UK ETS or a carbon emissions tax?

In line with the UK-EU Withdrawal Agreement, the UK will remain in the EU Emissions Trading System (EU ETS) until 31 December 2020 – that is, until the end of the current Brexit transition period.

From January 2021, the UK government plans to introduce a domestic emissions trading system (UK ETS) and to link this with the EU ETS “if it suits both sides’ interests”. However, if the on-going trade negotiations fail to yield such a link, then the UK has the option of introducing an “alternative carbon pricing mechanism”, in the form of a carbon emissions tax, instead of a UK ETS.

To this end, the government is preparing both a standalone UK ETS and a carbon emissions tax as possible alternatives. The Finance Act 2020, which received Royal Assent on 22 July, amends the Finance Act 2019 to enable the introduction of either a carbon emissions tax or a UK ETS (see sections 95-96 and Schedule 12 of the Act). The Climate Change Act 2008 also gives the Secretary of State powers to introduce secondary legislation fleshing out the detail of a UK ETS (see the Draft Greenhouse Gas Emissions Trading Scheme Order 2020 below).

It is anyone’s guess as to which route will ultimately prevail. But given that the UK’s place in the EU ETS is no longer about achieving a global climate win, and instead has become a pawn in the Brexit trade negotiations, it would be foolish to discount any of the options at this point.

This lack of clarity as to carbon pricing in the UK six months from now has negatively impacted liquidity in the carbon market generally and has left market participants unable to adequately plan or hedge their risks.

Options for implementation

If an extension to the transition period is agreed: The UK government is currently insisting on the country leaving the EU at the end of the transition period (31 December 2020) regardless of whether a UK/EU trade deal is agreed. If this stance were to change and an extension were agreed, it is most likely that UK installations would continue to be covered by the EU ETS from 1 January 2021, with the intention of agreeing a linked UK ETS in due course. However, it seems highly unlikely that an extension to the transition period would be sought by the UK government as the deadline for doing so under the current legislation has expired.

If the transition period ends and a deal is struck: The UK government has indicated that its preference is to proceed with a UK ETS that is linked to the EU ETS, which it would introduce through secondary legislation made under section 44 of the Climate Change Act 2008. However, even in this case, it remains unclear if a linked UK ETS could be implemented by 1 January 2021. The government has assured us that this is not due to problems with system-readiness but rather because of the timetable for approval of the system by the devolved administrations. Given the government’s commitment to retain carbon pricing in all circumstances, it is likely that an interim UK carbon emissions tax would be put in place until the UK ETS is operational and linked to the EU ETS.

If a ‘No Deal’ Brexit occurs: Whilst the government’s first prize in these circumstances would be to switch on a stand-alone UK ETS on 1 January 2021, this is unlikely to be the outcome given the challenging timetable for approval by the devolved administrations for such a system. It is likely then that a (temporary) carbon emissions tax would be implemented in the UK in the interim.

To tax or not to tax?

A UK ETS that links with the EU ETS would undoubtably mitigate the uncertainty going forward and give the UK market the long-term visibility, clarity and predictability as to carbon pricing beyond 2020 that it needs. Whilst most market participants believe a standalone UK ETS would not be able to deliver a sufficient level of liquidity for the market to operate efficiently, as the response to the government’s 2019 consultation revealed, a carbon emissions tax is not welcomed by the majority of the market either.

Although of course simpler to implement, the key failing of the alternative carbon tax model is that it does not allow for compliance at the lowest cost – which in contrast is at the heart of the carbon market model.

At a basic level, the tax will operate in a similar way to the UK ETS - the government will set a greenhouse gas (GHG) emissions allowance for each calendar year and GHG emissions above the allowance will be subject to the tax.

Highlights of the proposed carbon emissions tax are as follows:

  • Scope: The tax would apply to both stationary installations that are currently operators under the EU ETS, and installations holding an excluded installations emissions permit. The carbon emissions tax would not apply to aviation activities.
  • The tax would apply from 1 January 2021: Each reporting period would run for a calendar year to 31 December, with the first reporting date falling in April 2022, and the first payment due after that.
  • Banking would not be allowed: If an installation's GHG emissions were lower than its tax emissions allowance for the year, it would not be able to carry forward the unused tax allowance to a future reporting year.

However, there are still many aspects of the tax yet to be decided – for example, the rate of the tax, how carbon leakage will be addressed, or how the tax emissions allowances will be calculated for each installation. Without these critical details, it very difficult to satisfy the principles of predictability, clarity and certainty which market participants need in order to manage their risks effectively.

Which is why the government published a consultation on the detail of the tax on 21 July 2020. That consultation closes on 29 September 2020. However, given that the end of the transition period is 31 December 2020 and the government would need to introduce further legislation to give effect to the outcome of the consultation, the timing seems worryingly tight.

What do we know about the proposed UK ETS?

In early June 2020, the Government responded to the proposals set out in its 2019 consultation.

The response detailed its decisions on operationalising a UK ETS (stand alone or linked), which would be part of the policy package designed to meet the UK’s target of net zero carbon emissions by 2050.

Many of the features of the UK ETS would be the same or very similar to the EU ETS, which at least should give comfort to market participants:

  • Phases: The first Phase would run from 2021 to 2030.
  • Scope: All installations that are currently covered by the EU ETS would continue to be in-scope, and the UK ETS would continue to cover the same GHGs and the same sectors as the EU ETS currently does. In addition, if an agreement on linkage to the EU ETS is reached, domestic flights and flights between the UK and states in the EEA, Switzerland and Gibraltar would be covered. In any event, the government has indicated it will review the implementation of aviation offsetting under the International Civil Aviation Organisation's (ICAO) Carbon Offsetting and Reduction Scheme for International Aviation (CORSIA) alongside a UK ETS, so that airline operators will not pay twice for the same tonne of carbon dioxide emitted. The European Commission’s invitation for comments on a revision of the Aviation EU ETS Directive opened on 3 July 2020 and will run until 28 August 2020.
  • Cap: The cap will be set at 5% below the notional emissions cap for the UK under the EU ETS for Phase IV of that system (2021 – 2030) and would be reduced annually by 4.2M allowances so as to maintain that gap. This is clearly a departure from the EU ETS, and the government has not given much away as to the rationale other than citing the UK’s 2050 net zero emissions target. The annual reduction would not affect the number of free allowances that operators receive, as the allowances will be taken from the auction share of allowances. The government intends to reduce the cap further in line with its net zero target in an early review, anticipated in 2021, to be implemented by no later than January 2024.
  • Auctioning would be the main way of obtaining allowances, with a proportion to be allocated for free to mitigate the risk of carbon leakage. Such free allocation would be in line with what operators would have expected to receive in Phase IV of the EU ETS. Some free allowances would also be allocated to new entrants and installations that increase activity, in line with the approach under the EU ETS.
  • A cost containment mechanism (CCM) would be introduced to address the impact of any short-term significant spikes in the price of allowances. And to blur the lines between a cap-and-trade system versus a tax a little further - if the UK ETS were a stand-alone ETS, a reserve price of £15 per allowance would be set. This feature certainly looks and feels more like a tax.
  • International offset ‘Kyoto’ carbon credits would not be accepted in the UK ETS.
  • The carbon support price (CSP) would remain at £18.08/tCO2. The CSP taxes fossil fuels used to generate electricity, with the rates being set under the Climate Change Levy. Essentially the price floor consists of two components which are paid for by energy generators: (i) the EU ETS allowance price (or, from January 2020 the UK ETS allowance price or the carbon tax amount, depending on the option selected by the government); and, in addition (ii) the CPS.
  • There would be two reviews of the UK ETS. These would be aligned with the EU ETS Phase IV reviews and the global stocktake of how the Paris Agreement goals are being met.
  • The government has published the Draft Greenhouse Gas Emissions Trading Scheme Order 2020, which sets out the framework for the UK ETS. The Order will come into force on the day after it is made, to allow regulators to prepare for the transition from the EU ETS to the UK ETS at the beginning of 2021. Requirements on UK ETS participants will take effect from 1 January 2021 (the beginning of the UK ETS’s first trading period). The Draft Order is accompanied by a Draft Explanatory Memorandum that explains the Order in more detail.

As we head into the second half of 2020, given all of the unknowns around the carbon pricing in the UK after December of this year, planning for the future is a challenge that many in the industry are struggling to meet.