The future of the UK ETS - UK ETS Authority publishes its response to 2022 consultation

On 3 July 2023, the UK ETS Authority (the "Authority") published its response to the consultation launched in 2022 in relation to "Developing the UK Emissions Trading Scheme" (the "Consultation") (the "Response"). The Consultation, which ran from 25 March 2022 to 17 June 2022, sought views on a number of proposals to develop the UK ETS. For further information regarding the key proposals set out in the Consultation, please see our previous blog post here.

Following the Consultation, the Authority has decided to:

1. reset the UK ETS cap to be consistent with net zero;
2. smooth the transition to a net zero cap;
3. increase the industry cap to 40%;
4. amend certain aspects of the free allocation mechanism, including for electricity generators;
5. not extend free allocation for the aviation sector;
6. expand the scope of the UK ETS to include domestic maritime and Energy from Waste ("EfW");
7. introduce a new penalty for failure to submit information and a new enforcement notice; and
8. carry out a number of consultations and further reviews and develop certain elements of the UK ETS.

Although the Authority has taken a number of decisions in relation to the development of the UK ETS, there are a fair number of areas that are yet to be consulted on or further reviewed. Given the number of elements in this latter category, it is difficult to assess whether the UK ETS is now aligned with the UK's net zero ambition. However, the significant drop in price of UK ETS allowances following the publication of the Response suggests that industry is not concerned about the availability of allowances in the near future, which may suggest that the reforms are not as ambitious as the Authority's communications implied.

1. A net zero consistent cap

The UK ETS cap establishes a limit on the number of allowances that can be issued in a year, limiting the total emissions of sectors within the scope of the UK ETS. When the UK ETS was established in January 2021 following the UK's departure from the EU (and the EU ETS), the Authority committed to aligning the UK ETS with the UK's commitment to net zero, with any changes required to meet this commitment being implemented by January 2024.

To achieve this goal, the Authority has decided to reset the UK ETS cap for 2021-2030 at 936 million allowances, which is at the top of the net zero consistent range. In allowing a higher volume of allowances, the Authority hopes to provide greater flexibility to manage market and carbon leakage risks compared with lower options in the range.

It is noted in the Response that this cap will require further adjustment as new sectors are included within the scope of the UK ETS. For further information on this, see section 6 below.

2. The transition to a net zero cap

Respondents raised concerns about the step change in the cap from 2024 and the potential consequences of this. In response, the Authority has taken a number of decisions to facilitate the transition to a net zero cap, prevent a sudden drop in allowance supply between 2023 and 2024, and reduce the risk of an upwards price shock. Such steps include:

• bringing 53.5 million unallocated allowances to auction in the period 2024-2027 to address any potential short-term liquidity issues;
• protecting current levels of industrial free allocation until 2026, subject to Activity Level Changes ("ALCs"); and
• retaining 29.5 million allowances in reserve as the flexible share (subject to a review later in 2023) which can be used for market stability intervention.

The 2024 carbon allowance auction calendar was published on 5 October 2023 which implemented these plans to reduce the cap on carbon emissions under the UK ETS as part of the UK's net zero strategy. It limits the number of carbon allowances for companies to buy in 2024 to slightly under 69 million, 12.4 % fewer than in 2023. This figure will fall to around 44 million by 2027, before eventually reaching around 24 million by 2030.

3. Increased industry cap

The industry cap sets a limit on the quantity of free allocations that can be issued in each scheme year. This cap is currently set at the UK's notional share of the EU ETS industry cap for Phase IV of the EU ETS. It is a fixed volume which equates to 37% of the current UK ETS cap.

In the Response, the Authority confirmed it is minded to reset the industry cap in 2024 to: (1) align with the revised, net zero-aligned cap; and (2) to avoid consequences that could arise if free allocations made up the majority of allowances under the cap. The cap will be increased to 40% and will be expressed as a percentage rather than a set figure.

A quicker or a larger reduction in the number of allowances that are freely allocated could lead to a significant increase in the price of UK ETS allowances due to greater competition for available allowances. Such price increases would also increase the risk of carbon leakage. By implementing a higher cap, the Authority aims to retain flexibility in relation to free allocation whilst mitigating potential carbon leakage risks in the second allocation period (from 2026).

4. Amendments to the free allocation mechanism

The Response sets out decisions in relation to technical aspects of the free allocation mechanism, including to:

• amend the ALCs Regulation to provide for the optional recalculation of change in activity level in 2021 omitting the 2020 COVID year, for those operators who can demonstrate significant discrepancies between reductions in activity and emissions;
• not effect changes to ALCs Regulation to take into account the turn-off of activity (ALC policy aims to reflect activity levels and turn-off is part of an industrial operator's standard activity, so should not be treated differently under ALC policy); and
• retain the same benchmark values for the remainder of the current allocation period (2021-2025), save for certain specified benchmarks (eg the lime benchmark).

The Response also sets out decisions in relation to the treatment of electricity generators in the free allocation mechanism, including to:

• amend the electricity generator definition to consider electricity exports in the baseline period only, rather than electricity exports since 2005. This will allow operators to change their classification as an electricity generator if they have stopped exporting electricity to third parties;
• change the electricity generator classification to exclude installations that have produced electricity for sale, if that electricity was produced by a Combined Heat and Power Quality Assurance (CHPQA)-certified plant; and
• change legislation to allow electricity generators who have not exported measurable heat produced by means of high-efficiency cogeneration in the baseline period (2019-2023) to be eligible for free allowances once they can demonstrate that they meet the eligibility criteria. The determination of whether measurable heat is produced by means of high-efficiency cogeneration will be assessed over the most recent two-year period.

This latter amendment aims to ensure that industrial sites that have invested in CHP are provided the same levels of free allowances as comparable sites, and therefore remove a possible disincentive to invest in CHP. Under the existing legislation, electricity generators who have not exported measurable heat for purposes of district heating in the "relevant period", but which intend to do so in future scheme years, are eligible for free allocation once this has been demonstrated; however, electricity generators who cannot demonstrate that they have produced measurable heat by means of high-efficiency co-generation over the "relevant period" are not eligible for free allocation and there is no way for them to receive any free allowances if they can subsequently demonstrate that they meet the eligibility criteria.

5. Free allocation for the aviation sector not extended

The Authority has decided that free allocation for aviation will be phased-out by 2026. In light of this, the Authority also decided that:

• the aviation free allocation entitlement will reduce at the existing rate of 2.2% in 2024 and 2025, until the phase-out is complete and auctioning commences in 2026;
• it will not update the corresponding free allocation methodology, nor account for new entrants, given the timeline for the phase-out of free allocation. Although the Response recognises that the current aviation methodology calculation is based on a 2010 activity data which is inconsistent with current activity and can create competitive distortions between participants, the legislative and administrative steps that would be required to update this are disproportionate in light of the proposed timeline for phase-out; and
• it will implement a cap on the amount of allowances that an aircraft operator can receive through free allocation during the phase-out period. From 2024, this will be capped at 100% of each aircraft operator's verified emissions. The most efficient operators may therefore not be required to purchase allowances until 2026.

6. Expansion of the scope of the UK ETS

The Authority intends to include two additional sectors in the scope of the UK ETS:

• domestic maritime from 2026, based on vessel activity, for vessels over 5,000 Gross Tonnage; and
• EfW and waste incineration from 2028 (with a phasing period from 2026 to 2028). The Authority intends to include advanced thermal treatment (ATT), advanced conversion technology (ACT) and other related advanced waste technologies, including waste-to-fuel facilities, in the UK ETS.

With regards to the inclusion of waste incineration in the scope of the UK ETS, the Authority confirmed that it is not minded to exempt hazardous or clinical waste from the requirements of the UK ETS, but that it may explore including the wider waste sector (and additional greenhouse gases such as methane in this context) in the future.

The Response notes that the UK ETS cap will be adjusted to take into account new sectors included within the scope of the UK ETS, although any such adjustment would be general (as opposed to for the new sectors specifically).

The scope of the UK ETS will also be expanded to include process emissions from CO2 venting from the upstream oil and gas sector in the UK ETS. Any installation, regardless of whether they are already in scope of the UK ETS as a result of other activities, that vents process emissions over 1,000 tonnes of CO2 per annum will be required to hold an approved UK ETS permit and purchase and surrender allowances for all vented CO2 process emissions. No free allocation will be provided, and the cap in 2025 will not be adjusted to account for these emissions.

Each sector which is to come within the UK ETS will need to consider the impact on its economics and the extent to which it can flow the costs through its wider business. For example, for EfW plants this will involve reviewing the terms of waste supply contracts in particular.

7. Introduction of new penalty and enforcement notice

By 1 January 2025, the Authority intends to introduce a new penalty for a failure to submit information. Although operators are subject to a statutory duty to submit the information in Article 27a of the UK ETS Order, which can currently be enforced via an enforcement notice, the Authority is of the view that a direct penalty will facilitate more consistent enforcement.

Currently, if an operator fails to surrender allowances by the deadline, they are subject to an inflation-adjusted penalty of £100 per allowance not surrendered. The difference between allowances required and surrendered is added to that operator's reportable emissions for the next scheme year. The Authority has decided that in such scenarios, a 'deficit notice' will be issued, which would require the operator to surrender the deficit of allowances by a deadline (which would be the following 30 April, unless it arises in a permit surrender or revocation situation, in which case the deadline will be set by the Regulator). If the operator does not comply with the deficit notice then:

1. a mandatory penalty will apply, which will be calculated as a product of the number of outstanding allowances and 1.5x the carbon price calculated under Article 46 for the relevant scheme year; and
2. if the deficit is not surrendered within a further month of the deadline, a Regulator may issue an 'initial notice' so that a daily penalty will begin to accrue until the deficit is surrendered. The daily penalty will be set at £1,000 per day for each day that the operator fails to surrender the deficit.

This mechanism would force operators to surrender any deficit of allowances, which the Authority views as consistent with the overarching policy principle that allowances should be surrendered to cover emissions. It also believes that the penalties must be set sufficiently high to effectively encourage operators to comply with their obligations under the UK ETS.

8. Further consultations, reviews and developments

Whilst the Response sets out several areas of change to the UK ETS, much remains subject to further consultation and refinement before implementation. We have summarised these key areas below, as well as their anticipated timelines.