EU Carbon Market Poised for a Surge in 2025: Key Drivers to Watch

The EU carbon market is set for a potential rebound in 2025, driven by key regulatory developments, including the finalization of the 2040 climate target and the Clean Industry Deal. The Carbon Border Adjustment Mechanism (CBAM) is expected to create immediate cost impacts for importers, fueling hedging demand. With economic recovery and tightening supply-demand conditions, EUA prices could rise back to €100+ levels.

CONTENTS:

• The 2040 Climate Target
• The Clean Industry Deal
• Conclusion

EU Carbon Market Poised for a Surge in 2025: Key Drivers to Watch

Following the European Union’s adoption of the “Fit for 55” legislation, the EU carbon allowance (EUA) market saw substantial growth, appreciating by 156% from its proposal in 2020 until it became law in 2023. However, recent regulatory stagnation—partly due to the EU election cycle in 2024—led to a 16% decline in these gains by the end of last year. The REPowerEU initiative, designed to enhance the bloc’s energy independence and renewable energy transition in response to the Ukraine conflict, further affected EUA prices by increasing supply from 2023 to 2026. With no major regulatory changes, the market has been largely influenced by natural gas price trends and broader economic conditions amid Europe’s economic recovery.

A key upcoming development is the phased implementation of the Carbon Border Adjustment Mechanism (CBAM), a tariff on carbon-intensive imports. While initially expected to have minimal impact until the 2.5% compliance phase begins in 2026, sentiment around CBAM’s effects could shift in 2025, as market participants start pricing in its implications. This is already evident, with EUA futures rising by 15% year-to-date. As economic stability returns, policy decisions and supply-demand fundamentals will likely take center stage, driven by several critical developments:

• Finalizing the 2040 Climate Target: By mid-2025, the EU is expected to finalize its 2040 climate strategy, which aims for a 90% emissions reduction from 1990 levels. A stable and sufficiently high carbon price will be crucial in meeting this target.

• Clean Industry Deal Financing: The Clean Industry Deal, designed to support industrial decarbonization, will rely heavily on the EU ETS as a key funding mechanism.

• Immediate CBAM Impact: Despite a gradual phase-in approach, the actual impact on importers—especially those sourcing from carbon-intensive industries in developing countries—could be significant, driving hedging demand ahead of compliance.

These factors, combined with Europe’s ongoing economic recovery, could push EUA prices back above €100, a critical threshold for incentivizing energy transition and emissions reduction technologies. Given this outlook, there appears to be a strategic opportunity for investors in the KraneShares Global Carbon Strategy ETF (KRBN), which offers exposure to major carbon markets, including a 60% allocation to EUAs.

The 2040 Climate Target

In February 2024, the European Commission introduced its 2040 emissions reduction goal, bridging the existing 55% reduction target for 2030 under “Fit for 55” with the long-term objective of net neutrality by 2050. Based on recommendations from the European Scientific Advisory Board on Climate Change (ESABCC), the plan outlines key measures such as phasing out coal by 2030, eliminating unabated gas power by 2040, and scaling up renewable energy and electrification in transport.

This decade is particularly critical, as most emissions reductions must occur by 2040 to stay on track for the 2050 goal. However, concerns persist over the EU’s ability to meet these targets without additional policy measures. The European Environment Agency (EEA) recently projected that member states could fall short of the 55% reduction goal for 2030 by 5-10%, with an even greater risk of missing the 2050 net neutrality objective.

The 2040 strategy calls for annual investments of €1.5 trillion—equivalent to 7.5% of GDP—spread across energy systems and transport. Carbon pricing is set to play a pivotal role in this transition, providing a stable price signal to drive industrial transformation and support innovations in low-carbon processes, electrification, and circular business models. To achieve the 2040 goal, EUA prices will likely need to surpass €100 to incentivize emissions reductions at scale.

The Clean Industry Deal

Balancing climate goals with industrial competitiveness remains a major challenge for the EU. While the 2019 European Green Deal has laid the groundwork for emissions reductions through policies like “Fit for 55,” industry leaders have voiced concerns over economic pressures and the risk of deindustrialization. Following the introduction of the 2040 climate target, the Alliance for Energy Intensive Industries emphasized the need for policies that support business viability alongside climate ambitions.

In response, European Commission President Ursula von der Leyen has pledged to introduce a Clean Industrial Deal, focusing on infrastructure investment, energy cost reduction, and support for industries transitioning to greener production. Commissioner Wopke Hoekstra outlined key elements of this plan in December 2024, emphasizing the need for affordable clean energy, improved grid infrastructure, and carbon management solutions.

A critical funding mechanism for this initiative is the EU ETS, which generates roughly €40 billion annually for member states. Hoekstra has referred to the ETS as “the crown jewel” of EU climate policy, underscoring its role in financing industrial decarbonization. Ensuring stable and gradually rising EUA prices will be essential for both the Clean Industry Deal’s financial viability and the economic incentives needed for industries to decarbonize.

CBAM: A Significant Impact for Importers

The Carbon Border Adjustment Mechanism (CBAM) is designed to prevent carbon leakage by imposing tariffs on imported goods with higher carbon footprints than EU benchmarks. While the phase-in schedule may appear gradual, the actual financial burden on importers—especially those sourcing from regions with more carbon-intensive production—will be substantial.

CBAM liability is calculated based on the difference between an import’s carbon intensity and the EU benchmark, with free allowances for EU producers declining over time. Even in 2026, when CBAM is phased in at just 2.5%, importers will face immediate cost increases due to the disparity between their emissions intensity and the EU’s stricter benchmarks.

For instance, steel imports from China—where production relies heavily on coal-fired power—carry a carbon intensity of about 2.1 tons of CO2 per ton of steel. In contrast, EU steel producers operate at a much lower benchmark of 1.249 tons of CO2 per ton. Under current EUA price scenarios, importers could face additional costs amounting to 12% of revenue per ton of steel. Similar cost pressures will apply to aluminum, cement, and other carbon-intensive imports from countries such as India, Brazil, and Turkey.

With EUA prices potentially rising in 2025, many importers may seek to hedge their exposure in advance, further driving demand in the carbon market.

Conclusion

After a period of relative stagnation due to increased allowance supply and a lack of major policy shifts, the EUA market is poised for renewed momentum in 2025. The finalization of the 2040 Climate Target and the introduction of the Clean Industry Deal will reinforce the EU ETS’s central role in achieving emissions reductions. Additionally, CBAM’s approaching compliance phase in 2026 is expected to generate significant hedging demand.

While economic risks persist—particularly with Europe’s projected 1.5-1.7% annual GDP growth over the next five years—the regulatory landscape suggests a supportive environment for carbon prices. The tightening supply-demand balance, combined with strengthened policy measures, could drive EUA prices back to €100+ levels, reinforcing their role in financing Europe’s clean energy transition.