The UK was the first country in the world to introduce a national carbon market, launching its pioneering Emissions Trading System (ETS) in 2002. Three years later, the EU followed suit with its ETS, into which the UK system was absorbed. The EU ETS remains the worlds largest carbon market and is at the centre of the blocs response to climate change.

However, just weeks before the post-Brexit transition period ends and the UK is no longer governed by EU rules, the 1,000 or so British companies that are subject to the emissions cap imposed by the EU ETS have no clarity as to what regime they will face from 1 January – or, indeed, whether carbon trading will be abandoned altogether in favour of a carbon tax.

An activist waves a combination of the Union and the EU flags near the Houses of Parliament in central London on 10 April 2019.  (Photo by Tolga Akmen/AFP via Getty Images)

Under any scenario, the UK will no longer be part of the EU ETS from 1 January,” says Kerry Liebenberg, counsel at law firm Linklaters. There is great concern among industry that we are six weeks away from that deadline, and many elements are not clear, or even whether we will have a scheme.”

She adds: “It is very difficult for UK industry to plan ahead, to have their systems ready, or to hedge effectively. It is a problem.”

Three options

As of early November, three options were on the table: a UK ETS that is linked to the EUs carbon market; a stand-alone UK ETS; or a carbon tax levied on each tonne of carbon emissions instead of a trading scheme.

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Everyone wants a linked ETS,” says Adam Berman, head of EU policy at the International Emissions Trading Association (IETA). It makes both markets more efficient and, providing there is broad alignment between the emissions targets set within the two systems, it helps ensure a level playing field between the UK and EU economies.

But, for a host of political and technical reasons, that isnt going to happen before 1 January,” he adds. That is because the European Commission has said it will not begin negotiations on linking the EU ETS until a UK ETS is in place.

India Redrup, policy manager at trade association Energy UK, agrees. We are under no illusion we will have a linked system by 1 January 2021,” she says. That is a real pity because we were hopeful there would be a smooth transition from the EU ETS.”

In June, the UK Department for Business, Energy & Industrial Strategy (BEIS) unveiled rules for a UK ETS that would closely track existing arrangements under the EU ETS. These rules, which would govern either a linked or a stand-alone system, have progressed through parliament and are ready to be signed into law.

While the BEIS was developing its proposals, the UK Treasury was proposing a carbon tax as an alternative. It was initially framed as a fall backmechanism that could be deployed if agreement with the EU on linking was not forthcoming, or if the creation of a UK ETS was otherwise delayed. That was subject to a consultation that ran to the end of September; the results have not yet been published.

Speaking to a parliamentary committee on 12 November, Kwasi Kwarteng, Minister for Business, Energy and Clean Growth, said a decision between the three will depend on talks with Brussels over a UK-EU post-Brexit trade deal.

Those negotiations will substantially determine what our carbon pricing position is,” he said, adding that a carbon tax has not been removed from the table”.

Energy access

The uncertainty over what will happen to the UKs main tool for fighting climate change comes in the context of another uncertainty that’s become a main factor in the negotiations – access to the EUs energy market.

If the UK leaves the EU single market with no deal at the end of the year, it will also lose access to Europes single energy market. At least €6bn of trading in gas and electricity is at stake, shows research by Bruegel, a Brussels-based think tank. Electricity markets are most vulnerable since the UK is a net importer of electricity.

The EU has offered the UK continued access to its energy market as part of a post-Brexit free trade deal. However, if no deal is reached, it would mean that the two markets diverge, making trading more difficult. “For day-ahead prices, which is one set of prices, the UK would be decoupled,” says Severine Turgis, Brexit policy manager at Energy UK. “So you would have to book your capacity and volume separately, it’s two operations instead of one, so the outcome is that the trading would be less efficient.” A report by UCL European Institute concluded the cost for British consumers could be up to £2bn a year in energy costs.

Simone Tagliapietra, a Bruegel research fellow, says the costs of the lost efficiency will be much more significant for the UK because the continental market is well integrated and the gas imports from the UK to the continent shouldn’t be majorly affected. However, the effects on Ireland, which imports 56% of its gas consumption from the UK, could be severe. “The UK might only conduct tariff-free export and import of bulk electricity, like Russia or Morocco,” he says. Hence the UK would opt out of the joint optimisation of the linked systems, which would imply substantial efficiency losses, especially in the long term.”

The UK side believes these claims, which were recently highlighted by French President Emmanuel Macron and are being used to push the UK to make concessions on fisheries, are being exaggerated, and are based on an unlikely worst-case scenario. The British government says it is ready to continue energy trading on 1 January in a no-deal scenario.

Depending on the outcome of free trade agreement negotiations, alternative trading arrangements will need to be developed, including for trade between Great Britain and the Single Electricity Market through interconnectors,” the government said in a statement. Itwill continue to work as normal with regulators and transmission system operators to ensure existing measures are in place to deliver continuity of supply in all scenarios. Consumers need to take no action, but – depending on the outcome of FTA negotiations – trade on interconnectors may be less efficient.

The worry is that those alternative trading arrangements are not being developed. “This wouldn’t affect security of supply,” says Turgis. “But energy companies are in the same boat as everyone else in terms of what they’re worried about, which is wider disruption in terms of the system.” The uncertainty over emissions trading, she says, is actually more worrying to energy companies despite the ETS not featuring heavily in the negotiations.

And though UK Prime Minister Boris Johnson is expected to unveil a ten-point climate action plan this week, it is not expected to address the two biggest worries of carbon trading and energy market access.

Preference for ETS

Businesses would, in general, prefer to keep the status quo, sticking with carbon trading and access to the EU energy market. For many businesses, carbon trading is greatly preferred to a carbon tax because it typically offers more flexibility, allowing emitters to, for example, borrow allowances from future years if they need to ramp up production. Conversely, it can provide a financial incentive to reduce emissions more quickly and sell surplus allowances.

Crucially, an ETS imposes an overall cap on emissions, ensuring the environmental objective is met. Under a carbon tax, emitters can, in theory, emit as much as they wish, as long as they pay the levy. The grave shortfall of a carbon tax is that it doesnt reduce emissions,” says Leibenberg. That will have impacts on our net-zero target.”

There are also concerns a carbon tax could become a political football, tinkered with in each budget, with governments tempted either to hike it up to raise revenue or to give emitting sectors a free pass over concerns about jobs or competitiveness.

Berman at the IETA describes both the tax and the stand-alone scheme as less optimal than a linked system, but says the UK ETS proposed by the BEIS cleaves closely to existing arrangements under the EU ETS.

The proposed UK ETS sets a marginally tighter cap than the EU ETS – proposing an overall target that is 5% lower than that in the EU ETSs 2021–30 phase. However, given UK emitters’ relatively aggressive emission reductions to date, that tighter target is unlikely to prove a stretch.

A greater concern is how UK ETS targets are brought in line with the UKs longer-term target of net-zero emissions by 2050, says Fiona Ross, a senior associate at law firm Pinsent Masons. Following a planned consultation in 2021, it is anticipated that the cap would be brought into alignment with the UK’s net-zero trajectory by 2023 – potentially leading to a sharp downwards correction to UK ETS targets.

However, the most pressing concern is the potential for price spikes in an isolated UK market. The smaller a market, the more vulnerable it is to price volatility, and the inability of UK emitters to trade allowances across Europe risks sharp gyrations in pricing, warn market participants.

The UK should not attempt to set up a stand-alone carbon market,” warned climate think tank Ember in a recent report. There is a significant risk that this market would not be functional, condemned to high volatility, and plagued by speculators. The UK has declared a climate emergency – we cannot afford a decade of weak green investment due to low or highly volatile carbon prices.”

Prices in the wider EU ETS have been volatile since it was set up. After rising to almost €30/tonne of carbon dioxide early in its second phase (which ran from 2008–12), they collapsed in the wake of the 2008 global financial crisis, as weak economic growth reduced emissions and therefore demand for allowances. After years with prices in the doldrums, the European Commission acted to mop up excess supply in the market, setting the stage for recovering prices since 2018.

However, there are real concerns a UK ETS could be dysfunctional at launch, warns emissions trading veteran Louis Redshaw, CEO of advisory firm Redshaw Advisors. Most electricity companies tend to hedge their electricity sales – and the associated inputs – three years ahead, locking in their margins, he says. That means they will have sold their anticipated power generation forward and bought the coal or gas and the allowances they expect to need. On day one of a UK system, UK utilities will want to sell their EU allowances and replace them with UK ETS equivalents – creating massive immediate demand.

If you have got utilities chasing after every single UK allowance, and industry doing the same, the price is going to go through the roof,” he says.

The BEIS has proposed a cost-containment mechanism, by which the government could supply additional allowances into the system, but Redshaw does not believe it would be fit for purpose. Redrup at Energy UK adds that the BEIS is only proposing to run allowance auctions at some point in the second quarter of 2021, leaving a period of significant uncertainty.

Given this, Energy UK has expressed highly qualified” support for a carbon tax on a transitional basis over a stand-alone system, says Redrup. Both a tax and a stand-alone scheme are suboptimal,” she says, but the association would slightly favour” a tax on a short-term basis, given that it would offer more predictability than a UK-only trading system.

The end goal must be a linked scheme,” she stresses, adding there is no reason that negotiations with the EU to link the two markets couldnt continue with a temporary tax in place.

Given the inefficiencies involved, Redshaw regards a UK stand-alone system as highly unlikely. He believes the EU and the UK will reach a speedy agreement on linking, or the UK will introduce a transitional carbon tax. Either way, or even if there is a stand-alone scheme, he is advising his clients to use EU allowances to hedge their exposures ahead of any certainty.

However, he is keeping his fingers crossed for a broader deal with Brussels. Our view is that a linked UK-EU ETS is likely if there is a trade deal – and the election of Joe Biden in the US makes that more likely,” he says. “The UK is under more pressure to get a deal.”

However, adds Ross at Pinsent Masons, there is not a lot that emitters can do to manage uncertainty.

It is pretty difficult until there is a decision on it… As things currently stand, we still dont know if there will be a UK ETS, a carbon tax will be brought in, or whether there will be a transitional period,” she says. “Clarity is needed before firm steps can be taken.”