UK emissions trading scheme ‘could face rapid price spike’

Experts are concerned that the cost of the UK’s carbon emissions trading allowances could increase dramatically when auctions begin this week, possibly requiring government intervention.

The Scunthorpe steelworks has benefited from a hefty free ETS allowance. Photograph: David Goddard/Getty Images

There has been no domestic carbon trading since the Brexit transition period ended. That will cease from midday on Wednesday, when the first auction of 6,052,000 allowances will be held. The futures market will open the same day, with daily futures following on Friday.

At the end of the 2020, the cost of EU allowances was €33.43 (£28.84) per tonne. It has since risen to €56.35 (£48.61), following rising EU and national climate ambitions. It jumped 3% over the weekend alone, the market responding in particular to Germany’s new climate commitments. Only eight years ago, the price stood at only €2.81, due to a glut of allowances.

Analysts expect that the UK market could respond to recent climate policy announcements in similar fashion to the EU, exacerbated by four and a half months of unfulfilled demand and the loss of coal in the UK’s power system. The EU market will also serve as a reference point for the UK emissions trading scheme (ETS), Ingvild Sorhus, lead analyst at Refinitiv Carbon Research, told the Financial Times.

The combination of factors could put the cost of allowances far above the reserve auction price of £22 per tonne, up from an original £15. But not all operators will be affected equally.

For the electricity sector, allowances are supplemented with the Carbon Price Support (CPS) tax, set at £18/t. And for 461 participants, their emissions will be covered largely by free allowances, the recipients of which were disclosed last week.

The two greatest recipients are the Scunthorpe and Port Talbot integrated steelworks, which will receive 4.13m and 5.77m allowances for free every year to 2025. Their emissions in 2019 were 4.53 and 6.43 million tonnes of CO2, respectively.

In all, 39mt of allowances will be provided free, against an overall cap of 155.7m this year. Only 48 will see their allocation fall, by only 10%, over the next five years. The greatest absolute drops will be at Cargill’s wheat processing plant in Manchester and Tate and Lyle’s Silvertown sugar refinery in London.

“The UK has initially set its emissions cap 5% lower than the previous cap it had under the EU ETS, which logically could push prices higher. However, the Climate Change Committee note that real emissions for 2021 are likely to be significantly lower than this cap which could help balance the price,” said Laura Woolsey, Analyst at Cornwall Insight.

“A tighter, net zero aligned emissions cap is therefore likely to increase the cost of carbon over time. This price increase could be balanced to some extent by the planned phase-out of the CPS. However, the recent Budget announcement on extending the CPS through to April 2023 gave little in the way of a longer-term transition plan. Without this plan, the tighter caps points towards price rises,” she added.

Business secretary Kwasi Kwarteng dismissed such concerns earlier this month, saying that liquidity fears are overstated.

Fiona Ross, a senior environmental lawyer at Pinsent Masons, said that as the 2021 cap is “quite a bit higher” than total emissions from the UK’s EU ETS participants in 2019 and 2020, and also higher than projected ‘business as usual’ emissions for 2021. Combined with emissions being depressed due to the pandemic, there could in fact be “a glut of allowances” rather than a shortage, she believes.

But this may not be the case as the cap contracts in the future to align with a net zero trajectory, and given the regime’s possible expansion to other sectors, which could potentially include energy from waste, and shipping, and even commercial property, as the EU is proposing.

But Phil MacDonald, chief operating officer of decarbonisation NGO Ember, told ENDS that nowadays there is “no real prospect for coal to gas switching”- the way that the carbon market has usually responded to rising ETS prices. “It’s all on industry to reduce emissions now – and they have very little flexibility to do that, in the short term. There’s going to be a real scramble for allowances, and then the government has to intervene,” he said.

While MacDonald said he would be comfortable with seeing UK prices reach similar levels to those in the EU, going higher would lead to “a real outcry from industry”, he warned, adding that the government will have to do more than “tinker” with the system.

For the ‘cost containment mechanism’ to be triggered, the average futures contract price for December 2021 would have to remain above £44.74 for three months straight – lower than the current ETS price. The trigger will be reviewed on 10 June.

In the short term, the UK ETS Authority (made up of Whitehall and the devolved administrations) could respond by bringing forward auctions and auctioning reserve allowances, for example. But in the longer term, the country needs to go faster on plans for coal-free steel, carbon capture and industrial hydrogen, MacDonald said, with government support for these “not coming quick enough”.

Another way for price spikes to be avoided is for the UK and EU ETSs to be linked together, re-establishing a common market for carbon. The separation has created “huge fiscal uncertainty caused by the small pool of allowances to be traded and uncertainty over the actions of traders looking to hedge their requirements for future years,” according to the Confederation of Paper Industries.

“The new UK scheme has been designed to allow linkage to the EU scheme and we need politicians from both sides to step-up and show their commitment to address climate change is undiminished by Brexit. We need to move towards a genuinely global price for carbon - a fracture between the UK and EU is counterproductive,” said its director general Andrew Large.

In the longer term, a carbon border adjustment mechanism could replace the need for free allocations to guard against British industries being undercut. The European Commission is expected to publish its proposals for such a system this June, “something that the UK ought to look at”, said Ross.