UK-EU ETS linkage or not, the outlook remains bullish for the UK carbon market.
UK carbon prices have jumped more than 15% today following an article in the Financial Times revealing the UK has requested discussions on ETS linkage at an upcoming spring EU-UK summit, which will focus on a broad review of relations between the two sides. Since Brexit, there has been very little traction on linking the EU and UK Emissions Trading Schemes but the change in UK government has brought a renewed focus on the relationship with the EU. While aligning these schemes could offer mutual benefits, the path to such alignment is fraught with challenges. However, as we detail below, there are other reasons to be bullish about UKAs regardless of linking.
Linking the EU and UK ETSs would benefit both sides by expanding the pool of trading interest in the market as well as benefitting participants by simplifying the burden of administering two separate schemes. However, under the UK’s previous Conservative government the idea floundered for ideological reasons. Now that the Labour party is in charge, relations are expected to thaw, with Labour repeatedly promising an ambitious “reset" of EU-UK relations.
When Brexit finally happened the original European Union Emissions Trading System (EU ETS) was split in two, with the UK – responsible for around 10% of the old EU’s emissions - going its separate way and setting up its own UK Emissions Trading Scheme (UK ETS). Now, both the EU and UK are implementing Carbon Border Adjustment Mechanisms (CBAMs). This shared ambition to protect their economies from carbon leakage has rekindled discussions about linking the EU ETS with the UK ETS. Recent reports suggest that EU member states are generally receptive to connecting the EU ETS with the UK ETS. Carbon Pulse recently reported that a confidential document in support of linkage between EU and UK ETS, which was discussed in the Council of EU member states, noted “…most member states would be open to support the linking of the two ETSs in order to achieve efficiencies.” However, the EU has reportedly imposed stringent conditions for linkage, such as requiring the UK to significantly contribute to associated costs and other unpalatable conditions. These demands could complicate negotiations.
It is worth noting that the UK ETS differs from the EU ETS in one key aspect: it lacks a Market Stability Reserve (MSR). The MSR is a mechanism which helps stabilise prices by removing surplus EU Allowances (EUAs) from the EU ETS. Without a similar mechanism, the UK ETS has become oversupplied, and the price of UK Allowances (UKAs) has languished as a result. However, the UK Government is considering introducing a similar mechanism, called the Supply Adjustment Mechanism (SAM), and concluded its consultation on it on 11th March 2024. The UK Government’s response to the consultation is keenly awaited by market participants.
One of the consequences of the lack of MSR is that UKAs currently trade at a significant discount to EU Allowances (EUAs). On 27th January 2025, the difference between UKAs and EUAs stood at €40.04/tCO2e, marking the widest gap since September 2023. Due to the significant discount, not only is the UK government losing out on auction revenue to the tune of €2.2bn for 2025 alone, but UK exporters of CBAM goods will have to pay the gap between UKA and EUA prices to the EU’s coffers when the EU CBAM's definitive period begins on 1st January 2026 (if you want to know more about CBAM, click here). The risk of losing out on carbon revenue by handing it to Europe is another strong political incentive for the UK’s Labour Party to seek price parity before 2026.
The UK Government is also considering an increase in the auction reserve price. A higher auction reserve price would either bump prices up (if the reserve price was set higher than market prices) or de-risk long positions by underwriting the market at a higher level than the existing £22 reserve price.
Overall, linking the two systems would align carbon prices overnight, boost market stability and increase liquidity for all participants. A harmonised carbon price would result in a more streamlined implementation of CBAM and reduce administrative burdens. Additionally, a unified approach to cross-border taxes at a time when the Trump Presidency is expected to seek to drive tariff wedges between countries has to be desirable for both parties.
Despite potential difficulties in achieving EUA-UKA alignment, UKA prices are still expected to rise due to the introduction of the SAM, which would tighten UKA supply in the medium term by addressing the current oversupply in the market.
Stakeholders must monitor these developments closely, as they are set to have significant implications for carbon price exposure and hedging strategies. If the price of UKAs were to more than double overnight – with or without a linkage announcement – this would have a significant financial impact on UK companies.
Reach out to discuss how EU and UK ETS linkage and other policy developments could impact your business and explore tailored strategies to navigate this potential development effectively.