Pricing greenhouse gas emissions is essential for effective climate action.
As a member state of the European Union (EU), the UK has participated in the EU Emissions Trading System (ETS) (a cap and trade system). However, as the UK prepares to leave the EU and the transition period draws to a close, another policy must be put in place to ensure the pricing of carbon emissions continues on the 1st January 2021.
There are three potential options that UK government is exploring:
Standalone UK ETS
A standalone ETS would raise transaction costs due to low liquidity in the market. The increasing difficulty in finding counterparties for permit transactions reduces the number of beneficial transactions. This is also likely to be the worst performing option in terms of implementation cost. Furthermore, UK competitiveness could be damaged if emissions prices in the UK are greater than those in the EU. A standalone ETS does however give the UK more freedom to alter coverage and tie policy more closely to the net zero target. This could be achieved by including fossil fuel distributors in the ETS as is done in Quebec.
UK ETS linked to EU ETS
A UK ETS linked to the EU ETS is dependent on successful negotiations between the UK and EU. The main drawback of this system is the lack of control that the UK has in setting policy, as any linked ETS will need close alignment with the EU system. Other policies would be necessary to address emissions in sectors not covered by the EU ETS. However, the main concerns of the standalone ETS option would be addressed as UK companies would have access to a large liquid market and low transaction costs. Therefore, there would be no competitiveness concerns.
Carbon Tax
Initially, the Carbon Tax would cover the same sectors as the EU ETS at a very similar price (for 2021 and 2022 the price is based on the futures price of the EU system plus an uptick and then adjusted down to average EU ETS prices). Changes to prices and coverage are expected in the future, although details of this are yet to be published. While a carbon tax offers greater price certainty than an ETS, levels of emission reduction are less certain, and it is less responsive to economic shocks. However, the simplicity of the system allows for simpler implementation for a broad range of sectors.
All three options closely align with the EU system in terms of coverage. Free allocation would continue to a similar effect under all options with the Carbon Tax introducing a tax-free allowance.
The proposed design of a standalone and linked ETS are similar to the EU ETS, which allows for linking at a future date should negotiations fail at this stage. Both UK systems would have a cap 5% lower than the UK’s emission allowance share under the EU ETS, representing a higher level of ambition. Although a surplus in allowances will still exist to allow for hedging. One key difference is the minimum allowance price included in the standalone option, which is set at £15 / tCO2.
It seems like a linked ETS is the preferred choice by the UK Government with the Carbon Tax a sensible fall back due to the high costs of the standalone ETS. The immediate impact on the roughly 1,000 UK businesses covered by the EU ETS is likely to be small as these two options closely align with the EU system in the short term. In the medium term, we should see the Government increasing the coverage of the chosen system.
I believe a predictable and increasing emission price to be key in stimulating abatement investment. The EU ETS has historically struggled with low prices due to oversupply of emissions allowances, although measures have been taken to provide greater price stability under the European scheme. I believe the Carbon Tax to be the best choice as it sets a clear price signal and can be expanded in the future.
For more information on the future of carbon pricing in the UK you can read government consultations on the UK ETS and Carbon Tax.
Author: Jamie Mitchell Economist at Gemserv