UK carbon trading goes solo for now

The ending of the 11-month transition period following the UK’s formal withdrawal from the European Union early last year means it now must decide how to manage its emissions trading. A high price is necessary to pay for carbon mitigation schemes such as carbon capture and storage but the market itself needs to be orderly to ensure trade.

Since January 1 there have been an EU ETS and a UK ETS but while notionally separated, including the currency the certificates trade in, the two for now have the same terms and conditions. 

Set up in 2005 with the involvement of the then EU member UK, the EU scheme sets limits on the total greenhouse gas emissions across heavy industrial processes and power stations and other sectors. Progressively fewer allowances are given away over time, leading to a market developing where those short can buy from those long or change their processes.

This latter category should favour gas generators over coal, but governments in countries with high coal and lignite dependency have been slow to grasp the thistle for political reasons even while subsidising renewable energy. So ETS certificate prices were slow to rise in price.

The last UK coal-fired plants are to close no later than 2025 and even on the coldest days when there is almost no wind or sun, coal-fired plant accounts for only a few percent of the UK power mix. By contrast Germany has set the deadline of 2038 and burns coal and the even dirtier lignite instead of typically more expensive gas.

But in the last six months the price of the certificates has rocketed, as emissions have to fall. The market has also been a new speculative play for investors.

Stitching back together

In theory the UK and EU markets can be stitched back together again, but the longer it takes to do so, the greater the divergences may become. For example, the UK has set more ambitious carbon reduction targets than the EU, meaning the certificates should become scarcer sooner and so more expensive.

The UK in late 2020 set a CO₂ emissions reduction target of 68% by 2030 compared with 1990 levels, which overshoots the recently agreed EU target of 55% CO₂ reductions. But the EU is also revising its own allowances following its own plans to go faster towards net zero carbon.

The Trade & Co-operation Agreement (TCA) that two signed in a late-December 2020 rush, and which has already shown signs of strain between the counterparties in the Irish Sea, makes clear that both parties will have their own effective systems of carbon pricing in place to help fulfil respective climate goals. The two sides have agreed to co-operate on carbon pricing, including the possibility of linking the EU and UK ETS.

The European Federation of Energy Traders stressed in April that the EU and the UK “should 'seriously consider' linking their emissions trading systems” and such talks should begin “as a matter of urgency.”

The UK government has not yet decided which approach to take, however. The Department for Business, Energy and Industrial Strategy told NGW April 13 that its own scheme “is even more ambitious than the EU system it replaces, with the day one cap on emissions allowed within the system reduced by 5% – a crucial step towards achieving the UK's target for eliminating our contribution to climate change by 2050.”

The spokesman said also that international co-operation on carbon pricing and carbon markets can play an important role in cutting emissions in the most cost-effective way. This explains why “the UK is open to linking the ETS internationally in principle and we are considering a range of collaborative options…. We are considering a range of options but no decision on our preferred linking partners has yet been made.”

With so much at stake, the first UK auctions will be watched closely. The UK ETS went live on 1 January 2021 but UK ETS auctions and the secondary market will launch on May 19.

Having two separate markets means a drop in liquidity in both and in turn, an increase in volatility particularly in the smaller UK market. This means traders cannot exit or enter positions as fast and at the price they would like and will have a bumpier ride while holding the certificates.

The lead on carbon markets at UK consultancy Cornwall Insights, Tim Dixon, commenting on the likelihood of higher volatility, told NGW: “Prices will be more impacted by prevailing conditions in GB such as weather, demand, the generation mix, and plant outages.”

However, given that the design follows the EU design, initially at least, the UK ETS auctions have somewhat been expected to follow EU ETS, he said, with many participants in GB reported to have been hedging using EU ETS allowances.

The UK ETS auctions have been designed so that not all the allowances have to be sold for the auction to 'clear', helping allowances to flow into the market more smoothly, further supporting the liquidity of the market.

“It will be interesting to see if any stability measures are needed in the first few months, for example cost containment mechanism, the market stability mechanism account, or the auction reserve price,” he said.

Fieldfisher partners comment on the situation

The UK had been considering a number of options for limiting carbon emissions in order to achieve its planned level of cuts, partners at the European law firm Fieldfisher, David Haverbeke and Hugo Lidbetter, told NGW in April.

This included a carbon tax and also setting up a scheme of its own. But in the end, under the pressure of time to agree the TCA in late 2020, it more or less replicated the EU ETS, so allowing itself the chance to go back to the specifics later on and to modify them, and to preserve the option of linking the UK ETS with the EU ETS. Both sides are under an obligation to consider this as part of the TCA.

Now the two schemes are, as a result of that decision (and at least for the time being), very closely matched in terms of their scope and their applicability to industrial sectors: aviation, energy-intensive industry such as steel and chemicals; and power generation. They also have the same review periods and the same approach to determining free allowances.

So the architecture is the same, should the EU and UK want to link them. One difference is the UK has set an auction reserve price, which it introduced to maintain the integrity of the auction in the early years. It wants to keep the price meaningful  and it is slightly more ambitious in its reduction goals than the EU (with the initial cap being 5% lower than the UK's notional share of the EU's Phase IV target). The UK intends to harmonise its overall cap with the independent Committee for Climate Change’s advice on a net-zero compatible emissions reduction trajectory.

So for the immediate future, they can be treated as equivalent instruments. The first auctions of the UK ETS start in May and while there is considerable uncertainty, it is possible that they will go for a similar price (in phase 1) as the EU ETS certificates are going for now in their phase 4 (2021-2030) which happens now to be around €40/metric ton (which is unusually high for EU ETS allowances). The annual EU certificate reduction will go up to 2.2%/yr from 1.74% now.

Power plants with output below a rated thermal input of 20 MW remain carved out of the scheme as to include them would be administratively burdensome and also risk carbon leakage. If they were to be included, together with farming and agriculture, which also remain outside the scheme owing to the complexity of calculating their emissions, then the two schemes would diverge further too, the partners said.

Once the UK government begins to amend or change in any way the quotas or the scope of its own scheme, then it will become harder to measure the degree of equivalence between the two. Both schemes rely on a diminishing cap/number of certificates over time to drive down emissions and the pace may vary between the two. The registries will have to be set up to manage different currencies, although that extends to other areas than CO2, but the actual specifications of the two certificates will diverge as the terms and conditions behind each of the two schemes change.

The EU ETS does have very high visibility, and there are also in 2023 and 2028 the chance for the two sides to compare notes once more.

Investors might be worried about the size of the UK market, as that implies volatility in price. The best way to limit that could be to link the two. There are perhaps not at the moment strong drivers for prices to differ much between the two schemes, although that could feasibly change over the time if the UK ETS develops on a different course from the EU ETS.

There is a precedent for EU regulatory instruments being compatible with regulations in third countries, such as Guarantees of Origin, which are mutually recognised by the EU and non-member states Norway and Switzerland. These label electricity that has come from renewable sources, to provide information to electricity customers on where their power has come from. Something similar would be  needed with the EU ETS and the UK ETS in order to ensure equivalence, they said.