European Union Allowance (EUA) prices – the permits companies must hold to cover each tonne of CO₂ they emit – have fallen from around €90/tCO2e in January to below €65/tCO2e in March. This has been driven largely by uncertainty around reform of the EU Emissions Trading System (EU ETS).
For fund managers with exposure to European industrial equities, the implications for valuations and portfolio risk are direct – daily price movements have ranged from -6.5% to +6.4% over the past two months.
Our modelling shows that under current policy, fundamentals imply EUA prices as high as €163/tCO2e by 2027 and €283/tCO2e by 2035. For fund managers, the outcome of those reforms will determine the carbon cost burden and earnings outlook for industrial holdings across steel, cement, chemicals and aviation.
Why the July legislative package is the one that matters
Much of the recent market commentary has focused on the Market Stability Reserve (MSR) – the mechanism that manages the supply of allowances in circulation. The proposal would stop the automatic invalidation of allowances from the reserve once holdings exceed 400 million, allowing them to be kept as a buffer instead. Markets did not react materially to this announcement, in line with our modelling, which indicates the change will have little impact on prices before 2035.
For fund managers, the July legislative package carries far greater significance. Most major market rules are under active consideration, and the structural decisions made there will set carbon prices – and industrial equity valuations – for the rest of the decade.
The key variables to watch
The Linear Reduction Factor (LRF) is the rate at which the total supply of allowances is reduced each year. It currently stands at 4.3%, which will reduce total supply by 16% between now and 2030. A reduction in the LRF, actively under consideration with 3.4% proposed by MEP Peter Liese, would ease short-term carbon cost pressure for energy-intensive holdings after 2030, but will slow industrial emissions cuts and reduce the advantage of companies already invested in decarbonisation.
For fund managers assessing sector exposure, changes to free allocation – allowances distributed at no cost to certain industries – are the most important variable to watch. If free allocations become tied to abatement investment, the carbon cost burden will vary significantly across industrial sub-sectors. Companies that can pass carbon costs on to consumers, or that are slowest to decarbonise, will face a different risk profile from those under direct competitive pressure.
A slower phase-out of free allocation, currently due to end in 2034 for many sectors, would ease pressure on industries competing against cheaper imports. However, it could create problems for the Carbon Border Adjustment Mechanism (CBAM), the EU’s carbon border charge on imported goods. CBAM only functions as intended if EU producers face similar carbon costs to those being charged at the border.
A leaked European Commission document also points to a potentially significant change in how free allocation benchmarks are calculated. If updated to reflect indirect emissions, as proposed for the 2026-2030 period, European industry could receive an estimated €4bn worth of additional permits, with material implications for valuations across certain industrial sectors.
Aviation is also worth noting. The EU ETS currently covers only flights within Europe. Without extension of the “Stop the Clock” legislation due to expire this year, international flights could fall under the system, adding demand for allowances with no corresponding increase in supply proposed. The outcome of ongoing aviation negotiations remains uncertain, warranting close attention for funds with airline exposure.
The valuation implications
Fastmarkets modelling shows EUA prices could be as low as €88/tCO2e in 2035 with reform, or as high as €283/tCO2e under current policy. That is a gap of €195/tCO2e over nine years — a difference that flows directly into the earnings of heavy industrial emitters. Sectors that cannot absorb or pass on that cost face genuine margin risk if prices move toward the higher end of that range.
Fund managers should not wait for the July proposal to act. The LRF and free allocation decisions will set the carbon cost outlook for the rest of the decade. Portfolios with industrial equity exposure that have not been tested against different EUA price scenarios carry risk that current valuations do not reflect.
