The European Commission’s proposal for Phase 5 of the EU ETS, tabled on 17 July, could result in a net increase of more than 1.9 billion allowances by 2040, significantly expanding the market surplus, according to a new estimate reported by Carbon Pulse on 11 August. For compliance buyers planning procurement strategies and for investors positioned for structurally tighter EUA supply, the number cuts against the prevailing narrative: the world’s largest carbon market may be heading into its next decade with more supply, not less.

A Shallower Cap Decline Is the Core Driver

The single biggest lever is the linear reduction factor (LRF), the annual rate at which the cap shrinks. The Commission proposes an LRF of 3.7% for 2031 to 2035 and just 1.7% from 2036 onward, down from 4.3% for 2024 to 2027 and 4.4% from 2028 under current rules. The proposal frames this as consistent with the EU’s 90% net reduction target for 2040, of which at least 85% must be achieved domestically.

The practical consequence is significant: allowances would continue to be issued into the 2040s, whereas simply extending the current rules into Phase 5 would have ended new supply around 2039. A slower cap decline over a decade compounds into hundreds of millions of additional EUAs.

The Proposal Layers New Supply on Top

Beyond the LRF, the Phase 5 package adds allowances through several distinct channels, each tied to a policy objective:

  • Domestic carbon removals: the cap rises by 250 million allowances, auctioned between 2031 and 2040 to fund purchases of CRCF-certified BioCCS and DACCS, plus a 10 million allowance contingency reserve.
  • International credits: up to 260 million allowances would be ring-fenced and auctioned to buy up to 260 Mt of Article 6 credits between 2036 and 2040, roughly 2% of the EU’s 1990 net emissions, within the 5% ceiling set by the European Climate Law.
  • Industrial Decarbonisation Bank: a 400 million allowance Investment Booster in its first phase (2028 to 2031) to pay fixed carbon premia.
  • Free allocation: extended through 2040, though fully conditional on verified decarbonisation investment plans from 2031. For CBAM sectors, 15% of phased-out free allocation is reintroduced from 2028, stretching the phase-out to 2038. A parallel proposal on fallback benchmarks unlocks roughly 80 million additional allowances for energy-intensive industries in 2026 to 2030.

Individually each channel is defensible. Cumulatively, they explain how an estimate of more than 1.9 billion net additional allowances by 2040 is arithmetically plausible.

The Market Stability Reserve Gets Recalibrated, Not Removed

The MSR remains the system’s shock absorber, but the proposal softens it in three ways. From 2028, the intake rate is halved from 24% to 12%, slowing the pace at which surpluses are absorbed. A new lower buffer mirrors the upper one: releases become proportional between 400 and 300 million tonnes in circulation, with a fixed 100 million release below 300 million. And from 2029, all reference points decline 4% annually to track the shrinking cap.

Two adjustments pull in the other direction. The TNAC calculation will incorporate cumulative net aviation demand from 2012 to 2023, cutting the 2027 figure by about 173 million allowances and triggering earlier releases. Separately, the Commission’s April 2026 MSR amendment would end the invalidation mechanism, under which holdings above 400 million are currently cancelled. Ending cancellations removes the market’s only mechanism for permanently destroying surplus allowances, and it is arguably the most structurally bearish element of the entire package.

What Buyers and Investors Should Take From This

For compliance buyers, a larger long-run surplus argues against aggressive forward hedging at prices that assume scarcity. Phase 5 supply looks more generous than current rules implied, and free allocation conditionality means industrials that file credible decarbonisation plans keep receiving EUAs well into the 2030s.

For investors, the picture is more nuanced. The 1.9 billion figure is an estimate of what the proposals could add, not a forecast of what the market will absorb: if emissions fall faster than the cap trajectory, surplus growth accelerates. The historical record shows how persistent surpluses can be: the EU ETS surplus exceeded 2.1 billion allowances before backloading and the MSR were introduced to drain it.

The counterweights are real but conditional. If high-integrity international credits prove unavailable, the LRF reverts to 2.7% from 2036 and leftover set-asides flow to the Industrial Decarbonisation Bank. A Commission report on the international credits market, due by January 2033, becomes an early checkpoint for that scenario.

What to Watch

Three markers will determine whether the surplus estimate holds. First, the legislative process: Parliament and Council must agree a final text, with EU leadership targeting a deal by the end of the first quarter of 2027, and both institutions have historically pushed the ETS toward more ambition, not less. Second, the fate of the MSR invalidation mechanism, since ending cancellations is the single largest structural change to long-run supply. Third, the January 2033 credits report, which decides whether the international credits facility tightens the cap again or simply adds another 260 million allowances of demand-neutral supply.

The EU ETS spent a decade engineering scarcity. The Phase 5 proposal shows a system being redesigned for a different problem: keeping industry inside the carbon price while the cap still falls. Buyers who plan around that distinction will price the next decade better than those who simply extrapolate the last one.