UK and its role in EU ETS after Brexit

The United Kingdom is laying the ground for its imminent departure from the European Union. After abandoning the bloc of the 28 countries, the question is what role will it play in the EU Emissions Trading System (EU ETS)? In the last few days this issue has raised some doubts. Recently, British Conservative spokesman for Energy and Climate Change in the European Parliament, Ian Duncan, stated that after the Brexit, the UK has no future in the EU ETS, as this system is governed by the European Court of Justice. However, many British politicians, including Prime Minister, have declared their preference to keep the country within this common market of emissions. Examples of non-EU countries, but EU ETS participants, already exist. This is the case of Iceland, Liechtenstein or Norway.

The reality today is that it is one of several issues that remain to be negotiated in the long process that represents the departure of the United Kingdom from the EU. However, what are the feasible scenarios for Britain?

The EU Emissions Trading System (EU ETS) was created in 2005 and represents one of Europe’s fundamental pillars in the fight against climate change. It currently operates for 31 countries (28 EU members plus Iceland, Liechtenstein and Norway). The main objective of this market is to limit greenhouse gases emissions from more than 11,000 energy-intensive facilities and emissions from airlines operating between these countries. At present, this system covers about 45% of the emissions of the group of members. In order to meet environmental objectives and adapt to the Paris Agreement, emissions must be reduced by 40% by 2030 (compared to 1990). For their part, non-EU ETS sectors should reduce their emissions by 30%.

“British politicians have declared their preference to stay in the common market of emissions”

In the UK’s case, there are 700 facilities within the EU ETS. British energy regulation is clear in its objectives of complying with emissions reductions and the Paris Agreement. On a general level, and as already mentioned in a previous blog, the so-called Climate Change Act 2008, requires setting the so-called carbon budgets, that can allow them at least a reduction of 80% by 2050. The UK’s participation in the European emissions trading scheme has undoubtedly helped the country to meet its environmental policy objectives. Thus, it is within the EU ETS where the UK has witnessed a steeper reduction in its emissions. In total, the British country has reduced them by 35% since 1990.

Evolution of UK emissions since 1990.Source: Bloomberg

In this respect, it seems coherent to think that British government will continue with its policies of reduction of emissions and, therefore, must be part of a carbon market, to one degree or another.

Scenarios after Brexit

Therefore, Brexit raises three possible scenarios regarding emissions: 1) the creation of its own carbon market; 2) participate in a new system, such as China’s ETS; or 3) continue in the European EU ETS. As mentioned before, countries like Iceland, Liechtenstein or Norway are already playing this role. This third option is the optimum in terms of economic efficiency and political and institutional harmony. Moreover, it is the scenario by which more British politicians are in favor.

The first option would undoubtedly entail a great loss of economic efficiency for British companies. Be a member of the EU ETS allows UK to exchange emissions rights with other European countries by benefiting from it and reducing pollution levels at a lower cost than if it did so on its own. As has been said before, it is within this common system where the UK has reduced its emissions more steeply. In addition, it allows you to take better advantage of economies of scale. Europe’s climate targets, as a bloc, can be achieved at the lowest possible cost. It should also be noted that the EU ETS is currently the largest market in the world. If we speak of a UK system alone, the number of companies would be reduced to 780 (10.5% of total emissions in the EU ETS in 2015).

With respect to the second scenario, the UK’s participation in another emission rights system, there are several potential partners. The most important examples are China (intended to be the world’s largest carbon market and whose kick-off is planned for this year), the axis California-Quebec-Ontario, South Korea or New Zealand, among others. However, to be part of any of these markets, Britain would have to face several challenges of bureaucratic arrangements and procedures. On the other hand, according to several studies, the relatively smaller countries in terms of emissions are the ones that ultimately benefit most from this type of systems. Thus, China would not necessarily see a good ally in UK. On the contrary, the benefit that the British country can have within the EU ETS would be much greater than if it participated in smaller alternative markets, such as New Zealand.

In addition, there are sunk costs by the integration process already carried out in the EU ETS. Therefore, everything that means migrate to another system would represent additional costs.

What would these two scenarios imply for the price of emission rights?

Both scenarios, whether UK decides to form its own market or joins another, would imply the exit of the United Kingdom from the EU ETS. In this case there would be an undoubted effect to the decline in the carbon price. It should be noted that, in the days following the referendum on Brexit, the price of the emission rights (EUA) fell by 20%, to stand at 4.70 € / t. Moreover, the average price forecasts were bearish, around 1 €/ tonne for 2016, 2017 and 2018. It should be noted that the United Kingdom is the second emitter of greenhouse gases in Europe and, therefore, their companies are the ones that demand the most rights in the market. The disappearance of this agent would logically imply to increase even more the oversupply that currently exists in the carbon market, with the consequent fall in future prices. In that sense, if UK remains in the market it would generate benefits for both sides.

Finally, it should be pointed out that a reduction in the price of carbon would imply lower costs for the electric generation, but in turn would create a great disincentive to invest in technology that leads to produce in a way more respectful with the environment. In short, it gets cheaper to contaminate.

Price of EUA (EU Allowance Unit per ton of Co2). Source: Own elaboration

EU ETS is necessary for UK

In a nutshell, the third scenario (UK within the EU ETS) seems to be the most successful route. For Britain, creating their own ETS system or being part of another would be inefficient. This is also believed by the country’s environmental policy authorities. The Climate Change Committee, which spoke late last year on this issue, said that remaining in the EU ETS was for the UK the least expensive option to regulate emissions without entailing competitive challenges for its industry. For her part, the UK’s Prime Minister has recently stated that staying in the EU ETS is in the best interest of the country.

By maintaining their participation in the Eu ETS, the British will be able to continue negotiations with Europe on the best way to achieve the objectives of Climate Change by 2030, including the current negotiations for Phase 4 of the EU ETS market, which comprises the 2021-2030 period.

Enrique Battistini | Energy Consultant