What is required for the UK ETS to link to the EU ETS?
Comment by Dr. Danial Sturge
Carbon Policy Practice Manager - Markets, Policy and Regulation
The UK left the world’s largest carbon market – the European Union Emissions Trading System (EU ETS) – at the end of 2020. Last week, the UK held its first auction of allowances under its own ETS, clearing at £43.99/tCO2e and raising over a quarter of a billion pounds in revenue. While the first of many auctions (with the second happening next week), the market may well be a little bumpy at the outset as participants find their rhythm. Nonetheless, the UK market for carbon allowances seems to be emerging in a similar range to the EU system. So should we be starting to think about linking the smaller UK market to its larger and older European cousin?
We would argue that the answer is no, not yet. Any strategy for linking markets should consider the differences between trading systems and how those are expected to play out over time. The UK ETS decreased the cap (i.e. the total amount of certain greenhouse gases that can be emitted by installations covered by the system) compared to its notional share had the UK remained in the EU ETS. The Government will also be consulting on further increasing ambition and aligning the cap with Net Zero before the end of the summer. With a stricter emissions reduction target compared to the EU’s system already in place and potential for further divergence – in the near-term at least – linking the two systems is not likely to be a straightforward task.
What is the UK ETS?
The UK Emissions Trading System (UK ETS) came into operation on 1 January 2021 following the UK’s departure from the European Union’s ETS – covering electricity generation, heavy industry, and domestic flights. Under the ‘cap and trade’ principle, an upper limit of emissions is set – the cap – for all participating installations. Allowances for emissions within the system are auctioned off or allocated for free. Trading of allowances between installations can occur if an installation exceeds or outperforms its limit. In this way, installations are able to achieve emissions reduction in the most cost-effective way that meets their business needs. Government have said the emissions cap will soon be aligned with the UK’s 2050 Net Zero commitment.
Linking with the EU could also make us a rule-taker, rather than a rule-maker. This is not necessarily a bad thing, but with complete control of the UK ETS, we have a unique opportunity to develop it – and any associated carbon policies – at the pace and urgency needed to ensure our policy framework is fit for Net Zero.
If the UK does expand scope of its ETS or continues to diverge from the EU’s plans, linking the two systems will potentially require compromises in place so the two can play together. Distributional impacts are likely to vary between jurisdictions, especially if the buildings and transport sectors are brought in (as discussed in our earlier blogs). We would argue that the UK can contribute most by focusing on building a robust and enduring carbon market that is as close to economy-wide in scope and coherence as possible.
The UK has the opportunity to build an important Net Zero policy exemplar – creating a market and policy framework around our world-leading Climate Change Act and Carbon Budget regime. This, we would argue, is fundamentally more important than attempting to compromise a system ready for linking.
This is not to say the two systems should not be eventually linked. We believe there is great merit in linking carbon markets – as we’ve laid out in our recent work – but it must happen when the conditions are right. For that, negotiations should start happening in earnest now.
In addition, as discussed in last week’s blog, the EU is forging ahead with its plans to implement a Carbon Border Adjustment Mechanism (CBAM), which is very likely going to be integrated with the EU ETS. While directly linking the EU and UK ETS’s could take some time, the UK should work with the EU on proposals for a CBAM – and at the very least should be considering the potential impacts it could have on UK industry. With an effective carbon price that is currently broadly equivalent, the UK should be able to negotiate CBAM free access to the EU market, by achieving EU recognition of our MRV (monitoring, reporting, and verification) processes and alignment of free allowance distribution approaches.
Either way, the importance of MRV and accounting is going to increase on our pathway to Net Zero.
The role of a ‘Carbon Regulator’ – our proposal for providing oversight for MRV and accounting practices across the economy, and the role it could play on an international level.
Markets, Policy & Regulation
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