Future of free allocations under the UK ETS

The UK Emissions Trading Scheme (UK ETS) was launched on 1 January 2021 to replace the UK’s participation in the EU Emissions Trading Scheme (EU ETS). As explained in our previous blog post (here), both schemes work on the basis of a reducing cap with freely tradable allowances, and they currently cover the same industries. Allowances are obtained through either auctions or free allocations. The UK ETS currently uses the same benchmarks for free allocations as the EU ETS.

However, the Department for Business, Energy & Industrial Strategy (BEIS) recently launched a ‘call for evidence’ in relation to its review of free allocations under the UK ETS. A copy of the consultation can be found here.

All elements of the current framework are open to review, but as part of its review into the free allocation system, BEIS has confirmed that it expects to consider the following elements:

• How free allocations can be distributed more fairly in line with the reduction to the overall cap;
• The methodology for determining free allocations (including benchmarks, how carbon leakage risk is assessed, and the treatment of new entrants/participants); and
• How appropriate free allocation is as a policy in the UK ETS to mitigate against carbon leakage.

Although the call for evidence on free allocation closed on 23 April 2021, we set out below some of the key themes and/or issues we think that BEIS will likely need to consider as part of the development of the UK ETS more generally.

Carbon leakage

Background

Carbon leakage occurs when the obligations to decrease greenhouse gas (GHG) emissions in a Country A (due to climate change policies) results in the transfer of the underlying economic activity and associated emissions to a Country B, due to the fact that Country B does not impose as onerous emissions reduction obligations.

Carbon leakage presents a challenge for indigenous companies in carbon-intensive sectors and the competitiveness of their products as they are subject to a carbon price, while externally-produced goods are not captured under schemes such as the UK or EU ETS, arguably making indigenous production more expensive.

Position under the UK ETS

The UK ETS will initially use the same mechanisms as are currently employed by the EU ETS to tackle the challenges posed by carbon leakage. In Phase IV of the EU ETS, sectors that are considered to be at highest risk of relocating their production outside of the EU (example) will remain on the carbon leakage list, and therefore will continue to receive allowances equivalent to 100% of the relevant benchmark for free. The relevant benchmark is based on the performance of the most efficient 10% of installations of the sector in question. Only the most efficient installations in each sector receive enough free allowances to cover all their emissions.

Sectors which are considered to be less affected will see their free allocations phased out from the current 30% to 0% after 2026. This has caused issues for the Oil and Gas sector for example, as oil and gas facilities are categorised separately, even though facilities usually produce both oil and gas. Oil continues to be on the carbon leakage list whereas gas is no longer on the list, and subject to free allocation phase out.

In relation to the future functioning of the UK ETS, BEIS has expressed a willingness to re-evaluate not only the sector allocations that have been settled under Phase IV of the EU ETS but also the free allocation mechanism itself. Interested parties may wish to consider, and submit evidence in relation to, the economic impact of the relevant emissions reductions requirements on a their particular sectors.

Illustration of carbon leakage – natural gas production

Phase IV of the EU ETS requires significant emissions reductions for natural gas producing facilities. Following government projections, abated natural gas is expected to continue to play an important role in the UK’s energy mix, including in the development of a UK hydrogen market, and to a large part to secure the electricity supply as renewable energy becomes more prevalent in the UK energy mix. However, new technologies (such as CCS) and/or infrastructure (such as offshore electricity grids) will be crucial to abating emissions from natural gas. These technologies and infrastructure are yet to be developed and/or proven to be economic at scale in the UK.

Sector representatives have voiced concerns about the risk that if the withdrawal of free allocations is not properly aligned with the timescales for developing such technologies and infrastructure, (or possible regulatory alternatives – see CBAM below) the cost of this compliance with GHG emissions targets may lead to the premature cessation of production and/or decommissioning of UK natural gas facilities.

Moreover, as domestic demand for natural gas would still remain in the short term given the ubiquitous use of the Gas National Transmission System, it is likely that the gap in supply would be met, at least in part, from LNG imports. When the whole LNG supply chain is taken into account (up to the point of downstream combustion), LNG generally produces significantly more lifecycle GHG emissions than the predominately pipeline gas that is produced indigenously.

Regulatory response – CBAM

A UK carbon border adjustment mechanism (CBAM), similar to the EU CBAM recently approved in principle by the EU Parliament (see here), could protect the UK against carbon leakage and help preserve the competitiveness of operators in the UK. In principle, a CBAM adjusts the price of imported goods to account for the level of carbon emitted in their production.

As both domestically-produced and externally-produced products would be subject to carbon costs, this would create a level playing field for domestic and imported goods and therefore address carbon leakage. It may also help facilitate linkage with the EU ETS in the future.

Unavoidable emissions

Even with energy efficiency measures in place, there will be certain industrial processes from which emissions cannot be avoided. In this context, carbon capture and storage (CCS) technology and carbon offset schemes may need to be incorporated into the UK ETS so that operators are able to reach de facto net zero (to enable unavoidable emissions to be cancelled out).

Activity level reviews

Under both the UK ETS and the EU ETS a free allocation review will be triggered if activity levels increase or decrease by 15% compared to historical levels (calculated on a two year rolling basis). If a reduction is due to energy efficiencies, evidence of this can be submitted in an Activity Level Report. It is likely that BEIS will consider the impact of this threshold and its suitability.

In particular, we understand from sector representatives that certain operators have experienced issues with losing free allowances where there have been unexpected or anomalous reductions in activity. These issues could be resolved by looking back at activity levels over a longer period or holding over the loss of free allocations until the relevant reduction in activity levels is proven to be sustained over consecutive periods.

Funding

The EU has established a decarbonisation fund from auction revenues; Member States are expected to use 50% of auction revenues for these types of projects. It is currently unclear how revenues from the UK ETS will be used.

As BEIS moves towards a net zero consistent cap on emissions under the UK ETS, interested parties may wish to consider how auction revenues should be utilised by the UK government.

Linking the UK ETS to the EU ETS

BEIS has confirmed its intention to explore the possibility of linking the UK ETS with international emissions trading systems. However, no details of potential negotiations regarding linking with the EU ETS have been revealed. Linking the UK ETS with the EU ETS will only become increasingly difficult as the two systems diverge.

Contacts