UK risks a carbon price half that of the EU

The UK government can offer businesses more post-Brexit certainty by increasing the carbon price floor – ahead of aligning the market with net zero

With a week before the Brexit transition period ends, the UK is constructing an Emissions Trading System (UK ETS) to replace the existing EU scheme. While the EU ETS carbon price has been above £29/tonne (€32/tonne) in recent days, the UK ETS carbon price floor is just £15/tonne.

The current design of the UK market means there is a risk that the new carbon price begins at this £15 floor. Such a low price would be an international embarrassment ahead of COP26 in Glasgow, and damage the low-carbon investment signal the UK needs to achieve net zero.

How does the UK market design risk a low carbon price?

A key feature of a carbon market is the ultimate cap on emissions. For most of the first decade of the EU ETS, the cap was far above actual emissions with no mitigation measures, and consequently the carbon price was too low to have a meaningful impact on emissions.

The UK cap is ~38 million tonnes above actual emissions by Ember’s calculations – equivalent to around a third of total emissions in 2021. This leaves the UK market with a huge surplus – and no functioning way to mitigate this surplus. Aware of this problem, the UK has proposed a supply adjustment mechanism (similar to the EU market stability reserve) – but it won’t be operational at the start of the market. This surplus risks a low and ineffectual carbon price.

Prospects for a UK carbon price rise in the longer term

In the longer term, the UK intends to align its carbon market cap with net zero. The Climate Change Committee’s recent Sixth Carbon Budget makes a proposal for what that would look like: from 2023, a cap significantly below business-as-usual emissions reductions. So the market will begin with a large surplus, but with scarcity on the horizon. How market participants will react is unknown – and we won’t know at least until Q2 2021, when the UK carbon auctions start.

The carbon price for coal and gas

The UK power sector has an £18/t top up to the EU ETS price which has been crucial in securing the country’s speedy coal phase-out. This top up remains, but under the new market, UK power sector installations could be moving from a carbon price of ~£47/t (the EU ETS price plus the £18 top up), to a carbon price as low as £33/t (the £15 UK ETS carbon price floor plus the £18 top-up). UK coal is unlikely to return with a vengeance this winter, with increasing wind power and gas prices driven down by a low demand year, but as post-pandemic demand returns in 2021, will the UK ETS price be giving a clear enough signal to suppress coal generation?

What should the UK do now?

As the functioning of the UK ETS is ironed out in the coming weeks, a carbon price floor closer to the EU ETS price would give vital confidence to businesses to continue with low-carbon investment – and reduce volatility in the price over a year that is likely to be full of Brexit volatility. A price floor would also help mitigate the price signal gap until auctions can begin in Q2.

The EU ETS has averaged a price of around £22/t (€25/t) over the last two years, so it would make sense to set the UK carbon price floor to at least that level, especially with further reform to strengthen the EU ETS price due in the coming year. A significantly higher price may be necessary – Canada, for instance, is set to increase their carbon tax to $170 (£98) by 2030.

The UK ETS cap out to 2030 should quickly be established in law at the level recommended by the Climate Change Committee in the Sixth Carbon Budget, which will give real weight to the government’s promises to align the market with net zero, and may help lift the UK carbon price off the floor.

The government can also move quickly to include other sectors in the UK ETS, providing more opportunities for abatement. Applying the carbon price to biomass generation is an obvious change (under the EU ETS all biomass generation was incorrectly assumed to be carbon neutral). Another sector in dire need of carbon pricing (and regulation) is fugitive methane emissions released during the production and transport of coal and gas (we’ve recently explored how the issue affects coal production in Europe).

The UK should also explore how to better use the revenues from carbon pricing: some of the carbon market auction revenue flowing to the exchequer should be used to pay ‘carbon dividends’ to citizens. Such payments could improve public support for carbon pricing, and help mitigate the regressive effects of increased electricity prices.

Methodology

Footnotes

1 – The Future of Carbon Pricing, UK Government and Devolved Administrations. (June 2020) “The cap for a UK ETS will initially be set at 5% below the UK’s expected notional share of the EU ETS cap for Phase IV of the EU ETS. Based on the proposed design scope, this equates to around 156 million allowances in 2021.” “In a standalone UK ETS we will introduce a transitional Auction Reserve Price (ARP) of £15 (nominal) to ensure a minimum level of ambition and price continuity during the initial years of UK ETS.”

2 – Our calculations for emissions covered by the market cap are as follows: UK verified EU ETS emissions were 129m in 2019 (EUTL). We estimate emissions will be 118m in 2021, based on an estimated 5.5% fall due to Covid-19 in 2020, and a 2021 emissions fall of 2.9%, equivalent to the 2019 fall (CarbonBrief).

3 – The Sixth Carbon Budget, The UK Climate Change Committee. (December 2020)

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New UK carbon market risks a carbon price half that of the EU