The UK ETS: consultation on changes to the UK ETS to achieve cost-effective emission reductions

• United Kingdom

• Environment
• Energy and infrastructure

26-04-2022

The UK Emissions Trading Scheme (“UK ETS”) Authority (comprised of the UK Government, Scottish Government, Welsh Government and the Department of Agriculture, Environment and Rural Affairs for Northern Ireland) is seeking views on the further development of the UK ETS. The consultation, which opened on 25 March 2022 and will run until 17 June 2022 (the “Consultation”), explains the intention is for the UK ETS to be the world’s first net zero consistent cap and trade market, reflecting the Government’s commitment to achieve net zero greenhouse gas emissions by 2050.

UK ETS: a brief recap

The UK ETS is a cap and trade scheme that seeks to reduce greenhouse gas (“GHG”) emissions by requiring operators of installations in certain energy intensive sectors to surrender allowances equivalent to their GHG emissions within the scope of the scheme. Within the cap participants buy emission allowances at auction or on the secondary market or in some cases receive a free allocation. Over time the cap reduces which means emissions in the sectors subject to the scheme should fall.

Changes to the UK ETS: key proposals

Net Zero Consistent Cap

• The Consultation proposes to align the UK ETS cap and trajectory with the UK’s 2050 net zero commitment.
• In the Climate Change Committee’s Sixth Carbon Budget the cap for Phase 1 of UK ETS was initially set at 5% below the UK’s expected notional share of the EU ETS cap for Phase IV of the EU ETS (i.e. 2021-30). This equates to around 156m of allowances in 2021 and was set to reduce annually by 4.2m allowances.
• it is proposed that the Government will allow a cap for Phase 1(2021- 2030) of between 887 million allowances and 936 million allowances. This would be a reduction of 30-35% over Phase 1 compared to the current cap.
• The Government is inviting views on where to set the cap within this range. The level of the cap will be decided when responses to the Consultation have been received and evaluated.
• the new cap will apply from 2024 to maximise the period of notice to the market and enable the Government to consider the responses to the Consultation in full.
• a steep change in the level of the cap in 2024 will be required.
• to smooth this transaction consideration is being given to bringing a portion of 2021-2023 unallocated allowances to auction.

Free Allocation Review (for the stationary sector)

• the provision of free allowances is currently the main policy instrument used to mitigate carbon leakage.
• the initial approach to free allowances was similar to that used in EU ETS Phase IV; however, the Government has committed to review the UK’s approach to free allowances.
• the review will consider how best to align free allowance allocation with the proposed changes to the overall cap. Changes to give effect to this will be implemented to take effect in 2024.
• the second phase of the review will look at the methodology for distributing free allocation and any changes will be implemented to take effect by 2026.

Unallocated Free Allowances and Flexible Share

The Consultation sets out options for bringing unallocated allowances and the flexible share to the market/auction. To date these have not been utilised through existing mechanisms in the legislation. The Government is considering using part of the 2021-2023 unallocated allowances/flexible share to auction to smooth the transition to the tighter net zero consistent cap.

A call for evidence on future markets policy

• the call for evidence seeks to establish a framework within which ETS markets policies can be designed in preparation for evolving market conditions for participants.
• views are sought on the future objectives of UK ETS policies, including, cost containment mechanisms, auctions processes and the market stability mechanisms account. The Consultation also seeks views on the withdrawal of the Auction Reserve Price.

Aviation

• The Consultation sets out a review to the UK ETS aviation policy to ensure that the scheme continues to develop in a way that supports the Government’s net zero commitment.
• in doing so, it is seeking to balance decarbonisation of aviation in a way that preserves the benefits of air travel, ensures UK operators remain competitive, reduces the risk of carbon leakage (carbon emissions from particular activities simply being moved abroad), and being mindful of the sector’s difficult recovery following COVID in the short to medium-term.
• The Consultation includes options to increase the rate at which aviation free allocations are phased-out, with options ranging from early phase-out (2026), intermediate phase-out (2028) to later phase-out (2031).
• The Government is also seeking views on whether the baseline for free allocation benchmarking (currently based on 2010 activity data) should be updated, and better reflect prevailing operations including new entrants, and how to ensure regional connectivity is not disproportionately impacted. Changes to free allocation are expected to be implemented by January 2024
• it is also proposed that flights from the UK to Switzerland will be brought into the scope of the UK ETS from the 2023 scheme year.
• The Consultation also considers how changes to the use of sustainable aviation fuels could be incentivised and how the scope of the UK ETS in respect of aviation could be expanded to incorporate non-CO₂ impacts (e.g. NO_x).

Expanding UK ETS coverage within covered sectors

It is proposed that the scope of the UK ETS should be expanded to cover additional gases and activities to provide further opportunities for cost-effective emission reductions. Changes are proposed across certain sectors including:

Upstream oil & gas: venting & flaring

GHGs from the UK onshore and offshore upstream oil & gas sector are already partly covered by the UK ETS. The Government is considering expanding the scope of the UK ETS to cover GHG emissions from venting and non-combustion processes, methane and nitrous oxide emissions to provide an additional driver for the decarbonisation of the sector and make the UK ETS the most ambitious emissions trading scheme in the world. Proposals include:

• consultation on the inclusion of CO2 venting
• call for evidence on the inclusion of methane
• call for evidence on safety venting and flaring
• call for evidence on remaining upstream oil & gas emissions

CCUS & transportation

The UK ETS does not currently recognise the transportation of CO2 via means other than pipeline (i.e. shipping, rail, barge, and road) for the purpose of permanent geological storage. As a result, future industrial sites are likely to be dissuaded from looking for a non-pipeline solution to CO2 abatement. The Government therefore proposes to expand the UK ETS to allow for the transportation of CO2 through other forms of non-pipeline transport, by including them as a regulated activity.

Biomass

The Government is consulting on the treatment of solid and gaseous biomass under the UK ETS, in cases where it is combusted as a fuel by energy intensive industries and power generation sectors in scope of the ETS. The consultation looks at the inclusion of:

• solid biomass, e.g. forestry by-products, sawmill residues, waste wood or energy crops that can be used for solid biomass production
• liquid biomass such as waste facts, oils, grease that can be used for liquid biomass production
• other wastes, sewage sludge, slurries or distillery by-products that can be processed through Anaerobic Digestion to produce gaseous biomass and can be further processed into biomethane

To ensure a more consistent approach across other UK policy areas, e.g. Contracts for Difference and Renewables Obligation, the Government also proposes –

• sustainability criteria are applied to solid, liquid and gaseous biomass for all installations, using a set of criteria mirroring one of the UK policies which already applies these standards, to ensure a more consistent approach to biomass between the UK ETS and the relevant biomass policies in each sector
• requirements that for installations and combustion units which generate energy (power, heat etc.) solely through biomass combustion to be exempt from the UK ETS, they must exclusively burn biomass which adheres to the relevant sustainability criteria
• for HSEs, requirements that the sustainability criteria are applicable for the purpose of (a) assessing eligibility to be a HSE in the second allocation period, (b) calculating of emissions targets and (c) determining whether an installation’s reportable emissions exceed the emission targets

20MWth threshold and 3MW aggregation threshold

The Government considers there is emerging evidence that the current 20MWth threshold could be failing to meet ETS policy objectives by shielding some high emitting generators from the carbon price and is looking for further information to explore this. The Government would consider a change in the threshold if it can create a more level playing field by requiring more installations to consider the carbon price.

Expanding the UK ETS to new sectors

• in line with the “polluter pays” principle the Government intends to bring new sectors into the scope of the UK ETS to ensure more emissions limited.
• The Consultation includes two proposals to expand the scope to domestic maritime by the mid-2020s and to waste incineration with no energy recovery and energy from waste by the mid to late 2020s.
• further, the Consultation notes that the Government will explore expanding the UK ETS to more sectors of the economy including high emitting sectors and will look to provide further proposals in due course.

Domestic maritime

• The Consultation notes that in 2019 domestic shipping represented around 5% of UK domestic transport greenhouse gas emissions (which is more than emissions from the UK rail and bus network combined). It makes clear that the proposals apply to the UK maritime sector (not international maritime) although the Government states that it will monitor developments in international and regional carbon pricing instruments regarding shipping emissions and how such developments could interact with UK policy going forward.
• The Consultation sets out a number of options the lead one being to apply the UK ETS to ship owners or operators on the basis of vessel activity (similar to the current treatment for aviation under the UK ETS) – this option covers domestic journeys (being a journey which starts and finishes at a port in the UK). Two alternative options are also covered in the Consultation – (i) an approach which covers fuel supplied to the domestic maritime sector, and (ii) a hybrid approach (which is a hybrid of the lead approach and the fuel supply approach) – which, it is thought, may be helpful to recognise diversity in the sector.
• the scope of the proposals will be limited - (i) to avoid burdening smaller participants, it is likely that thresholds for inclusion will apply (at least initially), and (ii) the proposals will not cover non-commercial maritime activity. Even though the scope is limited, the proposals raise the risk of evasive behaviour and possible ship re-routing to add an extra port outside the UK so as not to fall within the scheme.

Waste incineration and energy-from-waste

• The Consultation notes that, in 2019, energy-from-waste plants emitted 6.3MtCO2e which represented circa 1% of total UK emissions. By issuing the call for evidence in the Consultation, the Government hopes to understand how “the UK ETS may raise the efficiency of conventional energy-from-waste plants by incentivising more plants to supply heat (i.e. heat offtake) or by potentially encouraging residual waste to be recovered in a way which lowers overall carbon emissions, such as chemical recycling”. The Consultation also mentions that the UK ETS could incentivise (i) decarbonisation technologies and practices in this area, and (ii) investment in Carbon Capture and Storage to reduce emissions from energy-from-waste. If energy-from-waste plants are brought  within the scheme, investors and asset owners will need to revisit their waste supply agreements to determine if there  are any knock-on consequences to the provisions or to the pricing of the contracted gate  fee.

Calls for evidence on GHG removals (“GGRs”) and agriculture and land use emissions

Evidence is invited to explore different phasing options and timings of eligible GGR projects for possible earlier inclusion into the UK ETS and the monitoring, reporting and verifying (“MRV”) of agricultural and land use emissions, including how to improve carbon auditing and MRV opportunities for the sector. Note it is not currently proposed to expand the UK ETS to include agriculture.

Operational amendments to the UK ETS

• a number of amendments are proposed to UK ETS legislation to resolve operational and technical issues identified in the legislation.
• The Consultation also states that the Government is open to the possibility of linking the UK ETS internationally.

What happens next?

The Consultation closes on 17 June 2022. Relevant companies should consider responding to the Consultation and follow further consultations expected to be published by the end of 2023.

UK operators should monitor these developments and consider the impact of the proposed changes on their business and operations as part of their compliance strategy and general ESG activities.

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