UK Emissions Trading Scheme (ETS): Where Are We Now?Share on LinkedIn
12 May 2021
May 2021 stands apart from May in previous years in that, in addition to the joys of spring, it brings with it the long-awaited start of the UK’s own Emissions Trading Scheme (ETS), following the UK’s withdrawal from the equivalent European scheme after Brexit. 19 May 2021 marks the ’go-live’ date, with the inaugural UK ETS auction taking place.
The auction will see the first 6 million UK carbon allowances (UKAs) put under the hammer, enabling large-scale UK emitters to purchase the carbon permits necessary to meet their obligations under the scheme which will spearhead the UK’s ambitious efforts for a 78% reduction in CO2 emissions by 2035 versus 1990 levels. With many details still to be ironed out, the UK ETS waters are somewhat muddier than those surrounding the European Union Emissions Trading Scheme (EU ETS), which has been active since 2006 and holds the title of the world’s largest cap-and-trade scheme for greenhouse gas emissions. However, there are a number of pertinent details regarding the UK Scheme that have become clearer since the turn of the year.
What We Know
As with the EU ETS, the UK scheme will operate as a 'cap and trade' system. Both schemes require larger, energy-intensive installations, electricity generators (who will remain subject to an additional £18/tonne levy on top of their ETS liabilities) – and the aviation sector – to each submit sufficient emissions allowances to cover their emissions of carbon dioxide, or other GHG equivalent, during the compliance period (April-April). These allowances can be obtained either through the ETS Authority’s free allocation programme, or purchased via auction or via the secondary market.
I. The Cap
Central to the scheme is the cap, which is ostensibly the hard limit of total greenhouse gas emissions permitted throughout the lifespan of the scheme. According to preliminary government information, the emissions cap will begin at 156 million tonnes of carbon dioxide equivalent (Mt-CO2-eq). Additionally, current literature suggests the cap will be reduced by around 3% each year, reaching 118 Mt-CO2-eq by the end of 2030. However, the existing cap and allowance withdrawal rate are temporary and will be adjusted before September 2021 to align the ETS with the UK’s sixth carbon budget (2033-2037).
The existing 2021 cap of 156 million is equivalent to 95% of the UK’s theoretical share of the EU cap, had the UK remained within the EU ETS. The more ambitious cap level is consistent with the UK’s more aggressive decarbonisation target, relative to that of the EU. By 2035, the UK is aiming to cut emissions by an amount equivalent to 78% of total CO2 emitted in 1990, while the EU is aiming for a 55% cut of the equivalent measure by 2030.
UKAs will be auctioned with a reserve price of £22/tonne, setting a price floor. Early auctions are likely to see UKAs fetch a price which is at a considerable premium to the reserve price, given both the arbitrage implications of the UK scheme with the EU ETS and the incremental reduction in total supply throughout Phase I of the Scheme (2021-2030).
In addition to the reserve price, the details of the auctions are also available – although dates and volumes were not made known to the public until February of this year. The first auction of UKAs will be held on the Intercontinental Exchange (ICE) on 19 th of May, with a total of 6.052 million allowances available in auctions taking place between May through July. Auctions held between September and year-end will offer around 5 million allowances each. The front loading of UKA volumes is, perhaps, an effort to address the likely excess demand that, in all probability, will characterise early auctions. ICE will also launch UKA futures contracts on the 21 st of May, two days after the first auction.
IV. Cost Containment Mechanism
To ensure price stability and the effectiveness of the EU ETS, the Market Stability Reserve (MSR) came into force in 2018. The UK ETS Authority aims to have a similar mechanism in place in the form of a Cost Containment Mechanism (CCM). Although similar in principle, the CCM will face additional challenges that the MSR may only treat as an afterthought. The UK ETS may suffer from low liquidity – the UK scheme will be ten times smaller than the EU equivalent – and this situation could persist, perhaps indefinitely, if a proposed link with the EU scheme never comes to fruition. Therefore, the ability of the CCM to affect the price by buying or selling allowances will perhaps be limited, and will risk exacerbating the price swings. Moreover, due to the low liquidity, it may be difficult for the CCM to be applied and possibly require large price swings before deciding to instigate some form of market stabilization.
V. Free Allocation
As under the EU ETS, some sectors participating in the UK ETS will receive a proportion of their allowances for free. Free allocation applies to industries for whom the technology is not yet available to decarbonise their production processes without rendering the process unfeasible and/or uneconomical. The provision of free permits aims to prevent carbon leakage, where expensive carbon prices for certain firms drive wholesale to offshore activities to locations where carbon prices are lower or don’t exist at all. As it stands, the free allocation will be determined using the same ‘benchmarks’ as were applied under the EU ETS. However, the UK ETS Authority is currently overseeing a ‘Call for Evidence’, for businesses to provide insight into how the free allocation model can be improved to support the UK’s drive towards net carbon neutrality by 2050 whilst protecting the competitiveness of UK businesses.
What We Don’t Know
I. The ‘Real’ Cap
As mentioned, the UK ETS Authority will adjust the cap later this year in line with the Committee on Climate Change’s recommendations relating to the UK’s sixth carbon budget. These recommendations will also affect the rate at which allowances are removed in subsequent compliance years, carrying significant implications for the price of UKAs.
II. Speculative Interest
The entrance of financial institutions into the European Union Emissions Trading Scheme has been one of the driving forces of the three-fold increase seen in the price of EUAs since last March. The cap-and-trade structure, in addition to the EU’s ambitious climate goals, gave rise to the consensus view that EUA prices have but one way to move, i.e., going up. This view was supported by numerous articles by major publications. With the UK ETS underpinned by the same structure, UKA prices could be supported, perhaps considerably, by the interest of money managers and investors.
On the one hand, these ‘for-profit’ players have provided improved liquidity and greater price transparency/ discovery to the EU ETS, something that many will likely welcome in the UK ETS given its inferior size relative to its European counterpart. However, as mentioned, the scale of their involvement has substantially boosted carbon allowance prices, largely to the detriment of participating installations. This has led to conversations within the European Commission for limiting positions that non-complying entities can hold – effectively capping their positions. This conversation appears to have since fallen quiet in Europe, but the UK government may be more critical of financial institutions inflating the price of carbon and negatively impacting the competitiveness of UK industry.
III. UK-EU Linked ETS
A linked or fungible UK and EU ETS scheme is a long-held idea by proponents within the field and there are suggestions that it could become a reality as soon as the spring of 2022. Clearly, there are obvious political barriers to such collaboration, with pro-Brexit parliamentarians likely to oppose a scheme that flies in the face of British political autonomy.
Nevertheless, the rationale behind such a scheme is considerable. A linked scheme would provide greater market liquidity and improved price discovery, a welcome feature particularly for UK emitters. It would also reduce the likelihood of price arbitrage between markets and, perhaps most crucially, a UK-EU ETS would invite further links with other non-EU states, paving the wave for a Europe-wide, or even intercontinental emission trading scheme.
What Can We Expect
The first UK ETS auction will mark a watershed moment in UK’s world-leading climate ambitions, leading the charge towards a 78% reduction in greenhouse gas emissions between 1990 and 2035 which would put the UK firmly on the path to net-neutrality by 2050.
Operationally, the scheme emulates the long-standing EU ETS which has been instrumental in a 23% reduction in carbon emissions between 1990 and 2019. Therefore, the long-run efficacy of the cap-and-trade model is not really up for debate.
Questions remain, however, regarding potential medium-run limitations and implications of a standalone UK Scheme which is a tenth of the size of the EU ETS. In particular, issues around limited liquidity will likely persist until a link with the European scheme is established. With limited liquidity, there will be questions regarding the ability for the Cost Containment Mechanism to operate successfully and ensure price stability.
Price volatility, arising from limited liquidity and third-party interest, could also carry significant implications for UK industrial competitiveness and stability of electricity prices. Nevertheless, either through regular evaluation by the UK ETS Authority and/or eventual cooperation between the UK and EU in establishing a Europe-wide carbon price, any proponent of the fight against climate change would hope that, despite the uncertainty that has surrounded the UK ETS since its announcement in December 2020, the scheme will eventually stand with the EU ETS as a pillar of market-led climate policy.
More: Research Notes, European Union Emissions Trading Scheme (EU ETS), Greenhouse Gas (GHG), Sustainability