Last month saw the launch of the UK Emissions Trading System (“UK ETS”), which replaces the EU equivalent which the country left at the beginning of the year with the implementation of Brexit. The first auctions on ICE took place on 19 May with the market price per tonne of carbon initially exceeding that in the EU regime.
Permits were sold at a price of £43.99 /tonne of CO2, climbing to just over £50 /tCO2 before falling back to around £45 /tCO2 later in the day. Trading in the EU ETS was €52.40 /tCO2 which was equivalent to £45.25 /tCO2. The scheme applies to all factories and power plants with a total rated thermal input of 20 MW or more.
“The first UK emissions auction clearing close to EU prices will bring a sigh of relief for industry and for policy makers. A smaller market and uncertainty about interventions to curb price spikes brought pre-auction worry that the permit prices would soar above those on the mainland and be volatile – potentially damaging the efficacy of carbon trading as a means of cutting carbon,” – Jonathan Marshall, head of analysis at the Energy and Climate Intelligence Unit
After initially attracting a premium to the EU ETS, possibly while the pent-up demand from close to six months with no market was satisfied, prices are now converging. The question is whether prices will continue to track those in the EU ETS.
Under the current market rules, the Government must consider measures to reduce the cost of allowances via the Cost Containment Mechanism (“CCM”) if they consistently trade at more than double their average price of the previous two years – since we don’t yet have a two-year trading history, the Government has set a threshold of £44.74 /tCO2, (~€52 /tCO2), based on EU ETS prices between May 2019 and December 2020.
If the CCM is triggered, a meeting of the UK ETS Authority will be called to consider what intervention, if any, to make based on addressing sustained price movements that do not correspond to market fundamentals. If there is no agreement on what action to take, the final decision will be taken by HM Treasury. This potential interventions include:
redistributing allowances between the current year’s auctions
bringing forward auctioned allowances from future years to the current year
drawing allowances from the market stability mechanism account
auctioning up to 25% of the remaining allowances in the New Entrants Reserve
At the end of May, Carbon Pulse reported that another possibility, is under consideration. When the UK ETS was first being designed, the original regulation indicated that the maximum number of UK allowances that would be allocated for free would be 58 million, but this limit was subsequently reduced to 39 million, leaving a bank of around 19 million unused UKAs. These were set aside to be used in the event that allocations of free UKAs to industry exceeded the market cap – rather than applying a “cross-sectoral correction factor” (a reduction in each installation’s free allocation) these UKAs would be allocated instead.
More recently the Government has been considering whether to add this reserve to the 2021 auction reserve, in response to concerns that early UKA trading and its premium to EUAs might see the market exceed the CCM trigger price. But the recent convergence with the EU ETS reduces that risk, and for the first time the UK ETS closed below the CCM trigger level last night, settling at £44.50 /tCO2.
The multiplier will change from double the average price now, to 2.5 times the average price next year, and then to 3 times in 2023, which will be on a par with the EU ETS although the front-year price must be above that level for six months. This sliding scale allows the UK government to intervene in the market at an earlier stage, which may be necessary while the market becomes established.
At the other end of the price scale, the Carbon Price Floor is an additional tax which applies when the market price of allowances falls too low.
As the British market is much smaller than the EU market, now that the initial demand has been met, there are questions over market liquidity and price volatility, and how this will impact the trading strategies of companies needing to buy allowances.
“One thing that’s clear is that carbon prices are growing, and it’s a cost that impacts almost all businesses. For those looking to reduce their carbon emissions or become net-zero, there are technologies and services that can help. By taking the cost of carbon off the books altogether, firms can avoid the market and hedging bets on how high carbon prices will go,” – Louis Burford, head of solution sales and optimisation at Centrica Business Solutions
After just one month of trading, it is difficult to draw any conclusions about the nascent UK ETS. While the Government clearly sees a role for carbon pricing, and a need to ensure prices are high enough to incentivise moves to cleaner technologies, it is also necessary to avoid economic shocks, particularly against the backdrop of a covid-depressed market.