Prices in European Union and United Kingdom carbon markets have diverged significantly in 2023.With the looming EU CBAM, the widening gap between UK and EU carbon prices will, if unchanged, become the price that UK industry will pay to export to the EU. The risk that the UK ETSand broader climate ambition will fail to keep pace with EU ETS reforms is both the cause of the price gap that may cause UK industry to be exposed to CBAM and the impediment to a policy solution – limiting the possibility of linking markets. With the UK ETS undergoing reforms to tighten the market balance for 2030, the fundamental picture iIs not as bleak as the price chart suggests. Rather the market and the carbon price signal are mirroring the sentiment of UK leadership.
After the two carbon markets split because of Brexit, the EU ETS and the UK ETS consistently traded in lockstep, or with UKAs at a premium to their continental counterparts, illustrated by Figure 1. Through 2023, the price of the front-December EUA contract has remained relatively stable, averaging €88/t. The equivalent UKA contract has fallen by 44% (-€36.58/t) since the beginning of 2023. The UKA-EUA spread has widened to €34.64/t as of 3 Oct.
Through 2023, both the policy context behind each of these markets and subsequent price development have changed drastically. In December 2022, the EU concluded interinstitutional negotiations to reform the EU ETS as a part of the overall Fit for 55 legislative package. Final adoption took place in May, but the throughline from these changes has been clear: the cap will shrink more rapidly, there will be less free allocation, and the market will be much tighter – all in respect of stepped up 2030 climate ambition.
TheUK ETS iscurrently undergoing reform processes to keep in line with the 68% emissions reduction target set in December 2020.InJuly, the Department for Energy Security and Net Zero (DESNZ) chose the ETS reform that was the least ambitious from the policy options on the table, cutting the cap to 936Mt. Support for UK industrials through free allocation will be expanded, increasing the share of the cap from 37% to 40%. Additionally, 53.5 million allowances, drawn from unallocated allowances under the industry cap, will be added to auction volumes between 2024-2027 to avoid the application of the cross-sectoralcorrection factor. Overall, the plan does increase the UK ETS ambition, but at a lower rate as compared to the EU ETS. Additionally, and more importantly for price formation, the UK ETS remains without a supply adjusting mechanism like the Market Stability Reserve in the EU ETS that has served as a bullish catalyst, limiting oversupply.
As the long-term impacts of these adjustments have been internalized and priced into each market, the closely linked price dynamic between these markets has shifted.
With the recent setback in climate ambition announced by UK PM Rishi Sunak, pushing key climate targets back, approving new oil and gas licenses, and pushing net-zero skepticism to the fore of the conservative platform, the UK’s role as a climate leader has been further undermined – as has confidence and predictability in their emissions trading system.
From 2023, businesses exporting to the EU from non-EU jurisdictions must comply with the EU’s carbon border adjustment mechanism (CBAM). The UK is no exception.
CBAM was introduced with the ‘fit for 55’-legislation to protect EU industries against international competition from exporters in countries with laxer climate ambitions and carbon pricing. As free allocation is gradually phased out in the EU ETS, European industry will be faced with the full carbon cost of its emissions. CBAM will become the main instrument to prevent carbon leakage by exposing third country imports to an equivalent cost, creating a level playing field. Industries importing iron & steel, aluminium, fertilisers, cement, electricity, and hydrogen to the EU will face obligations to pay CBAM costs from 2026, with full phase-in by 2034.
As of October 1, importers must comply with the EU CBAM’s monitoring, reporting, and verification requirements for emissions embedded in their products. The EU will allow for some flexibility in reporting methodology, allowing use of equivalent national systems, reference values, or the full EU methodology. From 2025, only the EU’s methodology will be accepted.
The CBAM regulation stipulates that the price to be paid for CBAM certificates can be reduced by the explicit carbon price paid in the country of origin. From its proposal in 2021, industry in the UK has paid little attention to the regulation. The equivalent carbon cost in the UK practically exempted imports and, up until March 2023, expectations were that prices would remain at comparable levels. The rapid fall in UKA prices as EUAs have held steady has shifted that picture.
As of 2022, the EU is the UK’s largest trading partner, with 40% of UK exports ending up on the continent. The widening gap between UK and EU carbon prices will, if unchanged, become the price that UK industry will pay to export to the EU.
Splitting the EU and the UK carbon market was Brexit ‘collateral damage’. From a market perspective, separating into two systems was sub-optimal, impactingliquidity and market predictability.Since the split, re-linking the markets has been the obvious solution, supported by market participants and experts, however politically and administratively this is getting less and less likely as the systems continue to evolve separately.
Immediately following the market split, the EU ETS and UK ETS were almost identical. At that point, a linked system would have likely been palatable from a compatibility standpoint. Now, with ambition and market function diverging, the merging of the markets would lead to a watering down of a central pillar of the EU’s emissions reductions mechanisms. Before discussions of linking can take place, the UK’s market would need to have comparable pricing (although prices would likely converge if linking were announced), comparable rules, and to earn the confidence that policy instability would not undermine the functioning of the market or the incentives for covered industry to decarbonize.
Furthermore, even if linking the markets was politically palatable, it is a step that would take time. Using the linking of the Swiss ETS as an example, negotiations to link Switzerland’s carbon market with the EU’s began in 2011 and concluded in 2016. The treaty was signed in 2017, ratified by both in 2019, and entered into force in 2020.Even with a shorter linking time, if joining the UK ETS and the EU ETS is to be intended toavoid adverse impacts of CBAM, it is unlikely that the process from negotiations to agreement to ratification could take place before the financial impacts were felt by UK industry.
At this point, the risk that the UK ETS will fail to keep pace with EU ETS reforms is both the cause of the price gap that may cause UK industry to be exposed to CBAM and the impediment to a policy solution.
Fundamentally, the weakness in the UK market does not line up with expectations. Despite the softening/prolonging of climate measures, the chosen policy option for UK ETS reforms willcut the cap by appx. 30%, down to 936Mt compared to the current 1365Mt.
The energy crisis, industrial slowdown through 2022 and 2023, and lower fossil fuel generation have all likely contributed to a more bearish picture for the UK ETS. From a supply perspective, the 53.5Mt of unallocated allowances from the industrycap that will be released between 2024-2027will add flexibility/oversupply, similar to the additional allowances (and bearish sentiment) being added to the EU ETS through REPowerEU. A major policy difference is that the UK ETS does not have a dedicated mechanism to manage this oversupply, whereas the EU ETS’s Market Stability Reserve will soak up these allowances and tighten the market late-decade. All of these factors areweighing and will likely to continue to weigh on prices in the near-term.
Likely more important is the signal that the UK’s government has provided for long-term certainty in the market. As a politically created market, the UK ETS, like the EU ETS, responds to signals from leaders on the direction and stringency of climate ambition. It’s nosurprise that when that messaging is ‘we are softening our targets,’ that the signal for emitters is that investments in abatement can wait. At this point, the market and the carbon price signal are mirroring the sentiment of UK leadership.
Whether through change in government, progress on reforms, or reaffirmation and clearer paths to climate targets, confidence in the market is likely needed for prices to rise to meet their earlier levels. The next UK general election will take place no later than January 2025.
Veyt specialises in data, analysis, and insights for all significant low-carbon markets and renewable energy.
