The UK government have confirmed that the UK will implement an Emissions Trading Scheme (ETS or UK ETS) on 1st January 2021 to replace the EU ETS at the end of the Transition Period. At this stage, the UK ETS will be a standalone system, but the UK government remains open to the possibility of linking to other schemes. The EU ETS, the largest and most liquid ETS in the world, would be the obvious candidate for a link but that hinges on successful trade deal negotiations and a linkage agreement.
How will a UK ETS impact me?
For EU installations there will be no change to the EU ETS infrastructure, however, there will be an impact on every installation across Europe through the EU Allowance (EUA) price as both the short and long-term supply/demand dynamics will change.
For companies with UK installations, procedurally everything stays the same as if they were still in the EU ETS (verification, free allocation etc.) except that they are required to open registry accounts in the new UK registry system and, when the April 2022 compliance deadline comes around, submit UK Allowances (UKAs) instead of EUAs. UK installations’ requirements to comply with the EU ETS for 2020 emissions remains unaffected.
What are the risks of the UK ETS going it alone?
The UK ETS will be a near-identical copy of the EU ETS. However, there is significant risk of price spikes in the early months, and potentially years, of the scheme caused by low liquidity in the much smaller system. The UK government does not expect UK Allowance (UKA) auctions to take place before Q2 2021 and free allocation is unlikely to be distributed any earlier. This means that through Q1 2021, demand for UKAs will build and the first auctions are likely to be oversubscribed. As a consequence we expect UKAs to trade at or above EUA prices until the end of the year. The lack of early liquidity is an own-goal for the UK ETS because it will automatically mean that companies with obligations cannot manage their risks, obviating the point of having a market based carbon pricing mechanism in the first place.
The Redshaw Advisors team, voted number one EU ETS consultancy/advisory in December’s Environmental Finance awards, voiced our concerns about the design of the UK ETS to the UK government and we suggested some simple fixes. Unfortunately, our concerns appear to have fallen in deaf ears. The risk of price spikes in the UK ETS, that could see UK emitters paying significantly higher carbon costs than their EU counterparts, remains very real. On the plus side, over time, the UK ETS is expected to be oversupplied and prices may bump along at the £15 per UKA floor price, if it doesn’t link to the EU ETS first.
Managing the risk
At present it is impossible for UK installations to directly hedge UK ETS risk because the market for UKAs will not be able to start until free allocation and auction commencement takes place in Q2 2021. In the meantime, EUAs remain the only related instrument that UK installations are able to use to hedge their future exposure. In the current environment of inexorably rising EUA prices due to a fundamental shortage of EUAs being sold, this ‘dirty’ hedge should not to be ignored. As set out above, UKA prices are expected to track EUA prices, mainly because the major UK electricity utilities have already hedged their forward power sales with EUAs and they will sell EUAs each time they buy UKAs. Therefore, the outlook for UKAs, at least in the short term, is as bullish as that for EUAs.
The UK government will be providing more information and adjusting UK ETS legislation in the second half of December. This will hopefully shed some more light on what UK installations can expect from the coming years. For example, how the UK ETS’s current 45% emissions reduction target (by 2030) will be adjusted to accommodate the recently announced 68% target.
To discuss your UK ETS and/or EU ETS risk and how to manage it, please get in touch with the Redshaw Advisors team