Government Response on the future of UK carbon trading confirms plans for UK ETS

The UK Government has, on 1 June 2020, confirmed in its consultation response The future of UK carbon trading (the “Consultation Response”) its intention to establish a UK Emissions Trading System (“UK ETS”). The UK ETS would run from 2021 (the end of the UK’s transition period for leaving the EU and, therefore, the EU Emissions Trading System (“EU ETS”)). For our commentary on the consultation proposals, please see here.

In short, the UK ETS system seeks to preserve the processes and obligations which previously applied under the EU ETS scheme. Although the Government has stated that it would consider linking UK ETS with EU ETS if this suited both parties’ interests, as favoured by most stakeholders responding to the Government’s 12 July 2019 consultation, at present the UK ETS would be a standalone regime.

The initial UK ETS cap will be set at 5% below the EU ETS Phase IV cap with further policy to follow by no later than January 2024.

Phase I of UK ETS is scheduled to run from 2021 to 2030, in line with EU ETS Phase IV, with two review processes (in 2023 and 2028).

Here we set out the key aspects of the proposed UK ETS regime, noting in particular the areas where it will differ from the EU ETS regime. In particular, participants should note the changes to monitoring and verification processes (as summarised below).

The Consultation Response confirmed that UK bodies currently carrying out functions under EU ETS – the environmental regulators of the UK and devolved administrations and the Financial Conduct Authority – would continue to undertake those functions under UK ETS.

Participants covered

As per its EU counterpart, under UK ETS, energy intensive industries, power generators and the aviation industry will be subject to a total annual cap on the amount of greenhouse gases (“GHGs”) they are permitted to emit each year. Participants emitting more than the capped amount of GHGs will need to buy allowances from other participants at auction, or face fines of up to £100 per allowance.

While the participants remain unchanged at present, the Government will consider having the UK ETS apply to new sectors. However, at present, at least insofar as waste is concerned, the Government considers that it would be difficult to include municipal waste incinerators in the scheme, due to their role in diverting waste from landfill. Also, UK ETS is not felt to be an appropriate measure to deal with emissions from land use and agriculture.

As regards aviation, the Government confirms that UK domestic flights and flights departing from the UK to aerodromes in European Economic Area states would be covered by UK ETS, whether a standalone system or one linked with EU ETS. Flights between the UK and Gibraltar will also be covered. Exclusions under the EU ETS to and from the Crown Dependencies or the nine EU Outermost Regions, will apply to UK ETS.

Addressing price volatility: MSR becomes SAM

Commentators have previously raised concerns that a standalone UK ETS would suffer from issues of price volatility, due to the reduced number of participants and a less diversified market. The Consultation Response addresses this, reiterating that an auction reserve price (“ARP”), supply adjustment mechanism (“SAM”) and cost containment mechanism (“CCM”) will be utilised.

Under EU ETS, the Market Stability Reserve (“MSR”) – which operates on pre-defined rules without discretion for European Commission or Member State intervention – determines whether allowances should be removed from auction and placed in reserve, to protect against a low carbon price caused by an allowance surplus. The UK ETS equivalent - the SAM - will operate based on emissions data from the previous year. This means that it will not be possible to introduce it during the UK ETS’ first year of operation. For that reason, a transitional ARP of £15 will apply, setting the minimum carbon price for that period.

The UK ETS will also have its own CCM to handle spikes in the price of carbon during the first two years of UK ETS, and the system will revert to the EU ETS CCM in year three, or earlier if the two systems are linked.

Assuming no earlier link, these triggers will be:

• For three consecutive months in year one, the carbon price is twice the average UK carbon price experienced during the preceding two years;
• For three consecutive months in year two, the carbon price is two and a half times the average UK carbon price experienced during the preceding two years; and
• From year three onwards, for six months the carbon price is three times the UK average carbon price experienced in the UK for the preceding two years.

Where the Government decides to take action following a trigger event, further allowances can be added by:

• Auctioning allowances from the reserve;
• Bringing forward allowances from future auctions; or
• Auctioning up to 25% allowances from the free allocations reserved for new entrants.

The UK ETS auction process will differ from its EU counterpart in that auctions will be allowed to ‘clear’ even when not all available allowances are sold. Unsold allowances will be rolled forward to the following four auctions, in which a maximum of 125% of allowances originally intended for sale can be offered in each, hence, in contrast to the EU ETS, a time period will apply in the UK ETS regime.

Free allowances

As under EU ETS, a number of free allowances will be allocated to participants who compete with similar businesses outside of the UK, to support competitive business and prevent against carbon leakage. Going further, the Consultation Response confirms that free allowances will also be made available to new entrants to emissions trading under UK ETS and to participants who increase their activity by 15% (with a reduction of allowances for a 15% fall in activity levels).

The Consultation Response confirmed that free allowances will be allocated to the aviation sector as they would have been under EU ETS Phase IV, but that, as under Phase IV, there will be no special reserve of allowances for distribution to any new entrants.

Exemptions

De minimis: As under EU ETS, UK ETS will incorporate a Small Emitter and Hospital Opt-Out scheme for installations with emissions lower than 25,000t CO2e per annum and a net-rated thermal capacity below 35MW. Participants in this scheme have to report on their emissions and meet annual reduction targets.

In addition, under UK ETS, installations emitting less than 2,500t CO2e per annum will be eligible for the Ultra-Small Emitter Exemption – exempting them from all elements of UK ETS other than the requirement to monitor emissions and report if they exceed this threshold.

Aviation exemptions: Certain aircraft operators flying UK ETS routes will be exempt from the scheme. These are:

• Commercial operators (i) who operate fewer than 243 flights per four-month period, for three consecutive four month periods, or (ii) who operate flights emitting less than 10,000 tonnes of CO2 per year; and
• Non-commercial operators who operate flights emitting less than 1,000 tonnes of CO2 annually.

This mirrors the approach under EU ETS.

UK ETS will also mirror EU ETS in exempting certain types of flights from the scheme. For example, military flights, flights performed for scientific research purposes and search and rescue flights will be excluded.

Monitoring, Reporting and Verification

The Consultation Response proposes several changes to monitoring, reporting and verification under UK ETS as compared to EU ETS. These include:

• introducing the ability to aggregate multiple emission source streams adding up to 10t CO2e or less;
• reducing the frequency of site visits to certain offshore operators; and
• updating the definition of ‘significant changes’ requiring notification to the regulator.

In addition, the Consultation Response confirmed that the UK ETS registry system would be simplified in comparison with the EU ETS, for example, to remove the mandatory requirement for each account holder to make annual declarations that their account information remains up to date.

Other points covered

The Consultation Response raises the possibility of establishing a fund to support industrial carbonisation, paid for in part through UK ETS, as well as through international agreements, product certification, demand-side measures and direct fiscal support. The Consultation Response does not provide further details but states the aim for an appropriate mechanism to be in place by the early 2020s.

The Government has confirmed that offsets, for example against Kyoto Protocol units, will not initially be permitted under UK ETS, but will be considered under the structured review process. In particular, the Consultation Response highlights that UK ETS will be aligned as far as possible with the Carbon Offsetting and Reduction Scheme for International Aviation (“CORSIA”), to ensure that participants are able to operate under both schemes. However, the 6 of June 2020 Decision by the Council of the EU to amend the CORSIA emissions baseline years from 2019/2020 to 2019 only, subject to approval by ICAO Assembly on 26 June 2020, raises a query as to whether the UK ETS may diverge in its level of ambition for aviation from CORSIA in order to meet UK’s net zero target by 2050. (See our recent Law-Now regarding changes to CORSIA.

Energy UK issued the statement that they “strongly support Government establishing a UK ETS linked to the EU ETS and back its efforts to agree this approach with the EU” and noted that this was “the best long-term carbon pricing mechanism to continue driving decarbonisation at the lowest cost to consumers [while allowing the UK] to benefit from the liquidity of the world’s largest carbon market and help [it] meet [its] net zero target by 2050”.

The Association for Renewable Energy and Clean Technology stated that the Consultation Response was “good news for the industry.” They urged the Government to expand the scheme to the heat and transport sectors, and to set the carbon price “in line with net zero by the end of [2020]”.

Comment and next steps

The Consultation Response will not surprise many in industry who anticipated a UK ETS regime closely aligned with the EU ETS regime. This alignment is helpful for reducing other uncertainties which loom as the end of the transition period approaches. However, some critics have voiced concerns that the UK ETS is not sufficiently ambitious to reflect the UK’s emissions or the additional carbon price signals which would help drive the decarbonisation agenda and help the UK meet its net zero target by 2050.

An opportunity to change the scale of ambition may be provided in September when the Committee on Climate Change is due to publish the Sixth Carbon budget (covering 2033 to 2037) and provide advice on the UK ETS cap. Representatives of the UK Government and all devolved administrations have confirmed to the Committee on Climate Change that once they have their advice on the Sixth Carbon Budget, they will consider this again immediately. Noting that “Our response therefore commits us to a second stage

during which we will swiftly consult on an appropriate net zero consistent trajectory for the cap for Phase I of the UK ETS within nine months of your advice being published. We will commit to implementing any changes by January 2023 if possible, and certainly no later than January 2024.”

Finally, the Government has confirmed that it will publish a further consultation in 2020 on a Carbon Emission Tax as an alternative to the UK ETS. Please see our earlier comments here on what the Carbon Emission Tax proposal may be.