Uncertainty Surrounding Brexit and Its Potential Impacts on the EU ETS
The UK’s upcoming referendum on whether to leave the EU has raised numerous questions about its potential consequences. Within the carbon trading community, predominantly based in London, the focus lies on the impact of a Brexit on the EU Emissions Trading System (ETS) and the carbon price. Amidst this uncertainty, many are attempting to anticipate what lies ahead. One prevailing question in recent months has been: How will our exposure to the EU ETS be affected by a Brexit? Understanding this risk is crucial for managing carbon exposure, but the appropriate approach will vary depending on each company’s circumstances.
In the event of the UK voting to leave the EU, it is challenging to envision the UK completely withdrawing from the EU ETS. Several supporting arguments suggest that the UK’s historical inclination towards market-based solutions and its significant role in the development of emissions trading make it unlikely to sever ties with the EU ETS. Moreover, the UK has set ambitious emissions reduction targets and recognizes the benefits of emissions trading in achieving domestic goals. Furthermore, any future trading agreement between the UK and Europe is likely to prioritize climate change mitigation and, consequently, continued membership in the EU ETS. Despite these indications, there is still a tangible risk associated with a Brexit, which could have substantial consequences for the carbon price, potentially leading to a drop of up to 50%.
Several factors contribute to this material price warning in the event of a vote to leave the EU. Firstly, the unwinding of hedging practices could lead to a flood of allowances in the market. UK electricity utilities have already sold power beyond two years, and uncertainty regarding the usability of EU Allowances (EUAs) for compliance after this period could prompt these utilities to sell surplus allowances. The resulting volatility in power and fuel markets, alongside the uncertainty surrounding the EU ETS, creates a challenging environment for risk managers involved in electricity production and consumption.
Secondly, the uncertainty caused by a Brexit could dampen short-term demand for carbon due to the economic repercussions and reduced demand for long-term power hedges in the rest of the EU. While auctions, including those in the UK, would continue as usual, supply would outstrip demand, especially after backloading ends and before the Market Stability Reserve (MSR) comes into effect in 2019.
Thirdly, the UK’s net importer status of EUAs and its strict allocation approach in previous EU ETS phases could result in reduced industrial demand for allowances. However, the impact of reduced industrial demand is unlikely to be felt for approximately two years, coinciding with the introduction of the MSR, which would moderate the effects.
Given that the UK is the second-largest economy and carbon polluter in Europe, it is imperative to establish clarity regarding the future of emissions trading as soon as possible in a post-Brexit world. Without such clarity, utilities and industries face challenges in planning sales, entering into contracts, and managing costs and prices. If the UK capitalizes on the opportunity to enhance the EU ETS by making targets, prices, and coverage more meaningful, alongside incorporating high-quality offsets from Least Developed Countries, it could be a positive outcome of a Brexit. However, clear rules and guidelines need to be promptly established to avoid unnecessary uncertainty and risk.
Moreover, the EU ETS already faces difficulties due to political conflicts and special interest lobbying. The increased volatility and prolonged uncertainty resulting from a Brexit could further hinder the effectiveness of the EU ETS, impeding the progress of carbon pricing and limiting efforts to address climate change.
Another important consideration is the potential dominance of carbon taxation as a pricing tool in a post-Brexit UK. The UK has implemented a carbon price floor tax for the electricity sector and has other tax-based carbon reduction schemes in place for various sectors. Post-Brexit, these taxes could be expanded to cover the entire economy, providing a more meaningful carbon price compared to the current EU ETS price. This approach would ensure that climate change issues do not significantly impact the UK’s trade negotiations.
The combination of these factors may not only lead to carbon taxation becoming the primary carbon pricing mechanism in the UK but could also influence the adoption of taxation, or virtual taxation through a price cap and floor, throughout Europe. Although this scenario may seem unlikely, a Brexit and EU ETS exit could pose challenges for emissions trading.
In conclusion, it is evident that a Brexit introduces economic uncertainty. However, the implications can be more intricate than initially apparent. The unintended consequences of a vote to leave the EU could have far-reaching effects on European emissions trading and, consequently, the environment as a whole.