The UK’s Emission Trading System: (de)linking challenges after Brexit

A post by John Ward (Pengwern Associates and LSE) and Josh Burke (LSE)

In 2016 the UK voted for Brexit and with it came regulatory disentanglement from the EU. Amongst other areas of policy, this included multilateral co-operation on carbon pricing via the UK’s membership of the EU ETS. The UK’s untimely exit from the EU ETS occurred when regulatory developments had transformed the EU ETS from a peripheral policy dogged by oversupply and low prices to a flagship policy that has increased low-carbon innovation, accelerated fuel switching and generated significant revenue.

The UK’s rejection of the single market necessitated the establishment of a new UK ETS. This became operational on 1 January 2021. The UK ETS covers electricity generation, heavy industry and domestic aviation. From the outset, the UK ETS was established with the promise of providing an opportunity for more ambitious carbon policy in the longer term. While the initial UK ETS arrangements largely mirror those of the EU ETS, the cap was reduced by 5% of what the UK’s notional share would have been had the country remained in the EU, making it more stringent. Going forward, the UK Government has recently consulted of aligning the emissions cap with net-zero and has announced it will consider expanding coverage to the two-thirds of emissions not yet covered by the UK ETS. Whilst expanding sectoral coverage to heat, buildings and road transport is not currently under review (unlike in the EU), the UK government is considering whether maritime, waste and greenhouse gas removals should be considered for inclusion.

Establishing a UK ETS involved opportunities and risks for the UK. On the one hand, the UK can re-optimise its system design swiftly and flexibly without seeking the approval of other EU member states. This process could be informed by the important lessons learned from its participation in the EU ETS, as well as other emissions trading systems. On the other hand, significant divergence from the EU ETS’s core design features will make linking with the EU, either now or in the future, increasingly complex.

The advantages and disadvantages of linking, and what this might mean for both the UK and the EU, are well known. At the time of writing, the price to take delivery of a UK allowance (UKA) in December 2022 is around £81, or €96 at current exchange rates. The price for the equivalent product in the EU market is closer to €83. This means that, with linking, regulated entities in the UK could access allowances for compliance that at present are almost 15% cheaper than otherwise available to them. This benefit might be provided at a point where concerns about inflationary pressures in the UK economy continue to mount and/or the efficiency gains could help support the expansion of ambition discussed in the UK’s recent consultation paper. At the same time, EU entities and traders would be able to sell their allowances into the UK market, taking advantage of the higher prices on offer.

These dynamics would, of course, result in the prices becoming equivalent. This in turn would help to reduce concerns regarding the risk of leakage between the two jurisdictions as the EU’s CBAM proposals bring this issue centre stage. The creation of a larger market should also help to reduce total price volatility, which is likely to benefit the UK in particular as the smaller, less liquid, market.

These benefits help to explain the widespread support for linking the two systems across industry, NGOs and some academics. Such consensus is rare in climate policy.

Set against these benefits, one potential financial disadvantage of linking, at least from the perspective of the UK government is that, in exchange for providing its regulated entities with access to a larger, lower cost and more liquid market, it would need to accept a small decline in auction revenues, assuming current price differences persist.

Since the design of the UK ETS replicates many features of the EU ETS (e.g., Market Stability Reserve, Auction Reserve Price), the main difficulties to the UK and EU seeking to link their systems in the near term are, of course, regulatory and political.

In the first instance, and as noted above, linking would require cooperation over regulatory design.

However, the most substantive political and regulatory challenge is that any linking negotiations would almost certainly become embroiled in the wider discussions on the post-Brexit relationship between the two jurisdictions. Trust between the two parties remains in short supply. Indeed, with the UK Government now planning to repudiate parts of the UK’s Brexit deal on Northern Ireland that the Prime Minister negotiated and subsequently signed, prospects for progress seem bleak with trade relations potentially set to decline further, it seems. This is important context as the EU-Switzerland linking agreement – often discussed/considered an analogous process – took over 10 years to conclude, in an external political context that was more propitious. In these circumstances, rapidly concluding a linking agreement – despite the obvious benefits it could provide – seems challenging.

More recently, the UK has announced that it will consult later this year on a range of carbon leakage mitigation options, including on whether a carbon border adjustment mechanism (CBAM) could be an appropriate tool in the UK’s policy mix. Given deep trade linkages and integrated supply chains with the EU, there is a much stronger case for multilateral cooperation with the EU on a robust policy package to support industrial decarbonisation. This presents an opportunity for policy co-operation with the EU which could help build confidence between both parties and help pave the way to a comprehensive linking agreement.

Of course, this would be a first best solution. But as the UK’s departure from the EU has demonstrated, cogency and logic doesn’t always prevail. Political and regulatory challenges dictate that second and third best solutions will instead be chosen. How the UK continues to price carbon is no different.

The views and opinions expressed in this post are solely those of the author(s) and do not reflect those of the editors of the blog of the project LIFE DICET.