Scaling through integration? Proposals on integrating greenhouse gas removals in the UK Emissions Trading Scheme

The day after former UK Prime Minister Rishi Sunak requested permission from the King to dissolve parliament and called a UK general election, the UK Emissions Trading System (“UK ETS”) Authority launched a consultation on proposals to integrate greenhouse gas removals (“GGRs”) (also known as carbon dioxide removals or CDRs in some markets) into the UK ETS, with a deadline of 15 August 2024 (the “Consultation”). The fact that the announcement was nevertheless released, despite the impending election and expected change of government, indicates broad cross-party political consensus on the development of UK GGR policy and the need to scale GGRs to achieve net zero targets.

While GGRs are presently unavailable at scale in the UK beyond nature-based approaches (such as afforestation, soil carbon sequestration and habitat restoration), the UK ETS Authority anticipates that integrating GGRs in the UK ETS will incentivise investment in, and the deployment of, a diverse portfolio of novel GGR methods. In this article, our team examines: the proposed scope and design for integrating GGRs in the UK ETS; the proposed timing and pathway for GGR integration; and how these proposals align with complementary decarbonisation policies in the UK and EU.

1. Introduction

In practice, the proposed GGR integration will allow GGR operators to generate and sell GGR allowances to UK ETS participants, which may surrender those GGR allowances to comply with UK ETS obligations, as an alternative to purchasing and surrendering UK allowances (“UKAs”). If taken forward, GGR integration would create a new market for GGR activities, by linking with the existing UK ETS market. This integration intends to address what the Consultation describes as a “market failure in the provision of GGRs” caused by systemic under-pricing of GGRs’ social, economic, and environmental value.

The existing UK Net Zero Strategy (set out under the Conservatives) includes deploying at least 5 MtCO2 per year of engineered GGRs, which include Bioenergy Carbon Capture and Storage (“BECCS”) and Direct Air Carbon Capture and Storage (“DACCS”) technologies, by 2030. The UK Net Zero Strategy further foreshadowed a potential scaling of engineered GGRs to 23 MtCO2 per year by 2035, and 75-81 MtCO2 by 2050.^[1] Yet, the UK Climate Change Committee’s Seventh Assessment Report indicates that progress on engineered GGRs, in particular, remains “behind schedule”, and that the government’s 2030 removal target is becoming “increasingly challenging”.^[2] On the other hand, pricing emissions through the UK ETS (and the EU ETS before Brexit) is already considered a successful pillar of the UK’s climate change policy, having been an important measure in reducing UK emissions by approximately 50% since 1990.^[3]

The Consultation reflects political positions agreed between the former UK government and devolved administrations. Publication by the UK ETS Authority (comprising the UK government, Scottish government, Welsh government, and Department of Agriculture, Environment and Rural Affairs for Northern Ireland) after the announcement of a UK general election, but before the prorogation of the UK Parliament, signals that the Consultation represents stable and uncontentious policy proposals by the UK ETS Authority. The Consultation envisions that GGR integration will operate alongside a separate GGR business model, which offers supply-side incentives for GGR projects,^[4] published in December 2023.

Although it is improbable that the new Labour government will retract from the Consultation proposal, it may seek to expedite the expansion and scale of UK GGR projects. Regardless, we expect that the government may aim to align its GGR policies with the UK Climate Change Committee’s Sixth Carbon Budget, which identified “the lack of a long-term price signal” as a major policy gap for incentivising GGRs.^[5] Integrating GGRs in the UK ETS could also facilitate a faster transition for GGR activities away from subsidy-based support schemes.

2. Adjusting UK ETS Caps

Integrating GGRs in the UK ETS will require adjustments to the UK ETS’s caps. UK ETS caps currently prescribe the number of UKAs over a specified period (for example, the current UK ETS Phase 1 runs from 2021 to 2025, and Phase 2 from 2026 to 2030). Fundamentally, GGR integration will create an additional source of allowances (those from GGRs) alongside UKAs, which the government currently allocates through fortnightly auctions. Accordingly, the integrity of the UK’s net zero targets will rely on the UK ETS caps accurately reflecting GGR volumes that are used for UK ETS compliance purposes. Recognising this, the Consultation considers three options for recalculating UK ETS caps to account for GGR integration.

Option 1: Increase UK ETS caps, by enabliing GGRs to increase the overall supply of allowances in the UK ETS

The first option, considered by the UK ETS Authority, is to issue GGR operators with allowances, in addition to the existing supply of UKAs allocated under UK ETS caps. This option would effectively increase the caps, by an amount corresponding to the volume of GGR allowances entering the UK ETS, and impose no restrictions on GGR supply entering the UK ETS market.

The UK ETS Authority recognises in the Consultation that this option could effectively permit UK ETS participants to emit more from their covered installations than the total limits set by existing caps. Such an outcome could undermine incentives for UK ETS participants to reduce their installation emissions (otherwise known as the risk of “mitigation deterrence”). Furthermore, the UK ETS Authority considers that this option would create a comparatively weak price signal, because the unconstrained supply of GGRs would lower prices and undermine GGR operators’ returns, particularly as technologies mature and deployment rates increase.

Option 2 (Preferred Approach): Apply existing UK ETS caps to GGRs for the initial phase of GGR integration

The second option is the UK ETS Authority’s preferred approach. It proposes replacing UKA allowances with any GGR allowances that are issued to GGR operators. In other words, for every allowance awarded for a GGR activity, the Authority would remove a UKA from the auction share under existing caps. Exchanging emissions allowances with GGR allowances will ensure an identical overall supply of allowances in the market. This exchange of UKAs with GGR allowances will provide certainty and retain alignment with the UK ETS’s net zero consistent trajectory.

Nevertheless, the UK ETS Authority recognises that replacing emissions allowances with allowances awarded for GGR activities may provide insufficient incentives in the long-term (the government’s projections indicate this may occur from the late-2030s onwards), especially where the quantity of GGRs entering the UK ETS exceeds the cap in any given year. In such circumstances, the quantity of emissions allowances will be inadequate to allow for full replacement by GGR allowances, causing an oversupply of allowances in the UK ETS and consequent price reduction, which would depress the GGR market. This raises potential uncertainties for GGR projects relying on ETS integration to achieve financial viability.

Consequently, to address this longer-term concern, the UK ETS Authority is considering measures such as setting revised caps based on the expected volume of GGR supply (akin to Consultation Option 3, below). It may also expand the scope and coverage of the UK ETS, thereby increasing GGR demand. A specific proposal under consideration involves setting long-term UK ETS caps at net zero with GGR allowances, which provides the only source of supply to balance residual emissions from ETS-covered sectors. Alternatively, some analysts suggest that the UK ETS Authority could set UK ETS caps at a “net negative” level.^[6] This would mean that the UK economy would remove more emissions than UK ETS participants emit. The additional demand required to achieve such net negative caps could derive from additional regulatory obligations, either from within or outside the scope of the UK ETS.

Option 3: Set new, lower caps to which GGR volumes do not apply

The UK ETS Authority’s third option would involve reducing UK ETS caps (and, thus, the number of auctioned UKAs) by the expected supply of GGR allowances entering the UK ETS. Allowances issued to GGR operators would then enter the market in addition to the supply of allowances set out by the revised caps. These revised caps would not limit the number of allowances distributed to GGR operators.

However, uncertainties in the initial scale of GGR deployment would make it challenging for the UK ETS Authority to forecast GGR supply, for the purposes of setting lower caps, accurately. If actual GGR deployment is lower than expected, the constrained allowance supply will result in high allowance prices. On the other hand, over-delivery of GGRs will increase covered emissions from the UK ETS by the amount of any GGR allowances exceeding the expected supply, with no impact on the UK’s actual economy-wide emissions.

In the long-term, greater certainty over GGR supply means that the government could set revised caps with increasing confidence, thereby reducing the risk to UK ETS participants from the possible under-delivery of GGRs.

Summary of Options

On one hand, Option 1 creates a potential mitigation deterrence risk for UK ETS participants. Its proposal to enable unrestricted integration of GGR allowances in the UK ETS could also suppress allowance prices, and the financial viability of GGR activities, especially as GGR deployment increases over time. On the other hand, implementing Option 3 effectively will necessitate accurately pre-empting annual GGR deployment rates. While achieving this with increasing certainty is likely possible in the longer-term, inaccurate forecasting could produce either excessively high allowance prices, or increase emissions from covered sectors under the UK ETS.

Option 2, the UK ETS Authority's preferred approach, reduces the mitigation deterrence risks inherent in Option 1 by maintaining (rather than increasing) an identical supply of allowances in the UK ETS, following GGR integration. Replacing UKAs with the number of GGRs actually supplied into the UK ETS may also provide additional certainty about the consistency of the UK ETS’s alignment with the UK’s net zero targets. This means that, in the short term, at least, Option 2 is likely to be the optimal model for adjusting UK ETS caps to account for GGR integration. Nonetheless, the UK ETS Authority is simultaneously considering how Option 3 might sustain GGR demand in the longer-term.