The UK says it wants the world’s first net zero carbon market

But the plans don’t yet add up...

Phil MacDonald

Managing Director

Ember

22 June 2020 | 2 min read

The UK government’s post-Brexit ambition for a net zero carbon market could be world-leading – but recently released plans repeat many of the mistakes of the EU system, including a very loose cap on emissions, and a market so complex it would make Rube Goldberg weep.

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The cap is too damn high

Emissions trading systems work by setting a gradually declining cap on emissions, which creates scarcity in the market of emissions permits. This scarcity is what sets the ‘carbon price’, or the cost to carry on emitting. A high enough price signal should encourage power stations and factories to switch to zero-carbon forms of generating electricity or manufacturing goods.

For most of its life the EU Emissions Trading System has been plagued by a massive surplus of allowances – something we’ve been highlighting (as Sandbag) since 2008. This surplus has meant the EU carbon price has often been environmentally meaningless – as low as €2 for a tonne of CO2.

In the new system, the UK government has proposed a cap on emissions at 156 million tonnes in 2021 (5% lower than under the EU system) – but the UK’s total power and industry emissions were just 129 million tonnes in 2019. There’s already a huge gap, and we expect the coronavirus pandemic will see emissions fall even further this year.

To guard against the carbon price falling to zero, the government proposes a temporary £15/t (€17/t) floor. This is below the current EUETS price of €23 (£20.50). With the cap (and therefore the supply of emissions allowances) so much higher than demand, any price above the floor is being left to the sentiment of traders – and the unknown volume of power company hedging. This is a risky game to play with a key UK climate policy – and all the more so given that the floor price is intended to be removed in 2022, and replaced with a supply adjustment mechanism.

The UK is building an extremely complex system. Complex systems are more subject to unintended consequences. We’ve written in detail to the government about the myriad ways the design risks outcomes that will not drive a green transition, and could even hinder one. As the government has indicated, the UK ETS is going to require a Supply Adjustment Mechanism (not yet designed) to smooth out the supply of allowances and dampen price volatility. The EU experience has been one of repeated difficult political battles to adjust their market stability reserve – which always lag major changes in the market. It’s going to be troublesome to fine tune.

Net zero is the future for all carbon trading systems

Despite all these risks, the glimmer of hope rests in the UK’s proposal for a net zero cap, in line with the country’s commitment to reach net zero emissions by 2050. As Brexit negotiations continue, the UK should make clear that, when linked, the EU ETS needs to be set on a net zero trajectory too.

As the EU investigates border carbon adjustments, expanding the scope of carbon pricing becomes a possibility again. The UK can lead here in two ways: first, by expanding the scope of UK carbon pricing. This could include putting a carbon price on gas for heating, shipping, or fugitive methane emissions, to name a few. There’s also an opportunity for the UK ETS to cover more emissions by ending the exemption for large biomass power generators, whose emissions are currently, erroneously, assumed to be carbon neutral. Secondly, by investigating carbon dividends to ensure the burden of carbon pricing doesn’t fall disproportionately on the poor, and to ensure wider support for carbon pricing.

Our recommendations

The government needs to firm up the net zero proposal into a real commitment, and ensure this commitment includes lobbying for the EU ETS to match it.
The UK should make the Auction Reserve Price (the carbon floor price) permanent, and with an upward trajectory (e.g. LSE suggests a whole economy price of £75 by 2030). Giving a guaranteed minimum cost to carbon pollution makes it much easier for emitters to be certain their investments in low-carbon technology or energy efficiency will pay-off. Supply adjustment mechanisms (as the UK has proposed for the future) have shown themselves to be cumbersome and slow to respond to a changing context.
The UK should abandon the carbon price exemption afforded to large power stations burning biomass – they should calculate and pay for the lifecycle CO2 they emit.

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