In an era of financialisation, it is not surprising that market forces have pulled environmental policy within their ambit. Emissions trading schemes, otherwise known as cap and trade regimes, are business-friendly market mechanisms that incentivize polluters to meet emissions reductions targets at the lowest possible cost.
What Is Emissions Trading?
They are favoured over traditional command and control regulation and even carbon taxes, which are viewed by many businesses and less-developed nations as inequitable constraints on economic development. Most commonly with cap and trade regimes governments or regional authorities set a cap on overall emissions and then allocate allowances to polluters up to the level of the cap.
These allowances can then be bought and sold freely in the market. The system aims to reward polluters who achieve emissions reductions through, for example, investing in clean energy sources by enabling them to sell their excess emissions allowances to higher emitters.
The biggest and most advanced scheme currently in operation is the European Union Emissions Trading Scheme (EU ETS). It is the EU’s central climate change policy mechanism which regulates 45% of the EU’s total greenhouse gas emissions and covers around 1,000 of the largest emitting industrial installations in the UK. In terms of the EU meeting its climate obligations, the EU ETS is thus hugely important.
Uncertainty over the EU ETS
In light of Brexit, there is considerable uncertainty around whether or not the UK will remain inside it once it officially leaves the EU. Importantly, participation in the EU ETS is not conditional on EU membership, therefore, the UK, if it wishes, would have to negotiate a special arrangement with the EU that keeps the UK inside the scheme.
Norway, Iceland and Lichtenstein are not in the EU but are nevertheless members of the EU ETS. The issue is that these countries are inside the European Economic Area (EEA) which raises questions as to whether single market access is a prerequisite for participation in the EU ETS.
In any event, the UK could pursue an alternative option and establish its own emissions trading system which could then be linked to the EU ETS at a later date. Although the opportunity is there to do so, it would ostensibly be an inconvenient course to take, as it would entail more complexity and bureaucracy for businesses.
The creation and administration of a domestic scheme would also entail more public expenditure, something to which the current UK Government is averse. Unfortunately for investors, the UK is yet to make its position clear on the EU ETS.
The Importance of UK Participation
Despite concerns over practicalities, it is in the interests of both the UK and the EU for the UK to remain in the EU ETS. The EU relies heavily on the UK for around £1.7bn worth of funding for the scheme, most of which goes to less-developed Eastern European Member States in the form of emissions allowances.
The loss of this funding would likely have a detrimental impact on the operation of the EU ETS and may require existing members of the scheme to increase their funding to keep the scheme running, an exigency that would prove to be politically unpopular.
Another issue is market prices. In the morning of the referendum vote, the EU carbon price dropped more than 15% in anticipation of the possibility of the UK leaving the EU ETS, which highlights the UK’s positive influence on the scheme’s operation.
The UK is the second biggest emitter in the EU and UK industry purchases a significant amount of allowances from the market. A UK exit, therefore, prompts fears over falls in demand and the consequent reduction in the price of emissions allowances which would have the effect of dampening the incentives for industry to meet climate targets. However, market hedging that occurred in anticipation of the referendum vote could mitigate these pricing concerns.
The UK has also been a fundamental contributor to the reform of the EU ETS both domestically and at the EU level. To alleviate the problems associated with low carbon prices that have plagued the EU ETS since the financial crisis, in 2010 the UK introduced a domestic carbon floor price to sustain meaningful incentives.
At the regional level, the UK negotiated hard alongside the Commission to reform the EU ETS. From Phase III of the scheme, the Commission, rather than the member states, now has the exclusive competence to set caps on national allocations of allowances. Previously, the member states were legally unrestrained in the number of allowances they allocated to domestic industry. Reform of this kind will help to prevent an oversupply of allowances and sustain competitive market prices.
Finally, the EU ETS is one of the central policies utilised by the UK to meet its domestic climate obligations under the 2008 Climate Change Act. The Act imposed a legal duty upon the Secretary of State “to ensure that the net UK carbon account for the year 2050 is at least 80% lower than the 1990 baseline“.
In light of such a demanding duty, one can reason that failing to negotiate an agreement to secure participation in the EU ETS is likely to set back the UK’s efforts to meet its statutory climate obligations and tar its renowned reputation as being a leader in combating climate change.
But as with the majority of uncertainties arising from Brexit, it all depends on the negotiations.