At the end of March, the UK Government published its long-awaited consultation on the further development of the UK ETS (the “Consultation“), indicating the future capacity and scope of the UK scheme. The UK ETS was launched on 1 January 2021 to replace Great Britain’s participation in the EU ETS after the end of the Brexit transition period and has been so far closely aligned to the EU ETS. The goal of the Consultation is to make the UK ETS the world’s first net-zero consistent cap and trade market, and ensure it plays a crucial role towards achieving the UK’s ambitious climate targets, including net-zero greenhouse gas emissions (“GHG”) by 2050.

The scheme is currently modelled on the EU ETS however it was more ambitious from the outset, having been established with a cap already 5% less than the UK’s notional share under the EU ETS Phase IV cap. Now, the UK Government is seeking to go even further to advance the UK ETS and expand its scope independently of the EU ETS.

Key proposed changes include:

  1. A net-zero consistent cap;
  2. Resetting the industry cap on free allocations;
  3. Bringing more unallocated allowances and/or flexible share to market;
  4. A comprehensive review of the drivers of UK ETS market conditions and policy;
  5. Phasing out free allocations for the aviation sector;
  6. Expanding the UK ETS scope of regulated activities within covered sectors (including upstream oil and gas); and
  7. Expanding the UK ETS to include previously uncovered sectors.

1. Net-zero consistent cap

The Consultation clarifies that the scheme will have a net-zero consistent cap from 2024, to be achieved by a cap of between 887 million and 936 million allowances for the entire Phase 1 (2021-30). The UK Government is currently minded to set the cap towards the higher end of the range to reduce the short-term pressure on allowances in the traded sector, allow for uncertainty over exact emissions savings across participating sectors, and smooth the transition to net-zero. A significant drop in allowances reaching the market in 2024 will be needed to implement the net-zero consistent cap, with the cap reducing over the Phase and an annual cap of around 50 million allowances in 2030.

2. Free allocation review

Free allocations (“FAs”) are the main instrument for addressing carbon leakage in the UK ETS. The government launched a FA review last year with a call for evidence in Spring 2021. The review will now be conducted in two phases. The first will look at aligning the share of free allocation with the net-zero cap and changes will be implemented by 2024. The second will focus on the distribution methodology and any changes that will be implemented by 2026.

  1. Free allocations in the context of a net-zero consistent cap

The industry cap indicates the upper bound on free allocations that can be issued each scheme year. As the overall cap tightens to align with net-zero targets, fewer allowances will be available each year over Phase 1.

If no change is made to the industry cap, then over Phase 1 the industry cap will remain higher than the number of free allocations published in the Allocation Table, restricting the number of allowances that can enter the market via auction or be freely allocated. FA will make up a larger share of the overall cap, restricting the steady injection of new allowances to the primary auction market, reducing liquidity, and impacting market function.

The UK Government is therefore minded to reset the industry cap to make up a percentage of the overall cap rather than being set at a fixed number, as in current legislation. This would result in the industry cap range falling below the level of free allocations and a cross-sectoral correcting factor (“CSCF”) applying to reduce each participant’s free allocations. Operators will be encouraged to decarbonise, the credibility of the UK ETS will be upheld, and market functioning and liquidity will be positively impacted

Whilst the CSCF could cause carbon leakage, the UK Government proposes reducing this risk by using its reserve of unallocated allowances or the flexible share to mitigate against any reduction to free allowances over Phase 1.

They will also consult on changes to Free Allocation Policy and its alignment with the Net Zero target no later than the end of 2023 and will implement changes to take effect by 2026.

  1. Free allocation technical changes

The Consultation proposes a number of changes to the Activity Level Changes Regulation (“ACLR”), the current instrument by which operator’s free allocation is calculated, to address issues that have a significant impact in the first years of free allowance allocation for various subsets of operators. These include amending the ACLR to:

  • account for reduced activity levels during the 2020 covid year by excluding the year from calculations;
  • treat existing sub-installations in the same way as new sub-installations when existing installations make investments to increase production capabilities;
  • bring UK benchmarks into UK ETS legislation, rather than relying on benchmarks adopted by the EU ETS;
  • amend the electricity generator definition to consider electricity exports in the baseline period, rather than electricity exports since 2005; and
  • amend the electricity generator classification to exclude installations that have produced electricity for sale to third parties.

3. Unallocated free allowances and the flexible share

Unallocated allowances arise when the number of free allowances is below the industry cap. There have been significant unallocated free allowances because the UK ETS industry cap was initially set at the UK’s notional share of the industry cap for Phase IV of the EU ETS despite UK operators being less production intensive than EU operators.

 

The Consultation sets out options for bringing unallocated allowances and the flexible share to the market and using them to mitigate against the application of a CSCF induced by resetting the industry capo (see above), smoothing the transition to a net-zero transition cap and supporting market liquidity. The retention of a portion of allowances to use for market stability purposes (see below) is suggested.

4. Call for evidence on potential drivers of market conditions

UK ETS auctions and secondary markets began in May 2021. The Consultation recognises the need to evolve UK ETS markets policy as the scheme develops and matures.

The UK Government has previously committed to consult on withdrawing the Auction Reserve Price, and the Consultation seeks views on its withdrawal, the timing, and whether it should be replaced.

The Consultation identifies issues that market policies can guard against and recognise the need to anticipate evolving future market conditions, and proposes five objectives for UK ETS markets policy in the coming years, centring around the identified issues of market stability, price fluctuation, liquidity, and market abuse. The feedback on these objectives will inform policy development down the line.

5. Aviation review

The Consultation summarises the call for evidence on aviation free allocation policy, as well as the economic research on the impacts of carbon pricing on the UK aviation sector. In light of these, the UK Government is considering withdrawing free allocation for the aviation sector faster than currently set out in UK law either via early, intermediate or later phase-out. It calls for further views on how sustainable fuels and the UK ETS will interact and considers consulting on bringing non-CO2 aviation emissions within the UK ETS.

6. Expanding UK ETS scope in covered sectors

The Consultation is considering possible changes to the rules for sectors currently covered by the UK ETS to ensure more GHG emissions are covered. The UK Government is consulting on expanding:

  • the upstream oil and gas sector to include CO2 venting and is calling for evidence on the inclusion of the remaining uncovered methane emissions from the sector and on the monitoring, reporting and verification of remaining GHG emissions.
  • The carbon capture, utilisation and storage sector to include in its scope the transport of CO2 through non-pipeline transport
  • The biomass sector to ensure that installations generating energy solely through biomass combustion will only be exempt from the ETS if they exclusively burn biomass that adheres to the relevant sustainability criteria.

7. Expanding UK ETS to new sectors

The Consultation proposes expanding the UK ETS to cover two new sectors. Firstly, it launches a consultation into bringing the domestic maritime sector within the scope of the scheme by the mid-2020s.

Secondly, the Consultation proposes a UK ETS expansion to cover waste incineration with no energy recovery, and energy from waste (EfW) by the mid-late 2020s. The starting proposition is that the ETS should cover the incineration of fossil material by all waste incinerators, placing an obligation on all operators of incinerators to comply with the UK ETS obligation for robust monitoring, reporting and verification (MRV) in relation to fossil waste only. The MRV obligations would be determined by both individual plant monitoring and using an estimate for the composition of waste (an emission factor).

The rationale for this proposal is to cause a reduction in emissions of the sector by incentivising energy from waste and EfW plants to supply heat, increase the recovery of residual waste in ways that lowers overall carbon emissions, and adopt decarbonisation technologies and practices. In addition, the UK ETS could also incentivise investment into CCS to reduce emissions from EfW, which would explain the UK Government’s decision in 2021 to include EfW within the UK’s Industrial Carbon Capture business model.

The UK Government is seeking views on whether other parts of the waste management system, such as landfill or wastewater, should be covered. It is also consulting on additional policies needed to support the UK ETS in decarbonising waste incineration and EfW, relating chiefly to CCS and recycling targets. For more information on the Consultation’s proposals in relation to EfW see our blogpost.

8. Call for evidence on GHG removals and agriculture and land use emissions.

The Consultation calls for early views on incorporating GHG removal into the UK ETS in the future and the MRV requirements needed to address GHG in the land and agriculture sectors. It emphasises this development is at an early stage, and that the UK Government does not propose extending the UK ETS to agriculture at this time.

Next steps

The Consultation closes on 17 June 2022 and responses will inform policy development. After reviewing responses and evidence, the final position will be published in the government response to this Consultation.

Silke Goldberg
Silke Goldberg
Partner, London
+44 20 7466 2612
Jannis Bille
Jannis Bille
Associate, London
+44 20 7466 6314