Reed Smith Client Alerts

Authors: Adam Hedley Nicholas Rock Peter Zaman

Through the referendum held on 23 June 2016, the United Kingdom voted to end its membership of the EU. Although the timeframe for withdrawal under Article 50 of the Lisbon Treaty limits the window for negotiations to two years, this window can be extended by agreement. Given the complexity of the negotiations, this timeframe may very well be extended.

The UK’s legislative history, including that in relation to its energy and climate change policy, has been intertwined with that of the EU for the past 44 years. As highlighted by a recent House of Commons Environmental Audit Committee report, “A large proportion of UK environmental policy is shaped at EU level”. It will be no small feat to work out precisely how that can be unravelled through the negotiations anticipated over the next two years.

Possible EU ETS exit date After an exit from the EU, one option for the UK is to re-establish its own UK ETS and pursue a path of linking it with the EU ETS. The foundations for doing this exist pursuant to the UK’s own Climate Change Act 2008, which requires the Government to set a series of carbon budgets to enable at least an 80 per cent reduction of greenhouse gases by 2050 as compared to 1990 levels. The EU ETS is currently in the middle of its third phase, which expires on 31 December 2020. 1 January 2021 is, therefore, a natural break point in terms of the nature of any changes to the UK’s involvement in the EU ETS. A mid-phase break would be complex and difficult to manage. It will raise issues relating to management of compliance deadlines, allocation of the number of allowances, decision on banking allowances from phase 3 to phase 4, use of the Union Registry etc.

The UK relationship with the EU ETS after the exit date Given the UK’s long-standing support for the EU ETS, it is likely that there will be some form of future linkage. Three potential options are:

  • The Norway Model: the UK would join the European Economic Area and the European Free Trade Association (EFTA), thereby giving it access to the single market and subjecting it to EU standards and regulations without much ability to influence them.
  • The Swiss Model: the UK would join the EFTA and negotiate bilateral agreements governing UK access on a sector-by-sector basis.
  • The FTA Model: the UK would sign a free trade agreement with the EU which would include in its terms arrangements concerning the EU ETS.

In all but the Norwegian Model, it is likely that the UK would need to first establish its own UK ETS, which could be very similar in terms of how it operates to the way the EU ETS currently operates, thereby making any subsequent linkage that much easier.

Impact on phase 4 negotiations of the EU ETS The negotiations in relation to the next phase of the EU ETS are already under way. Legally, until its exit date, UK representatives in the EU Parliament and the Council of Ministers can be involved in those negotiations without restriction. However, given that the UK may need to follow a policy of selective disengagement, it is also difficult to see the political feasibility of the UK having a persuasive voice in the phase 4 negotiations (although it will still have a vote).

Impact on the Paris Agreement Where parties have not already done so, the Paris Agreement obliges parties to the UNFCCC to submit their nationally determined contributions (NDCs) by November 2016. The UK did not submit its own intended NDC in the run up to Paris, as its submission was included within that made by the EU on behalf of its Member States. Since the UK may not be part of the EU at the time of the start of the Paris Agreement, as with the separate submissions made by EEA countries, the UK may need to make its own submission to the UNFCCC under the Paris Agreement.

There will also be knock-on consequences on how the EU manages the distribution of the effort sharing arrangements (for non-EU ETS sector greenhouse gas emissions) of EU Member States for their commitments under the second compliance period of the Kyoto Protocol if the UK is not part of the EU on 31 December 2020.

Next steps To ensure the least possible disruption, it is anticipated that the UK and the EU will negotiate the UK’s exit from the EU in parallel with the agreement on its future relationship. However, to do so will probably extend the exit date and so prolong the period of uncertainty in the EU ETS.

Although it is too early to make determinative predictions on what may happen in the future, the more likely scenario is that there will be a continuation of the UK’s carbon trading arrangements with the EU ETS. If this is the case, the real question will be about the timing and the manner in which this is achieved. No doubt a timeframe on this will evolve in the coming months even if the actual exit may not occur for some years yet. In view of this, until the exit date for the UK is known, UK compliance entities as well as active UK non-compliance participants in the EU ETS must continue as they are.

However, once clarity on the timing and manner of the exit is available, it will be necessary for market participants in the EU ETS to assess their portfolios and, in particular their longer dated futures contracts, to determine how any exit or transition period impacts them.

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