Following a public consultation last year, on 1 June 2020 the UK’s Department for Business, Energy and Industrial Strategy (BEIS) published its plans to implement a UK ETS starting in 2021 (The future of UK carbon pricing). In the UK, this will replace the EU ETS, which the UK is set to leave at the end 2020 with the termination of the Brexit transition period. This is part of the UK government’s plan to drive domestic and international action on climate change and, as such, to deliver on its net-zero carbon target by 2050.
Linking the UK ETS with the EU ETS
As to future relations with the EU ETS, the clear ambition is for the UK to negotiate a linking agreement with the EU ETS to allow UK operators to maintain access to the world’s largest carbon market (and avoid the potential vagaries of a UK-only carbon pricing mechanism). Whether and when that happens – any linkage could take several years to agree – will depend on how the ongoing trade negotiations between the UK and the EU turn out.
If such negotiations fail, the UK could turn to other carbon markets, such as California or New Zealand. Should this also fail, business groups fear that a resulting stand-alone UK market would lack the necessary liquidity, which could in turn lead to volatile prices and additional costs for covered entities.
Should the UK not be able to implement a UK ETS in time for the end of the transition period, the UK will likely fall back on a carbon tax as an alternative (which was announced last year as the default interim measure for the UK pending a long-term alternative scheme). A separate consultation on this is in the pipeline. However, much of the legal and governance framework for a UK ETS is already in place through the UK’s participation in the EU ETS, so the UK government should be able to realise its ambitions for dovetailing the UK scheme with its exit from the EU ETS.
What sectors will the UK ETS cover?
For now, the UK ETS is set to cover all sectors the EU ETS currently regulates: the power generation sector, energy intensive industries, and aviation. The government confirmed it would contemplate potentially expanding the UK ETS to other sectors during its first planned review of the scheme by 2026.
The UK ETS will closely resemble the EU ETS but with some key differences. The familiar aspects of the new scheme are intended to allow for a smooth transition to the new UK carbon-pricing regime, from both a compliance and carbon trading perspective. The first phase of the UK scheme is expected to run alongside Phase IV (2021-30) of the EU ETS.
However, the UK’s plan contains several features that appear more progressive than the EU ETS, which could lead to UK emitters facing different carbon costs than their continental peers.
At what level will emissions be capped?
In order to reach net-zero emissions by 2050, the UK ETS emissions cap will initially be set 5 per cent below the country’s notional share of the EU ETS cap for Phase IV; i.e., the UK is being more ambitious than it would otherwise have been obliged to be under the EU ETS. The Committee on Climate Change will advise the government later this year on cost-effective measures to achieve net-zero emissions with its publication of the Sixth Carbon Budget. The aim is to align the cap with a net-zero trajectory by January 2023.
Will there be free allowances?
Yes – to ensure a smooth transition for participants, free allocation of allowances will continue via a similar approach to that of the EU under Phase IV of the EU ETS. The level of free allocation will initially be set at the UK’s notional share of the EU ETS industry cap for Phase IV, equating to roughly 58 million allowances in 2021 and an annual reduction of around 1.6 million allowances. The UK also intends to provide for a New Entrants Reserve (NER) of allowances in the UK ETS, similar to that of the EU, in order to allocate free permits to new installations and airlines.
How will price and supply be managed?
The proposal foresees a Cost Containment Mechanism (CCM), which would allow for the auctioning of additional allowances should prices rise too high. The government will also consult on the design of a Supply Adjustment Mechanism (SAM) in a stand-alone UK ETS, if necessary. This would mimic the EU’s Market Stability Reserve (MSR) and adjust the number of allowances to be auctioned if predefined volume surplus triggers were activated. However, the UK would not be able to introduce a SAM until mid-2022 due to the requirement for at least one year of verified UK emissions data on which to base adjustments to auction volumes.
Will auctioning continue?
Yes – auctioning will carry on with a similar proportion of allowances that are auctioned vs those allocated for free. Under a stand-alone UK ETS, a transitional Auction Reserve Price (ARP) set at a nominal £15 would be introduced.
What is going to change for the aviation sector?
The UK ETS will apply to domestic flights, flights between (both to and from) the UK and Gibraltar, the UK and the European Economic Area (EEA), and the UK and Switzerland if an agreement is reached with the EU ETS. The government says it will begin a review on how a UK ETS could interact with the implementation of the UN’s International Civil Aviation Organisation’s Carbon Offsetting and Reduction Scheme for International Aviation (CORSIA).
What about offsets?
Consistent with Phase IV of the EU ETS, offsets will not be eligible for compliance within the UK ETS, but the government has announced it is open to reconsidering this option during one of its ‘whole-system reviews’, especially in deciding how best to implement CORSIA alongside a UK ETS. The government emphasised that the time it takes to introduce offsets, and to develop standards and tests for their acceptance, means that they would not be ready for the launch of the UK ETS on 1 January 2021. Also, it recognised that the effect offsets have on the environmental integrity of the UK ETS needed to be factored in: the government noted that “Without adequate mitigation, the usage of offsets could lead to an over-supply of allowances under the cap and therefore reduce our ability to achieve our overall environmental ambition.” Allowing offsets under the UK ETS would also imperil a potential future linkage between the UK ETS and the EU ETS – this was one of the facets of the Swiss ETS that ultimately had to become aligned with the EU ETS before a linking agreement could be finalised.
Will opt-outs be permitted?
Yes – the UK ETS will introduce a small emitter and hospital opt-out programme for installations with emissions below 25,000 tonnes of CO2 per annum and a net-rated thermal capacity lower than 35 MW, akin to the EU’s Phase IV. An exemption will also apply to ‘ultra-small emitters’ with emissions below 2,500 tonnes per year.
When is the UK ETS going to be reviewed?
In alignment with the EU ETS Phase IV reviews and Paris Agreement global stock take efforts, an initial review will take place in 2023 to assess performance with any necessary changes to be implemented by 2026. A complete review is scheduled for 2028 to assess the system performance across all of Phase 1 with any remaining changes to be realised in Phase 2, starting in 2031.
The UK government must now table draft legislation for the UK ETS, with a view to having it agreed and ready before the UK exits the transition period at the end of 2020.
Overall thoughts?
There is little doubt that the primary purpose of this current approach has been to prioritise alignment of the UK ETS with the EU ETS. This makes sense given the UK, although no longer part of the European Union, remains a part of Europe. Just as the EU ETS has expanded beyond Member States to include EEA countries and Switzerland, if the UK did not link to the EU ETS it would be an outlier in terms of European climate change policy. Currently, the UK’s climate change ambitions align with, or are greater than, those of the EU. However, implementation of the EU Green Deal will cause the EU to raise its ambitions and engineer a complete overhaul of its energy economy. The EU ETS is a key tool to deliver on that outcome and therefore, unless the UK’s approach towards its energy economy continues to be aligned with that of the EU, it will find that its UK ETS link will force it to follow the EU policy drivers that impact the EU ETS. In short, the UK will be obliged to align with EU policy drivers if it wishes to maintain its EU ETS link. If the seven years taken for the Swiss negotiations for its link to the EU ETS tell us anything, it is that these things are never simple and will take a lot longer to resolve than expected.
Client Alert 2020-388
