Review of the UK Emissions Trading Scheme (UK ETS) and potential future developments

Overview

In this article we look at the first year of trading of the UK ETS, look at its origins stemming out of the EU ETS and future developments including links between trading systems and the advent of a potential global ETS.

What is the UK ETS

The UK ETS is a cap and trade scheme which seeks to reduce greenhouse gas (GHG) emissions in energy intensive sectors. A cap is set on the maximum level of total emissions in certain sectors (which decrease over time) and allowances are created up to the cap for each unit of emission.

Certain eligible participants are allocated free allowances (e.g. steel, cement and chemical manufacturers) and residual allowances are auctioned which can be traded with other participants. Participants need to surrender equivalent allowances at specified dates to their total emissions. The allocation of free allowances is to tackle carbon leakage where companies may transfer operations to other countries with less stringent GHG emission regulations which may potentially increase the total emissions of that country.

Introduction and developments of the EU ETS

The EU ETS was launched in 2005 (and at that time included the UK) and despite teething troubles it has been considered to be an effective mechanism to drive decarbonisation. The EU ETS now covers approximately 45 percent of EU GHG emissions arising chiefly from the energy, power and aviation sectors.

Revisions to the EU ETS, as part of the Fit for 55 package proposed by the European Commission, seek to extend the reduction targets to 61 percent reduction (from 1990 levels) by no later than 2030. It is proposed this is achieved by increasing the annual percentage reductions and extending the scheme to the maritime sector, extending the decarbonisation measures in sectors (e.g. aviation) and extending ETS to emissions from fuels in road transport and buildings from 2026.

Introduction of the UK ETS

Following Brexit, the UK ETS came into effect on 1 January 2021. The framework is set out in the Greenhouse Gas Emissions Trading Scheme Order 2020.

Currently the UK ETS replicates the EU ETS and is divided into phases. Phase 1 running between 2021 – 2025 and Phase 2 from 2026 – 2030. The initial cap for the UK ETS during 2021 was 156 million allowances (which was 5% lower than the UK’s share of the EU ETS cap). The UK ETS cap reduces annually by approximately 4.2 million allowances.

The performance of the UK ETS is being watched with interest in its first year of trading which began in May 2021. There were around 84 million allowances available for auction in 2021 and around 80 million will be auctioned throughout 2022 and auctions are held every two weeks.

Allowances are held in the UK ETS Registry administered by the Environment Agency (EA) for all of the UK. The ETS Registry is the equivalent of a bank for allowances and records free allowances, annual verified emissions, allowance transfers and allowance surrenders. In case of breaches, the EA can issue an enforcement notice and if that is not complied with the relevant national regulator can impose a civil penalty.

The carbon price has risen over the first year of trading and this is likely to escalate as the first compliance deadline for surrendering allowances comes in April 2022, which will be a busy period for participants and recent guidance has been published on the Government website on how to prepare for this.

Triggering of the Cost Containment Mechanism (CCM) in the UK ETS

The UK ETS Authority will monitor the UK market and in the event of significant market instability may consider taking action. During the initial years to prevent instability there is the auction reserve price where the minimum bids in UK ETS auctions is set at £22. At the other end of the scale, the CCM has been integrated in order to control escalating prices. The CCM is triggered if the prices of allowances are higher for three consecutive months than twice the average price in the previous two year period. The CCM in the UK ETS is based on the same mechanism as within the EU ETS, however in the UK ETS there are lower price and time triggers in the first two years whilst it beds in and in year three the UK ETS CCM will correspond to the position in the EU ETS.

The CCM was triggered in the UK ETS in December 2021 and January 2022 when the average carbon prices rose above £52.88 and £56.58 respectively. This provided the UK ETS Authority two weeks from the trigger date to determine whether to take action. In both instances, it was confirmed that no action would be taken to curb the prices which in some heavy energy use sectors is causing concern of a gap forming between UK industries and their competitors.

Developments in the UK ETS

On 7 February 2022, the GHG ETS (Amendment) Order 2021 came into force making technical and operational changes to the UK ETS. It mainly provides for:

• installations in the hospital and small emitter opt-out scheme to apply to increase emissions targets;
• installations exceeding the threshold for the small and ultra-small opt out schemes to benefit from fee allocation upon joining the ETS;
• correction of the methodology for calculating the entitlement to free allocation of certain aircraft operators;
• clarification of the rules for the use of aviation fuels; and
• changes to the issuance of permits (once a monitoring plan has been approved), permit variations (which now include cases where installations are increasing emission targets and partial transfers) and transfers (taking into account the monitoring plan).

Future developments to the UK ETS

Penalties and enforcement

The UK Government plans to introduce further amendments to the UK ETS scheme in 2022 pursuant to the GHG ETS (Amendment) Order 2022, which is currently in draft form before Parliament. The proposed changes address penalties, the UK ETS Registry enforcement powers and include powers of entry and inspection for the regulator and the introduction of surrender and revocation notices.

Net Zero Strategy (NZS) alignment

Additionally, as part of the UK’s NZS which sets out how the UK Government plans to deliver its emissions targets of Net Zero in 2050 and a 78% reduction from 1990 to 2033, the UK Government committed to:

• reviewing and consulting on the UK ETS’s cap to pursue greater climate ambition and develop the scheme to meet the net zero target. Changes are to be implemented in 2023 (or 2024 at the latest) and will include a review of the allocation of free allowances to maintain a balance between carbon leakage and incentivising decarbonisation. The UK ETS Authority will consult in the coming months on a net zero consistent cap;
• considering how the UK ETS can be a potential long-term market solution for stimulating investment in GHG removals (GGRs) where GGRs may be a negative emission within the ETS given the NZS emphasises the importance of engineered and nature-based GGRs; and
• consulting on extending the UK ETS to the two-thirds of emissions that are not currently included. This may include road transport and heating to align with the proposals in the EU.

Linking the UK ETS

There has been debate over the possibility of the UK ETS linking with the EU ETS (pursuant due to the EU-UK Trade and Co-operation Agreement) or on an international platform. The UK Government has indicated that they remain open to linking the UK ETS internationally in principle but has made no decision on the preferred linking partner.

Since COP 26 and the finalisation of Article 6 which envisages linking ETSs globally enabling the international transfer of carbon credits and a new mechanism based on emission reductions from low-carbon projects, there is the possibility for a global ETS in the future. However, this is only a possibility at this stage and there are concerns regarding how a globalised system can be established as it may mean implementing a potentially different system in jurisdictions that have embedded and established ETSs.

The drive to establish any global ETS will largely depend on the political will of individual countries. To move forward to a unified international system consideration needs to be given to how key mechanisms would work such as preventing carbon leakage, subsidies for abatement, alignment of import standards and carbon adjustment mechanisms and each one of these may be very complicated and difficult to agree at a global level. Additionally, even current measures in established ETSs may not be deemed sufficient in hard to abate sectors and setting a global carbon price may be impossible to achieve given the price in a certain jurisdiction/sector may not be deemed high enough to incentivise abatement in one area whereas it could be viewed very differently in another part of the world.