This Insight looks at the joint consultation of the UK, Scottish, Welsh and Northern Irish governments on Developing the UK Emissions Trading Scheme (UK ETS) and its role in the reduction of greenhouse gas (GHG) emissions. The Consultation, open until 17 June 2022, seeks views on its proposals for the UK ETS and calls for evidence on potential future opportunities. 

The Consultation 

The UK Government in its Net Zero Strategy has set a target to reduce its emissions to 'net zero' by 2050. The Scottish Government has set an even more ambitious target in its Climate Change Plan to achieve net zero emissions by 2045. The UK ETS is a part of these strategies and is focussed on energy intensive industries, particularly in relation to those sectors which are naturally more difficult to decarbonise such as heavy industry, the power sector and aviation. 

This Insight addresses the first four chapters of the Consultation, namely:  

1. implementing a net zero consistent cap;

2. reviewing the free allocation policy; and

3. future markets policy. 

We will look at the UK ETS in relation to aviation as well as its potential expansion to other sectors, such as biomass, upstream oil and gas, maritime, agriculture and GGRs and energy from waste in separate Insights to follow. 

Net Zero Consistent Cap 

The UK ETS works on a cap and trade principle, meaning each sector in the scheme can only produce GHG emissions up to a cap. Operators of installations covered by the scheme can emit greenhouse gases up to the amount set out in the permit for that installation and have to buy allowances for any surplus emissions. These can be purchased at auctions or on the secondary market. This limits the total carbon production, with the cap and allowances decreasing over time. The Consultation sets out proposals to align the UK ETS cap with the above net zero targets. 

The UK ETS original cap was set at 5% below that of phase four of the EU ETS (2021-2030), equating to approximately 156 million allowances in 2021. This was set to reduce annually by 4.2 million allowances. The Climate Change Committee (CCC) recommended that the UK ETS cap be adjusted to align with the net zero trajectory in its letter of advice to the Government dated June 2021. The Government took this into consideration in the Consultation, but ultimately decided that the cap should be based on the UK Government's Net Zero Strategy published October 2021, reasoning that the Net Zero Strategy was published more recently than the CCC's letter of advice and includes stricter recommendations and would therefore allow for a stricter trajectory in the fall of emissions production. Accordingly, the Consultation proposes that the Net Zero Strategy provides the base for the cap trajectory from 2024. 

What, then, is this trajectory proposed to look like? The Government has set a suggested range of values to reflect uncertainty in expected sectoral emissions reductions. This range is set between 887 million and 936 million allowances for the entire first phase (2021-2030), equating to a reduction of around 30-40% from the current cap for phase 1 (1365 million allowances). The Government is leaning towards setting the cap at the higher end of this range, which would allow for more emissions and is a higher risk approach in achieving net zero. The Government submits, however, that this approach factors in uncertainty over exact emissions savings and the possibility that carbon reductions could exceed what is required for the fourth carbon budget. Sticking towards the lower end of the range (i.e. allowing less emissions) would be lower risk to ensure compliance with the Net Zero Strategy, carbon budgets and the UK's 2030 Nationally Determined Contributions (NDCs) under the Paris Agreement. 

The Government has also decided to delay implementation of this net zero consistent cap from 2023 to 2024, to lengthen the period of notice to the market and enable the Emissions Trading Scheme Authority to consider responses to the Consultation in full. 

Free Allocation Policy 

The UK ETS currently provides free allowances to those sectors at risk of carbon leakage. Carbon leakage is where carbon emissions are displaced to another country due to a lack of consistency in climate policies and their implementation. Those receiving free allowances allocated to mitigate carbon leakage will need to buy fewer allowances to cover their emissions, in turn reducing their carbon price. Recipients of free allowances also have the option to sell these on the secondary market and make a profit. A list of the UK ETS allocation table for 2021-2025 can be found here. 

There are currently a fixed number of free allowances distributed per year. In 2021, this was approximately 58 million, which will reduce annually by around 1.6 million. Free allocation entitlement is then calculated based on a range of factors, including risk of carbon leakage, efficiency against a benchmark and historic activity levels. This limit is called the industry cap which, if exceeded, will trigger application of a cross-sectoral correction factor (CSCF) which applies a proportionate reduction to the recipient's free allowances. If the number of free allowances awarded is lower than the industry cap, they can be set aside for future use. This is to ensure that the distribution of free allowances remains stable whilst they are reduced, and that the industry cap is not exceeded. The UK ETS Authority ran a call for evidence into the UK ETS free allocation policy, which closed in April 2021. This review looks at three elements: aligning the share of free allocation with the net zero cap, the underlying methodology for distribution of free allowances and the government's response to the free allocation review. 

In order to align free allocation with the net zero cap, as the UK ETS cap is reduced, there will be fewer annual allowances available over phase 1 of the UK ETS (2021-2030). The number of free allowances offered will therefore be directly related to the industry cap. The Consultation proposes two options for the cap: to either leave the cap as is; or, reset it. The first option is set out for completeness, but the Consultation does not propose this as a preferred option. The second proposal is to reset the industry cap to make up a percentage of the overall net zero cap, rather than being set as fixed numbers as is currently the case. The Consultation suggests changing this to a percentage of 37% of the overall net zero cap, so that the allocations are reduced consistently with the cap and overall net zero ambitions. These changes would not be implemented until 2024.  

The Government looks to review the methodology for the calculation of free allowances to ensure fair distribution. The Government will consult on these proposals by 2023 and any changes would take effect by 2026. Any changes will be made according to the following three principles: 

1. appropriate mitigation of carbon leakage, ensuring an accurate reduction of global emissions;

2. consideration of the availability and affordability of decarbonisation technologies; and

3. changes to the free allocation must align with wider climate targets. 

The Consultation also addresses unallocated allowances and the flexible share, the latter being a pot of allowances representing 3% of the industry cap for phase 1 of the UK ETS. These exist to top up the industry cap, can prevent a CSCF being applied and prevent reductions in free allocation. Neither mechanisms have been used yet, but the pot of unused allowances is predicted to grow as free allowances continue to fall below the industry cap. The Government is considering options for bringing these unused allowances to market, which will need to be addressed along with changes to the net zero cap and free allowances. 

Future Markets Policy

The Consultation calls for evidence on the UK ETS markets policy, so that this policy evolves at the same pace as the UK ETS. The UK ETS can be stabilised through a range of market stability mechanisms, such as auction reserve prices and supply adjustment mechanisms. Some of the current mechanisms in place to ensure market integrity are the auction reserve price (set at £22 per emissions allowance), the cost containment mechanism (which is triggered by elevated prices and auctions additional allowances from within the cap to offset these rapidly rising prices) as well as a structured auction process through which allowances are distributed across the calendar year in accordance with the auction calendar. The Government intends to withdraw with auction reserve price, and seeks views on when it should do so as well as whether the mechanism should be replaced. 

The Consultation also sets out 5 objectives for the future UK ETS markets policy, to: 

1. provide long-term reassurance to participants with a rules-based approach to Authority intervention;

2. design any market stability policies which reduce the ability of any entity to 'game' the policy;

3. counter excessive unexpected and destabilising fluctuation in price or demand shocks in the market; 

4. support price discovery and liquidity in the UK ETS markets;

5. guard against market abuse and market destabilising activity.

The Consultation seeks feedback on these objectives to ensure that they are the correct market policies for the future of the UK ETS. 

Conclusion 

This Consultation gives us a general overview of what policy decisions the Government is inclined to make, particularly in relation to the market cap and free allocation. The Consultation is thorough and covers a range of issues that need to be addressed to ensure that the UK ETS is effective and contributes to the net zero target. Setting a stringent cap in line with the net zero target is crucial to the UK ETS' contribution to wider climate targets. 

The Government's review of the free allocation policy will be critical to the overall success of the UK ETS, and must ensure a fair and transparent system which creates a stable carbon price and should not allow participants to be cost-neutral or make a profit from the UK ETS. Linking the UK ETS with other schemes internationally will reduce the risk of carbon leakage and in turn reduce the need for free allowances. The Government remains open to linking the UK ETS with other schemes worldwide, but had not yet committed to doing so. Now that Article 6 of the Paris Agreement has been finalised after COP26, hopefully the UK Government will be encouraged to cooperate more internationally to avoid too much differentiation of climate policies and emissions trading scheme implementation across the globe. 

To read more about our take on the Net Zero Strategy, click here.