UK Emissions Trading Scheme Consultations

In December 2023, the United Kingdom's Department for Energy Security and Net Zero ("DESNZ") launched two consultations to garner views on the efficient operation of the UK's Emissions Trading Scheme ("ETS").

Post Brexit, following the UK's withdrawal from the EU ETS, the UK ETS commenced in January 2021, so as to replicate for UK participants the main elements of EU ETS. It operates on a similar basis to the EU scheme so as to help the UK to achieve its international net zero commitments. As a cap-and-trade scheme, it seeks to reduce greenhouse gas emissions by requiring operators in certain energy-intensive sectors (including manufacturing, power stations, and aviation) to surrender an equal number of emission allowances as the total emissions incurred by such operators for that year. Some allowances are allocated for free, while others are purchased at auction or through the secondary market. Currently, scheme participants are required to obtain alowances for every unit of carbon they emit. These allowances are then traded between participants, generating a carbon price. The UK ETS runs in allocation periods, with the next one being 2026-2030. 

UK ETS: Free Allocation Review

The first of the consultations relates to a review of the free allocation of allowances to participants. Free allocation is the main policy tool to address the risk of carbon leakage, i.e., the risk that production and associated emissions of operators is shifted from one country to another due to varying carbon pricing and climate change policies across jurisdictions. The free allocation policy under the UK ETS addresses carbon leakage by reducing a firm's exposure to the carbon price. 

The UK ETS Authority is seeking views on proposals to alter the free allocation methodology for the stationary sectors to better target those most at risk of carbon leakage and to ensure that free allocations are fairly distributed. 

There are four principal areas of focus:  

• How to account for emissions and activity: A dynamic allocation is proposed whereby free allowances at the start of the scheme would be provisional, and subsequently adjusted after the end of each year of the scheme to reflect recent activity levels. This means the free allocation provision would reflect actual activity levels for every scheme year.
• Benchmarks: It is proposed tht the existing benchmarks should be updated based on UK installation data to account for improvements in efficiencies achieved by the industrial sectors. 
• The Carbon Leakage List ("CLL"): The CLL is a list of sectors deemed to be at risk of carbon leakage. The UK ETS Authority is considering the best data set to use to produce the CLL, namely whether it should continue to be calculated on the basis of emissions intensity and trade intensity, or whether other factors should be included. 
• Additional factors: The UK ETS Authority has also considered additional factors that could be introduced to the free allocation methodology; in particular, the availability of decarbonization technology and adding further conditionality to the provision of free allocations. 

UK ETS: Future Markets Policy

The second of the consultations relates to a review of the UK ETS market policy, as the UK ETS Authority wants to ensure that it remains fit for purpose and is effective in managing the risks faced by an established and maturing scheme. The aim is to help maintain stable and effective market conditions that will continue to incentivize decarbonization in the traded sector. Currently the UK ETS features two market stability mechanisms: (i) the Auction Reserve Price ("ARP"), which currently sets a minimum price of £22 per emissions allowance; and (ii) the Cost Containment Mechanism ("CCM") that is triggered if current prices are elevated for a sustained period relative to a historic average. 

In particular, the consultation focuses on: 

• Whether the UK ETS Authority has identified the most significant risks to effective market functioning; 
• The suitability of different policy options to address the risks identified; and 
• How individual market stability policies should be designed to most effectively address market risks while minimizing intervention and disruption in the market. 

The following proposals have been made in the consultation paper: 

• The implementation of a quantity-triggered supply adjustment mechanism to address the risk of demand shift with long-term impacts in the market; and
• The retention of the ARP and the CCM to mitigate the risk of sudden, significant, and sustained price decreases or increases. 

The proposals contained in these two consultations are likely to have a significant impact on the less efficient carbon emitter participants, in particular ones who may have been over-reliant on free allowances. The consultations are due to close in March 2024, with the UK ETS Authority aiming to publish a response later this year.

Read the full Climate Report.