Carbon Emissions, Pricing and Removals
Greenhouse Gas (GHG) Emissions
In 2019, the UK became the world’s first major economy to legislate for a target to bring all greenhouse gas (GHG) emissions to net zero by 2050. The EU followed shortly after in 2021 with the EU Climate Law, meaning that the climate objectives of both the EU and UK were aligned.
The EU’s Climate Law sets the bloc on a course to becoming the world’s first climate neutral continent and will ensure that there can be no back-sliding from subsequent European Commission administrations on their Paris Agreement commitments.
To help deliver on its mandate of net-zero emissions by 2050 and a 55% reduction in GHG emissions by 2030 relative to 1990 levels, the European Commission adopted its landmark Fit for 55 Package on 14 July 2021. The Fit for 55 Package is the EU’s principal legislative vehicle for achieving said ambitions and includes transformational policy on emissions.
CO2 emissions pricing is seen by both the UK and EU administrations as central to addressing the issue of heavy industry related climate change.
The EU’s cap-and-trade scheme for carbon emissions is called the Emissions Trading System (ETS). It has been in place since 2005 and covers around 45% of the bloc’s carbon emissions. The ETS is currently subject to a revision in light of the Fit for 55 Package. The European Commission’s proposal for the revision increases the ETS reduction target for 2030 to -34% compared to 2005 emission levels, meaning that the cost of carbon emissions will increase significantly for covered sectors.
The scope of the EU’s ETS system is also extended to include maritime transport emissions. This will be gradually introduced over the next four years, and will mean that for the first time, ships travelling within the EU (100%) as well as entering and leaving the EU (50%) will be subject to the overall emissions cap and will be required to gradually surrender allowances starting from 2023. The policy is likely to have knock on implications on the cost of international trade and import/export of products.
Finally, a separate but adjacent mechanism is to be set up for buildings and road transport, meaning that the cost of running a car and the cost of heating a home are set to increase. This poses a challenge to the Irish government’s carbon taxation policy, and a potential risk to Irish tax revenues for the Just Transition Fund moving forward.
When the revised Directive was published in July 2021, EU allowance prices averaged c. €50 p/t. The Commission had stated that it was aiming for a 50% increase in the cost of carbon emissions on the market, and indeed the latest ETS price, as of end November 2022, is over €80 per tonne. Such significant price rises in a short period of time should once again cause reflection for business leaders regarding what additional steps they can take to decarbonise their sectors.
The UK Emissions Trading Scheme (UK ETS) went live on 1 January 2021, replacing the UK’s participation in the EU ETS. Under the Ireland/Northern Ireland Protocol, electricity generators in Northern Ireland remained within the EU ETS. The UK system is organised in the same way as the EU ETS, with an auction price determined by the market. The ETS price in the UK is around £65 per ton and fluctuates depending on supply and demand in the secondary market. This matters for businesses, as significant price differences between the two jurisdictions could create a more favorable business environment.
To guard against carbon pricing impacting on investment / relocation decisions, a large percentage of ETS allowances – up to 94% for industrial emissions1 – are currently allocated freely. The EU, however, plans to gradually phase out free allowances, while the UK’s free allowances are only in place until 2025, meaning that in the future, EU and UK companies could be put at a competitive disadvantage relative to international companies, operating in countries which do not have a price on carbon.
To address this carbon leakage threat, the European Commission has proposed to introduce a Carbon Border Adjustment Mechanism (CBAM), which is linked to a free allocation phase-out.
The CBAM Regulation has been one of the most anticipated measures in the Fit for 55 Package and could have major implications for UK-EU trade. The Mechanism aims at setting up a form of import certification scheme, that would lead importers to buy CBAM certificates to import certain goods based on the carbon content of said goods. The price of the certificates will be dependent on carbon price of the ETS system and will have to be paid by third country companies that do not have a carbon pricing mechanism in place, or not to the standards of the EU.
The products covered under the scope of the European Commission proposal are aluminium, cement, electricity, fertilisers, and iron and steel. From 2023, companies exporting to the EU will need to calculate the embedded emissions in the processes and products covered, and from 2026, they will need to pay for the price of embedded carbon in said products, unless exporting companies can demonstrate equivalent policies apply in the place of production.
The UK is also working on a CBAM, and while the UK ETS mirrors that of the EU’s, the UK cannot be exempted. Thus, limiting vulnerability of UK trade to the EU is dependent on maintaining similar price levels and market design. It is therefore important for UK exporters, that the UK government expedites the publication of a CBAM Regulation, so that companies can invest in rapid decarbonisation without being exposed to cheaper, more polluting third country products.