On Wednesday, the European Commission published a Recommendation for a Council Decision that would establish a negotiating mandate for the linkage of the EU ETS with the UK ETS. This marks the first official step from the European side towards formal mutual recognition of the two emissions trading schemes following the 19 May Common Understanding (for a review of that document, see here).
With the news breaking shortly before 14:00 CET, UKA prices jumped sharply. The UKA front-Dec contract first gained GBP 2.90/t (5.8%), reaching GBP 52.70/t before settling into a range between GBP 51.00/t and GBP 51.50/t by the end of the day. UK carbon settled at GBP 51.14/t, up 2.8% day-on-day, its highest level since late June. This step forward seemed to breathe new life into a market that has recently shown signs of stagnation in the absence of policy developments.
Simultaneously, EUAs experienced a similar but slightly muted reaction, rising EUR 1.20/t to reach EUR 72.39/t before returning to rangebound trading between EUR 71/t and EUR 71.30/t. While a market linkup is expected to be bullish for UKAs, we expect the impact on EUAs to be neutral or mildly bearish, though headlines around linking may spur kneejerk reactions as was seen in Wednesday’s trading.
The Commission’s recommendation for the negotiation mandate is straightforward, with most aspects drawn directly from the Common Understanding. The key elements of the negotiation topics include the following:
Mutual recognition/fungibility of emission allowances.
Mutual CBAM exemption (assuming that the agreement meets the criteria of the EU CBAM Regulation’s exemption rules).
Scope of the agreement should include: electricity, industrial heat generation, industry, domestic and international maritime transport, domestic and international aviation – and should include a provision to expand this list as necessary.
UK rules must dynamically align with relevant EU ETS legislation.
The UK’s cap and its supply reduction must be as or more ambitious than the EU’s.
Firstly, sectoral alignment may be a sticking point. The Commission recommendation prescribes sectoral alignment between the two systems, including international aviation and international maritime – both of which are not covered, and are not planned to be covered by the UK ETS.
While the EU ETS does not currently impose compliance obligations on international flights, the ‘stop the clock’ derogation that excludes these emissions is set to expire by 2027. If CORSIA is determined to be an insufficient incentive for decarbonization (which seems likely), the EU ETS will revert to the inclusion of departing international flights under the scope of the trading scheme. The details for how this will take place will likely be a point of discussion in the 2026 EU ETS review.
A UK system that does not include international aviation presents an environmental integrity challenge, as international flights departing the UK would not be covered. This could provide a route for airlines to circumvent the carbon cost imposed by the EU. Currently, the UK government has put forward no plans to extend their carbon market to international shipping or international aviation, though the Commission’s recommended negotiating mandate indicates that this will be a requirement. The extension of UK coverage to international aviation is sure to face robust opposition from airlines (this has already begun within the EU) and may be a stumbling block for negotiations or the implementation of an eventual agreement.
International maritime faces a similar concern. Without equivalent coverage of international voyages, the UK could become a target for circumvention via transshipment (the process by which cargo is transferred at a port closer to the EU in order to avoid carbon costs for the entirety of the route). The EU is unlikely to accept a deal through which shipments to/from the EU face carbon pricing while UK shipping is not exposed to the same costs.
From the beginning of the UK-EU linking saga, the EU has pushed for the dynamic alignment of UK ETS rules with those under the EU ETS. “The agreement should require the United Kingdom to dynamically align to the relevant acquis, notably Directive 2003/87/EC and derived legislation. The scope of dynamic alignment should also include all the provision of the EU financial regulatory and supervisory framework applicable to trade in allowances of the Union emission trading system (EU ETS) and derivatives thereof.”
For the UK’s market to interact with the EU ETS, the UK must become a rule-taker. The agreement, as preferred by the EU, would commit the UK to continuously adjust its legislation to be in line with or more ambitious than the EU. As the EU’s system undergoes reforms, the UK system would be expected to change in concert with it. Dispute settlement would take place through an independent tribunal. The EU also intends to pursue dynamic alignment under which the Court of Justice of the European Union has authority over EU law.
Based on what is currently publicly available, the setup would be very similar to the Swiss-EU ETS linking agreement. The main difference is that the EU-Swiss agreement makes no mention of the Court of Justice of the European Union. Instead, either party may suspend mutual recognition of emission allowances given specific conditions laid out in the linking agreement.
Dynamic alignment will be contentious for UK lawmakers. Publicly, it may be construed as a walking back of Brexit and/or as a loss of British sovereignty to the EU. This document reveals no new information about how either dynamic alignment or the Court of Justice of the European Union could interact with the agreement.
As this document is a ‘Commission recommendation for a Council decision,’ the next step will be approval within the European Council. The soonest that this could take place is today (18 July), as the Working Group on the United Kingdom will be meeting (9:30 CEST) ahead of the General Affairs Council meeting (press conference at 13:30 CEST). If not taken up on 18 July, it may be approved at the Foreign Affairs Council that will take place in late August.
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