UK Emissions Trading System or a carbon tax?

The UK’s transition period for leaving the European Union ends on 31 December 2020. Until this date (unless it is extended) the UK will remain part of the EU emissions trading scheme (EU ETS) and must meet its EU ETS obligations for scheme years 2019 and 2020. Following the transition period, the UK is currently looking at two options to replace the EU ETS (is is not clear, at present, if COVID-19 will influence the UK’s thinking in this regard and, if so, how). The two options are either to introduce a UK emissions trading system or a carbon tax. We discuss below the state of current proposals and what this means for businesses in practical terms.

Background

EU ETS is the world’s largest carbon market, incorporating the European Economic Area (which comprises the EU member states plus Iceland, Lichtenstein and Norway). In the UK, it is primarily implemented through the Greenhouse Gas Emissions Trading Systems Regulations 2012.

The aim of EU ETS is to reduce greenhouse gas (GHG) emissions. In practice it does this by:

• Imposing a limit on emissions from over 11,000 heavy energy using installations and over 140 airlines. (Maritime transport emissions are currently excluded but that is likely to change in the next phase of the EU ETS)
• Providing a ‘Cap and Trade’ system whereby in-scope operators are subjected to a total cap on certain GHGs that can be emitted every year, within which they can buy and trade emissions allowances as needed.
• Requiring operators to surrender enough allowances to cover their own annual emissions, with heavy fines imposed for failure to do so.
• Enabling any spare allowances – for example, because an installation reduces its emissions – to be applied against future emissions from that installation or sold to another entity that is short of allowances.

Since it was established in 2005, EU ETS has been through two ‘stages’ so far and is currently in Stage 3 (2013 – 2020). The regime has broadened in scope since inception, both in terms of the GHGs monitored and the sectors affected. Currently, carbon dioxide, nitrous oxide and perfluorocarbon (from aluminium production) emissions are monitored i.e. about 45% of EU GHG emissions. Industries in the EU subject to the EU ETS include power stations and industrial plants, including offshore platforms. Any airlines operating within the EU (where the aerocraft takes off from or lands in an EU member state) is also included in respect of the relevant flights. Other large organisations such as universities and hospitals may be captured depending on type and quantum of emissions they generate on-site. Note, however, that emissions from maritime and road transport in the EU are currently excluded from the EU ETS.

UK participants in the transition period

Participating UK operators should be mindful of the following deadlines[1]:

Options post UK transition period

Pursuant to the Brexit Withdrawal Agreement, which came into effect on 1 February 2020, the EU ETS will cease to have effect in respect of UK emissions produced from 1 January 2021 (the UK will retain its obligation to enforce the EU ETS 2020 surrender obligation on 30 April 2021).

In the Spring Budget 2020 of 11 March 2020, the UK Government announced its intention to apply an “ambitious” carbon price following the expiry of the transition period. In line with confirmations made in the Budget, the Finance Bill and explanatory notes were published on 19 March 2020. The draft Bill (clause 93) provides for both a UK Emissions Trading System (UK ETS) and a carbon emissions tax as an alternative (clause 92 and Schedule 11). How these two options are to be developed, including whether this will be together or separately, remains to be seen.

UK ETS: linked with EU ETS

The Finance Bill sets out the option of a UK ETS. There is no detailed guidance on how this might be structured and operate. One question which arises is whether a UK ETS would be linked with the EU ETS. The Government previously voiced its support for such linkage. In a paper dated 27 February 2020 and entitled ‘The Future Relationship with the EU: The UK’s Approach to Negotiations’, the Government confirmed that it would consider linking any future UK ETS with the EU ETS, provided this suited both UK and EU interests (the Swiss have a national emissions trading system and this is linked with the EU ETS).

To be compatible with the EU ETS, it is likely that any future UK ETS would have to be mandatory, provide an absolute cap on emissions and generally work within similar parametres.

UK ETS: not linked with EU ETS

In the event that the UK and EU emissions trading systems are not linked, the UK would introduce an alternative pricing mechanism for carbon applicable within the UK ETS.

Some commentators raise concerns that a standalone UK ETS would suffer from issues of price volatility, due to the reduced number of participants and a less diversified market. The Finance Bill attempts to tackle this with provision for market stability mechanisms such as a cost containment mechanism which would respond to any significant short-term price spikes by setting a ceiling, and an auction reserve price which would provide a price floor.

Added to this is a predicted continual fall in emissions from UK power stations. As these emitters would form the majority of UK ETS traders, their downward trajectory in emissions suggests, to some commentators, that there will be insufficient liquidity to maintain a standalone system.

Another concern raised is that a carbon price discrepancy between the UK ETS and EU ETS and indeed a carbon emissions tax and EU ETS (see below) could impact competition between emitters in the UK and those in the EU.

Carbon emissions tax

The Finance Bill provides for the creation of a new carbon tax, as an alternative to a UK ETS. If introduced, the tax would apply to the same entities to which the EU ETS currently applies, except for the aviation sector and certain other low emitters. The tax would apply from 1 January 2021 on an installation basis. It would apply to emissions in excess of an emission allowance given to the particular installation. Any installation whose emissions fell below its allowance would not pay the tax. All emissions that exceed the annual allowance would be taxed on a carbon equivalent basis at a rate for 2019 of £16 per tonne. The first emissions reports would cover 1 January to 31 December 2021 and the tax would be collected by HMRC annually. The plan is to issue bills relating to first reports in the summer 2022. The tax would rely on data supplied by taxable installations under existing (and continuing) emissions reporting arrangements. Provisions are also made in the Finance Bill for civil penalties to be applied where there is a failure to comply with the carbon tax requirements.

A consultation on the more detailed arrangements for the tax will take place in spring 2020 to inform statutory instruments that would be laid in late 2020 if the tax were to be introduced from 1 January 2021. For further details on the proposed carbon emissions tax please see here.

Net zero

As a reminder, in June 2019, the UK committed in legislation to achieving ‘net zero’ greenhouse gas emissions by 2050. The Climate Change Act 2008 (2050 Target Amendment) Order 2019 amended Section 1 of the Climate Change Act 2008 so that (subject to limited exceptions), the Government is obliged to reduce the net UK carbon account to at least 100% lower than the 1990 baseline. The reference here to “carbon” is shorthand for all the greenhouse gases. Essentially the UK’s greenhouse gas emissions are to be reduced (at least) to net zero by 2050.

Either a UK ETS or the carbon tax could be important levers to be used by the Government in years to come to meet this target.

Comment

It remains to be seen how effective either a UK ETS or a carbon tax will be at reducing greenhouse gas emissions, if this is the political aim and remains the political aim. Politics cannot be ignored. This is clear from the EU ETS, the history of which is very chequered. Politics interfered very considerably with the working of the EU ETS over the years. Very few would suggest the EU ETS has been successful when measured against its objective. However two things stand out in terms of moving forward. First is that the UK did not abandon the concept of carbon pricing for major emitters, whether this be via a standalone emission trading scheme or a tax. Second, the UK is committed to net zero by 2050 (of course the EU Commission has recently also identified this as its aim). It may be that whatever UK carbon price system(s) is put in place, it will gain prominence as a lever in time to come in tackling UK emissions. Future UK governments could find that the legal obligation to meet the net zero target may well fetter political inclinations to interfere with carbon pricing as a short term politico-economic measure.

[1] We note that despite some participants having requested an extension to the deadline in light of the restrictions imposed as a result of Covid-19, the European Commission confirmed on 26 March 2020 that there would not be a delay this year’s carbon market compliance deadlines.

[2] This follows the submission of the Verified Annual Emissions Report for 2019 emissions which was due on 31 March 2020.