UK’s ETS Will Demonstrate Its Ability to Impact Emissions if Appropriate Future Market Policies are Put in Place

The UK Emissions Trading Scheme (UK ETS) replaced the UK’s participation in the European Union Emissions Trading Scheme (EU ETS) on 1 January 2021. Phase 1 runs between 2021 – 2025 and 2 from 2026 – 2030. The initial cap for the UK ETS in 2021 was 156 million allowances (covering only a quarter of UK emissions, 108 MtCO2e).

The UK ETS was established through the Greenhouse Gas Emissions Trading Scheme (GHG ETS) Order 2020. It is a cap-and-trade scheme that aims to reduce greenhouse gas emissions in sectors covered by the scheme. A cap is set on the maximum annual level of emissions for these sectors and sets an overall limit on allowances for participants, split into free allocations, new entrants, auctions, and flexible shares.

FREE ALLOCATION POLICY EXPLAINED

The UK ETS currently provides free allowances to those sectors at risk of carbon leakage. Carbon leakage is where carbon emissions are displaced to another country due to a lack of consistency in climate policies and their implementation. Those receiving free allowances allocated to mitigate carbon leakage will need to buy fewer allowances to cover their emissions, reducing their carbon price. Recipients of free allowances also have the option to sell these on the secondary market and make a profit. There is currently a fixed number of free allowances distributed per year. Free allocation entitlement is then calculated based on various factors, including the risk of carbon leakage, efficiency against a benchmark, and historical activity levels. The Government’s review of the free allocation policy will be critical to the overall success of the UK ETS. It must ensure a fair and transparent system that creates a stable carbon price and should not allow participants to be cost-neutral or profit from the UK ETS. Linking the UK ETS with other schemes internationally will reduce the risk of carbon leakage and, in turn, reduce the need for free allowances.

The UK ETS applies to energy-intensive industries, the power generation sector, and aviation. Activities in the scope of the UK ETS are listed in Schedule 1 (aviation) and Schedule 2 (installations) of the Greenhouse Gas Emissions Trading Scheme Order 2020.

For aviation, the UK ETS covers domestic flights, flights from the UK to countries within the European Economic Area, and flights between the UK and Gibraltar. The aviation sector is eligible for free allocation, but the government will be phasing this out in 2026. The Aviation Allocation Table (see Ref. 1) gives each operator’s free allowance for 2024 and 2025, but these numbers should be treated as indicative because the free allocation system is currently under review.
For installations, the UK ETS applies to regulated activities that result in greenhouse gas emissions, including fuel combustion on a site where combustion units with a total rated thermal input exceeding 20MW are operated (except in installations where the primary purpose is the incineration of hazardous or municipal waste).

Emitters in energy-intensive industries or power generation must apply to the UK ETS Regulator for a greenhouse gas emissions permit. To trade-in allowances, they must have an Operator Holding Account (OHA) with the UK ETS registry. Aircraft operators must have an Aircraft Operator Holding Account (AOHA) to trade.

The UK ETS participants are free to buy and sell allowances from each other. Each year, they must purchase and surrender 1 UK Allowance (UKA) per tonne of emitted CO₂ equivalent (CO₂e). The price of an allowance at any point is the carbon price. As the cap decreases over time, this reduces the availability of allowances and signals the market to decarbonize.

The UK ETS is run by the UK ETS Authority, which has four constituent members:

The UK Government,
The Scottish Government,
The Welsh Government, and
Northern Ireland Department of Agriculture, Environment and Rural Affairs.

Participants in the UK ETS must hold a permit or emissions monitoring plan (for aircraft operators). The UK ETS Regulators issue these. The ETS Registry is administered by the Environment Agency (EA) and operates similarly to an online bank account. The Registry is a secure web-based application that records free allowances, annual verified emissions, allowance transfers, and allowance surrenders. UK ETS verifiers have access to the online reporting platform and must be accredited by the UK Accreditation Service. Where breaches occur, the EA can issue enforcement notices, and non-compliance can result in the imposition of a civil penalty.

In July 2023, the UK ETS Authority outlined a range of policy developments for the ETS, including aligning the UK ETS cap to the UK’s Net Zero target, expanding the scope of the scheme, and developing free allocation and aviation policies in the future.

From 2024, the industries covered under the UK ETS must decrease their emissions enough to reach net zero goals. The number of carbon allowances companies buy at auction is limited to 2024 to 69 million. By 2027, this will fall to around 44 million before reaching around 24 million by 2030. Extra allowances will also be made available to the market between 2024 and 2027, while the current levels of free allocation of allowances for industry have also been guaranteed until 2026 to protect them from international pressures.
The Authority has also announced the initial expansion of the UK ETS: more comprehensive coverage of emissions by sectors already in the scheme, including coverage of CO2 venting by the upstream oil and gas sector from 2025; expansion to domestic maritime emissions in 2026 to energy from waste and waste incineration in 2028; and, subject to consultation, its intention to include engineered greenhouse gas removals (GGRs).

Last year, the UK ETS Authority started a 2-phase evaluation programme to provide evidence on:

the effectiveness of the scheme’s implementation
the early outcomes of the scheme
its longer-term impacts

This first phase of the evaluation, covering process, outcomes, and early impacts, was completed in December 2023. In this review, based on the evidence collected, the UK ETS Authority concludes that “the UK ETS has been achieving its purpose so far and continues to be an integral part of the transition to net zero. The Authority will be better able to assess and understand the scheme’s impacts and contribution towards long-term decarbonization after a longer period of operation through further planned evaluation”. Phase 2 of the evaluation will be undertaken in 2028.

The website of the ICE Exchange, where UK ETS trading takes place, has a list of all the UK emissions auctions that have taken place since trading opened in May 2021. This includes the price of a UK allowance at each auction. Figure 1 below shows critical price fluctuations in the UK ETS:

The consultation, which closed last March, gives some clues as to what other changes the government is considering, including the possible implementation of a Supply Adjustment Mechanism (SAM) to keep the market stable. It is also worth noting that the EU-UK Trade and Cooperation Agreement, signed in 2020, mentions explicit cooperation on carbon pricing. It says: “The Parties shall cooperate on carbon pricing. They shall give serious consideration to linking their respective carbon pricing systems in a way that preserves the integrity of these systems and provides for the possibility to increase their effectiveness.” In November 2023, Parliament asked questions about the EU and UK systems divergence and whether this would cause future problems for UK exporters. To avoid such problems, it may be that the UK ETS evolves to align more closely with the EU system or even link up with it.

The UK government has indicated that it remains open to linking the UK ETS internationally. The drive to establish a global ETS will largely depend on the political will of individual countries. To move forward, consideration needs to be given to how fundamental mechanisms would work, such as preventing carbon leakage, subsidies for reduction, and carbon adjustment mechanisms. Each of those issues may be very complicated to agree on at a global level. Additionally, even current measures in established ETSs may not be deemed sufficient in hard-to-abate sectors, and setting a global carbon price may be impossible due to the apparent disparity in market price and fluctuation worldwide.

This Post was submitted by Climate Scorecard UK Country Manager Camille Brandon-Martinez.

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