Public consultation launched for including Greenhouse Gas Removals in the UK ETS

Introduction

The risks associated with climate change demand an urgent worldwide response. Reaching the temperature targets set out in the 2015 Paris agreement requires greenhouse gas emissions to reach net zero by 2050. This will not be achievable with emissions reductions alone. Therefore, success in meeting the global target also requires the use of Greenhouse Gas Removals (GGR) – taking emissions out of the atmosphere for permanent and safe storage – to bring the atmospheric CO₂ concentration down to safe levels.

In light of this urgency, and as part of wider international efforts, the UK government launched a consultation in May 2024 to assess how GGR could be integrated into the UK Emissions Trading Scheme – the country’s legally binding carbon compliance market. The consultation will run until 15^th August 2024.

The purpose of the UK ETS consultation is to gather inputs from a broad range of stakeholders, including industries, financial institutions and environmental groups, to help understand how best to design policies that would include GGR – also known as ‘carbon removals’ – into the UK ETS in the most effective way, including engineered removals and high-quality nature-based removals.

Background information

The UK Emissions Trading Scheme (UK ETS) is a legally binding cap-and-trade system designed to reduce the UK’s greenhouse gas emissions, chiefly carbon dioxide (CO₂), over a specified timeframe in an economically efficient way. The system regulates emissions from electricity generation and other emissions-intensive industries such as metals, cement, refining, aviation and other sectors.

The system includes a legally-binding annual limit or ‘cap’ on emissions and creates carbon allowances (called ‘UK Allowances’) each year to match the cap. Companies regulated by the UK ETS must surrender each year a number of allowances matching their verified annual emissions in the previous calendar year. Since the cap on emissions declines each year, emissions are reduced over time. To encourage emissions reductions to take place at the lowest cost, companies that can cut emissions at a price lower than the price of allowances can sell any resulting surplus allowances to those for whom cutting emissions is more expensive. As a result, the emissions reduction target is achieved at a lower cost to the economy than would be the case if all entities were required to reduce emissions according to individual targets.

The UK ETS has been designed to replace the UK’s participation in the EU Emissions Trading System (EU ETS) from 1^st January, 2021, following the UK’s exit from the European Union.

The UK ETS consultation on integrating greenhouse gas removals follows similar and related consultations which looked into addressing carbon leakage to support decarbonisation; a consultation on carbon and biodiversity credits; and a consultation on the introduction of a UK carbon border adjustment mechanism (CBAM), among others. 

The regulatory body in charge of the UK ETS is the ‘UK ETS Authority,’ which is made up of representatives from the UK government, the Scottish and Welsh governments, and the Department of Agriculture, Environment and Rural Affairs for Northern Ireland. 

In March 2022, the UK ETS Authority consulted on a wide range of proposed changes to the scheme, including a call for evidence on the role of the UK ETS as a long-term market for greenhouse gas removals (GGRs).

In July 2023, the Authority said it believed the UK ETS was an appropriate long-term market for GGRs and set out its intention to include engineered removals in the UK ETS. This was on the condition that the proposal would be subject to further consultation, robust monitoring, reporting and verification (MRV) and the management of wider impacts. It also said it believes the UK ETS could provide a market for high quality nature-based carbon removals, subject to further work to assess the range of potential issues raised regarding permanence, costs and wider land management impacts.

Current proposals

Principles for policy design

The integration of GGRs into the UK ETS is a complex undertaking and requires careful consideration for a number of reasons. These include the need for appropriate incentives, maintaining environmental integrity, achieving the desired environmental outcome, and avoiding negative disruption to the functioning of the UK ETS – a market in which considerable investments have been made by UK-based CO₂ emitters and financial entities.

The UK ETS Authority therefore set out eight policy design principles to guide the UK ETS consultation on carbon removals. These are:

1. Maintain the incentive to decarbonise: integrating GGRs must ensure the incentive to reduce emissions continues to exist for sectors already covered by the UK ETS, in line with the UK’s net zero target.
2. Maintain market integrity: integration should ensure the effective functioning of the UK ETS and should not undermine the meaningful carbon price signal generated by the annual cap. This could include an assessment of market liquidity, volatility, predictability and the opportunity for market abuse.
3. Efficient long-term deployment of GGRs: The inclusion of GGRs should ensure that CO₂-emitting companies can make economically efficient choices between reducing emissions and using a diverse portfolio of high-quality GGRs in a way that is consistent with national and international climate commitments. However, the emphasis will remain on taking ambitious decarbonisation measures as the primary method of achieving net zero targets.
4. Environmental integrity: Integration should be underpinned by evidence-led methodologies and standards, including monitoring, reporting and verification, for high quality, robust GGRs that can be legitimately regarded as equivalent to emissions reductions under the UK ETS.
5. Deliverability: Integration of GGRs should be designed such that it is operationally feasible in timescales relevant to the UK’s net zero target and interim carbon budgets and targets.
6. Simplicity: Integration should be consistent with the government’s approach to wider GGR policy and consider best practice internationally or in other markets. Intervention should only take place where necessary and should aim to minimise additional burdens.
7. Futureproofing and flexibility: Integration should be designed to take account of and adapt to future changes to both the UK ETS and wider GGR policy and deployment.
8. Fiscal impact: Integration should be delivered in a way that maximises value for money for the taxpayer, taking into account the overarching objective of creating a self-sustaining market for GGRs and reducing government support over time.

CAP policy options:

The UK ETS is based on the principle of ‘cap-and-trade’, which means that a cap is set on the total emissions that can be released each year, and this cap declines gradually over time, reducing emissions. The cap is the primary lever for setting the environmental ambition of the UK ETS.

Each year, regulated entities must acquire and surrender allowances that match their independently verified annual emissions, or face heavy fines for non-compliance. These allowances (UK Allowances) are provided to industry through a combination of free allocation and auctions. Companies can buy and sell allowances in an open market, helping to increase flexibility in how to comply with the scheme. From January 2024, the UK ETS Authority decided to implement a new cap that is consistent with the country’s long-term goal to reach net zero emissions. 

The UK ETS Authority has said GGRs must be an additional element in the road to net zero, rather than a replacement for emissions reductions, and this is consistent with the wider scientific consensus, including the Intergovernmental Panel on Climate Change. Integrating GGRs in the UK ETS therefore needs to be implemented in this context, and it will be important to do so in a way that avoids any negative impact on the annual cap or the wider functioning of the UK ETS.

The UK ETS Authority will need to create allowances for GGRs that meet the UK ETS market participation requirements by removing and storing carbon. Since this has implications for the total supply of allowances in the UK ETS, the allowances from GGRs must remove an equivalent tonne of CO₂ emitted by a participant in the UK ETS.

With these considerations in mind, the UK ETS Authority is considering various approaches to integrating GGRs into the scheme’s annual cap. Among the various elements being studied, one is the temporal nature of GGRs, whereby GGR deployment may be relatively small while it is a nascent industry, but growing over time as the removals industry matures.

In its UK ETS consultation, the Authority is considering three main options to integrate GGRs into the annual cap, as follows:

1. Increase the gross cap: under this approach, the annual cap would be increased from the existing level, to allow for GGRs. Regulated entities would be issued allowances in addition to the existing supply set out under the cap. The incentive to decarbonise created by the UK ETS could be undermined by the unlimited supply of GGR allowances.
2. Maintain the gross cap: under this approach, the gross cap would be maintained while integrating GGR allowances. This would be achieved by ensuring that a UK Allowance was replaced every time an allowance is issued to GGR operators. This would ensure that the overall supply of allowances remains unchanged.
3. Create a new net cap: under this approach, a new lower annual cap would be set under the UK ETS that did not apply to GGRs. Allowances issued to GGR operators would enter the market in addition to the supply of allowances created by this new cap. The new cap would not impose a limit on the number of allowances that could be distributed to GGRs.

For initial integration, the Authority has proposed that option 2 is used, so that for every allowance awarded to a GGR, one UK Allowance will be removed from the auction share under the existing gross cap. This is because the Authority wants to ensure that gross UK ETS emissions continue to reduce in line with the net zero trajectory of the existing cap, with GGRs providing additional net savings across the economy.

In effect, this means that the incentive to decarbonise is kept in line with net zero, but in a longer-term case where GGR deployment outstrips the size of the UK ETS, the system would no longer sustain GGR demand needed to achieve net zero emissions.

In the longer-term, the Authority is considering the option of setting a new net cap and enabling the allocation of allowances from GGRs to enter in addition to the supply of allowances set out under a new cap. Choosing when to set any new cap is expected to be a complex issue and largely determined by the extent to which UK ETS sectors have decarbonised, and the supply of GGRs.

Allowance design for GGRs:

Integrating GGRs into the UK ETS will require standards and methodologies to help ensure that projects generate robust, high-quality credits. This will include quantifying the amount of CO₂ removed from the atmosphere and permanently stored. 

The Authority has proposed that GGR operators should be issued with allowances in the UK ETS after the removal has taken place and been verified (ex-post). This is considered the most environmentally robust form of crediting and will help build confidence in the market as GGRs are integrated into the UK ETS.

The Authority has proposed that only UK GGRs should be allowed to participate in the UK ETS, as this would support the development of the GGR sector across the UK. In addition, opening up the UK ETS to international GGRs would have significant implications for the stability of the UK market.

GGR allowances could take various forms, including:

1. No new type of allowances (GGR operators would simply be issued with UKAs)
2. A generic GGR Allowance would be created, which would be technology-agnostic
3. Technology-specific GGR Allowances would be issued to operators which would provide detail on the method used to generate the allowance

In addition, the Authority is considering various routes to market for GGRs, including combined auctions, separate auctions, and separate auctions by removal type.

Permanence of carbon storage:

The UK ETS Authority will only consider GGRs for inclusion in the UK ETS where there is strong confidence that the greenhouse gas storage provided is highly durable and risks of carbon leakage are minimal and can be sufficiently managed. Any GGR technology must deliver a ‘negative emission’ which means it must remove more GHGs from the atmosphere than are generated from the carbon removal process.

The UK government has set out three criteria for robust negative emissions:

1. CO₂ must be directly capture from the atmosphere or seawater (via biological, chemical or geochemical means).
2. End-to-end CO₂ emissions must be lower than the total amount of stored carbon. For some technologies, requirements would be set to limit the level of supply chain emissions, to ensure that GGR technologies achieve a minimum level of net negative emissions.
3. Once captured by a project, carbon must be sequestered in a highly durable store. This should include the ‘risk of reversal’ which means the likelihood of captured carbon being re-emitted into the atmosphere.

Other considerations linked to permanence include a minimum storage period, liability in the event of a reversal event and fungibility measures, for example awarding some GGRs with fewer allowances compared to the carbon that has been stored, on the basis that there is sufficient risk that some of the stored carbon may be released.

Pathways to integration:

To enable the integration of GGRs in the UK ETS, the Authority is considering two key aspects:

1. The degree of integration: whether a separate market for removals should be established and whether any supply restrictions should apply on the GGRs entering the UK ETS and/or demand restrictions on who can buy GGRs in the UK ETS.
2. Timing: this refers to the point in time from which GGRs that meet the specified requirements are allowed to enter the UK ETS.

The Authority has proposed that additional supply controls should be adopted, in view of the need to provide a strong demand signal to GGR developers. It has also said it is not considering creating a new and separate market for GGRs and is not proposing to place demand controls on who can buy GGRs in the UK ETS at this stage.

An integrated market for removals means that GGR operators would be able to sell directly into the compliance market. In this context, the government may wish to exert some control over when and how GGRs can be used within the UK ETS. Various methods could be used to achieve these controls as follows:

Supply controls: these would set quantitative limits on the supply of GGRs entering the UK ETS. This could include a GGR ‘cap’ within the overall UK ETS cap, which could increase over time.

Demand controls: these would set constraints on the way in which allowances from GGRs could be used. This could include determining which UK ETS participants are allowed to purchase GGR allowances, or setting a limit on the proportion of a participant’s compliance obligation that can be achieved through GGRs.

Other novel uses of GGRs: these could include replacing free allocation of UK Allowances with GGRs, or using GGRs to stock a supply adjustment mechanism (SAM). A SAM would adjust the supply of allowances in the market in response to certain pre-determined criteria and market conditions.

Importance of GGR integration

Incentivising investment

The UK government wants to incentivise investment in Greenhouse Gas Removal (GGR) and sees the integration of GGRs in the UK ETS as a way to create demand for removal projects based in the UK. This would allow GGRs to form a key part of the UK’s target to reach net zero emissions by 2050. This would generate a robust price and provide a clear demand signal for companies planning to invest in GGR projects in the UK.

If designed properly, this could be achieved while preserving the primary focus on direct emissions reductions, with removals playing a complementary role, while also avoiding negative effects on the functioning of the UK ETS market.

Long-term market implications

If the UK ETS Authority adopts a mechanism to integrate GGRs in the UK ETS without increasing the gross cap on emissions, this would help to avoid a negative impact on the price of UK Allowances and avoid disrupting the existing market structure. This is important as hundreds of UK-based companies have made investments based on the current pricing environment, including complex hedging arrangements that could be negatively affected by a sudden change in fundamental supply and demand that would impact the UKA price.

In the long-run, the integration of GGRs in the UK ETS should help underpin a nascent domestic market for GGRs in the UK by allowing regulated entities to use allowances from GGR removal projects for compliance with the scheme.

Hurdles to overcome first

Before GGRs can be integrated into the UK ETS, the government will need to consider the responses to its consultation which will end on 31^st August, 2024. In designing the rules for GGR integration, the UK ETS Authority will need to strike a careful balance between various views expressed by respondents, while seeking to achieve its goal of establishing a solid market with demand for domestic removals while maintaining a strong incentive for entities regulated by the UK ETS to continue to reduce their own direct emissions.

This work will involve decisions on how to amend the UK ETS cap to integrate GGRs, designing appropriate methodologies for GGR projects, addressing permanence and liability for emissions reversals, and on the timing of various elements of the integration process.

How to become better informed

Companies regulated by the UK ETS may need to develop a clearer understanding of how the integration of GGRs in the UK ETS could affect them, including any risks and opportunities created by this step-change in the market’s development.

In addition, companies considering investments in nature-based and engineered removals projects should equip themselves with knowledge of the rules governing GGR allowances in the UK ETS and how the regulatory framework could change over time as the carbon removals industry develops and grows.

Are you prepared for the arrival of GGRs in the UK ETS? Do you want to understand the implications for the functioning of the UK carbon market and gain a clearer understanding of how the markets for carbon removals will develop?

Redshaw Advisors can help with these urgent questions, bringing a depth of understanding and experience to help companies understand their risks, opportunities and regulatory obligations arising from the inclusion of GGRs in the UK’s legally binding carbon market. Please get in touch with us to find out more about how you can get ahead of these important developments: https://redshawadvisors.com/contact-us/

In addition, domestic aviation emissions are also regulated by the UK ETS, and the system will soon be expanded to include shipping emissions from 2026. Emissions from the maritime sector were also brought into the wider EU Emissions Trading System (EU ETS) from January 2024. Find out more about shipping and the carbon markets here: https://redshawadvisors.com/ets-shipping-compliance/

And for specific training on emissions trading systems, please visit: https://redshawadvisors.com/ets-training/