Parliament and the Thames by Phil MacDonaldWhether the UK should leave the EU ETS is a complex question, and ultimately will be decided by the broader political context of the type of Brexit the UK pursues and the overall deal that is achieved.  Our analysis shows there are a range of options for moving forward – but on balance we believe the UK should attempt to stay in the scheme. Whatever approach the Government decides, it is clear that the current level of ambition in the traded sectors is not in line with the Paris Agreement – in the EU or the UK.
On the 14th March Sandbag gave evidence at the House of Lords EU Energy and Environment Sub-Committee meeting to discuss our findings. Debbie Stockwell, Sandbag’s Managing Director, represented Sandbag, alongside Silke Goldberg (Partner at Herbert Smith Freehills) and Lawrence Slade (Chief Executive of Energy UK).
Without new agreement, the default is a UK exit from the EU ETS on the 29th March 2019.
This would trigger, among other things:

  • recalculation of the EU emissions cap and auctioning shares;
  • a requirement to develop new UK policy to cap power and industrial emissions, with a new regime for business to implement and a possible hiatus before a scheme us put in place;
  • an impact on some of the solidarity mechanisms built into the system e.g. value of the Modernisation Fund
  • the need for a change to the accounting of traded sector emissions under the UK carbon budgets;  
  • possible damage to international climate action if there is a decrease in ambition in either the remaining EU ETS and/or UK action to reduce emissions in the traded sector; and
  • possible loss of UK-based auction house and carbon traders.

We believe it would be more straightforward for the UK to remain in the scheme, because of the time it is likely to take to negotiate an alternative UK scheme, and the fact that they UK has always been a key proponent of the EU ETS and pushed for increased ambition.  There is a real risk that the scheme will be less ambitious after the UK leaves.
Added to that, the EU ETS provides mechanisms to ensure that the UK Treasury spends the auction revenue on climate measures and enables allowances to be put towards an innovation fund.
Of course a UK scheme or carbon tax could do all of these things, but there is a considerable risk that they will not.
However, we recognise that the UK Government will not have the same opportunities to influence the scheme and will have to do more indirectly, and that if the UK leaves the single market and the jurisdiction of the European Court of Justice, then additional measures will need to be negotiated and agreed for the scheme to work, as has happened in Switzerland.  This may take some time and ultimately may tip the balance to the UK setting up its own scheme.
In between the options of the UK being fully in the EU ETS and setting up a stand alone scheme  there are a range of ways to maintain a linkage with the world’s largest carbon market. This spectrum of possibilities is set out below:

Option Operation Pros/Cons New cap? Comparisons
UK remains part of the EU ETS As now Depends on overall Brexit deal
UK likely to have less influence over future form
Would UK have access to NER and Innovation Fund?
Difficult if UK leaves single market
No N/A
UK is linked to the EU ETS (‘Norwegian model’) UK continues to issue allowances under an agreement EEA countries are all part of the single market
EU may be less willing to extend membership to an external country
Likely not to need CJEU jurisdiction but needs some kind of dispute resolution framework
Much bigger share of cap then current EEA members
No Like EEA countries – Norway, Iceland, Liechtenstein
Two way linking with a UK ETS (‘Swiss model’) UK establishes own ETS, most likely with recognition of each others allowances Linkage may be contentious if the coverage of UK ETS is different
Have previous experience of UK ETS
Dispute resolution may be difficult
The setting of caps may cause delays
Yes Like Swiss model or Western Climate Initiative (California, Quebec and Ontario)
One-way linkage Allowing EUAs as compliance in a UK carbon pricing system up to a limited percentage May not require formal EU27 agreement
Involves transfer of funds to EU
Doesn’t need a UK ETS, could apply under a carbon tax
Yes Former Australian model or early Norwegian model
One-way linkage with limited scope Allowing EUAs as compliance in a UK carbon pricing system up to a limited percentage, restricted to certain sectors Same as above, but apply to limited sectors like those on carbon leakage list, allowing them to comply with their obligations by surrendering EUAs
Reduces competitiveness concerns so may reduce concerns about transfer of funds
The volume of allowances bought would not be a large proportion of the system
Complete separation (the default option) The UK separates from the EU ETS with no linkages Most straightforward option, but requires creation of UK’s own climate policy
Decisions would be needed on what would happen to unallocated allowances

A link between a separate UK ETS and the EU ETS is a possibility, but experiences in linking other carbon markets internationally have shown the process is not instantaneous. The EU ETS and Swiss ETS linking negotiations began in 2010 and are expected to conclude with a link in 2019. Ontario joined the Western Climate Initiative carbon market this year, following discussions that began in 2007. However, the UK has previously operated a separate market, and so the process could be considerably quicker.
A broader carbon tax is another option the UK could pursue.  The UK’s Carbon Price Floor (around ~€30/tCO2 in total) has been extraordinarily successful at cutting emissions from coal – and there are signs that this will soon be replicated by European neighbours.  However, this only affects the narrow range of emissions from the power sector: other policies would still be required for industry and other sectors.  If the carbon tax applied to these sectors this would require substantial change in the regulatory framework. Additionally, taxes like this entail political risk; the UK carbon price floor was conceived as an escalator, which was quickly frozen, and is currently only guaranteed until 2025..

Should I stay or should I go now?

In the near term, the UK should agree to a transitional arrangement to remain in the EU ETS at least until the end of Phase III (May 2021). This will reduce complexity of leaving if that decision is eventually taken, and allows time for a UK alternative system to be developed. Leaving in March 2019 is likely to cause significant disruption to business, a loss in auction revenues (the UK government received €604 million in 2017), and a fall in the carbon price as operators sell allowances in the run up.
Whatever happens the EU ETS still needs reforms.  The cap needs to be based on actual emissions. In the longer term, the EU ETS is still not resilient to all emission scenarios, as the cap continues to be disconnected from real emission levels. A widespread coal phase-out, for instance, would keep the ETS allowance surplus high, the carbon price low, and prevent the system from driving a cost-effective transition. If the review of the Market Stability Reserve and the EU ETS as a whole in the early 2020s do not deliver this reform then the UK should look again at designing  its own more effective climate change policy for the traded sector in the 2020s.