The UK government has introduced legislation to establish a UK Emissions Trading System from 1 January 2021 to replace the EU ETS, which the UK is set to leave at the end of this year with the termination of the Brexit transition period.
The Greenhouse Gas Emissions Trading Scheme Order 2020 entrenches in law the policy features unveiled by the government in early June, as well as the market’s basic rules and criteria for participating and opting out.
The draft order is being laid in the legislatures of the UK, Scotland, Wales, and Northern Ireland. Additional elements of the UK ETS, which will include provisions for free allocation and the UK ETS registry, will be introduced through a second instrument, due to be laid before Parliament in November 2020.
As with the current EU ETS, the UK ETS will apply to energy-intensive industries, the power generation sector and aviation. The government estimates that around 1,000 stationary installations will be covered when the UK ETS launches, as well as a few hundred aircraft operators.
Taking into account responses to a consultation held last year, the UK's Department for Business, Energy and Industrial Strategy (BEIS) said the scheme is closely aligned to the EU ETS, though there are some key differences.
For instance, the UK ETS emissions cap will initially be set 5% below the UK’s notional share of the EU ETS cap for Phase IV (2021-30). The scheme also includes a transitional auction reserve price of £15 to safeguard the value of UK carbon allowances during the initial years of the UK ETS.
Link to EU ETS
Emissions trading systems work on a 'cap and trade' principle, where a cap is set on the total amount of certain greenhouse gases that can be emitted by installations and aircraft covered by the scheme. Tradable emission allowances are allocated to participants in the market via free allocation and auctions.
Companies that go over their limit must buy emission allowances from auctions or the secondary markets. Companies that reduce their emissions below the target level—for example by switching to cleaner fuels—can sell those excess allowances. The goal is to create economic incentives for companies to reduce their emissions with market dynamics of supply and demand determining the price of allowances. The cap is reduced over time, so that total emissions fall.
A clear ambition of the government is for the UK to negotiate a linking agreement with the EU ETS. In an Explanatory Memorandum to the draft order, BEIS said a link could help to establish a much larger carbon market, which could increase opportunities for emissions reduction and cost-efficiency of emissions trading.
BEIS also noted that ensuring the UK ETS legislation is delivered before the end of the transition period "increases the likelihood that the UK will be able to secure a linking agreement with the EU through negotiations."
Linking a separate national emissions trading system with the EU ETS is not unprecedented — at the start of this year, Switzerland successfully linked its ETS, although the process took nearly a decade.
"The timing of the legislation is key because a condition of the European Parliament accepting an agreement between the EU and UK is that the UK has in place (before the EU's vote on any draft agreement) carbon pricing measures that are at least as stringent as the EU ETS," Kirsty Souter, senior associate at law firm Clifford Chance told MarketVoice.
While linking does seem like a possibility, market participants say it is not clear when it would occur. According to the Explanatory Memorandum, further secondary legislation would be required to "operationalise any linking agreement" secured through negotiations with the EU and such legislation would not be laid before Parliament until the first half of 2021.
"When the UK and EU systems are linked is likely to depend very much on when, and if, agreement is reached on the broader trade agreement," said Souter. "It took almost ten years of negotiations to agree the Swiss-EU ETS linkage, although the delay was largely unrelated to carbon markets. Even if a deal is reached on linking the two schemes before the end of the year, it seems that the UK ETS will start life as a standalone regime and there is a good chance it may be a lot longer before we see the systems come together."
If linking the UK ETS and the EU ETS cannot be agreed, there is a risk that the UK market could be impacted by liquidity issues and volatile prices. According to energy trade groups, the much smaller size of the UK ETS market means it would not be sufficiently deep or liquid to allow for genuine price discovery, leading to wider bid-offer spreads and increasing compliance costs for market participants and end-consumers.
"It is expected that the majority of trading under a UK ETS would be between power sector firms which are not allocated any free allowances, and as power sector emissions are expected to fall significantly over the next decade, the potential for an illiquid market may be exacerbated," said Souter.
Illiquidity could also lead to price volatility and higher transaction costs, Souter said. Volatile prices mean there is no clear price signal on which investment decisions can be based, with the result that investments in measures that reduce or avoid emissions may be delayed or not adopted at all.
"While the UK ETS contains measures to try to address price volatility with the transitional auction reserve price, the most effective way of dealing with these risks would be to increase the size of the market by linking it with the EU ETS. Failing that, further tweaks to the design of the UK-ETS may be needed down the line once any issues are better understood," Souter said.
While the UK government says provisions for free allocation and the UK ETS registry will be laid before Parliament later this year, there is a lack of information on how market participants will be able to trade allowances.
ICE Futures Europe hosts the UK platform for the EU ETS allowance auctions on behalf of BEIS. A spokesperson for BEIS told MarketVoice that further details on the auction platform provider would be provided in due course.
Should the UK not be able to implement a UK ETS in time for the end of the transition period, the government has a contingency plan of rolling out a carbon tax as an alternative “to ensure a carbon price remains in place in all scenarios”.
A separate consultation on this was published on 21 July and closes on 29 September 2020.