What would (re-)linking UK and EU ETS regimes mean for business? - Trade Treasury Payments

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What would (re-)linking UK and EU ETS regimes mean for business?

On 19^th May, the UK and the EU announced plans to link the UK Emissions Trading Scheme (“ETS”) with the EU ETS. 

The UK and EU ETS regimes are ‘cap and trade’ carbon pricing regimes, meaning they require affected businesses – predominantly industrial installations and aviation operators –  to surrender emissions allowances at the end of each reporting year equal to their carbon footprint. 

In a way, linking these regimes would not be a new development. After all, prior to Brexit, UK industrial installations and aviation operators were subject to the EU ETS, with regime divergence only coming into effect in 2021 when the UK launched its own ETS – a very similar regime to the EU’s. There are also still some UK businesses, such as Northern Ireland-based electricity generators, that remain subject to the EU ETS regime.

This creates a somewhat unique policy position. While ETS regimes have linked previously, for example the Swiss ETS linking with the EU ETS since 2020, there do not appear to be any previous instances of ETS regimes diverging from a single point, before then re-converging into a linkage arrangement.

Questions surrounding implementation

As the agreement was only recently reached, information on what the linkage could look like in practice remains scarce. Three outstanding areas of uncertainty are:

1. Linkage mechanism – It is not yet confirmed how interoperability and mutual recognition of emissions allowances between the UK and the EU would work in practice. For example, whether daily movement of allowances between registries would be employed, as is the case with the Swiss-EU ETS linkage, or some other alternative.

2. Exemptions – A key principle underlying the proposed linkage is to mitigate exposure of UK exports to EU Carbon Border Adjustment Mechanism (CBAM) costs, and vice versa. However, it remains to be seen how such an exemption would operate practically, such as the possible impacts on compliance or reporting requirements for relevant importers. The UK Government estimates that the exemption could prevent approximately £800m in potential CBAM payments on UK exports to the EU by 2030.

3. Timings – Previous ETS linkages have taken multiple years to actually deliver following the initial agreement, not least the aforementioned Swiss-EU ETS linkage. Given the intention of exempting UK goods from the EU CBAM, and vice versa, time pressure will be significant, with first EU CBAM certificate surrenders currently being required in 2027 – only 18 months away. 

Potential implications for business

Despite the ongoing areas of uncertainty, it is possible to predict some potential impacts for business. Five notable areas to monitor include:

1. Pricing –  Over the last year, UK ETS allowances (UKAs) have been trading at a substantive discount to their EU equivalents (EUAs).  At the time of writing, UKAs are trading at around £50 (c€60), while EUAs are trading at around €70. Linking the regimes could re-align pricing, boosting the price of carbon in the UK.

2. ETS scope – The UK and EU regimes have started to diverge in scope, slightly. For example, the current EU ETS coverage of maritime is more expansive than recent proposals to expand the UK ETS into that sector, with EU ETS coverage including 50% of any journey landing in the EU (subject to certain exceptions), unlike proposed initial UK ETS maritime scope expansion. Linkage could require scope alignment between the regimes in areas such as this.

3. Free allocation – Many ETS-exposed businesses in each jurisdiction currently receive some UKAs or EUAs without charge, based upon the ‘free allocation’ system. Over time, these free allowances are phasing out, but at different speeds for different sectors – in part due to policies such as CBAM. The EU’s free allocation phase-out trajectory has diverged slightly from the UK, most saliently regarding accelerated free allowance phase-out for CBAM-covered sectors. Aligning regimes could require convergence in free allocation policy across both jurisdictions, impacting the effective carbon price for exposed businesses.

4. Cost compensation – Businesses that are major consumers of energy and are exposed to ETS-driven costs currently receive varying degrees of cost compensation in both the UK and the EU, through initiatives such as the UK’s Energy Intensive Industries (EII) ETS Compensation Scheme. Regime linkage and alignment could impact evolution of these mechanisms moving forward, given the need for regime comparability to allow for effective CBAM exemption.

5. CBAM exposure and implementation – Regime linkage could enable mutual exemption of CBAM exposure for businesses trading goods between the two jurisdictions, as well as impacting the UK’s implementation of its own CBAM, which is currently planned for 2027.

Responding effectively

A proactive response to this developing policy will help reduce business uncertainty. 

As a result, companies should consider their approach to monitoring and engaging with the policy development. This could include participating in any consultations opened by authorities on the topic, or engaging with industry bodies’ advocacy efforts.

The uncertainty concerning carbon pricing is most stark when it comes to the actual price applied to carbon. Many advanced businesses with significant ETS exposure are already applying hedging and trading strategies to allowances to manage price risk – and the imperative to do this will only increase as policy developments threaten to shift pricing.

Finally, there is  CBAM exposure for many UK and EU businesses that may change due to these policy developments. At a general level, businesses should ensure that they have a clear view of their cost and compliance obligations arising from both the EU and emerging UK CBAM, as this can present not just an incentive to act on compliance, but also a case to decarbonise supply chains or make other structural changes to manage exposure. An up-to-date impact assessment on EU and UK CBAM obligations and exposure, which reflects the latest policy changes, is therefore also worth considering.