EU Emissions Trading System (ETS2) and Social Climate Fund: Mechanisms, challenges and conditions for a fair decarbonisation in buildings

Trend in decarbonising buildings

Buildings account for 40% of total final energy use in the EU and 33% of energy-related GHG emissions. Building decarbonisation is therefore central to achieving climate neutrality. Total GHG emissions from buildings in the use phase fell by 43% between 2005 and 2023. However, emissions of buildings fall under two categories. Direct emissions come from fossil fuel burning on-site for heating, hot water or cooking, while indirect emissions come from electricity and district heat. The original EU Emissions Trading System (ETS1) covers indirect emissions from buildings, while the new ETS2 targets direct emissions, pricing fossil fuels used in buildings to encourage low-carbon heating and energy efficiency.

Road transport and direct emissions from buildings (covered by the ETS2) emitted 1,235 million tonnes of carbon dioxide equivalent (MtCO₂e) in 2023. Buildings accounted for 28% and 61% came from road transport (EEA, 2026a). Indirect emissions from electricity and heat used in buildings declined by 47% between 2005 and 2023, while direct emissions from fossil fuel combustion in buildings fell by 37% (see Figure 1). This reflects a rapid decarbonisation of electricity and heat, though many buildings still rely heavily on gas and oil to heat space and water.

Direct emissions must also be distinguished between residential and non-residential buildings to understand how the impact of the ETS2 will be felt across stakeholders. Residential buildings account for roughly 75% of the building sector’s fossil fuel consumption, with the remainder from non-residential (EEA, 2025). Households are therefore likely to be significantly affected by the ETS2.

Figure 1. Trends in GHG emissions from energy used in buildings (EU-27)

Emissions in the sector have fallen due to improvements in energy efficiency (e.g. insulation), the increased use of renewable energy and the deployment of low-carbon technologies such as heat pumps. However, progress remains too slow to meet the objective of the Renovation Wave, the EU’s strategy to drive energy efficiency in the building sector. The average annual renovation rate in Europe is 1%. Reducing energy use by over 60% compared to 2015 levels would require at least doubling this rate in residential and non-residential buildings by 2030 and initiating deep energy renovations.

While building emissions have decreased since 2005, there is still substantial potential for decarbonisation. This includes rationalising the use of the building stock, combining insulation, ventilation and shading strategies with low carbon technologies for heating and cooling (e.g. heat pumps and solar energy systems) and supporting users to change their behaviour (e.g. minimising energy waste). The revised Energy Performance of Buildings Directive (EPBD) and Energy Efficiency Directive (EED) define clear frameworks to achieve this ambition. These include national building renovation plans and mandatory efficiency improvements for public buildings.

Persistent barriers continue to slow the transition, including high upfront costs, limited installation capacity, affordability constraints, insufficient support, contradicting signals, long payback periods and split incentives (ETC ST, 2026).

The ETS2, adopted as part of the EU Fit for 55 legislative package, strengthens the economic case for energy efficiency, renewable energy and efficient heating and cooling technologies, as well as electrification in buildings by reflecting the carbon cost in fuel prices from 2028 onwards.

It is complemented by other policies and instruments such as standards, regulations, national support schemes, information and awareness measures and provides an additional economy-wide price signal. Fossil fuel energy prices are expected therefore to become a stronger driver for consumers and suppliers to shift towards a more rational use of energy, better insulation, roof photovoltaic (PV) systems, heat pumps and other low carbon options. ETS2 can improve the relative competitiveness of electricity-based options such as heat-pumps over fossil-based options (see Box 1).

The functioning of ETS2 for cleaner buildings

The functioning and objectives of the ETS1 and the ETS2 are very comparable. However, because building and transport sectors differ fundamentally from the large industrial sector covered by ETS1, abatement costs differ widely. This is why the two markets operate independently, allowing ETS2 to provide a carbon price signal tailored to the level of incentive required in buildings (and transport).

In practice, ETS2 will apply a carbon price to fuels used in road transport, buildings and small industrial emitters not covered by ETS1. It will follow the same ‘cap-and-trade’ principle as ETS1 (see Box 2). All emission allowances will be auctioned, and fuel suppliers will be required to surrender allowances equivalent to emissions caused by sold fuels used in activities covered by ETS2. The total allowance volume will be capped and decline annually, with a target 42% reduction in emissions from 2005 levels by 2030 (see Box 2).

All auction revenues under ETS2 will be used to support vulnerable households and small industries, helping fund renovation, clean heating and temporary income support (see Box 2 and Box 4).

The future price of a tonne of carbon will be set by the ETS2 market. It will depend primarily on energy consumption in the road transport and building sectors and the pace of energy efficiency improvements, including the uptake of heat pumps in buildings and zero-emission vehicles. Broader developments in energy markets and macroeconomic conditions will also play a role.

In addition, interactions with other EU legislation — including energy efficiency, renewable energy and CO₂ emission standards for vehicles — as well as complementary national policies and measures, will influence the demand for emission allowances over time.

Like the ETS1, the ETS2 system will include mechanisms designed to stabilise the carbon price and ensure mid-term predictability and stability. This is key to supporting investment decisions. A declining cap and the use of a market stability reserve (MSR), in the event of supply imbalances or rapid price increases, will help to adjust the supply of allowances, reducing the risk of sustained price volatility.

A distinctive feature of the ETS2 is the inclusion of innovative mechanisms designed to ensure fairness, particularly in light of geopolitical developments that may affect energy prices and exacerbate existing socio-economic disparities. These include the establishment of the SCF — which will be funded by revenue from auctioning allowances — and the option to delay the start of the ETS2 if oil and gas prices are excessively high.

In the context of negotiations on the 2040 GHG emission target, the European Council and European Parliament agreed to delay the ETS2 in November 2025. It will now begin in January 2028 instead of 2027. In addition, the European Commission has proposed amendments to the Market Stability Reserve decision to facilitate a more gradual and smoother introduction and implementation of the ETS2 (EC, 2025).

While this postpones the carbon price signal for the building sector, Member States are still responsible for reaching their effort-sharing targets in sectors not included in ETS1. Structural decarbonisation measures are even more important to mitigate impacts of carbon price on individuals under ETS2.

The ETS 2 as one instrument in a broader coherent policy mix

It is widely recognised that significant emission reductions will only be achieved if ETS2 is combined with a broader, coherent EU and national climate policy mix. Its effectiveness and social acceptance will depend on complementary policies and measures that guide technology, behaviour and the development of infrastructure.  

These measures can form a coherent policy mix in which the ETS2 provides a broad market incentive, while regulatory, information and economic instruments accelerate the investment in infrastructure, behavioural change and the uptake of technology.

The ETS2 therefore also represents an incentive to implement other policy instruments and measures effectively, as emission reductions will help limit demand for the allowances and keep the carbon price in check.

In the building sector, these measures are encouraged directly by EU legislation, such as the Energy Performance of Building Directive, the Energy Efficiency Directive (which includes the Energy Efficiency First principle) and the Renewable Energy Directive. Other measures provide indirect support, for example the EU taxonomy for sustainable activities, which covers new constructions and renovations.

In practice, many well-known options are possible in the building sector. The Avoid-Shift-Improve (ASI) framework provides a structured approach for assessing emission reductions options from buildings according to:

• strategy (avoid-shift-improve);
• timeframe (short-medium-long term);
• level of action (individual, community, policy) (see Box 3).

The more efficient and socially targeted these are, the lower the carbon price needs to be to meet the targets and social impacts of carbon pricing.

The social challenges of the ETS2 in buildings

Specific attention must be paid to the challenges faced by the most vulnerable groups when introducing carbon pricing in buildings (EEA, 2021). Low-, lower-middle-income households and energy-poor households using fossil fuels for heating are particularly exposed and can be disproportionally impacted. More frequently they live in inefficient homes, already struggle with energy bills and lack the necessary capital to invest in renovation or clean heating technologies such as heat pumps. These issues could jeopardise the ETS2’s effectiveness and the extent to which it is accepted publicly.

The ETS2 will affect energy bills both for heating and road transport, creating excessive cumulative pressures unless mitigated through specific policies and measures. ETS2 impacts are exacerbated in countries with more vulnerable households, higher heating demand and greater fossil fuel share.

To address and anticipate these issues, Member States are requested to develop national social climate plans (SCPs) outlining proposed measures and investments in the 2026-2032 period to soften the social impacts of the ETS2. Possible actions include subsidies for insulation and renewable energy systems (e.g. heat pumps) and temporary income support.

The SCPs must be coherent with national energy and climate plans (NECPs) and other strategic documents, such as the forthcoming national building renovation plans, recommendations from the European affordable housing plan and the citizens energy package. SCPs will be co-financed by the SCF which will be funded primarily by ETS2 revenue (see Box 4). The fund will financially support Member States to invest at the national and local levels in low-carbon structural measures and direct income support, as identified in the SCPs.

The SCPs must be submitted to the EC by Member States as a pre-requisite for accessing the funds. The draft plans were expected by 30 June 2025 (EU, 2023). By February 2026, Latvia, Lithuania, Malta, the Netherlands and Sweden had submitted their SCPs to the EC. The Swedish plan has now been adopted, and others are currently under assessment (EC, 2026).

The effectiveness of each SCP will depend on how funds are allocated and translated into concrete and well-targeted measures at the national level early enough before the ETS2 begins to impact prices.

The Commission recently identified examples of policies and measures implemented by Member States that could be included in SCPs (EC, 2025b), categorised as follows (Figure 3):

Figure 3. Examples of policies and measures implemented by Member States that could be included in SCPs

Other potential options include advisory programmes, targeted information campaigns tailored support by one-stop-shop. These may be combined with solutions that make electricity cheaper and promote the uptake of heat pumps. This includes electricity tariffs, encouraging off-peak electricity use, or reduced VAT rates on electricity consumption.

Crucially, SCP preparation must include public consultations involving local and regional authorities, social partners and civil society organisations to enhance coordination, transparency and public engagement. This should ensure that SCF spending aligns with national needs while raising citizen awareness of the impacts of the ETS2.

The ETS2 and Social Climate Fund (SCF): A Pivotal Step and Remaining Challenges

The implementation of the ETS2 and the SCF together marks a pivotal step in Europe’s path towards climate neutrality. By extending carbon pricing to transport fuels and using the revenue to support those most affected to decarbonise, the EU is combining environmental effectiveness with social responsibility.

The success of the ETS2 will depend on both national implementation and policy coherence. If implemented in isolation, the ETS2 risks fuelling public resistance by raising fuel prices without offering alternatives. However, supported by the SCF, the system could become a powerful driver of building decarbonisation and equity if combined with robust housing and social policies that reduce the demand for fossil fuels.

To ensure success for the SCF and ETS2 in the building sector, Member States should prioritise three key actions:

1. Accelerate sustainable building renovation (energy efficiency, decarbonised heating/cooling systems and considering circular economy principles) This can be done through the deployment of financial instruments and advisory services designed to reach adequately all social groups, including low-income, vulnerable and energy-poor households.
2. Ensure policy coherence. Carbon pricing, energy taxation and support schemes must align to ensure the price of electricity for heating is competitive against gas in a socially fair tariff system. Further improve the attractiveness and fairness through, for example, target subsidies, tailormade technical and administrative support.
3. Enhance communication and transparency in the use of EU ETS2 revenues, as well as demonstrating tangible immediate multiple co-benefits to citizens. Examples include energy poverty reduction, heath, lower energy bills and improved comfort. These actions are crucial for public acceptance (Mohammadzadeh Valencia, 2024).

With effective and well-timed national implementation and coordination with other EU policies, the ETS2 could help transform Europe’s building stock, reducing emissions, improving air quality and enhancing energy security. With sufficient and coherent policy action and social dialogue, the reward could be a low carbon EU building stock filled with resilient, low energy and affordable houses.