Thrown out of the European carbon trading system, UK emitters of greenhouse gas are in climate-policy limbo

SHAMBOLIC
Without knowing the price of carbon over the next few years, British industry and energy providers are unable to price their own products effectively

CLUBBING
Should the CPTPP trans-Pacific partnership become a club of emissions-trading countries with British membership sparked by Brexit, the EU may ultimately decide to join as well, benefitting the global energy transition

SMALL WORLD EFFICIENCIES
As carbon markets and the world of trade are increasingly digitised, geographic proximity might not be quite so important; countries can cut more emissions for each dollar or euro spent if they work together on carbon pricing and trade deals

KEY QUOTE
If the EU ultimately rejects the UK as an emissions-trading partner, other countries may find a partnership with Britain attractive as they seek a low-cost transition underpinned by lots of GDP-enhancing trade

With several weeks still remaining before UK industry can buy and sell emission allowances in a new post-Brexit British carbon market, the country’s factories and power stations are striking contracts to sell their manufactured products or electricity without knowing a key element of their costs—carbon. Meantime, European emission allowances are surging to previously unseen levels. Prices for the credits reached above €37 a tonne of CO2 towards the end of February 2021 more than double their value a year earlier after taking a plunge at the beginning of the global coronavirus pandemic in early 2020. Carbon markets are used to reduce greenhouse gas or carbon emissions by regulating limits and allowing for the trading of these units between entities. The EU’s Emissions Trading System (ETS) was introduced in 2005. Participating installations must surrender emission allowances to match the emissions they produce. Those who can easily reduce their emissions at a lower cost can sell their extra allowances to other entities which find it more difficult or expensive. Balancing the supply and demand of allowances creates a traded price for carbon. Being unable to predict the cost of carbon makes it difficult for British emitters to put a price on their products and might leave them exposed to market forces because they have no way of using forward carbon markets to hedge against sky-high levels of CO2, says Lawson Steele, an analyst with merchant bank Berenberg. “There’s a limbo out there at the moment.” Ideally, a European company holds enough carbon allowances to cover any contract to sell its products so it can be sure it is locking in the profit margin. Without knowing the price of carbon over the next few years, manufacturers and energy providers are unable to price their own products effectively. Carbon allowances now make up more than half of Europe’s wholesale power costs. “It’s a shambles,” says Louis Redshaw, founder of Redshaw Advisors, a carbon risk management and procurement firm in London. Intercontinental Exchange (ICE), a global exchange group and provider of marketplace infrastructure, won a deal to hold auctions of UK carbon allowances starting in the second quarter of 2021. The sales of the allowances would start by the middle of the year and ICE plans to offer futures in the same time frame, giving UK emitters the ability to manage the risks of their exposure.

ON THE OUTSIDE

Linking back into the EU ETS system seems to be the British government’s Plan A. It is the most natural way to go, Steele says. Meantime, the UK’s carbon emitters could use the EU market as a proxy to hedge risks, he adds. Many generators in the UK which have exposure across Europe may be holding on to their existing cache of EU allowances instead of selling them to deal with the possibility of a drastically different UK carbon price. Once the first UK auctions have occurred to provide a price signal and free allowances have been distributed, a secondary market will be established and the new market may settle down, says Guy Buckenham at EDF Energy, a French-owned multinational. The UK should consider “front-loading” the volumes to be auctioned to ensure adequate liquidity in the market as soon as possible, Buckenham adds. When the UK programme could link back into the EU market is unknown. “Both sides have been through a long and difficult negotiation and they’re probably getting their breath back. We certainly hope and expect to see that linkage. The EU emissions trading system has to be the most obvious candidate for the UK to link with,” says Buckenham.

RISKIER ALTERNATIVES

Linking to other carbon markets that are less robust and less mature, perhaps with lower ambition in terms of what they are trying to achieve, may be riskier. Such markets may also not be as effective in reducing global emissions, Buckenham says. Even so, the UK is exploring a range of alternative deals from Asia to Africa. It may not necessarily need to link with the EU market immediately. As carbon markets and the world of trade are increasingly digitised, geographic proximity is less important than it once was for climate cooperation and trade alignments. The UK’s international trade secretary Liz Truss has applied for the country to join the Comprehensive and Progressive Trans-Pacific Partnership (CPTPP). The $12 trillion partnership will reduce tariffs on exports by UK industries to member nations, including on food and cars, while also creating new opportunities for cutting the cost of the climate transition and selling services linked to the shift, such as legal advice and finance. The members of CPTPP are interested in carbon pricing, which could be of benefit to the UK. Canada and New Zealand already have carbon markets. Singapore, another member of the partnership, wants to be Asia’s carbon-market trading hub, should one evolve. South Korea, also hoping to join the partnership, has Asia’s biggest carbon market after China. There is speculation the US and China could also be interested in joining the partnership.

COOPERATION CUTS COSTS

UK government intentions are to align new trade agreements with trade policy that supports national ambitions to build back greener and lead the global green industrial revolution. Officially that includes promoting clean growth, reaffirming the UK’s commitment to international standards, increasing trade in goods and services that can help to reduce emissions, while encouraging other countries not to sacrifice their environmental protections to gain a trade advantage. The UK has trade deals with most of the CPTPP members which could ease a path to membership of the partnership. Countries can cut more emissions for each dollar or euro spent if they work together on carbon pricing, trade deals, agreed energy efficiency standards and green finance. Climate disclosure regimes could help that cooperation. Even if the UK is ultimately rejected as an emissions-trading partner by the EU, other countries may still find it attractive to link with Britain as they seek a low-cost transition underpinned by lots of GDP-enhancing trade. Should the CPTPP become a club of emissions-trading countries, the EU also may ultimately decide to join as well. The EU’s biggest economy, Germany, was part of a group of countries seeking ambitious global carbon markets immediately after the 2015 Paris climate deal was struck. Many of the other countries that were involved at the time are now members of the CPTPP.

BRILLIANT BORDER TACTIC

Whether the EU’s carbon market remains separate or not, the bloc’s policies are having an impact globally. The plan for a carbon border adjustment mechanism to protect the EU’s industry from dirtier external competition is seeing other countries become more ambitious in rescuing our climate. Under the plan, products exported to the EU would be disadvantaged at the border if the climate policy of the originating country is deemed insufficiently ambitious. UK prime minister Boris Johnson is reportedly considering using his G7 presidency to try and forge an alliance on carbon border taxes, adopting the EU’s idea for the UK and potentially other nations. Any action in this direction would make corporations with factories in the EU and UK think twice about increasing production in other countries with less-ambitious climate policy. The EU’s border mechanism plan is particularly spurring a green shift in China, the US, and more broadly across Asia, the Americas and Africa. “The carbon border adjustment mechanism by the EU is a brilliant tactic,” says Ken Schneider, founder of Grey Epoch Trading, a US firm that handles carbon options trading. “It’s a great weapon on many fronts.” Faced with the real possibility of border carbon adjustments making trade with the EU more expensive, word is that the CPTPP has not ruled out making carbon prices or carbon markets mandatory among its members. That would require a way to determine whether a country’s climate policy is sufficiently ambitious to become a member of a CPTPP—or G7—carbon club without triggering a border adjustment at the door of the huge EU market. Other options for determining whether a country is ambitious enough to join any international carbon club might include the emissions intensity of its economy—CO2 output per unit of GDP—or the emissions intensity of a country’s power grid, says Ashutosh Shastri of London-based EnerStrat Consulting. “All future trade deals will have an underpinning of climate protection. That’s the only way these deals can be sold, given domestic politics,” says Shastri. Still, setting up carbon markets for industries such as offices and buildings may not work. The risk is that it may lead to fuel switching from coal to natural gas instead of cutting energy demand, says Susanne Dyrbøl, from Rockwool Group, a Danish manufacturer of building insulation material operating in 22 countries. “The people living in fuel poverty will be the ones being hardest hit by carbon pricing.” Joined-up energy efficiency policies will be a better way than carbon trading to get the dramatic reductions in emissions from buildings that are required in the next ten years and beyond, Dyrbøl says. Direct industry-based measures could become another element of a carbon club such as the CPTPP or G7, alongside environment and social governance rules, green finance measures and climate disclosure standards.

GLOBAL CARBON TRADE

The timing of when a global carbon market could form is potentially coming into focus. The UK and Canada both want to start making climate risk disclosure mandatory by 2023, which could potentially underpin a market forming about 2024. That would also be the first year after the pilot phase of a carbon offsetting trading programme for the aviation industry and gives the US and China a chance to finalise their climate plans. The world needs to cut emissions by about three billion tons a year through 2030 to stay within reach of hitting the Paris accord’s target for stopping global climate temperatures from rising more than 1.5C above pre-industrial levels. “What the private sector needs is really this clear signal and commitment from governments,” Rockwool’s Dyrbøl says.

TEXT Mathew Carr