Sending a smoke signal – the potential of emissions trading

A year on from the launch of the UK Emissions Trading Scheme, experts came together to discuss what the challenges are and how the UK can make the most of the system to deliver on its net-zero targets. Alex Brinded reports.

Brexit happened less with a bang and more an extended fizzle. As such, the UK Emissions Trading Scheme (UK ETS) – Britain’s divergent national version of the EU ETS – began last year with a faltering start in January 2021. Proceedings only really began in earnest with auctions last May.

Rachel Armstrong, Director of Industrial Decarbonisation and Emissions Trading at the Department for Business, Energy & Industrial Strategy, reviewed the progress so far at a recent Westminster Energy, Environment & Transport Forum policy conference.

‘We’ve come a really long way since we consulted on the design of the UK ETS in 2019. And we did do this jointly with the devolved administrations because this is a largely devolved policy area,’ she explained. ‘We said from the start of the UK ETS that we saw the scheme playing an important role in delivering our emissions reduction commitments. And the UK Government’s Net Zero Strategy published in October 2021 underlines this – placing fair carbon pricing as one of the key principles of the UK’s approach to net-zero.’

Armstrong noted that developing the UK specific scheme ‘wasn’t without challenges. But our experience of the EU ETS was valuable as we sought to balance continuity for participants with ambition.’ The sectors covered are the same as in the EU ETS – industry, power and aviation – with the cap reduced by 5% compared to the UK’s notional share of the EU ETS cap.

She outlined how the UK Government issued nearly 130 million allowances in 2021, through a combination of free allocation and options, with revenues from the latter reaching over £4.5bln across the year.

Fair transition?
Dr Ralf Martin, Director of the Growth Programme at the Centre for Economic Performance at the London School of Economics and Political Science, UK, reflected on lessons learnt from the EU ETS. ‘There seems to be an investment specifically in equipment that is more efficient. And that’s how [sectors] achieve these carbon reductions,’ he said. ‘And we find so far, that we don’t need to worry too much about any leakage effects…[But] if you want to make the system more efficient, you should not allocate too many permits for free to the regulated businesses.’

Lord Deben, Chair of the independent statutory Climate Change Committee, stressed the importance of a fair transition. ‘The one thing we do have to say is that, because we make special arrangements for industries which are heavy users of energy, [this] means that they also have a special responsibility to seek to reduce those emissions. In other words, it’s a deal.’

He noted the value of cooperation. ‘We don’t want those emissions exported, not just for economic reasons, but for climate change reasons. Because if you export them, you no longer have any control over reducing them. So, it’s crucially important that you should keep those industries here.’

George Anstey, Director of the National Economic Research Associates consultancy, highlighted the difference between theory and practice. ‘The UK ETS is, broadly speaking, a carbon copy of the EU ETS at this stage – it’s almost like a policy in search of a specific problem,’ he argued. ‘And from its very inception, it was viewed as an opportunity to drive an efficient decarbonisation path across Europe. And in practice, it’s kind of a failed policy. Fundamentally, prices have never really been high enough to force the decarbonisation required.’

Dr Daniel Sturge, from the UK’s Energy Systems Catapult, also talked about the challenges involved. ‘Our international analysis, that we did [looking at] a range of case studies across the globe, suggests that trying to implement a simple carbon tax or a blanket carbon price across the economy faces a range of political challenges, distributional challenges and fundamentally are unlikely to deliver the policy stability that we need to deliver net-zero.

‘And also, practical experience suggests that the challenges and indeed the opportunities for emissions reduction policies vary for different sectors and across the economy. So, trying to treat them equally is maybe not necessarily the best thing to do in the near term in particular.’

Adam Berman, European Policy Director of the International Emissions Trading Association, added, ‘The UK ETS is trading systematically at a premium to the EU ETS. And what that means in practice is that British companies...are at a competitive disadvantage in relation to EU companies because they pay a higher carbon price.’

Richard Woolley, Head of Energy and Climate Change at the Chemical Industries Association, echoed that assessment, ‘Carbon prices are trading consistently above the EU carbon price since about mid-June. All of this is important because it puts UK manufacturers at a competitive disadvantage at a time when they’re looking to make huge investments in the net-zero transition.’

‘We need...a carbon border adjustment mechanism, that’s going to ensure that we do not simply import our carbon emissions from elsewhere,’ postulated Anstey. ‘Because fundamentally, if we have a very high carbon price in Britain and export our carbon emissions by losing heavy industry and losing emitters in the UK, that’s going to result in political pressure for reform of the system and undermine the carbon signal.’

As Claire Thornhill, Associate Director of Frontier Economics, noted, ‘The EU ETS will introduce a Carbon Border Adjustment Mechanism (CBAM) in 2023, it’s very much aimed at the energy intensive adjustment.’

Guy Buckenham, Head of Strategic and Emerging Markets Policy at EDF Energy, continued, ‘It’s still a relatively immature market’, and addressed the issue of the delayed auctions from January to May 2021. ‘That meant for many fossil generators...they couldn’t even buy carbon allowances to match what they already generated. So, there’s quite a catch-up [from] last year.’

Across the borders
Inter-country and inter-ETS collaboration was a common theme. ‘One of the great advantages of an emissions trading system, a cap-and-trade system over carbon tax, is that it allows international cooperation,’ Berman asserted. ‘Article Six of the Paris Agreement, which was just finalised at COP26 in Glasgow, is the first such mechanism that genuinely allows countries to work together.’ He discussed the possibility of linking the UK ETS with others. ‘I think the best we could hope for is a kind of plurilateral mechanism in which different countries work together, perhaps through formal linkages, perhaps through a couple of mechanisms from the Paris Agreement.’

Anstey pointed to external investment, ‘Does non-territorial, decarbonisation count? Are you doing your bit if actually carbon emissions fall in Spain, because it’s cheaper for carbon emissions performance in Spain, than for carbon emissions to fall in the UK and, historically, given the way that countries are incentivised and effectively performance is managed by their peers. There’s just no credit for doing that.

‘And so fundamentally addressing the system of measurement is going to be really helpful for motivating change because then you can say, ‘Look, Britain is funding decarbonisation…and that way of measuring progress is correct.’

Thornhill added, ‘The first best option for addressing carbon leakage threats is greater international collaboration and linking up schemes and agreeing climate targets across multiple countries.’ However, she recognised this was easier said than done.

Laith Whitwham, Senior Policy Officer at the Aldersgate Group, also enthused about the possibility of a global ETS to improve best practice. ‘At the moment in the UK, what we do in terms of allowing and benchmarking for free allowances is that we base it on the top 10% most efficient installations, a problem that we have…[is that] just as we transitioned over into the UK system, in some heavy industries, the top 10% of firms, or top 10% of installations, might be two or three sites because there’s simply not a large market.’

Berman felt the UK Government could do more. ‘There are some really great prospects internationally for the UK ETS to lead by example. But I would say that so far, we’ve seen relatively little willingness from the British Government to really utilise this mechanism to the best of its potential.’

Cap and trade

Emissions trading schemes usually work on the ‘cap and trade’ principle, where a cap is set on the total amount of certain greenhouse gases that can be emitted by sectors covered by the scheme. As the cap decreases over time, it is intended to make a significant contribution to net-zero targets and other legally binding carbon reduction commitments.

Within this cap, participants receive free allowances and/or buy emission allowances at auction or on the secondary market which they can trade with other participants as needed.

The UK Emissions Trading scheme (UK ETS) applies to energy intensive industries, the power generation sector and aviation. Each year, installation operators and aircraft operators covered by the scheme must surrender allowances to cover their reportable emissions. The cap is reduced over time, so that total emissions must fall.

The installations affected are those with activities that result in greenhouse gas emissions, including combustion of fuels on a site where combustion units with a total rated thermal input exceeding 20MW are operated (except in installations where the primary purpose is the incineration of hazardous or municipal waste).

If eligible, installations with emissions lower than 2,500t CO₂e per annum may obtain ultra-small emitter status. They would not be required to hold a permit but are still required to monitor and must notify their regulator if they go over the threshold.

The free allocation of allowances to eligible installation operators and aircraft operators will continue, and is designed to reduce the risk of carbon leakage for UK businesses. The initial approach to free allocation is similar to the EU’s approach for Phase IV of the EU ETS. This ensures continuity for businesses.

Source: Participating in the UK ETS, Department for Business, Energy & Industrial Strategy

Showing leadership
‘The alliance of businesses [that]Aldersgate Group represents wants to know where we are heading’, said Whitwham. ‘What we'd like to see constantly with a strong ETS system, is a sense of certainty about the availability and costs of low-carbon infrastructure, be that technology or alternative fuels.’

Woolley, highlighted funding differences, ‘We also need significant support. A colleague of mine totted up the government support for industrial decarbonisation over the next five years that’s been announced. This is an order of magnitude lower than the support that the power sector has received to decarbonise. It is actually the same over the next five years, £4.3 billion, as the ETS auction revenue was in year one of the scheme.’

He was strident in calling for government leadership. ‘So far, we’ve had no detail from Treasury on the most important measure, which is the UK position on a carbon border adjustment mechanism. We’ve seen the EU talking and developing their thinking apace, we’re told Treasury are working at it, but we’ve had nothing publicly – we've had no engagement, and it’s not only the UK position on a UK carbon border adjustment, but [our] position on an EU [adjustment] that’s important too.’

Buckenham is also looking for clear signals from government. ‘The government consultation on next steps on the UK ETS is hopefully coming very soon. I think it will be really important if that [provides] some direction to help us all have a better fundamental understanding of what to expect from the UK ETS.’

Whitwham believes that the scheme can go further. ‘First and foremost, for the ETS to be able to do its job as a cap-and-trade system, we need to see that ambition is in line with our net-zero target.

‘If you take the heavy industries, for example, we need to reduce emissions by two-thirds by 2035 and 90% by 2050. So as part of the UK’s broader transition to net-zero, we should see emissions allowances available to heavy industry under the ETS reflect that trajectory.’

Taking this a step further, Whitwham laid out his alliance’s vision. ‘I believe in the EU’s system, member states are expected to reinvest around 50% of the revenues from the EU ETS in climate and energy spend. This is absolutely something that the Aldersgate group and many of our members advocate for as well. We’ve heard how revenues could essentially be reinvested in home insulation, heat pumps, grid development, electrification, and several other forms of climate and energy spend. I think it’s really key to a just transition at the time of an energy crisis that we’re using revenues raised through these kinds of systems to actually enable smoother transition across the economy.’

Woolley advocated similarly for the chemical sector. He noted that, from 1990, the UK chemical sector has increased production by about 40% while reducing Scope One greenhouse gas emission intensity by over 80%. ‘Essentially, we provide the advanced materials that go into the products that will underpin our green economy. So, we really want to be here in 2050, we want UK manufacturers to be churning out these products and driving that green growth engine.

‘In fact, in 2050, we’re still going to be using energy on an industrial scale, to make the products that we use in everyday life, whether that’s your dyes, your paint, glues, the rubber on your tyres – all of these require large amounts of energy to make. So, where we get that energy matters.’

He mused that the low-heat processes in the chemical industry could be carried out with electricity, at the right price, but that processes with high heat demanded hydrogen, and quick.

Woolley pointed to UK industrial electricity prices being 80% higher than the EU median, and that the issue was an increasing wholesale cost and network cost.

‘As mentioned, our low hanging fruit – efficiency gains have been implemented. And you can see that in our emissions profile. So, what we’re looking at now is fuel switching to hydrogen, but that hydrogen needs to be available, and it needs to be available at a cost that allows us to remain internationally competitive on global markets.’

‘Hydrogen – it is still very, very early days, we don’t yet have a low-carbon hydrogen plant in commercial operation,’ Buckenham added. ‘We will find that, in time, the carbon price is a key part of making, for example, low-carbon hydrogen competitive with existing suppliers and grey hydrogen.’

Armstrong outlined the government’s next steps. ‘We intend to launch a call for evidence in the coming months to explore the role of the UK ETS as a potential long-term market for greenhouse gas removals.’ But she noted that ‘we are clear that greenhouse gas removals must not be pursued as a substitute for decisive action across the economy to reduce emissions’. How exactly, was hinted at – ‘expanding carbon pricing to gas is one possible way to achieve this. But no decisions have been made yet’.