The UK Emissions Trading Scheme – An overview

The UK ETS became operational in January 2021 following the end of the Brexit transition period. Having explored several options for carbon pricing post-Brexit (including continued participation in the EU ETS and a carbon emissions tax) the UK Government opted in its December 2020 Energy White Paper for a separate UK ETS which mirrored the EU ETS in almost all regards. Although both systems have undergone reforms since, they both operate on the basis of the same fundamental principles. Like the EU model, the UK ETS is mandatory for operators in scope, and the system works on the basis of a 'cap and trade' model.

The UK ETS also aims to help the UK move towards its climate goals, ie, a reduction of GHG emissions by 68% by 2030 and 77% by 2035.

Scope

Participation in the UK ETS is mandatory in respect of certain gases and activities, including the following:

Mechanism

The Monitoring and Reporting Regulation and Accreditation and Verification Regulation from the EU ETS were incorporated into UK law with certain amendments. While the majority of these are minor to reflect that the UK is no longer party to the EU and the UK ETS is a separate system, others aim to streamline certain requirements. The monitoring, reporting and verification requirements from the EU ETS therefore form the basis of the corresponding requirements under the UK ETS:

• Each year, operators must submit an emissions report to the competent authority (covering the preceding year) which has been reported on and verified in accordance with the relevant regulations.
• Following verification, operators must surrender a number of allowances (UKAs) equivalent to the total emissions emitted during that year. However, the UK ETS does allow for deductions to be made for installations that are capturing and permanently storing CO2 transported via pipeline. (In June 2023, the UK ETS Authority indicated that it would consider how non-pipeline transport of CO2 can be integrated into the UK ETS framework).

Operators of industrial installations and aircraft are required to have an approved plan for monitoring and reporting annual emissions.

UKAs (each of which represents one tonne of CO2e) are allocated freely in certain circumstances (see below) or purchased, either in a UKA auction or on a secondary market.

Free allocation

As with the EU ETS, a free allocation mechanism is included in the UK ETS in order to mitigate the risk of carbon leakage. Sectors on the Carbon Leakage List (CLL) – which is based on the equivalent list under the EU ETS and identifies sectors most at risk of carbon leakage – receive a provisional allocation of 100% of their benchmarked free allocation during the preliminary free allocation stage. Sectors which are not on the CLL receive a provisional allocation of 30% of their benchmarked free allocation.

The UK ETS currently uses the same benchmarks as Phase 4 of the EU ETS. However, as data from UK installations was not used to calculate these, the UK ETS Authority is considering whether these should be revised.

Cap

As for the EU ETS, the UK ETS aims to reduce emissions by capping the number of allowances issued, both for each phase of the UK ETS (ie, 2021 – 2025 and 2026 – 2030), as well as for each year within a phase.

The caps, which the UK ETS Authority has indicated aim to align with the UK's net zero trajectory, are calculated based on a formula which takes into consideration:

• The base number of allowances for the relevant scheme year multiplied by a reduction factor.
• The balance of allowances in the new entrants' reserve.

Market stability mechanisms

To prevent market instability and control the price of allowances, the UK ETS uses two market stability mechanisms: the auction reserve price (ARP) and the cost containment mechanism (CCM).

• ARP: the ARP is effectively a minimum price for UKAs, which is set at £22 per allowance. Bids below this price are not accepted.
• CCM: the CCM is designed to enable the UK ETS Authority to intervene and mitigate sustained fluctuations in the price of UKAs. The price triggers for the CCM are based on a rolling average of previous years' prices. If triggered, the UK ETS Authority may authorise a number of interventions under the CCM, including increasing the number of UKAs to be auctioned or amending the distribution of auctioned allowances.

Penalties

If an operator, aircraft operator or shipping company fails to surrender enough allowances in respect of their emissions, they will be liable to:

• A penalty of £100 per tCO2e (adjusted for inflation over time) for which the operator or aircraft operator has not surrendered allowances.
• Surrender the amount of allowances in respect of those excess emissions.

The UK ETS also has penalties for:

• Non-compliance.
• Failure to comply with a "notice to return allowances" (the penalty for which is (a) £20,000 and (b) £1,000 for each day that the person fails to comply with the requirements of the notice).