The proposals outline the potential new UK system after Brexit, which could be linked to the EU Emissions Trading System. 

By Paul Davies and Michael Green

On 1 June 2020, the UK’s Department for Business, Energy and Industrial Strategy (BEIS) published proposals outlining a new UK-wide Emissions Trading System (UK ETS) contained within a response document to a consultation conducted in May 2019. The proposals were jointly designed by the UK, Scottish and Welsh governments, and the Northern Irish Executive (together, the government). The government has stated that the proposals are a “crucial step” towards achieving the UK’s net zero carbon emissions target by 2050.

Carbon Pricing Options

The government has been assessing the UK’s long-term approach to carbon pricing, including whether to:

  • Continue participating in the EU Emissions Trading System (EU ETS)
  • Implement a UK ETS (either linked to the EU ETS, or standalone)
  • Implement a carbon emissions tax

The UK is scheduled to exit the EU ETS at the end of this year, coinciding with the end of the Brexit transition period. Meanwhile, the EU ETS is due to enter into Phase IV of the scheme, from 2021–2030.

Following the UK’s departure from the EU on 31 January 2020, the government indicated its preferred policy was a UK ETS linked to the EU system. Linking a separate national emissions trading system with the EU ETS is not unprecedented, with Switzerland having successfully linked its separate emissions trading system to the EU ETS; however, the process took nearly a decade. The consultation response document notes that a large proportion of respondents believed the UK ETS should link to the EU ETS, and other commentators have expressed concern that a standalone UK ETS would encounter liquidity issues, due to its size.

However, the potential for the UK ETS to link to the EU ETS is subject to ongoing Brexit negotiations and “inherent uncertainty”. In the event that a linked UK-EU ETS cannot be agreed upon, the government has planned to introduce either a standalone UK ETS or a new carbon emissions tax. The government has described the new carbon emissions tax as a “fallback carbon pricing option”; however, further details will be confirmed after a consultation later this year. To date, the government has not expressly indicated a preference between a standalone UK ETS and a carbon emissions tax, but aims to ensure a UK carbon price in all scenarios by preparing both systems as alternative carbon pricing policies.

The government consultation response document sets out several key features of a proposed UK ETS that could operate either linked to the EU system or in standalone form. The proposals envisage a “smooth transition for businesses” between schemes, with details on the precise relationship with the EU ETS to be confirmed, although the response highlights certain approaches that would differ under a linked or standalone system. The UK ETS would be part of a policy framework aimed at achieving the UK’s net zero target, alongside a £2 billion fund to facilitate decarbonisation in a number of sectors, and a £315 million Industrial Energy Transformation Fund to support industry investment in energy efficiency and decarbonisation technologies.

Similarities Between the UK Emissions Trading System and EU Emissions Trading System

Scope

Similarly to Phase IV of the EU ETS, the first phase of the proposed UK ETS would run from 2021–2030. The scope of the UK ETS mirrors that of the EU system, applying to energy-intensive industry, power generation, and aviation. The UK ETS will cover the same greenhouse gases as the EU system. The UK’s Committee on Climate Change (CCC) had suggested including agriculture and land within the scope of the UK ETS, as well as proposing that carbon pricing be applied to municipal waste incinerators. The government rejected the CCC’s suggestions, but stated that it would consider extending the scope of the UK ETS during the first review of the system. The proposals envisage two reviews occurring during the first phase of the UK ETS, with the first occurring in 2023 (for implementation in 2026), and the second in 2028 (for implementation in 2031).

Free Carbon Allocations

The UK ETS would provide most carbon allowances to the market through auctions, as is the case under the EU system. The proposals note that, in order to “safeguard competitiveness in the UK ETS and reduce the risk of carbon leakage”, the UK ETS approach will be “similar to that of Phase IV [of the EU ETS]” in allocating a number of free allocations. According to the government, this would equate to 58 million allowances in 2021 — the same level as the UK’s notional share of the EU ETS industry cap for Phase IV. The proposals also include a New Entrant Reserve (NER), whereby certain free allowances will be made available to new stationary entrants to the UK ETS, as well as existing operators increasing their activity.

Supply Adjustment Mechanism

In the May 2019 consultation, the government had proposed introducing a supply adjustment mechanism (SAM) based on the EU’s market stability reserve (MSR). This mechanism would be activated by certain pre-defined volume surplus triggers, after which the SAM would accordingly alter the number of allowances to be auctioned in certain years. However, the consultation response stated that the SAM cannot be introduced before data from the UK ETS is received on allowances in circulation at the close of the previous year. In the event of a standalone UK ETS, the government will fix a transitional auction price (ARP) of £15 for the initial years of the system, in addition to consulting separately on the operation of a SAM in a standalone UK system.

Cost Containment Mechanism

The consultation also suggested introducing a cost containment mechanism (CCM), reflecting the EU ETS’s own CCM, which would operate by auctioning further allowances within the cap in order to address any significant price spikes. The new proposals state that during the first two years of the UK ETS, the CCM will have lower price and time triggers to prevent high price spikes. However, this will revert to the EU ETS CCM in the scheme’s third year (or sooner, if the systems are linked).

Aviation

The proposals concerning aviation also mirror the approach of the EU ETS, with the UK ETS applying to domestic flights, flights between the UK and Gibraltar, the UK and the European Economic Area (EEA), and the UK and Switzerland. The EU ETS correspondingly only applies to flights within the EEA, although this will be subject to review in order to align with the implementation of the UN’s International Civil Aviation Organisation’s Carbon Offsetting and Reduction Scheme for International Aviation (CORSIA). Additionally, the UK ETS will provide exemptions for ultra-small emitters, and a small emitter opt-out mechanism, aligned with the EU ETS.

Differences Between the UK Emissions Trading System and EU Emissions Trading System

The UK ETS’s cap will initially be set 5% below the UK’s notional share of the EU ETS cap for Phase IV of the EU ETS, at approximately 156 million allowances for 2021. Forthcoming advice from the CCC on the Sixth Carbon Budget, expected in December, will also advise on the appropriate cap level in order to achieve the UK’s carbon neutrality goals. The government intends to make any adjustments required to align the UK ETS cap with the UK’s net zero trajectory by January 2024 at the latest.

The proposals note that international credits will not be permitted under the UK ETS, given insufficient time to develop the necessary standards and acceptance testing required. By contrast, the EU ETS allows a limited amount of certified emissions reduction credits to be used for compliance. However, the proposals acknowledge that the UK ETS position on the issue may be revised, in order to align the system to CORSIA.

Next Steps

The government states that it is “on track” to implement the UK ETS scheme from 1 January 2021. However, the UK must now present legislation for the UK ETS in four legislatures. Audrey Gallacher, the interim chief executive of Energy UK, welcomed the UK ETS proposals, stating, “we strongly support the government establishing a UK ETS linked to the EU ETS and back its efforts to agree this approach with the EU”. However, the group also urged for greater clarity on the potential plans for a carbon emissions tax.

Latham & Watkins will continue to monitor developments in relation to this matter.

This post was prepared with the assistance of Emilie Cornelis in the London office of Latham & Watkins.