What does the future look like for emissions trading in the UK?

 Gavin Watson and Henrietta Worthington, partner and counsel at Pillsbury Winthrop Shaw Pittman LLP explain what the future of the UK’s emissions trading will look like.

Following the expiry of the transition period signifying the UK’s withdrawal from the EU, the UK has developed its own autonomous carbon emissions trading scheme (UK ETS) replacing the UK’s participation in the EU emissions trading scheme.

The UK ETS is governed by the Greenhouse Gas Emissions Trading Scheme Order (the ETS Order).

The new UK ETS signals the creation of a new financial market aimed at helping the UK to meet its emissions reductions goals under the Paris Agreement. An emissions trading scheme establishes a methodology to assign a value to greenhouse gas emissions. The ETS Order mandates that certain operators from specified industries (namely electricity generation, heat generation, industry and aviation) must participate in the UK ETS.

Participants are subject to a ‘cap and trade’ system under which a cap is set on the quantity of emissions permitted in each sector. This cap is gradually reduced over time, resulting in transparent emissions reductions. Participants may be entitled to certain allowances, which can also be purchased through government auctions, and which can be traded with other companies on the secondary market.

Participation in an ETS will not be new for most of the in-scope UK companies which were formerly operating in the EU ETS. To ensure a smooth transition to the UK system, many of the key characteristics are based on the existing EU system. For example, the regulated industries and the approach to free allocations mirror the current EU framework.

Global carbon markets

The UK and the EU have also expressed a firm intention to link their schemes. The EU-UK Trade and Cooperation Agreement included a commitment to ‘cooperate on carbon pricing…[and] give serious consideration to linking their respective carbon pricing systems’.

Switzerland became the first country to link its ETS to the EU ETS at the beginning of 2020. However, this approach is not without its challenges: the process took almost 10 years to complete. The EU ETS can be linked with other schemes provided that the linked ETS is mandatory, has an absolute emissions cap, and is compatible with the EU ETS. Whether the proposed linking of the UK and EU systems will be possible will therefore depend on the careful alignment of the parties’ respective regulatory frameworks and ETS infrastructures.

Similarly, in North America, the Californian ETS has been linked to the Québécois scheme since 2014. This was also briefly linked to the Ontarian ETS until the latter’s termination in 2018. Where the linking of schemes is possible there are tangible benefits with regard to pricing and efficiency.

Carbon markets are set for significant growth globally. 2021 has already seen significant developments in this sector, with China, the world’s largest emitter, announcing the launch of its ETS as a tool to meet its 2060 climate neutrality goal. There are currently 31 trading schemes in operation (or shortly to be in operation) around the world.

There have also been increasing calls to develop voluntary carbon markets. In January, the Taskforce on Scaling Voluntary Carbon Markets (TSVCM) published a report detailing its findings following a public consultation. The report includes 20 recommended actions and a roadmap to deliver a ‘transparent, verifiable, and robust’ carbon market geared towards supporting the movement of capital to meet global climate goals.

The potential of the UK ETS

Notwithstanding the possibility of future links, the ETS Order has been hailed in the UK for providing the scope and flexibility for the system to evolve over time. This may involve straying from the EU model. The UK ETS is designed to be a robust market within a framework that promotes expansion and innovation.

On the 14th December 2020, the UK government published its Energy White Paper which affirmed the UK’s intention to expand the scope of the UK ETS to include two-thirds of the UK’s emissions which currently fall outside of its remit. On the 19th January, the European Commission published a strategy for the development of its financial market infrastructure, which identified the maritime sector for inclusion in its ETS. It is likely that the UK will follow suit.

In addition to expanding its industry coverage, discussions are underway as to how the UK ETS can be used to incentivise the development of emissions reduction technologies.

The leaders of the TSVCM have also highlighted the critical role of carbon markets in mobilising the private sector to invest in removal technologies and measures. The TSVCM is a strong advocate of coalescing the evolution of emissions trading with the funding of innovation activities in order to achieve climate goals. The government’s White Paper confirms that the UK will investigate “how the UK ETS could incentivise the deployment of greenhouse gas removal technologies”.

Conclusion

Trading schemes are a cost-effective and transparent way to reduce emissions and support the drive towards a zero-carbon economy. This is a developing sector, and the landscape will undoubtedly expand and mature over the coming years.

The UK has been a self-proclaimed ‘pioneer’ in emissions trading since 2002 and looks set to continue playing a leading role. There are compelling arguments for global collaboration, however, the UK also has ability to shape its own autonomous emissions trading future. It has developed a framework which can be refined and will likely provide sufficient flexibility to remain at the forefront of this evolving industry.

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