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17 November 2021

UK emitters rue splendid isolation from EU ETS

The UK Emissions Trading System may have confounded the worst predictions ahead of its launch – but market dislocation could be just around the corner.

By Mark Nicholls

In most markets, bigger is better. The greater the pool of liquidity, the easier it is for a buyer to find a seller, and the more efficient price discovery and trading tend to be. Hence the dismay from the roughly 1,000 UK-based greenhouse gas emitters when the government announced at the start of this year that its post-Brexit emissions trading system, the UK ETS, would not be linked to the existing EU ETS – which, before the launch in July of China’s ETS, was the world’s largest emissions market.

Those concerns, allied to delays in announcing the UK ETS rules, and the need for emitters to access millions of allowances to allow them to hedge future emissions, led to dire warnings of extreme volatility and market shocks.

Sun rising over the centre of Drax power station, Drax, North Yorkshire, England. (Photo by Phil Silverman via Shutterstock)

The worst of these have not come to pass. “Predictions that the system would collapse have not been borne out,” says Adam Berman, head of European policy at the International Emissions Trading Association (IETA).

System collapse is a low bar, however. In September and October, as a shortage of natural gas plunged the EU and the UK into an energy crisis, prices of UK Allowances (UKAs) hit a record £75.50 per tonne (t) of CO2 equivalent, some £20 higher than equivalent EU Allowances (EUAs) at the time.

As utilities cranked-up carbon-intensive coal generation and scrambled to find UKAs to account for the higher emissions, “the market spiked on the back of very limited liquidity and a lack of the offer side in the secondary market”, says Tim Atkinson, director of sales and structuring at CF Partners, a London-based provider of energy, environmental and commodity risk management for industrial and commercial clients.

Immature and volatile

“Divergence in the two markets is undoubtedly linked to the immature nature of the UK ETS, which is a smaller scheme [than the EU ETS] and is therefore susceptible to greater volatility,” says Luke Ansell, an analyst at energy consultancy Cornwall Insight. He notes that daily price swings in the UK ETS have reached £8.00/t. The standard deviation of the average daily UK ETS price in September was approximately four times that of EUA prices, he added.

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The problem, explains Atkinson, is both that the UK market is structurally short of allowances by design, and that it lacks the pool of available allowances that has built up in the EU ETS over time. In the EU, more than one billion EUAs are in circulation. Most of these are in the hands of industrial emitters, which have received free allowances and are stockpiling them as free allocations decline and targets tighten. Nevertheless, some of them can be sold to soften price spikes.

In the UK, in contrast, only 68 million UK allowances have been auctioned since the system was created, in addition to nearly 40 million free allowances issued to operators in May.

“The majority of industrial operators will be buyers, and utilities are also mainly purchasing UKAs because they have only just started to hedge future power sales,” says Atkinson. “In addition, unlike the EU market, we don’t really have any speculators in the UK market yet who may be looking to unwind positions and sell.

“Basically, there is one natural seller in the market, and that is the UK government through the auctions.” 

Compliance deadline poses risk

Liquidity problems could worsen in early 2022, ahead of the first compliance deadline at the end of April. Emitters are calling for the UK government to front-load next year’s auctions to ensure adequate allowances are available.

There is also potential for the UK government to increase supply to the market through the UK ETS's cost containment mechanism (CCM). For 2021, this is triggered if average UKA prices are more than double the average of UKAs (or, before that, EUAs) for the prior two years, for three consecutive months. (From 2022, the threshold gets higher and the trigger period longer, making the CCM harder to trigger.) If the CCM is triggered, the regulator has discretion to take one of a number of actions to increase allowance supply – or take no action at all. “There is no set process of how this will work,” says Atkinson. 

He adds that the design of the market means there is no quick fix for the lack of liquidity – apart from linking the UK system to its European equivalent. Such a link “is still very much an industry ask”, says Kisha Couchman, senior policy manager at the industry lobby group Energy UK. Emitters on both sides of the channel remain “very positive on linking”, she says, as is the European Commission. However, “there are no expectations that it is going to happen in the immediate future”, given the lack of political will in the UK and current poor relations between London and Brussels.

Berman at the IETA says there is a strong case for linkage. The EU’s current thinking around its proposed Carbon Border Adjustment Mechanism would only exempt linked emissions trading systems. Unlinked systems create a regulatory border between Northern Ireland and the Irish Republic.

He adds that, while there are informal discussions between UK and EU officials, those conversations cannot progress until the political dynamics change. Should that happen, progress could be swift. “I see no reason why the necessary technical negotiations couldn’t be completed within six months or a year, given how similar the systems are,” he says.

UK eyes carbon removal credits

The prospects for linking do, however, raise questions over an eye-catching proposal in the UK’s recently unveiled net-zero strategy. That suggested the UK ETS could be used to incentivise investment in greenhouse gas removal (GGR) technologies, such as direct air capture. The government is to launch a consultation on “the role the UK ETS could have as a potential long-term market for engineered or nature-based GGRs”. This will explore possible eligibility criteria for participation in the UK ETS, different types of market design, and timings for when GGRs could be added to the market.

This proposal, says Berman, shows “confidence from the government that the ETS is the right tool” to help drive the UK’s decarbonisation. He also notes it is important to begin talking now about how an ETS will operate in future decades when economies are substantially decarbonised.

“What [UK] policymakers are seeing is the possibility of creating a system with a longer-term trajectory, that achieves not absolute zero but net zero, and incentivises removals as part of that,” he says. The EU is thinking along similar lines, Berman adds, but the UK is slightly further down the road.

Atkinson, however, is more cautious. He notes that any divergence in rules on the use of GGR credits between the UK ETS and the EU ETS would make linkage more problematic.

Six months into the operation of the UK ETS, emitters remain frustrated about low liquidity and the implications of paying a higher carbon price than their EU competitors. However, in the absence of full-blown crisis and with little appetite in the UK government to mend fences with the EU, there is little prospect of them benefitting from the economies of scale that a reintegration with the EU ETS would deliver.

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