On 1 June 2020 the UK Government published details of its plans to implement a UK Emissions Trading System (“UK ETS”), starting in 2021. The UK ETS will replace, in the UK, the European Union’s system for trading carbon emissions (“EU ETS”).
Since its inception in 2005 the EU ETS has been the Union’s flagship regulatory tool for reducing greenhouse gases (“GHGs“), notwithstanding its many ups and downs. With the UK due to leave the EU ETS when the Brexit transition period ends on 31 December 2020, UK industry has been awaiting details of the UK ETS proposal and its potential contribution to the country’s legally binding commitment to achieve net zero emissions by 20501.
This client alert assesses the key components of the proposed UK ETS and how it compares to the EU ETS.
The Department for Business, Energy & Industrial Strategy published this proposal on the design and operation of a UK ETS in response to a consultation on the future of carbon pricing in the UK, launched in May 2019 (the “2019 Consultation“). The proposal states that the UK Government is open to considering a link between the UK ETS and the EU ETS (as Switzerland has done with its ETS2), an approach favoured by a large proportion of respondents to the 2019 Consultation. The UK Government acknowledges, however, that linking is subject to on-going trade negotiations with the EU. If linking is not possible the UK will either introduce a standalone UK ETS or opt for a new carbon emissions tax. That said, as highlighted below the proposed UK ETS has clearly been designed with a view to linking to the EU ETS as it shares many of its features.
Key Features Scope:
At the outset the UK ETS will cover the same greenhouse gases and sectors as the EU ETS. These are as follows3:
• carbon dioxide (CO2) from:
• power and heat generation;
• energy-intensive industry sectors including oil refineries, steel works and production of iron, aluminium, metals, cement, lime, glass, ceramics, pulp, paper, cardboard, acids and bulk organic chemicals;
• commercial aviation:
• until 31 December 2023 the EU ETS will apply only to flights between airports located in the European Economic Area (“EEA”);
• the UK ETS will apply to domestic UK flights, flights between the UK and Gibraltar, flights from the UK to the EEA and flights from the UK to Switzerland (if the EU ETS and the UK ETS are linked). The aviation cap would be calculated to ensure that it is at least as ambitious as the UK’s notional share of the EU ETS Phase IV cap;
• nitrous oxide (N2O) from production of nitric, adipic and glyoxylic acids and glyoxal; and
• perfluorocarbons (PFCs) from aluminium production.
In time, the UK may expand the scope of the UK ETS to cover more sectors and installation types in order to achieve its net zero emissions target. It will conduct a review to this effect no later than 2026.
Cap: Both the UK ETS and the EU ETS are cap-and-trade systems, with caps reducing over time. The cap for the UK ETS will initially be set at 5% below the UK’s expected notional share of the Phase IV EU ETS cap (around 156 million allowances in 2021), including emissions from aviation. The proposed cap is intended to balance climate ambition against the risk of disproportionate costs to businesses. The initial cap will reduce by 4.2 million allowances annually to maintain a cap 5% below the UK’s notional share of the Phase IV EU ETS.
The UK Committee on Climate Change is expected to advise the UK Government later this year on a cost-effective pathway to net-zero emissions. The UK Government will then consult with industry on a trajectory for the UK ETS cap, with a goal to align the cap with a net zero trajectory by January 2023 if possible and no later than January 2024.
will be the default method of allocating allowances in the UK ETS, as is the case with the EU ETS, with both systems having a similar proportion of allowances auctioned versus those allocated for free.
Free allocation under the UK ETS will also follow a similar approach to Phase IV of the EU ETS, with the UK using data from Phase IV to calculate an installation’s entitlement to free allowances. The level of free allocation will initially be set at the UK’s notional share of the Phase IV EU ETS industry cap, which equates to around 58 million allowances in 2021 and an annual reduction of around 1.6 million allowances. Like the EU ETS, the UK ETS will also include a reserve of free allowances for new entrants and for existing operators who increase their activity. The UK Government will undertake a full review of possible future changes on free allocation later in 2020.
Market stability: To maintain a supply-demand balance and to ensure cost-effective decarbonisation, the UK ETS will include:
• a Supply Adjustment Mechanism (“SAM“), broadly based on the EU ETS Market Stability Reserve. The SAM will adjust the number of allowances to be auctioned in certain years if predefined volume surplus thresholds are reached. Under a standalone UK ETS, the SAM would not be introduced immediately as it needs data from UK ETS allowances in circulation at the end of the first year before it can be implemented. A transitional auction price reserve will be in place over the interim period (see below for details); and
• a Cost Containment Mechanism (“CCM“) that mirrors the design of the EU ETS CCM but with a lower price trigger and time trigger4 for the first two years of the UK ETS (if standalone). The CCM would be triggered if the carbon price is:
• Two times the average carbon price in effect in the UK in the two preceding years, for three consecutive months, in year one;
• Two and a half times the carbon price in effect in the UK in the two preceding years, for
• three consecutive months, in year two; and,
• three times the carbon price in effect in the UK in the two preceding years, for six months, from year three onwards.
If the CCM is triggered, the relevant decision makers will convene a meeting between officials from the UK Government and the Devolved Administrations5 and if it is agreed that action should be taken, additional allowances from within the cap can be added to subsequent auctions as follows:
• auctioning allowances from the UK’s allowance reserve;
• bringing forward a quantity of allowances from future auctions;
• auctioning up to 25% of the remaining allowances in the new entrants reserve.
• under a standalone UK ETS, the UK Government will set a transitional auction reserve price (ARP) of £15 for the first few years of the scheme. This will be removed once the SAM becomes operational.
Small emitter opt-out and an ultra-small emitter exemption: These will be aligned with the EU ETS, including the thresholds:
• “Small Emitter and Hospitals Opt-Out Scheme” – installations emitting less than 25,000t CO2e13 per year and having a net-rated thermal input below 35MW can enter this simplified scheme, pursuant to which they have to monitor and report their emissions and meet annual emission reduction targets; and
• “Ultra-Small Emitter Exemption” – installations emitting less than 2,500t CO2e per annum will be exempt from all aspects of a UK ETS except a requirement to monitor emissions and notify the regulator if emissions exceed this threshold.
International carbon credits: UK ETS operators will not be allowed to use international carbon credits when the scheme is introduced. This is in line with the position in the EU ETS after 2020 (emitters are currently allowed to buy a limited amounts of international credits from emission-saving projects until 2020)6. The UK Government will review how to implement aviation offsetting under the International Civil Aviation Organisation’s (ICAO) Carbon Offsetting and Reduction Scheme for International Aviation (CORSIA) alongside a UK ETS.
Market reviews: An initial review will take place during the first half of Phase I (2021-2025) to assess the performance of the UK ETS from 2023, with any necessary changes implemented by 2026. A second review from 2028 onwards will assess the whole scheme in Phase 1 (2021-2030) and any amendments will be introduced before Phase II commences in 2031. These reviews will be aligned with the EU ETS Phase IV reviews.
The UK ETS proposals are particularly relevant to companies in energy-intensive industries such as steel, the power generation sector and aviation. Currently, approximately a third of UK emissions and 1000 UK factories and plants are covered by the EU ETS and will continue to be covered by the UK ETS. The proposals indicate that the UK ETS will be designed to ensure minimal differences for businesses in these sectors compared to operating under the EU ETS. The UK ETS will be part of a broader policy framework to deliver the UK’s net zero target by 2050, including a £2 billion fund to support decarbonisation in a range of sectors and the £315 million Industrial Energy Transformation Fund7 to support industry to invest in energy efficiency and decarbonisation technologies.
Next Steps The Government must now present legislation to the Parliament at Westminster, the Scottish Parliament, the National Assembly in Wales, and the Assembly in Northern Ireland in 2020, so that the UK ETS can be launched in January 2021.
We will continue to monitor developments and provide analysis in relation to the design and implementation of the UK ETS. Please do let us know if you have any questions or would like to discuss.