Since the end of the Brexit transition period on 31 December 2020, the UK is no longer a participant in the EU Emissions Trading Scheme (the EU ETS). The UK has therefore launched its own post-Brexit “cap and trade” carbon system aptly called the UK Emissions Trading Scheme (UK ETS) [Fn1] which is modelled largely on the EU ETS (which in turn was modelled on an original UK system from 2002).
The new UK ETS is likely to be stricter than the EU ETS as the UK government has stated that it will be a key tool in achieving net zero carbon emissions by 2050. This client alert briefly summarises the new policy framework in which the UK ETS will operate, identifies the sectors to which it will apply and considers the trading documentation used to trade UK ETS allowances (UKAs).
The Structure of the UK ETS and Affected Sectors
The EU ETS is a “cap and trade” system which aims to reduce greenhouse gas emissions from companies based in the EU and was established on 1 January 2005. The UK ETS is almost identical to the EU ETS in terms of how it operates and the fundamental cap and trade concepts which underpin it.
In summary, a defined number of UKAs will be issued each year which will be subject to an ever-decreasing cap. Over time, this will reduce overall carbon emissions from companies in the UK which are covered by the scheme. In the UK’s flagship Energy White Paper December 2020 (the Energy White Paper) the UK government stated that:
“The UK ETS will be a market-based measure which will provide continuity for businesses. A cap is set on the greenhouse gases that businesses can emit (via the total number of allowances in circulation), which will decrease over time. Businesses then buy and sell emissions allowances through government auctions or secondary markets.” [Fn2]
The UK ETS also applies to the same energy-intensive sectors as the EU ETS, namely:
- heavy industrials;
- generators (heat & electricity); and
- aviation, covering UK domestic flights, flights between the UK and Gibraltar and flights departing the UK to European Economic Area states.
It is clear from the Energy White Paper that the UK government considers the UK ETS a central pillar to its net zero carbon policy goals. Furthermore, the UK government intends to extend the UK ETS to other sectors across the broader UK economy to cover two thirds of uncovered carbon emissions. [Fn3]
Free Allocation Principles of the UK ETS – Avoiding Carbon Leakage
The UK ETS will follow a similar approach to the EU ETS by providing special treatment to industrial installations and certain aviation operators which are considered to be at a high risk of “carbon leakage” in order to maintain their competitiveness internationally. Carbon leakage is the term given to a situation whereby a business transfers its operations to another country with less strict carbon regime to avoid costs of climate policy compliance.
The aim of this special treatment (akin to a government subsidiary) is to prevent an overall net increase in emissions from large industrials should they move offshore. As with the EU ETS, the form of the special treatment will be an allocation of a higher proportion of free UKAs. In theory this will help such businesses de-carbonise whilst retaining their international competitiveness. At least initially, the UK will use the same benchmarks used to calculate free allocation entitlement as in Phase IV of the EU ETS.
Will the UK ETS be linked to the EU ETS?
In the coming months, we may see movements to link the UK ETS and EU ETS in the same way as the EU and Switzerland did in 2020 [Fn4]. Indeed, in the EU-UK Trade and Co-operation Agreement [Fn5], the EU and UK agreed that:
“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.” [Fn6]
As at the time of writing the UK has only stated that it will consider linking with the EU ETS, but has made no firm decisions on which international partners to work with. [Fn7]
UK ETS Carbon Cap Levels and Auction Reserve Price
The UK ETS will have an initial cap of 155.7mn allowances for 2021. This is 5% lower than the UK’s notional share of the EU ETS phase 4 (2021-30) cap. This cap will reduce in future years as the UK progresses towards a net-zero carbon economy.
The UK published the Auctioning Regulations on 11 February 2021 (the Auctioning Regulations) [Fn8] which govern the auctioning of UKAs and establishes the secondary market for trading of UKAs.
The UK ETS has been designed to initially include a transitional Auction Reserve Price (ARP) of £22 per metric tonne of CO2 [Fn9] which will be the minimum price for which UKAs can be purchased via the auction mechanism.
A further statutory instrument has been published by the UK government called the Recognised Auction Platforms (Amendment and Miscellaneous Provisions) Regulations 2021 [Fn10]. This gives the Financial Conduct Authority the power of oversight over the UK ETS and makes it clear that a UKA is to be considered a “financial instrument” in the UK. This designation ensures that the trading of UKAs is subject to stringent checks and balances applicable to all other financial instruments under UK legislation. ICE Futures Europe will provide the auction platform for UKAs (with the first auctions due to take place in May 2021) and will facilitate the secondary trading of UKAs until December 2022.
Contractual Documentation for the trading of UKAs
EU ETS Allowances are typically traded using an ISDA Master Agreement, IETA contract or EFET contract (with appropriate annexes).
So far none of the industry bodies has published updated contracts for the trading of UKAs. Working groups have however been set up and we are likely to see new addendums / appendices to the main suites of trading documentation in the coming months. We will publish a follow-up client alert once new documentation has been published.
Footnotes
Fn1: The UK ETS was established by the Greenhouse Gas Emissions Trading Scheme Order 2020 (SI) 2020 No. 1265, available here.
Fn2: See page 129, Energy White Paper, available here.
Fn3: See page 129, Energy White Paper, available here.
Fn4: Agreement between the European Union and the Swiss Confederation on the linking of their greenhouse gas emissions trading systems, available here.
Fn5: EU-UK Trade and Co-operation Agreement, available here.
Fn6: See TCA, Part 2, Heading One, Title XI: Level Playing Field for Open and Fair Competition and Sustainable Development, Chapter 7 (Environment and Climate), Article 7.3(6) (Carbon Pricing).
Fn7: See page 129, Energy White Paper, available here.
Fn8: The Greenhouse Gas Emissions Trading Scheme Auctioning Regulations 2021, available here.
Fn9: see Section 6(9) of the Auctioning Regulations.
Fn10: The Recognised Auction Platforms (Amendment and Miscellaneous Provisions) Regulations 2021, available here.
The information contained in this Client Alert is intended to be a general guide only and not to be comprehensive, nor to provide legal advice. You should not rely on the information contained in this Client Alert as if it were legal or other professional advice.
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