The future for carbon trading in the UK
As part of the negotiated Withdrawal Agreement of the UK from the EU and as a means of enabling the UK’s net-zero carbon strategy until the middle of the century, the UK government has confirmed in this week’s White Paper that it will establish a UK Emissions Trading Scheme (UK ETS) from 1st January 2021 to replace the UK’s current participation in the EU ETS. The scheme has been designed by the Department for Business, Energy & Industrial Strategy (BEIS) to closely replicate the EU system that UK companies have been part of for almost 15 years and is intended to promote cost-effective decarbonisation by ensuring the emissions reduction goals of the UK’s carbon pricing policy are met without unduly damaging the competitiveness of UK businesses.
While we have a good level of detail published by BEIS this week, full guidance to advise businesses of their compliance obligations within the UK ETS will be released by the newly established UK ETS Authority in early 2021 alongside additional guidance for small and ultra-small emitters as well as a Hospital Opt-Out Scheme.
Which sectors are covered under UK ETS?
As with the EU scheme it replaces, the UK ETS will apply to energy intensive industries, the power generation sector and aviation. It will cover activities involving combustion of fuels in installations with a total rated thermal input exceeding 20MW (except in installations for the incineration of hazardous or municipal waste). The UK ETS will also include all UK domestic flights, flights between the UK and Gibraltar, and flights departing the UK to European Economic Area states conducted by all included aircraft operators, regardless of nationality. All businesses that carry out an activity covered by the UK ETS will need a greenhouse gas emissions permit and may also need a small emitter or hospital permit or an emissions monitoring plan.
Cap and Trade Methodology
The UK ETS will work on the ‘cap and trade’ principle as with the EU ETS, where a cap is set on the total amount of certain greenhouse gases that can be emitted by sectors covered by the scheme. This limits the total amount of carbon that can be emitted and, as it decreases over time, will therefore make a significant contribution to how the UK meets its Net Zero 2050 target. The scheme is designed to be more ambitious than the EU system it replaces as the cap on emissions allowed within the system will be reduced by 5% annually compared to the EU ETS annual reduction factor of 2.2%, with the cap starting at 155m tonnes in 2021 and falling to 117.5m tonnes by 2030.
Within this cap, participants receive free allowances and/or buy emission allowances at auction or on the secondary market which they can trade with other participants as needed. Each participant’s free allocation will be published in an allocation table soon after 1 January 2021. Stationary operators will also be required to submit verified Activity Level Reports by 30 June in 2021, and by 31 March each year after that. If data contained in these reports show an increase or decrease in activity of 15% or more, the operator’s free allocation will be recalculated in line with this change.
Emissions Trading Registry
As with the current EU ETS scheme, a UK Emissions Trading Registry has been developed for the UK ETS and participants require an Operator Holding Account (OHA) in the UK ETS Registry to acquire and surrender allowances in line with their obligations. Once a scheme participant has been issued a permit or emissions monitoring plan, the regulator will instruct the Registry Administrator to open an OHA on their behalf. They will then be contacted by the Registry Administrator and asked to provide details of a primary contact as well as authorised representatives to operate the OHA. Further information on onboarding will be provided in early 2021. It is this registry that will be used for businesses to submit UK Allowances (UKAs) ahead of the first compliance deadline in April 2022.
Auctions will continue to be the primary means of introducing allowances into the market and participants will also be able to trade UKAs on a secondary market, with confirmation this week that the Intercontinental Exchange (ICE Futures Europe) will provide the auction platform and secondary market services under the UK ETS until December 2022 with an auction calendar to be published early next year. Despite the scheme officially launching on the 1st January 2021, auctions for the UK ETS are not likely to commence until some point in the second quarter of 2021, although ICE is working to start auctions as soon as feasible subject to regulatory approval. Unlike the EU ETS, the UK ETS will have a £15 Auction Reserve Price which establishes a floor price for which allowances can be sold at auctions. In addition, there will also be a cost containment mechanism providing a mechanism for BEIS to manage any significant price spikes in the market.
EU ETS obligations for the 2020 scheme year
During the Brexit transition period from 1 February to 31 December 2020, the UK remains a full participant in the EU ETS. This means that all UK businesses that currently participate in the EU ETS must continue to comply with their EU ETS obligations for the 2020 scheme year. The deadlines for UK operators participating in the EU ETS during the transition period are:
- 31 March 2021 – submit Verified Annual Emissions Report for 2020 emissions
- 30 April 2021 – surrender equivalent allowances to 2020 verified emissions
Potential price implications for UK businesses
The UK ETS has been purposely designed to mimic the current EU carbon market it will replace to reduce the administrative burden on UK businesses. However, as the UK carbon market will be much smaller than its EU counterpart (covering just 155m tonnes of emissions p.a. in 2021 compared to the EU market of 1.57b tonnes), there is a significant risk of high volatility and price spikes in the early months of the scheme due to poor market liquidity. The delay to fully functioning auctions until Q2-21 could also lead to a significant supply-demand imbalance in the early months of the scheme. Some analysts also doubt whether financial players will be attracted to participate in the scheme given its smaller scope and artificial floor price mechanism curtailing speculative opportunities, further harming liquidity. In the long term, questions also remain as to whether the UK scheme will continue as a standalone market or seek to align itself with other global carbon markets as part of post-Brexit trade negotiations to ensure a level competitional playing field, be it the EU arrangement it replaces or similar carbon reduction schemes in the US or Asia.
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