The UK ETS after Brexit

The post below was first published on our Energy Notes blog.

The end of the Brexit transition period on 31 December 2020 brought an end to the UK’s participation in the EU Emissions Trading System (the EU ETS), the bloc’s flagship ‘cap and trade’ scheme for reducing greenhouse gas (GHG) emissions. Having substituted this scheme for a near-identical UK alternative, there is now the possibility of divergence which recent UK climate policy suggests could be towards a stricter, rather than looser, regime.

New but familiar

Having explored several options for carbon pricing post-Brexit, including continued participation in the EU ETS and a carbon emissions tax,^[1] the UK Government opted in its December 2020 Energy White Paper for a separate UK ETS which nonetheless mirrors its predecessor in almost all regards.^[2] The UK ETS adopts the same principle of a cap on emissions reducing over time and, within this, freely tradeable emission allowances. The industries within the scope of the two systems are the same, covering electricity and heat generation, heavy industry and aviation, as are their approaches to free allocations, which aim to prevent carbon leakage from manufacturers moving carbon-intensive industries overseas.

The systems may become closer still, with the EU-UK Trade and Co-operation Agreement (the TCA) committing both parties to co-operate on carbon pricing and “give serious consideration” to linking the UK and EU ETSs^[3], akin to the landmark link between the EU and Swiss ETS which occurred in 2020. While business groups have encouraged such a move, the Government appears less enthusiastic, having said in its Energy White Paper that it was “open to linking the UK ETS internationally in principle”, but had made “no decision on our preferred linking partners”. Linking would be easiest now, while the schemes are almost identical, and will only become more difficult as any divergence begins to occur.

Without a link, certain operators now face complex situations. Northern Irish industrial installations are now subject to the UK ETS, while Northern Irish electricity generators remain part of the EU ETS. Aircraft operators flying between the UK and Europe are under UK ETS obligations for outbound flights to EEA countries and EU ETS obligations for inbound flights to the UK.

Alignment to net zero

Although the UK ETS remains detached from its EU counterpart, giving the UK Government autonomy to reshape domestic carbon pricing policy, it must do so carefully, as the TCA includes strict obligations of non-regression, including on carbon pricing. Still, early indications are that regression fears are unfounded, with the UK ETS having been launched as the “world’s first net zero carbon cap and trade market”^[4] with plans to align the cap to ensure the UK meets its commitment to net zero emissions by 2050.

In the short term, the cap on UK ETS allowances will be set 5% below the UK’s notional share of the EU ETS cap for Phase IV (2021-30), and will reduce to remain proportionally so in future years. Consultation on the cap’s trajectory will form part of the Government’s work on the UK’s next carbon budget and the Government intends that net zero changes will be implemented by 2023 if possible, and no later than 2024, with market participants given at least a year’s notice of any changes. The UK’s greater ambition on the ETS cap mirrors its greater climate ambitions more widely, such as the UK Government’s loftier target of cutting emissions by 68% by 2030, compared to the EU’s 55% target.

Auctions

In February 2021, the Government published draft Auctioning Regulations and updated guidance for UK ETS participants. These confirmed that the auction reserve price for allowances would be higher than initially planned, at £22 per tonne of CO₂ compared to £15^[5]. This pricing likely seeks to minimise the risk of a significant fall in the UK carbon price, caused by a sharp price fluctuation due to the UK ETS market’s much smaller size than the EU’s, which could undermine confidence in the UK’s new system. Later in 2021, as part of its consultation on the UK ETS cap, the Government will consider withdrawing the auction reserve price. Auctions will start as soon as feasible and no later than Q2 2021.

Carbon border tax

An open question is whether the UK will introduce a carbon border tax, similar to that currently being drawn up by the EU, which would see penalties on goods imported from countries with weaker climate measures. The UK Government is thought to be monitoring developments on such measures in the EU and is thought to be aiming to foster international agreement over such an adjustment when the UK hosts the G7 later in 2021.

Follow the HSF Energy Notes blog for all the latest on the UK ETS and the UK’s carbon pricing regime.

^[1] “The future of UK carbon pricing”, Department for Business, Energy & Industrial Strategy (BEIS) (June 2020), available at https://www.gov.uk/government/consultations/the-future-of-uk-carbon-pricing

^[2] “Energy white paper: Powering our net zero future”, BEIS, available at https://www.gov.uk/government/publications/energy-white-paper-powering-our-net-zero-future

^[3] Article 7.3, EU-UK Trade and Cooperation Agreement, available at https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:22020A1231(01)&from=EN

^[4] p.129, Energy White Paper

^[5] “Participating in the UK ETS”, BEIS, available at https://www.gov.uk/government/publications/participating-in-the-uk-ets/participating-in-the-uk-ets