Consultation opens on developing the UK Emissions Trading Scheme

United KingdomScotland

On 25 March 2022, the UK, Welsh, and Scottish Governments and the Department of Agriculture, Environment and Rural Affairs in Northern Ireland (the “Authority”) launched a joint consultation (the “Consultation”) on proposed amends to the UK Emissions Trading Scheme (“UK ETS”).

Specifically, the Consultation seeks views and evidence on:

  1. proposed options for a net zero consistent cap;
  2. changes to Free Allocation policy in the context of a net zero consistent cap;
  3. options for the expansion of the UK ETS to cover waste and maritime sectors; and
  4. future opportunities for scheme development.

Where does this fit in the policy framework?

The UK ETS was launched on 1 January 2021 (see our commentary here). It is a UK specific scheme that is intended to provide some continuity with how the EU Emissions Trading System (“EU ETS”) works in regulating the greenhouse gas emissions of the UK’s most energy intensive industries, whilst keeping the UK on track with its net zero goals. It sits alongside the Industrial Decarbonisation Strategy (see our commentary here), which sets out UK’s wider decarbonisation framework especially for decarbonising the industrial sector.

A net zero consistent cap

From 1 January 2021, the cap for Phase 1 of the UK ETS was initially set at 5% below the UK’s expected notional share of the EU ETS cap for Phase IV of the EU ETS (2021-2030) and was set to reduce annually by 4.2 million allowances. This cap will now remain in place until the end of 2023. However, following advice from the Climate Change Committee (“CCC”) and based on the UK’s Net Zero Strategy, the Consultation proposes a more ambitious carbon-reducing trajectory from 2024.

A net zero consistent cap would mean that the total cap for the entire first Phase is set at a figure between 887 million allowances and 936 million allowances, a reduction of between around 30-35% over the course of the phase. This would require a significant change in the level of the cap from 2024 onwards with steady reductions such that an annual cap of around 50 million allowances is in place in 2030.

Nevertheless, the Authority is inclined to set the cap towards the higher end of the proposed range (i.e. closer to 936 million allowances) due to the uncertainty over exact emissions savings across sectors covered by the Net Zero Strategy, and the possibility that emissions reductions could exceed the requirements of the fourth carbon budget[1]. However, the final trajectory will be subject to consultee views and updated assessments of emissions abatement progress.

Free allocation review

Since fewer allowances are expected to be available each year over the course of the first phase of the UK ETS, the Consultation proposes to reset the industry cap to make up a percentage of the overall Phase IV cap (rather than it being set as fixed numbers). This would, per the Authority, avoid any unintended impacts to market functioning, stability or liquidity which could arise if free allocations made up the majority of allowances under the cap.

However, the Authority is aware of the potential impacts this may have on operators which receive free allocations as the net zero consistent cap is implemented. Thus, if a cross-sectoral correction factor (“CSCF”)[2] is triggered before 2026, due to the chosen level of industry cap, the Authority will use its reserve of unallocated allowances or the flexible share[3] to mitigate against any reduction to free allocations for the first allocation period, 2021-2025.

The Authority also acknowledges that this method of altering the distribution of free allocations does not take into consideration the differing carbon leakage risks for each sector. The Authority plans to consult on the methodology for distributing free allowances by the end of 2023 so as to implement any changes to take effect by 2026 to align with the second allocation period of the UK ETS.

According to the Authority, this timeline allows it to have a clearer picture of alternative carbon leakage mitigation policies, pathways for decarbonisation of different sectors, and business models for the implementation of decarbonisation technologies such as carbon capture, usage and storage (“CCUS”) and hydrogen.

Options for expansion

The Authority is considering expanding the UK ETS within sectors already covered by the scheme (energy intensive industries, the power generation sector and aviation). For example, the UK ETS does not currently cover greenhouse gas emissions from methane, nitrous oxide and non-combustion processes in upstream oil & gas. The Authority considers that expanding UK ETS coverage in this sector would provide an additional driver for decarbonisation which would be aligned with other industry commitments such as the North Sea Transition Deal, which commits the industry to achieve net zero by 2050. In particular, the Authority therefore:

  1. consults on extending the current Monitoring, Reporting and Verification (“MRV”) regime to cover CO2 venting;
  2. calls for evidence on including methane emissions within the regime, including venting, cold flaring, methane slip and fugitive emissions; and
  3. calls for evidence on extending the MRV regime to cover all other GHG emissions from the upstream sector.

Currently, the UK ETS does not recognise the transportation of CO2 via non-pipeline transmission (e.g. shipping, rail and road) for CCUS. Industrial emitters may therefore be dissuaded from adopting a non-pipeline solution to CO2 abatement as CO2 not transported via a pipeline would be subject to the full carbon price liability. The Consultation proposes that the UK ETS be expanded to allow for the transportation of CO2 through other forms of non-pipeline transport by including them as a regulated activity under the scheme.

The Authority is also considering expanding the scope of the UK ETS to the domestic maritime sector and waste incineration and energy from waste by the mid-2020s, as these have been identified as high emitting sectors. According to the Authority, in 2019, domestic shipping activity was responsible for more emissions than the UK rail and bus network combined, and energy from waste (“EfW”) plants emitted ~1% of total UK emissions.

For domestic maritime, the Authority notes a number of recent initiatives aimed at reducing approximately 5% contribution by this sector to UK transport GHG emissions in 2019. To try to reduce emissions from the domestic shipping sector the Authority aims to encourage investment in energy efficiency and alternative fuels, so that under all of the options it is considering, emissions would be a calculated based on the volume and carbon intensity of the fuel. The current lead option is to define domestic shipping on a vessel activity basis, in a similar approach to that used for the aviation industry. The obligation for compliance would be placed downstream in the supply chain on either the vessel owner, or the vessel operator. The Authority considers that this will capture more emissions than an obligation which is levied upstream. The Authority also notes that it is mindful that international and regional developments in this area may be relevant, as organisations like the International Maritime Organization look to reduce global shipping emissions. It confirms that it will seek to avoid an approach which leads to double charging of emissions.

For emissions from waste incineration, the Authority believes that the UK ETS should cover the incineration of fossil material by all waste incinerators. This means the UK ETS obligation for robust MRV would be placed on all operators of waste incinerators. For EfW, this would mean conventional incineration and ATT/ACT (pyrolysis/gasification) would fall under the scope of the UK ETS and pay a carbon price according to their greenhouse gas emissions. This would bring the UK in line with and in fact given the definition of “incineration” go further than the EU ETS which proposes to include municipal waste incineration in the EU ETS from 2028.

Future expansions: GGR, land use and agriculture

The Consultation calls for evidence on a number of potential future opportunities for scheme development, including future markets policy, the incorporation of greenhouse gas removal (“GGR”) into the UK ETS and on the MRV requirements necessary to address greenhouse gas emissions in the land use and agriculture sectors.

It also includes further proposals to support effective operation of the UK ETS by addressing a number of operational issues identified during the development of policy and legislation for the scheme. For example, the Authority wishes to explore whether electricity generators who have not exported measurable heat produced by means of high-efficiency cogeneration in the 2021-2025 allocation period, but start to do so in following scheme years, should be eligible for free allocation.

In addition, it is currently not possible for the Authority to create the total amount of allowances from the flexible share in a scheme year, as this would surpass the cap on the amount of allowances that can be created each scheme year[4]. This could prevent the flexible share from fulfilling its intent to mitigate the triggering of a CSCF, should it be applied in a scheme year. The Authority is proposing to amend the UK ETS legislation to allow the Authority to create the total number of allowances from the flexible share in a scheme year, in addition to the annual cap.

Comment and next steps

As outlined above, the Consultation proposed a significant expansion to the scope of the UK ETS scheme. In addition to the installations already within the scope of the UK ETS, which will need to consider the impact on their activities and plan for impacts of the net zero cap proposals further reducing the quantity of free allowance, the Consultation impacts a number of other industries. For example, the extension of the scheme in upstream oil and gas and inclusion of the maritime industries is a bold move to bring into the scheme emissions and sectors which have thus far not been affected by this decarbonisation tool. Furthermore, given the impacts from land use and agriculture, the potential to expand the scheme to these sectors will be a novel challenge to a sector already grappling with significant changes to its status quo. However, for CCUS and hydrogen projects looking for non-pipeline transport routes, the proposal of a potential shield against the full exposure to the global carbon prices may be welcome news. It will need to be considered alongside the proposals for industrial CCUS business models which are seeking to develop a robust reference point that will encourage decarbonisation of the industrial sector.

The Consultation closes on 17 June 2022 and responses can be sent via the online survey or by email.

[1] The fourth carbon budget applies to the period 2023-2027, as required under Section 4 of the Climate Change Act.

[2] If the number of allowances allocated for free in a scheme year is higher than the industry cap, a CSCF is applied, which applies a proportionate reduction to each participant’s free allocations.

[3] A portion of up to 3% of the cap, 40,984,970 allowances over the 2021-2030 phase, that is held in reserve and can be drawn from by the cost containment mechanism or used to mitigate the application of a CSCF should it be applied in a scheme year.

[4] Article 20 of the Greenhouse Gas Emissions Trading Scheme Order 2020