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Exploring a new emissions trading scheme

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The UK exited the EU’s emissions trading scheme (ETS) at the end of the Brexit transition period. The UK government and the devolved administrations prepared for this by designing and implementing the UK’s own ETS on the recommendation of the Climate Change Committee. The recent Energy White Paper stated that the UK ETS has a significant role to play in achieving the 2050 net zero target, but it is only one of the tools available to policy makers to meet a highly challenging target that is likely to require fundamental changes in the way that energy is produced and consumed.

Established in 2005, the EU’s ETS adopted a ‘cap and trade’ approach that places emissions limits on intensive fossil fuel use in each member state. There have been various phases of the EU ETS, with electricity generation and heavy industry, such as steel production and oil refinement, targeted initially, followed more recently by air travel.

A cap and trade system is designed to force those covered by the scheme to reduce emissions to below current levels with progressively lower caps introduced over time. The trading aspect is designed to reduce the overall costs of reducing emissions by allowing parties that can achieve reductions most cost-effectively to sell any excess allowances they might hold to those for whom it may not be economic to abate emissions.

The UK was instrumental in developing the EU ETS and operated its own voluntary scheme between 2002 and 2006 as a forerunner to the EU ETS. As such, it is perhaps unsurprising that the new UK ETS has been modelled on the EU scheme. Accordingly, the UK ETS initially covers energy-intensive industry, fossil-fueled power stations and the aviation sector, mirroring the scope of the EU’s scheme. One important difference is that the UK has opted for a cap that is five per cent lower than would have applied had it continued in the EU scheme and the cap will be linked to the UK’s carbon budgets.

Operators of static facilities covered by the scheme and aircraft operators will need to open accounts in a new UK emissions registry and purchase allowances to cover their emissions. Allowances can be purchased either in an auction of new allowances issued by government or in a secondary market. The platform for both mechanisms has recently been launched by ICE Futures Europe. Aircraft operators and some industrial operators in manufacturing sectors where there is a risk of carbon ’leakage’ through off-shoring production will be entitled to claim some free allowances. The Energy White Paper contained a commitment to “exploring expanding the UK ETS to the two thirds of uncovered emissions”. With a target to reduce emissions by 78 percent by 2035, it might well be necessary to extend the scheme to other sectors.

The UK ETS has been designed as a stand-alone market and, given its relatively small size, risks low liquidity. In order to guard against the risk of instability, the scheme features both an auction reserve price to guard against abnormally low prices in the auction of allowances and a cost containment mechanism whereby additional allowances can be made available if the auction prices spike too high. There is also the potential to introduce a supply adjustment mechanism in future if experience shows this to be necessary.

Concerns have been expressed by some commentators that there will be insufficient liquidity in the secondary market leading to higher prices for allowances and that will potentially make UK industry less competitive internationally. One way to tackle this would be to link the new market with other schemes internationally. Ironically, the most obvious scheme to link with, given its compatibility with the UK ETS is the EU’s scheme. However, this remains uncertain, notwithstanding the commitment to exploring such linkage in the EU-UK Trade and Cooperation Agreement.

Although the new UK ETS should prove to be an important tool in lowering emissions, the scale of change required to transition to net zero should not be underestimated. The ETS needs to be part of a range of policy initiatives across the different sectors of the economy.

Real progress has been made in decarbonising the UK’s power generation sector and the EU ETS may have played some role in that, although the Carbon Price Floor has been a key driver. However, much of the heavy lifting to achieve the net zero target needs to be done in the domestic heating and road transport sectors which account for a large proportion of UK carbon emissions. It is difficult to see how the ETS can be expanded to cover such activities and other measures will be needed to drive out carbon in those sectors.

Mark Bartholomew's photo
Contributer

Mark Bartholomew Partner, Shakespeare Martineau

Mark Bartholomew is a partner in the energy team at law firm, Shakespeare Martineau.

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