On 25th March, the UK Emissions Trading Scheme (ETS) Authority published a consultation to seek stakeholder views on a range of proposals to develop the UK ETS in line with the government’s decarbonisation ambitions.

Background

The UK was formerly part of the EU’s flagship carbon pricing mechanism – the EU Emissions Trading System (ETS), launched in 2005. After withdrawing from the EU at the end of 2020, the UK replaced the EU ETS with the UK ETS, a near-identical scheme that opened for trading in May 2021.

This consultation signifies the first time that major developments on the future of the UK ETS have been announced, sending a clear signal to the market that those who decarbonise will thrive as we transition to a low-carbon economy, whilst laggards must pay.

What is a ‘cap and trade’ scheme?

The UK ETS is a ‘cap and trade’ scheme meaning that a cap on emissions from in-scope sectors is set for each phase or period of the ETS. The supply of allowances into the market is less than the expected emissions, incentivising companies to decarbonise where the price of emissions allowances exceeds their marginal cost of abatement. Key features include:

  • The first trading phase of the UK ETS will run until 2030
  • Selected industries receive a free allowance allocation, historically around 43 percent of the total
  • Remaining allowances are auctioned periodically throughout the year, historically around 57 percent of the total
  • Businesses can then trade allowances between each other to ensure they have enough allowances to cover their annual emissions
  • At the end of the year, businesses surrender their allowances to the UK ETS Authority
  • When the new year begins, the cap (total annual allowances within the system) is reduced and the process repeats, with emissions under the system reducing over time

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Summary of UK ETS proposed changes

  1. Net Zero aligned cap and reduced number of free allowances from 2024

    The UK ETS cap is expected to be aligned with the UK’s Net Zero target. To achieve this, the number of allowances in the scheme has been proposed to reduce significantly from 2024, such that the total cap for the entire of Phase 1 (2021 – 2030) will be reduced by 30-35 percent from current legislation. This brings it on par with the EU who recently aligned the EU ETS cap with Net Zero in their ‘Fit for 55’ package.

    In addition, the free allowances allocation, distributed within certain industries to mitigate carbon leakage, will be reviewed with an expectation that these will also be reduced from 2024. While all sectors will be reviewed, the UK ETS Authority is specifically requesting information from the aviation industry to complete a sector-specific review of the free allocation policy and decide on a phasing out approach.

  2. Additional sectors to be brought under coverage

    Domestic maritime and waste sectors are to be introduced incrementally by mid-2020s and late-2020s, respectively. Domestic maritime activity was responsible for more emissions than the UK rail and bus network combined, while waste contributes around 1 percent of UK emissions (Developing the UK Emissions Trading Scheme (UK ETS), BEIS, p.101 & p.113). Although this falls short of the additional sectors that the EU ETS is planning to bring under scope coverage, which includes maritime transport, road transport and upstream emissions from buildings, the UK ETS Authority has kept the door open for additional sectors to be added in future.

    In addition, the consultation is currently gathering evidence over the consequences of incorporating carbon removals into the UK ETS, both nature-based and engineered, but their role in any potential market is at an early stage of thinking.

  3. Additional GHGs to be brought under coverage

    There has been clear global attention on the impact of greenhouse gases other than carbon dioxide, with the notable Methane Pledge made at COP26. Therefore, proposals to include methane and other gases for selected activities under UK ETS coverage recognises the impact that these gases have. This is particularly important given the global warming potential of these other gases, with methane’s impact twenty-five times greater than carbon dioxide (List of greenhouse gases with corresponding global warming potential (GWP), BEIS).

  4. Carbon Border Adjustment Mechanism (CBAM)

    To mitigate against carbon leakage, where domestic industries are undercut by competitors based outside the UK in jurisdictions that have less costly carbon pricing policies or none at all, the UK ETS Authority is exploring options including a UK Carbon Border Adjustment Mechanism. This would apply an additional cost to goods imported to the UK to ensure they reflect the emissions-related costs they would have incurred if they had been produced in the UK.

    The EU CBAM is further ahead in its developments than the UK CBAM, with the EU Commission approving the policy in March 2022 to be gradually phased in from 2023 and charges applied from 2026. Recently, a select committee of MPs, the EAC, called for the UK government to introduce a CBAM given that imports account for 43 percent of the UK’s consumption emissions. It is expected that further detail on a UK CBAM will be published in response to this consultation.

Key implications for businesses

  1. Higher carbon prices

    The price of UK ETS allowances (the cost per tonne to emit CO2e) has risen significantly since inception of the scheme in May 2021 at £47/tonne to current levels of £78/tonne. It is expected that the price trajectory of allowances will continue and even accelerate as the total number of allowances reduces to align the scheme with the UK’s Net Zero target, in addition to fewer free allowances.

    This will likely increase the cost base for businesses either through a direct effect where companies are required to purchase allowances at a higher carbon price, or an indirect effect as the higher price is passed along the value chain. As a result, businesses should look to implement at least one of the following mitigation measures:

    - Reduce volume of material from in-scope ETS sectors
    - Change mix of products
    - Undertake emissions reduction measures

  2. Value chain implications

    With additional sectors expected to come into scope, businesses should deepen their understanding of value chain emissions. This includes identifying where the business is most exposed to carbon pricing impacts and defining mitigation practices to limit risk exposure, with considerations around carbon accounting critical to defining the impact.

    The proposed UK CBAM also raises a strategic question for businesses given that relocating the supply chain overseas will no longer be a viable option to avoid higher carbon pricing.

  3. Considering emissions beyond carbon

    Attention to greenhouse gases other than carbon dioxide is increasing. The proposals to include methane and other gases for selected activities under the UK ETS mean businesses need to gain a strong understanding of these greenhouse gases and consider how they can be incorporated into decarbonisation and nature-related plans.

    This would require CO2e (carbon dioxide equivalent) calculations to express the total greenhouse gas inventory in terms of CO2 based on their relative global warming potential and for companies to monitor and set targets at the individual greenhouse gas level.

    This broader trend also links with other new regulations and initiatives including The Taskforce on Nature-related Financial Disclosures (TNFD) for which air pollution is a key consideration, bringing the wider carbon, climate and nature-related considerations closer together.

How we can help

  1. KPMG Climate IQ

    Our market leading tool KPMG Climate IQ can help you to assess potential carbon price exposure in key markets and sectors under different policy scenarios and explore opportunities to minimise or manage exposure.

  2. Value chain mapping – CBAM

    Our climate and supply chain experts can review and map carbon emissions across geographies at each stage of your value chain, helping you to identify exposure hotspots and support your mitigation strategy.

  3. Quantify potential exposure to ETS and CBAM proposals

    Our team of climate regulation and carbon pricing experts can help you to understand, manage and mitigate exposure to current and incoming carbon and emissions regulations so that you are best placed to perform in a changing environment.

  4. Develop a strategy to reduce all types of emissions

    Our team of climate change and strategy experts can support you to develop a transition strategy that reduces both your carbon and non-carbon emissions. This will support you to reduce exposure to ETS price increases, meet the pending TNFD recommendations and meet stakeholder and regulatory expectations.