Recent changes to the UK emissions trading system (ETS) diverge from the EU ETS, but what are the implications?
While EU ETS and UK ETS allowances have previously traded near parity, since March 2023 the UK ETS has consistently traded at a discount compared to its EU equivalent. The gap widened in July 2023, when the UK Government set an emissions cap that was higher than anticipated and offered more free allowances to carbon intensive industries. In September 2023, prices under the UK ETS fell to their lowest ever level at around €40 (£34) per tonne, while the EU ETS was trading near €84 (£73).
The price disparity between the UK and EU ETS could lead to a carbon ‘tax’ for UK manufacturers exporting to the EU under the new Carbon Border Adjustment Mechanism (CBAM) regime. This is because under the CBAM, imports of certain goods into the EU will be subject to a carbon levy from 2026 unless the states of origin have an equivalent carbon price in place.
EU importers of the relevant goods covered by the CBAM must register with Member State authorities. Following the registration, they can purchase CBAM certificates which are priced based on weekly EU ETS allowances. When goods are imported into the EU, the importers must declare the emissions embedded in the imports and surrender the corresponding number of certificates annually. However, if the importers can prove that (some) carbon price has already been paid during the production of the imported goods, that amount can be deducted from the total amount of emissions. A lower carbon footprint of imports will result in a lower CBAM debt.
When UK goods are exported to the EU, the cost of UK ETS allowances embedded in the production will be deductible from the overall CBAM obligation. However, the devaluation of the UK ETS allowances could mean that UK participants pay less to the UK Treasury when purchasing allowances but have to surrender their saving to the EU Commission in CBAM charges; thus transferring receipts to the EU without any benefit to the UK exporters.
The UK government is seemingly aware of this and has consulted on introduction of the UK CBAM earlier this year. It was expected that this measure would be introduced in the Autumn Policy Statement, however, the Chancellor only mentioned UK CBAM in passing.
In any event, the obligations under CBAM will only kick-in in 2026. That gives UK policy makers two years to strengthen the UK ETS relative to the EU ETS or work on a national CBAM policy.
Phase out of free allocations:
Under the EU ETS, some sectors continue to receive 30% of free allocations. However, no free allocations will be available after 2026. Also, the CBAM will phase in from 2026-2034, replacing free allowances for carbon leakage sectors that currently get 100% of free allocations.
The UK Government is reviewing its free allocation policy to better support sectors at risk of carbon leakage, but no changes to free allocations are planned until 2026.
Divergence in Scope:
The UK ETS is expanding to include domestic maritime emissions, similar to the intra-EU now within the scope of the EU regime – but the UK is not as yet proposing to expand the UK ETS to also include international voyages to and from the UK. Also, the EU’s timeline is two years ahead, requiring allowances for 40% of emissions from 2024, increasing to 100% by 2026.
Both the EU and UK ETS are phasing out free allowances for aviation by 2026, but the EU is ahead in considering aviation greenhouse gas emissions other than carbon dioxide and has a more advanced Sustainable Aviation Fuel policy.
The EU ETS also plans to cover ‘EU ETS II’ emissions from fuel used in buildings and road transport from 2027, a move not mirrored in the UK.
While the UK ETS did not immediately diverge much from the EU ETS following Brexit, the schemes have now started to drift apart in certain respects. This divergence may have significant impact on UK manufacturers exporting to the EU if they become subject to the requirement to buy EU CBAM certificates. Linking the UK and EU emissions trading systems together, a possibility the UK government remains open to, may solve this issue. Whether there would be any incentive for the EU to agree to such a request is another story.