Greenhouse gas emissions trading schemes: A global perspective - UK

by White & Case LLP

White & Case LLP

EU's trading scheme framework dominates, but Brexit brings uncertainty

As early as 2002, the UK began preparing for international emissions trading. It initiated a pilot emissions trading scheme (UK ETS) in anticipation of its mandatory contribution toward the EU Kyoto Protocol targets.

The UK ETS was the first cross-industry cap-and-trade greenhouse gas (GHG) emissions trading scheme of its kind in the world. It applied to certain named installations that were given caps on emissions and allowed these installations to purchase emissions in the event of a shortfall, or sell any excess to those installations that needed them to comply with their obligations under the UK ETS. By the time the EU Emissions Trading Directive came into effect in 2003, the UK had ample experience with pricing, auctions and other mechanics of emissions trading. Today, emissions trading in the UK is predominantly refected in the EU framework, as incorporated into domestic law by the UK Climate Change Act 2008 (CCA) and the Greenhouse Gas Emissions Trading Scheme Regulations 2009, which have been updated for the current trading period of 2013 to 2020.

The CCA is the core UK statutory basis for climate change mitigation measures. It commits the UK to a target of lowering GHG emissions by the year 2050 to 80 percent below 1990 levels (which translates to 160 MtCO2-equivalent emissions). From 2008 to 2012, the UK was capped at 3,018 MtCO2, decreasing to 2,782 MtCO2 between 2013 and 2017. This will further decrease to 2,544 MtCO2 between 2018 and 2022, and it provides mechanisms by which this target can be achieved. Specifcally, it confers powers to establish trading schemes for the purposes of limiting GHG emissions and encouraging activities that reduce emissions or remove GHG from the atmosphere. In theory, therefore, the UK could participate in any, or multiple, emissions trading schemes worldwide.

In November 2015, the UK reaffirmed its commitment to mitigating climate change on the world stage as a signatory to the Paris Agreement. The UK has developed and submitted its Nationally Developed Contribution (NDC) to achieving the targets of the Paris Agreement.

The Market Stability Reserve is another mechanism introduced to solve the problem of surplus EUAs causing a disincentive to reduce GHG emissions.

What is covered

The CCA caps the UK's total net GHG emissions each year, and national authorities issue a fixed number of emissions allowances (EUAs) that may be used or traded as required and entitle relevant installations to emit a corresponding quantity of GHG. The UK ETS applies to a range of GHGs—CO2 methane, nitrous oxide, hydrofluorocarbons, perfluorocarbons and sulphur hexafluoride. Regardless of the specifc GHG, EUAs are calculated as CO2-equivalent emissions, so volumes of each GHG are converted to one ton of CO2. One EUA entitles the holder to emit one ton of GHG.

Installations that carry out "regulated activities" beyond a threshold amount must obtain a permit and either buy or be allocated EUAs under the ETS. The threshold for covered installations is thermal input in excess of 20 MWs (i.e., through the combustion of fossil fuel), or the production of certain listed substances such as ammonia or nitric acid, given that GHG is inherently released during the production of such substances.

Covered activities are listed in Annex A of the Regulatory Guidance for Installations. One thousand of the 11,000 covered installations participating in the EU ETS are in the UK. These include power stations, oil refneries, offshore platforms and industries that produce iron and steel, cement and lime, paper, glass, ceramics and chemicals.

What is required

The "polluter pays" principle applies to environmental protection requirements in the UK. For air emissions permits, the release of GHGs is permitted so long as the "polluting" installations pay for the right to create GHG emissions; that is, installations may only carry out regulated activities up to the number of their allocated EUAs. A proportion of those EUAs are allocated for free, and others must be purchased by auction. EUAs must be used for compliance or may be traded if the installation has a surplus of them.

Given that the aim of the ETS is to progressively reduce GHG emissions, the default position is that EUAs must be acquired at auction, with concessions being made for certain sectors to continue to have a free allocation. Under the UK ETS, each year fewer EUAs are allocated for free and more must be bought at auction. In 2013, installations that received an allocation received 80 percent of it for free. In 2020, covered installations will receive only 30 percent of their EUAs for free, and by 2027 all EUAs must be purchased at auction. Auctions are conducted through an agent (ICE Futures Europe is currently the exchange appointed by the government as the auction agent).

Installations must be able to surrender EUAs corresponding to the amount of GHG they emit each year. If they have insuffcient EUAs to match their emissions, they must either cut their emissions or acquire more EUAs on the open "carbon market." If they have excess, they may save the EUAs for future accounting periods or sell them to other installations. This ensures that emissions are reduced where it costs the least to do so.

Future outlook

The UK introduced the Carbon Price Floor in 2013 to complement the effectiveness of its emissions trading system. Since the global financial crisis in 2007/2008, industrial output in the UK markedly decreased and, as a result, many of the covered installations ended up with surplus EUAs. These surpluses caused the market price for allowances to plummet, in addition to taking the pressure off installations to shift toward reducing GHG. The Carbon Price Floor scheme, which came into effect April 1, 2013, ensures that it does not become cheaper for installations to pollute rather than improve energy effciency and cleanliness by imposing an annually increasing surcharge on top of the market price of EUAs for installations that are fossil fuel-burning power stations. By most accounts, the UK’s carbon price floor has been successful in producing cost-effective emissions reductions. By facilitating the switch from oil to gas, it has also contributed to large-scale emissions reductions (80 percent from 2012 to 2016).

The Market Stability Reserve is another mechanism introduced to solve the problem of surplus EUAs causing a disincentive to reduce GHG emissions. This mechanism, which will be in force from 2019, is designed to automatically withdraw a proportion of EUAs available on the carbon market and place them into a reserve once the number of freely available allowances reaches a certain threshold. In theory, this will increase the demand for allowances and stabilize their price. If the number of available allowances should drop below a set threshold, some allowances will be released from the reserve.

The Paris Agreement will also likely have a considerable impact on the future of emissions trading in the UK and around the world. The agreement provides for the international connection of emission trading systems to facilitate the meeting of each country’s commitment under the Agreement via so-called "internationally transferred mitigation outcomes." The Paris Agreement provides no detail, however, on how such a mechanism would be developed, and at present emissions trading around the world lacks the uniformity for the various systems to become interconnected.

Trading across borders

The UK ETS is inextricably linked to, and indeed a branch of, the EU-wide scheme provided for in the EU ETS Directive. As the carbon market is EU-wide and there is mutual recognition of EUAs across the EU, UK ETS allowances may be freely traded by installations throughout the EU.

Having one of the biggest economies in the EU, the UK is a major player in the EU ETS both in terms of influencing policy and market activity. The EU ETS is in essence a vehicle that helps both the UK and the EU as a whole reduce their GHG emissions and meet international commitments, in particular the Kyoto Protocol and the Paris Agreement. Through the 2004 Linking Directive, the EU ETS is linked to other emissions reduction schemes provided for under the Kyoto Protocol, namely Joint Implementation and the Clean Development Mechanism. Credits earned under these schemes (emission reduction units (ERUs) and certifed emission reductions (CERs) respectively) may be used in lieu of EUAs for compliance with the EU ETS.

It is unclear what the efect of Brexit will be on the UK ETS.

Effect of Brexit

It is unclear what the effect of Brexit will be on the UK ETS given its connection to the wider EU scheme. If, upon leaving the EU, the UK chooses to leave the EU ETS but seeks continued access to the EU carbon market, this would need to be negotiated. The terms of access may be contained in a free trade agreement (should one be agreed to) with the EU.

Although Brexit's immediate effects are not known, it is predicted that for the UK ETS, the effects are not likely to be dramatic, as many of the legal bases for the UK ETS are now derived directly from domestic law. Nonetheless, new policies will be needed to ensure continued efforts at reducing GHG emissions where previous policies were mandated through the EU, and the government has declared its intention to do this. The UK's targets as part of the global transition to a low-carbon economy and to combat the effects of climate change will remain independent of the EU stance. The UK is a participant in the United Nations Framework Convention on Climate Change and a signatory to the Kyoto Protocol and the Paris Agreement in its own capacity as well as in its role as part of the EU; therefore, its obligations under these agreements are not dependent on its membership in the EU.

Through the 2008 Climate Change Act, the UK is required to establish carbon budgets to ensure progress in GHG emissions reduction and other climate change-related commitments. Although the UK's 2050 GHG reduction targets and the legislated carbon budgets (including the recent fifth carbon budget, which runs from 2028 to 2032) remain intact, going forward the UK's carbon budgets need to be adaptable to the reality of an uncertain future if the UK is to meet its global commitments. This includes addressing the prediction that one of Brexit's consequences and the uncertainty during negotiations will be an economic downturn for the UK. This may potentially lead to a reduction in GHG emissions, simply as a result of reductions in industrial output, lower energy consumption and other economic consequences. Having ratifed the Paris Agreement, the UK will need to submit its own commitments and targets for carbon reduction actions into 2050. The UK's access to the low-cost emission reduction market of the EU ETS is an important mechanism for achieving targets set by the UK. Whether Brexit means that the UK cannot continue to participate in the EU ETS after leaving the EU is an open question.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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