May 20, 2021 - Regulatory, United Kingdom

UK’s new emissions trading scheme hosts first auctions

Stephanie Pong, London trainee solicitor contributed to the writing of this article.

On January 1, 2021, the UK launched its very own emissions trading scheme (the “UK ETS”) exercising its autonomy since departing the EU. Under this scheme, companies operating in certain sectors can trade emission allowances (also known as carbon credits). On May 19, 2021, Intercontinental Exchange, Inc. (“ICE”) hosted the scheme’s first emission allowance auctions on behalf of the UK government.

The benefits of the scheme are twofold. Not only does it provide continuity from the UK’s participation in the EU’s equivalent emission trading scheme (the “EU ETS”), but it also focuses efforts to reach the UK’s goal of reducing all greenhouse gas emissions to net-zero by 2050 as announced in June 2019, and other carbon reduction commitments.

The UK ETS largely mirrors the EU ETS

Similar to the EU ETS, the UK ETS works on the cap and trade principle (i.e., market participants buy or receive emission allowances within the cap and then trade those allowances with other participants), which provides economic incentives for reducing industrial pollutant production.

Established through the Greenhouse Gas Emissions Trading Scheme Order 2020, the UK ETS currently covers the same industries as the EU ETS: 1) the power generation industry; 2) the aviation sector; and 3) other energy intensive industries. The UK government has, however, stated that it intends to expand the scope of the UK ETS to other sectors.

The first auction under the UK ETS took place on May 19, 2021, on ICE, which also hosts the EU ETS. On May 10, 2021, the UK government published guidance on the supply of allowances in the UK ETS (the “Guidance”). The Guidance clarified that auctions under the UK ETS will take place every two weeks, with around 83 million allowances (divided between the fortnightly auctions) predicted to be sold this year. For the 2021 auction calendar, please follow the link here. The 2022 auction calendar will be published by July 15, 2021, and the UK ETS Authority has anticipated 80 million allowances will be available for the 2022 period. The first auction saw all of the available allowances sold to 14 bidders, at a price of £43.99.

The Auctioning Regulations and guidance for UK ETS participants provide that the Auction Reserve Price (“ARP”) is £22 per tonne of carbon dioxide equivalent, which is the minimum price at which emission allowances can be sold at auction. The UK government will consider withdrawing the ARP later in 2021 as the scheme matures and certain amendments to the Auctioning Regulations, most notably the removal of the requirement that a natural person be established in the UK to submit, modify, or withdraw a bid under the UK ETS, have been made and came into force on May 19, 2021. Further, the UK’s implementation of the “monitor, report, and verify requirements” under the Carbon Offsetting and Reduction Scheme for International Aviation (“CORSIA”) comes into force on May 26, 2021, and the UK government will hold further consultations this summer on proposals for implementing CORSIA and its interaction with the UK ETS; further developments of the UK ETS are therefore expected over the coming year.

Certain sectors deemed to be exposed to a significant risk of “carbon leakage” receive free allowances. “Carbon leakage” refers to businesses transferring production to other countries with less stringent emission constraints, therefore leading to an increase in total emissions. The UK ETS uses the same benchmark to calculate free allocations as the EU ETS. The UK government closed its consultation in April 2021, which called for evidence on how to use its free allocations effectively under the UK ETS. The UK government published an allocation table setting out operators of stationary installations’ entitlement to free allowances for 2021‑25 and aims to have those under the scheme year 2021 allocated by May 28, 2021; the aviation allocation table is expected in June 2021. We expect to hear further related proposals later this year.

ICE UK Allowance (UKA) Futures

Coinciding with the start of the first UK ETS auction, and subject to regulatory approval, ICE plans to launch the ICE UK Allowance (“UKA”) Futures contracts, with UKA Daily Futures following on May 21, 2021. ICE UKA Futures will trade on ICE Futures Europe and clear at ICE Clear Europe alongside ICE’s global environmental complex, including European Union Allowances (“EUA”), California Carbon Allowances (“CCAs”), and California Carbon Offsets (“CCOs”). By facilitating trading in allowances through futures contracts, market participants may benefit from a more liquid market, improved price discovery, and the ability to sell or procure allowance on a forward basis and otherwise hedge market exposure.

The UK ETS is more ambitious than its EU counterpart

Although the UK ETS largely mirrors the EU ETS, one key difference is that the UK ETS has a more ambitious emissions reduction target. The UK’s initial cap on the total amount of certain greenhouse gases that can be emitted by the installations covered by the system (i.e., allowances) is 5% lower under the UK ETS than the UK’s share cap under the EU ETS. As the UK ETS has a smaller market than the EU ETS, a lower cap will help maintain market stability by limiting price spikes and aggressive price fluctuations. Further, the threshold for triggering the UK ETS cost containment mechanism, which would allow the UK government to intervene should price spikes occur, was set at £44.74 a tonne by the UK government on May 10, 2021. This is a lower threshold than that under the EU ETS. Future contracts traded as high as £50.23 a tonne on the first day, however this settled back to £45.75 after the first auction. The high prices were driven by high levels of interest in the first auction, and by a small number of bidders. The initial volatility is expected to settle over time, however there remain concerns that the UK government may need to step in within the first few weeks of the UK ETS’s launch.

New entrants to the UK ETS will need to ensure that they are accurately recorded on the new UK ETS registry. Further, a new permit system is expected to replace the current permit system, which was set up and managed in accordance with the EU ETS, in the near future.

Enforcement of obligations under the UK ETS will be carried out by the relevant UK environmental regulators with civil penalties of £100 per tonne for exceeding emission allowances, which is a slight increase from the €100 fine under the EU ETS.

The UK and EU ETSs will likely remain largely parallel

The EU-UK Trade and Co-operation Agreement (the “Agreement”) does not provide much wriggle room for the UK ETS to diverge significantly from the EU ETS. Under the Agreement, the EU and UK agreed that they are both committed to cooperate on carbon pricing. “Serious consideration” will be given to linking up the UK and EU schemes, similar to how the EU and Swiss schemes were linked in 2020. At present, aircraft operators, for instance, must comply with the UK ETS for flights from the UK to EEA countries, and the EU ETS for flights from EEA countries to the UK. Divergence of scheme rules will only make it more complex for market players to ensure compliance. Regardless, it is unlikely that the UK ETS will become substantially different, or less stringent, compared to the EU ETS, given the UK’s ambitious net zero 2050 target and 68% emission cuts by 2030, versus the EU’s 55% target.

The approach to carbon pricing was addressed in a briefing paper published by the House of Commons on May 4, 2021, which indicates the government’s preference to link the UK ETS with the EU ETS to ensure market liquidity and price visibility and to reduce the risk of carbon leakage. However, for this to be achievable, the two schemes must be closely aligned including both adopting net-zero targets. A risk of linking is that it may limit the policy autonomy that the UK has over its scheme in relation to governance arrangements and the proposed expansion of the UK ETS to other sectors. Alternatives suggested in the paper include having a standalone UK ETS or implementing a carbon tax.

Emission Trade Schemes around the world

United States

In contrast to the UK and EU, the United States lacks a nationalized carbon market. Rather, carbon trading in the United States takes place across a variety of fractured markets, with some being driven by voluntary private trading, and others by various government regulations.

Market drivers from the federal level include the recently updated 45Q tax credit for certain forms of carbon sequestration, and several programs administered by the U.S. Environmental Protection Agency.

A minority of states have also constructed state-level exchanges. These include the Cap-and-Trade Program in California, and the Regional Greenhouse Gas Initiative (RGGI), which is a cooperative effort between eleven eastern states (Connecticut, Delaware, Maine, Maryland, Massachusetts, New Hampshire, New Jersey, New York, Rhode Island, Vermont, and Virginia).

On the private side, organizations such as Verra and the American Carbon Registry operate their own voluntary registries. These private organizations also interact with the various regulatory markets by providing standards and quantifying and verifying carbon valuations. For instance, Verra helps administer California’s Cap-and-Trade Program.

Asia

Korea has the second largest in scale emission trade scheme (“ETS”), after the EU ETS, which was launched in 2015 and is also based on the cap and trade principle. This year, the scheme entered into its final phase (2021-2025), which further reduces the proportion of free allocations.

China, the world’s largest emitter of greenhouse gases, launched its national ETS on February 1, 2021. China’s ETS covers the power generation sector in its initial phase. Since August 2017, China has operated seven regional ETSs that will gradually transition into a single national scheme.

Similar to the United States, Japan does not have a nationalized carbon market; however, it was a pioneer in that the Tokyo metropolitan government launched the Tokyo ETS in 2010, which notably targets office buildings, educational institutions, and commercial buildings, as well as factories and other industrial/energy sector facilities. The Tokyo ETS is linked to the Saitama ETS, which was established in 2011 by the Saitama Prefecture.

Latin America

Latin American countries including Chile, Mexico, Argentina, and Columbia have taken a different approach of introducing carbon taxes and other carbon pricing mechanisms to tackle the climate crisis. However, the efficacy of these solutions is debatable, especially given their very low carbon tax rates, which may fail to discourage carbon-intensive activities.

Concluding Remarks

It is clear that countries across the globe recognize the need to take extensive action to tackle the climate crisis, in particular by reducing their respective greenhouse gas emissions. A popular and effective solution that has emerged over the last 5-10 years is the emission trade scheme. However, such schemes have proved to be costly and highly complex to implement, often requiring a pilot phase.

The UK ETS represents a promising test as to how a new emission trade scheme can begin to grow and develop, using established emission trade schemes (such as the EU ETS) as models. As we look to the future, more countries might begin to adopt nationalized carbon markets and schemes in order to meet their carbon reduction commitments, and we may even see major emission trade schemes linking up to unify humanity’s attempt to reverse climate change.

Visit our Climate Briefing Room, Environmental, Social, and Governance (ESG) resource center and follow our Life Sciences blog to stay informed about any progress on this matter.