocation falls. An EU cement producer who today (with high free allocation) faces minimal ETS cash cost will, by 2032-2034, be purchasing most or all of their required allowances at auction prices. At an EU ETS price of €80/tonne and cement production intensity of roughly 0.8 tCO₂ per tonne of cement, this translates to a carbon cost increase of approximately €64 per tonne of cement - a material impact on production economics requiring either decarbonisation investment or price adjustment.
Monitoring Free Allocation for CBAM Adjustment Purposes
The accurate calculation of the CBAM adjustment factor requires the European Commission to obtain data on actual free allocation to EU installations in each sector. This data flows from the EU ETS registry, which records the allowances allocated to and surrendered by each installation annually. The Commission derives sector-level free allocation ratios and translates these into the published CBAM adjustment factors.
Importers do not calculate the adjustment factor themselves - it is published by the Commission. However, importers benefit from understanding the underlying methodology to anticipate how their CBAM costs will evolve as free allocation is progressively withdrawn from EU producers in the CBAM-covered sectors.
Key Takeaways
- 1Free allocation and CBAM both provide leakage protection, and having both at full strength simultaneously would over-compensate EU producers; the CBAM Regulation therefore links the phase-out of free allocation to the phase-in of CBAM
- 2The CBAM adjustment factor - published annually by the European Commission - reduces the certificate surrender obligation proportionally to the residual free allocation that comparable EU producers still receive
- 3In 2026 the surrender obligation is minimal (a few percent of embedded emissions); it rises each year as free allocation falls, reaching 100% of embedded emissions by 2034
- 4From an EU producer's perspective, the phase-out means a rising absolute carbon cost each year, offset by a more level competitive playing field as imports face correspondingly higher CBAM costs
- 5Importers should model their future CBAM liability using the phased adjustment trajectory - costs will increase substantially between 2026 and 2034 even if the EU ETS price remains constant