With the UK general election scheduled for 4 July, prices in the UK market have risen steadily. In part, this is due to stronger climate commitments from the anticipated victor, Labour, but also rising prices can be attributed to the perception that a new government would be more open to re-linking the EU and UK markets.
For the vast majority of market, compliance, and regulatory stakeholders, linking the markets is desirable. Fungibility between UKAs and EUAs means more liquidity for the market, improved price discovery, and a more robust price signal. Furthermore, by linking the markets the UK will avoid the additional pricing and reporting complexity from CBAM.
Despite the clear advantages to linking and the regulatory similarity of the systems, the negotiations to do so may not be as simple. From a public acceptance perspective, there may be some opposition to moving closer to EU institutions, however the political salience of carbon markets is low enough that this should not be the major concern.
Instead, carbon leakage policy may form the largest hurdle to re-linking. The EU has embarked on a novel carbon leakage deterrence policy with the CBAM. This is scheduled to replace the competitiveness support (in the form of free allocation) that iron & steel, aluminium, cement, fertilisers, and hydrogen receive. On the UK side, free allocation will remain in place with no plans to phase out the policy even as a UK CBAM has been proposed.
The EU’s CBAM regulation states that carbon markets that are fully linked to the EU ETS are exempt from the EU CBAM. If linked as-is, free allocation would continue for UK producers while being phased out for EU producers. This would create a competitiveness distortion within the combined European carbon markets through which UK producers of iron & steel, aluminium, cement, fertilisers, and hydrogen would only pay a portion of their emissions costs while EU producers would be fully exposed. The EU, which has recently turned attention towards industrial competitiveness as a key policy priority, is unlikely to accept this as an outcome of the UK-EU ETS linkage.
Additionally, beyond free allocation, CBAM would be a concern. While the UK government has stated that implementing a CBAM of their own is a priority, it is not yet in place. Placing a price on imports (excl. EU imports) to the UK would necessarily be a prerequisite to linking the systems. If imports do not have a carbon cost, this opens a backdoor to carbon leakage for the EU. Imports of untaxed emissions, intensive products into the UK that are then transferred to the EU undermines the integrity and efficacy of the EU’s CBAM. The EEA relevance of the CBAM regulation is under consideration for Norway, Liechtenstein, Iceland, and Switzerland. If deemed not relevant, there will be similar risks for the EEA countries covered by the EU ETS but not CBAM.
As the UKA price reflects the burgeoning hope for a re-linking of the systems, it is important to reiterate that these systems have evolved independently, despite having a common regulatory foundation. Linking would have been simple prior to Fit for 55 outcomes, but with the introduction of CBAM, the phase-out of free allocation, and international shipping, the UK ETS will need to undergo changes in order to align with the EU ETS. Even with support from most participants, negotiations will not be a breeze.
Veyt specialises in data, analysis, and insights for all significant low-carbon markets and renewable energy.
