Morality and Law
How Brexit Will Affect Emission Allowance Trading in Europe

The European Union has highly developed policies and laws to combat climate change. Among them is the Emission Trading System (ETS), the first and still the biggest such system in the world.

The ETS includes the 27 EU countries, three countries of the European Economic Area (Iceland, Norway and Lichtenstein) and, for now, the UK that left the EU on January 31, 2020. Collectively, ETS-registered industries account for about 45 percent of European greenhouse gas emissions, including carbon dioxide, PFCs, and nitrogen oxide. It is a “cap and trade” scheme under which emissions of certain substances in a defined area are capped at a certain level and then allowances for these emissions are distributed – either for free or at auction – to market actors, who can sell surplus allowances or keep them for future use.

It should be noted that Brussels is largely dissatisfied with this market-based mechanism, having attempted to introduce in the 1990s a European carbon tax and to prevent flexibility from being introduced in the Kyoto Protocol for fear that this would allow major emitters like the US to avoid making cuts by buying emission rights from other countries with the help of offset allowances. Both attempts ultimately failed, for which the UK shoulders part of the blame. First, the UK blocked the European Council’s decision to introduce the carbon tax, viewing it as interference in British internal affairs. Second, when the talks on the Kyoto Protocol reached a stalemate, the UK suggested amending the text so that allowance trading would not begin until the parties came to terms on detailed rules for using the “flexibility mechanisms.”

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The EU, in turn, accepted this scheme in exchange for the US undertaking to reduce emissions. The flexibility mechanisms, including emission markets, were added to the Kyoto Protocol, but the United States still reneged on its side of the agreement and refused to ratify in 2001.

In early 2001, these two circumstances led the EU to step up efforts to establish a European emission market. Since its launch in 2005, the ETS has gone through three phases replete with problems and challenges related to the allowance price distribution and stabilisation mechanisms, the transfer of allowances from phase to phase, greenhouse migration, harmonisation of oversight and reporting rules, and expansion of the ETS list of industries and countries.

Currently, the ETS is gearing up for the transition to the fourth phase that will last from 2021 to 2030. But there is a new problem, the UK’s withdrawal from the EU, which inevitably will entail changes in how the emission market functions. The UK plays an essential role in the ETS, with a national register of about one thousand entries, and London has always been an important node in the allowance trading system in Europe on par with Germany, Denmark, the Netherlands, and France.

It is still unclear what the UK’s post-Brexit climate policy will look like. The only thing London and Brussels have managed to coordinate is a decision on a transitional period: the UK and its emitters will remain committed to the ETS at least until December 31, 2020, which means that they will be included in the phase three reporting period.

Beyond that the outlook is rather murky. The UK may choose to impose a national carbon tax and create an allowance trading system of its own, which will either remain independent or will be linked with the European emission market (or possibly with some other market, but this seems highly unlikely at the moment). The first two cases would mean a total break with the EU, because an important new feature of phase four is the end of offset allowances. This means that the emission allowances obtained outside of the ETS countries cannot be counted toward post-2020 emission reduction pledges.

Within the next few months, the UK will launch consultations on alternative carbon pricing policies based on a national emission tax. This is spelled out in the draft budget released in the first half of March. The law also says that the UK is planning to create a national emission market and does not rule out its linkage with the ETS. The final decision will depend on numerous factors, not least the note on which the UK and the EU part on the remaining issues.

By all evidence, a hard Brexit will increase UK spending on climate policy but will positively influence the same indicator for the remaining EU members. In addition, the UK’s full withdrawal from the ETS will make it more homogeneous and facilitate the decision-making process. But, of course, the system itself will have to be restructured so as to increase the role of Germany and France, because a portion of smaller registers is still tied to London.

It will be hard to predict the consequences should the UK create its own emission market and link it to the European market. London is yet to make a final decision and so it is still premature to talk about the potential market’s design. However, if things go right, the players may even fail to notice the effects of Brexit, with the linked EU and UK markets (if they are created on the ETS model) functioning as though the EU and the UK had never parted ways.

The allowances held in the UK right now are another problem. Lacking clarity regarding the would-be market, UK companies that have no partner businesses in the EU may very well prefer to get rid of surplus allowances rather than keep them in the hope that they will be accepted in a national system, if one is ever created. This will inevitably affect supply and demand in the ETS that is already dealing with the problem of excessive allowances and the need to stabilise prices. In the meantime, European leaders reached an agreement on December 11, 2019, to be carbon neutral by 2050. This is likely to lead to an upward revision of reduction targets from the current 42 percent to 52-62 percent by 2030 (relative to the 2005 benchmark), which will affect the size and general condition of the emission market as a whole.  

The unfavourable international situation is not making things any easier. However urgent the challenge of climate change, the international community has been consumed for months with the fight against the COVID-19 pandemic. The UN has had to cancel or postpone several climate-related events, while EU climate policy lawmaking has slowed down, meetings are being postponed where possible, and ETS allowance prices continue their free fall despite considerable government stimulus measures. One thing is clear: it will take time to address all the issues related to the future of the European emission market and the UK’s role in it.

All we can do now is wait and see. And wash our hands, of course.
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