Brexit: the impact on carbon price, the EU ETS and beyond

united kingdom exit from europe relative image

The UK’s referendum on whether to leave the EU on the 23rd June has many unknown impacts but in the carbon trading community, that is largely based in London, the impact of a Brexit on the EU ETS and the carbon price has everyone trying to guess what will happen next.  The question we have been asked the most in recent months is: how will our EU ETS exposure be affected by a Brexit? Understanding this risk is key to managing carbon exposure but exactly how to manage it very much depends on an individual company’s circumstances.In the event of the UK voting to leave the EU, on balance, it is hard to foresee the UK leaving the EU ETS, consider the following supporting arguments:

·         As a trading nation the British see markets and the competition that they bring as the most efficient answer to most problems. Trade fosters good relations and cooperation, reduces corruption, rations finite resources most efficiently and supports a service industry. The EU ETS was largely designed by British civil servants taking up residence in Europe. Take for example Peter Vis, long credited with being the Father of the EU ETS. As another example, the UK led the way in Europe with the first emissions trading scheme in the form of the UK ETS pre-2005.

·         The UK has very ambitious emissions reduction targets.  They understand and welcome the benefits (i.e. lower costs and innovation) of emissions trading to meet their domestic target.

·         Any future trading agreement between the UK and Europe is likely to have climate change mitigation, and therefore continued membership of the EU ETS, as one of the core requirements.  After all it is the EU’s ‘flagship’ climate policy (albeit one that is constantly undermined by member states, even the UK).

Despite what we consider to be a near-certain continuation of the UK in the EU ETS there is a material price warning in the event of a vote to leave the EU. Even though an actual Brexit is at least 2 years away and even if the UK decided to stay in the EU ETS, there are a number of reasons why the price of carbon will be negatively, and potentially materially affected (by which we mean a drop of up to 50%);

·         Hedging unwinds. While a potential exit from the EU ETS is at least 2 years away, and therefore, in theory, of limited impact on supply and demand (the UK is a net importer of EUAs therefore demand is the area of interest here), UK electricity utilities have already sold power beyond 2 years as typically they hedge 3+ years out.  In the event of a Brexit it won’t be clear that EUAs can be used for compliance for whatever comes after 2 years so expect a glut of allowances, bought for hedges that are more than 2 years out, to appear on the market soon after a vote to leave.  It simply wouldn’t be prudent risk management to hold on to EUAs that may not actually serve as a hedge for carbon exposure. Another consequence will be volatility in associated power and fuel markets as those long term hedges will likely also be unwound. The UK power market will become increasingly short-termist until there is clarity on how polluters can stay in compliance with whatever comes next.  Uncertainty over the EU ETS makes Brexit a nightmare for risk managers, including those involved with electricity production and consumption alike.

·         Lower short term demand. To a lesser degree the uncertainty that a Brexit creates in Europe’s economy will slow down the demand for long term power and other hedges in the rest of the EU that will in turn reduce short term demand for carbon.  The auctions however, including the UK’s, will continue unabated so supply will further outstrip demand from 2017 (after backloading has stopped and before the Market Stability Reserve (MSR) kicks in in 2019).

·         Lower long term demand. The UK was one of the only countries to take allocation seriously in Phase 1 of the EU ETS (2005-2007) and as a consequence many industrial companies faced a shortage of EU Allowances even then.  This approach has been continued into Phase 2 and 3 and consequently the UK is a net importer of EUAs from other member states.  The UK also had one of the lowest allowed use of offsets in Phase 2 (8%) that has compounded the net shortage.  However, any impact from industry reducing its demand if the UK leaves the EU ETS won’t, in all likelihood, be felt for 2 years (industry typically hedges as it uses or often even in the year after use). In two years’ time the MSR will be just around the corner so the effect of reduced industrial demand will be muted.

As the second largest economy and carbon polluter in Europe it is essential in a post-Brexit world that there is clarity as soon as possible about whether and how the UK will continue with emissions trading. Utilities can’t plan sales of electricity because they won’t want to lock in prices with no way of locking in costs, industry can’t enter into long term contracts for its own goods or electricity. If the UK seizes the opportunity to improve on the EU ETS and make targets, prices and coverage meaningful, as well as the use of high quality offsets from, for example, Least Developed Countries then that will be a welcome outcome of a Brexit but the rules of engagement need to be known fast to avoid unnecessary uncertainty and risk.

The climate benefits from mechanisms that put a price on carbon, such as the EU ETS. The EU ETS faces enough problems of its own, in part caused by the political wrangling and special interest lobbying that are part of the reason there is motivation for a Brexit, and the ‘fixes’ have sent the market up, down and sideways. More volatility and prolonged uncertainty (for example what happens to the cap if the UK leaves the EU ETS) will further hinder the EU ETS, don’t aid the cause of carbon pricing generally and therefore harm efforts to limit climate change.

The elephant in the room is carbon tax. As we have previously mentioned, the UK is pro-markets. Other dominant forces in the EU, that will get stronger and louder in the event of a Brexit, are less so. The UK, in an attempt to create a meaningful carbon price and prop up power prices to allow the government’s pet nuclear and wind projects to appear less loss-making, have implemented a carbon price floor tax for the electricity sector.  The UK has a number of other tax based carbon reduction schemes in operation for other parts of the economy. If there is a rush to provide climate change legislation certainty to UK industry post-Brexit, those taxes could be brought to bear on the whole economy.  This might not be a bad policy option for the UK as it will be relatively simple to implement (by widening coverage of existing schemes) and the taxes will be more meaningful than the current EU ETS price which will mean that the UK’s trade negotiations shouldn’t be affected by climate change issues.

When combined, the two notions above could not only lead to carbon taxation as the dominant carbon pricing tool in the UK but it could also lead to taxation, or more likely, virtual taxation via a price cap and floor, taking over in Europe as well.  However unlikely this scenario may be, a Brexit and EU ETS exit may not help the cause of emissions trading.

That Brexit creates economic uncertainty is hardly news.  However, as we have argued, the forces at play can be far more nuanced than are at first apparent.  The unintended consequences of a vote to leave could be far reaching for European emissions trading and thus the environment as a whole.

Redshaw Advisors specialises in helping companies understand and manage their carbon risk, if you would like to know more about how a potential Brexit affects your specific circumstances, please let us know.