Following the minor amendments to the UK ETS which came into force on 1 January 2024, the Department for Energy Security and Net Zero (DESNZ) is consulting on technical matters concerning the future structure and operation of the UK ETS. One consultation considers the UK ETS target free allocations for sectors most at risk of carbon leakage (the Allocations Consultation), whilst the other concerns the UK ETS future markets policy (the Markets Consultation) (together, the Consultations).

Free allocation policy

Carbon leakage is the movement of production activities and the associated carbon emissions out of the UK, in order to avoid higher levels of carbon pricing and more stringent climate regulation. The risk of domestic carbon leakage can be mitigated by reducing the carbon price that operators pay under the UK ETS. The free allocation policy concerns the provision of free UK ETS allowances so that operators can purchase fewer allowances to cover their emissions. The overall incentive to decarbonise is maintained as, in general, recipients of free allocations that successfully decarbonise their business operations are allowed to keep any surplus free allocations.

Free allocations are calculated using the following equation:

Preliminary Free Allocation

=Historical Activity Level ×Benchmark ×Carbon Leakage Exposure Factor

The historical activity level is calculated based on an average annual activity of an installation's output during a baseline period of five years.

The benchmarks utilised by the UK ETS are the same as those set out under the EU ETS, and act as reference values for greenhouse gas emissions relative to production activity. There are currently 52 product benchmarks, which represent the average figure of the top 10% most efficient installations for each benchmark product across Europe.

The carbon leakage indicator (CLI) seeks to quantify the carbon leakage risk of UK ETS-covered industries. The CLI is converted into a carbon leakage list (CLL), which sets out the sectors and sub-sectors most at risk of carbon leakage. The CLL is then converted into the carbon leakage exposure factor (CLEF), which is currently a binary measurement which deems sectors at risk, or not at risk, of carbon leakage. Those at risk then receive additional support, through allocations, to bolster installations' competitiveness and dissuade entities from moving their operations overseas.

The Allocations Consultation

The Allocations Consultation broadly focuses on proposals which aim to account for emissions and activity, benchmarks, the CLL, and additional factors that could be introduced to the free allocation methodology. It seeks respondents' views on proposals to:

  • Calculate provisional allocations through a dynamic method, whereby an entity's initial allocation is provisional, based on a rolling period of the two most recent full years of activity. The allocation would then be adjusted after each scheme year.
  • Update benchmarks to include UK installation data, in an effort to reflect improvement rates achieved by UK installations.
  • Amend the method for tiering the CLEF, based on different CLI scores.
  • Bring forward the phase out of free allocations to 2026 for sectors whose CLI scores deem them not at risk, thereby reducing the overall number of free allocations under the scheme and allowing them to be better targeted at high-risk sectors.

Future markets policy

When the UK ETS was initially established, various market policies were put in place to support the launch of the new UK ETS market, and the effective operation of the new scheme. The auction reserve price (ARP) is an effective policy mechanism to mitigate the risk of sudden, significant and sustained price decreases. The current minimum ARP is £22 at primary auctions, below which UK allowances will not be sold. The cost containment mechanism (CCM) is triggered if the price for allowances is elevated for a sustained period relative to a historic average. If the CCM is triggered, the UK ETS Authority (the Authority) can intervene and reduce prices. It has thus far only been triggered twice, with no action taken either time due to the Authority concluding that the trigger was attributable to recent developments in energy markets or fundamental market drivers. The CCM therefore serves as a complementary market policy which is utilised to mitigate the risk of sudden, significant, and sustained price increases.

The Markets Consultation

The Markets Consultation seeks respondents' views on the most significant risks to effective market functioning under the UK ETS, and different policy options to address these risks. It also considers each option's relative suitability, and the design of market stability policies to promote effective management of market risks while minimising intervention and disruption. The key proposals in the Markets Consultation are:

  • The implementation of a quantity-triggered supply adjustment mechanism, which would amend the supply of allowances in the market in response to pre-determined criteria and market conditions. This would aim to address the risk of demand shift with long-term impacts in the market.
  • The retention of the ARP, which is considered by the Authority to be a temporary policy to be phased out as the market matures, with potential adjustments which aim to maximise the risk mitigation provided.
  • The introduction of additional mechanisms alongside the ARP to mitigate the risk of excessive and sustained low prices.
  • The potential retention of the CCM, with adjustments to the trigger thresholds to increase the reactivity of the mechanism.

Implications and next steps

The Consultations set out significant proposals which, if implemented, will alter the design and operation of the UK ETS in an effort to render it a more effective mechanism for continuing to combat domestic carbon leakage.

The NRF Environment team will continue to monitor amendments to the UK ETS and provide a further update once the government response and industry feedback into future developments to the UK ETS are published. Our global climate change and sustainability practice has extensive experience advising clients across all key environmental and carbon markets.

With thanks to Rebecca Bell (trainee solicitor) for her contributions.

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