UK and EU Emissions Trading Schemes – drifting in different directions?

Sam Lowe and James Low explore the benefits and challenges of linking the UK and EU Emissions Trading Schemes.

Article 392 (6) of the EU-UK Trade and Cooperation Agreement (TCA) states that [emphasis added], ‘The Parties shall cooperate on carbon pricing. They shall give serious consideration to linking their respective carbon pricing systems in a way that preserves the integrity of these systems and provides for the possibility to increase their effectiveness.’

This clause is unusual in the context of the TCA, given that it actively leaves open the possibility of future EU and UK regulatory convergence and the possible linking of their respective Emissions Trading Systems (ETS).

Linking the EU and UK ETSs would have two major advantages:

First, the joint, larger, ETS market would allow for more efficient price discovery and make trading easier by increasing the pool of buyers and sellers of CO2 permits. This should lower the cost of decarbonising both economies.

Second, ETS linkage could ensure that UK exports of high-carbon products to the EU are fully exempt from the EU’s carbon-border adjustment mechanism (CBAM). The CBAM’s transitional phase enters into application on 1 October 2023 – EU importers of cement, iron and steel, aluminium, fertilisers, electricity and hydrogen will be required to report on the direct and indirect greenhouse gas emissions embodied in their imports.

From 1 January 2026, importers must purchase and surrender so-called CBAM certificates in sufficient quantities to ‘pay’ for the embodied CO2 imported into the EU. Foreign carbon pricing mechanisms – such as the UK’s – can be accounted for by EU importers, with the foreign price ultimately deducted from the import price. However, even if the price is equivalent, importers will still need to comply with the new reporting requirements, which are administratively burdensome and come with an associated cost.

The only route towards a full exemption from CBAM obligations is via the full participation of the EU ETS (as Iceland, Liechtenstein and Norway have done) or full linkage to the EU ETS (as Switzerland did).

This means that, without linkage, UK exporters of CBAM-covered goods will face new administrative hurdles when selling into the EU, potentially reducing the appeal of their products. CBAM also potentially creates distinct problems in respect of Northern Ireland. These could be made even more complicated if the UK implemented its own CBAM scheme – something that is under active consideration.

However, despite the core ETS scheme designs being similar, post-Brexit changes to the UK scheme – announced in the government’s July response to its ‘developing the UK ETS’ consultation – are creating a growing risk of divergence over time.

Differences in approach are already leading to a notable discrepancy in ETS permit prices – something that cannot all be down to market speculation. At the time of writing, UK permits were trading at around £40 per tonne, and EU permits at around €87 per tonne. Linking the two schemes will be difficult if prices remain some way apart for an extended period, especially on the UK side, where linkage would probably drive up the cost of credits.

However, current price differentials should not be taken to mean that linkage is now impossible.

The EU and UK schemes remain broadly similar, with the total cap on allowances now readjusted for similar net zero targets, and the sectors identified for expanding the schemes being similar. The approaches to aviation are also similar, apart from a relatively large EU subsidy scheme for sustainable aviation fuel.

In theory, any technical differences between the two schemes – such as dates or thresholds – could be bridged and addressed during the process of linking, if a political decision is taken to do so.

And it is politics that could prove to be the major obstacle.

Currently, UK ETS policymaking takes place in isolation from the EU – there is no dialogue between officials on alignment, besides informal conversations on the direction either side is moving in.

The EU has also agreed to expand the ETS to buildings and transport, something which would be difficult for the current UK government, or a future Labour one. The EU has also made greater progress with the CBAM and the related phase-out of permit-free allocation, something the UK has not yet committed to doing.

There could also be political disagreements about control.

The EU and UK have different mechanisms in place to retain control and stability over the market – which mechanisms can be used in a linked ETS and who can use this power, and the circumstances when it can be used could be difficult to agree. In addition, linkage could require changes to those elements of each scheme already agreed (to ensure consistency), which could create political problems in the UK.

The EU also takes a cut of ETS revenues for the purposes of the EU Innovation Fund (and some other funds) before distributing revenues to member states. The UK may have become used to having full flexibility over how it uses the revenues from its ETS.

These political challenges mean that, even if a current or future UK government decided to pursue ETS linkage with the EU, it would probably want an arrangement more akin to Switzerland’s than Norway’s. Such partial linkage would result in both markets co-existing and UK allowances fungible in the EU market and vice versa. The linkage would also probably be confined to specific sectors.

However, as ever, it is not certain that the EU would agree to such a partial arrangement in this instance. And the longer the current situation goes on – where both schemes evolve in isolation ­– the more difficult linkage will become.

Some of the main emerging differences between the UK and EU Emissions Trading Schemes are set out in the table below:

By Sam Lowe, Partner, Flint Global, and Senior Visiting Fellow, Policy Institute, KCL, and James Low, Consultant, Flint Global and former Senior Policy Advisor, UK Department for Energy Security and Net Zero.