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Glossary · Energy industry & energy transition

Free allocation (kostenlose Zuteilung)

free allocation EU Emissions Trading certificate trading Carbon leakage Benchmarking

Free allocation is called „kostenlose Zuteilung“ in German. It means that companies or installations in an emissions trading system receive emission allowances without having to buy them at an auction. In the EU Emissions Trading System (EU ETS), one allowance entitles the holder to emit one tonne of CO₂ equivalent within a given period. Only the tradable right is free of charge. The emission itself does not become free, and the scarcity within the system remains. At the end of a year, an installation must surrender one allowance for every tonne emitted, regardless of whether it was auctioned, purchased or allocated free of charge.

The core point is the separation between the climate target and the distribution of costs. The total quantity of allowances is limited by the cap, i.e. an upper limit. Whether allowances are auctioned or given away does not initially change this cap. It does change who bears the costs of scarcity, how much money companies need to have available, and how strongly the CO₂ price is reflected in product prices and investment decisions.

Allowance, auction and free allocation

In an auction, the company pays the state directly. With free allocation, it receives an asset instead. It can use this asset itself for surrender or sell it on the market. This has an often overlooked consequence: a free allowance is worth just as much on the market as an auctioned one. Anyone who uses it for their own emissions forgoes the possible proceeds of a sale. Economically, these are opportunity costs. Free allocation therefore relieves the balance sheet and liquidity. However, it does not eliminate the CO₂ price as a signal at the margin, i.e. for every additional tonne emitted. An example: a plant receives 1,000 allowances but emits only 800 tonnes. It can sell 200 allowances. Every tonne saved therefore earns money here as well.

Since 2013, free allowances have gone mainly to installations in the manufacturing sector. For electricity generation, there is in principle no longer any free allocation; power plants generally have to buy their allowances. Exceptions exist only to a limited extent. These include transitional allocations for the modernisation of the energy sector in Member States with lower per capita income, and allocations for heat from district heating and high-efficiency combined heat and power, but not for the electricity generated in the process. For industry, such as steel, cement, chemicals, paper or refineries, free allocation, by contrast, remains central.

Carbon leakage as the rationale

The most important reason for free allocation is protection against carbon leakage. This means that production and emissions relocate to regions where CO₂ is priced less strongly or not at all. If a European plant loses market share to a competitor abroad that produces the same good with higher emissions, and that good is imported, global emissions do not fall. The European balance then looks better, but the climate target is partly missed. Free allocation reduces the average cost burden of particularly exposed installations without suspending emissions trading. It does not, however, protect against structural change in general: which sectors benefit, and to what extent, is determined by a list of exposed sectors, benchmarks, activity levels and correction factors.

Benchmarking instead of rewarding high historical emissions

In the first trading periods, allocation was strongly based on an installation's historical emissions (grandfathering). This created wrong incentives: those who had emitted a lot in the past received a lot. Since 2013, the EU ETS has therefore worked with EU-wide uniform benchmarks, see benchmarking in emissions trading. A product benchmark indicates how many tonnes of CO₂ equivalent the most efficient installations emit on average per tonne of product. The yardstick is, in principle, the average of the 10 percent most efficient installations in a sector. The basic formula for allocation is: production quantity times benchmark value. Where no product benchmark exists, fallback approaches based on heat, fuel or process emissions are used.

A benchmark is not a limit value but a distribution yardstick. Only installations that are roughly at the level of the best receive enough allowances for their needs. Less efficient installations have to buy additional allowances. The benchmark values are lowered on the basis of real data for the periods 2021–2025 and 2026–2030. For 2026–2030, the Commission presented updated values in 2026. According to its figures, free allocation will thus continue to cover around 75 percent of industrial emissions on average. Further parameters apply: if production falls or rises significantly, the allocation is adjusted. If the sum of all entitlements exceeds the available quantity, a cross-sectoral correction factor reduces all allocations. Since the 2023 reform, allocation can also be made subject to conditions, such as the implementation of recommendations from energy audits.

Even with benchmarks, free allocation works differently from full auctioning. Because allocation is coupled to production quantity, it can keep production in the EU. At the same time, it can weaken the incentive to replace emission-intensive products with lower-emission alternatives, since those who produce more also receive more allowances.

Common misunderstandings

  • „Free allocation is a permit to emit without climate impact“: This conflates allocation to individual installations with the total quantity. As long as the cap is binding, the quantity remains limited. Free allocation shifts who receives the value of the allowances, but it does not remove the quantity limit.

  • „Free allocation is neutral in terms of climate policy“: This is not true either. It influences whether costs are passed on in prices, how investments pay off and how well the policy is accepted. Even at the same market price, liquidity needs, risk and distributional effects differ.

  • Windfall profits: If companies include the value of allowances received free of charge in their prices as opportunity costs, additional profits arise. Whether this succeeds depends on competition and market structure. For goods that are heavily traded internationally, pass-through is often limited; with little import competition it can be higher.

Distinction from state aid, subsidies and CBAM

Free allocation transfers economic value, but it is part of the architecture of emissions trading and not a payment from a budget. It also differs from targeted investment support, such as carbon contracts for difference: it does not finance a specific climate-friendly installation but reduces ongoing CO₂ costs according to sectoral rules.

The carbon border adjustment mechanism CBAM (Regulation (EU) 2023/956) changes this arrangement. Since 2026, importers of certain goods have had to pay for the emissions embedded in them. Affected are iron and steel, cement, aluminium, fertilisers, hydrogen and electricity. To avoid imports being burdened twice, free allocation for the production of these goods in the EU is reduced via a „CBAM factor“. Under current law, this factor is 97.5 percent in 2026, 95 in 2027, 90 in 2028, 77.5 in 2029, 51.5 in 2030, 39 in 2031, 26.5 in 2032 and 14 percent in 2033. From 2034, there is no longer any free allocation for these goods. Sectors on the carbon leakage list that are not covered by CBAM continue to receive up to 100 percent of the benchmark quantity.

As of November 2026, this path is politically open. On 17 July 2026, the European Commission proposed a revision of the Emissions Trading Directive, COM(2026) 616, procedure 2026/0212(COD). The proposal would slow the phase-out for CBAM sectors: from 2028, part of the allocation already phased out would return, and the complete end would be postponed from 2034 to 2038. From 2031, free allocation is also to be tied to binding decarbonisation investment plans. In parallel, the Commission has proposed allocating more free allowances for 2026–2030 through revised heat and fuel benchmarks. Neither is yet applicable law unless Parliament and Council have agreed.

Significance for the power system and industrial electrification

Free allocation also affects the power system. Many pathways to climate neutrality rely on the electrification of industrial processes: electric furnaces, industrial heat pumps, electrolysis or direct reduction with hydrogen for green steel. If free allocation reduces the CO₂ costs of fossil-based processes, the cost comparison with electric alternatives changes. This indirectly influences how quickly new electricity loads emerge and how much grid, generation and flexibility are needed. However, the effect depends on the specific rule. Depending on how the benchmark is designed, an electrified installation may receive fewer allowances because electricity emissions are indirect. For indirect CO₂ costs in the electricity price, separate state aid rules exist (electricity price compensation). Slow electrification can therefore not be blamed on free allocation alone. Permits, grid connection, electricity prices, capital risks and the credibility of future regulation all play a part.

Assessment

Free allocation is not the opposite of emissions trading but a distribution rule within the system. It determines how the value of scarce emission rights is distributed between the state, companies and customers. Whether it is well designed shows in several questions: Does it effectively limit carbon leakage? Do the benchmarks allow for innovation? Do product prices reflect scarcity? And does the phase-out of allocation fit with the border adjustment and with investment support? For legal statements, the applicable status must always be borne in mind, because the rules for the period after 2030 are currently being renegotiated.

Sources

Related glossary entries

Edited by eCMS on 12.11.2026 05:05

© 2026 Erik Schmidt. All rights reserved. Quotations with a link to the source are welcome.