Emissions trading: the market overlooks UK cap reforms

The commitment to strengthening – and potentially expanding – the UK Emissions Trading Scheme (ETS) is instrumental in achieving the country's net-zero goals and enhancing opportunities for carbon investors. But the necessity of a robust ETS, confirmed recently in Whitehall’s “Powering up Britain” strategy, has been overlooked amid the media’s focus on the lack of green-industry incentives.

Drawing fire

The much-awaited relaunch of the UK government’s net-zero strategy, announced in late March on the eve of the legally mandated deadline, met widespread criticism for two main reasons.

First, its lack of a grand package of green subsidies to rival those of the US Inflation Reduction Act (IRA), drew fire. Second, its continued support of oil and gas development, necessitating a reliance on unproven, large-scale carbon capture and sequestration technology to achieve the UK’s net-zero goals, saw the strategy dubbed an inconsistent “mish-mash” of policies. 

There is also continuing uncertainty about whether the government’s policies will curb emissions in line with the successive five-year carbon budgets it aims to meet. Official modeling of what the new measures will achieve shows that, without relying on unquantified measures, they fall short of driving the decarbonisation targeted by 2030 and staying within the legally established carbon budget for 2033 to 2037.

Indeed, scepticism is warranted. But the news isn’t all bad.

Backing carbon markets

What policy watchers and commentators are missing is the strengthening role of market forces, based on a compliance carbon-market system, in meeting the UK’s net-zero ambition. The government is doubling down on its commitment to the UK ETS: a cap-and-trade system which sets declining annual emission limits for the country’s energy and industrial sectors, and a corresponding amount of carbon allowances that can be traded among businesses. 

In the relaunched strategy, the government reaffirmed its commitment for this year to not only align the caps with net zero until 2030, but also legislate a net-zero-consistent extension of the programme to at least 2050 to provide certainty to the market. In addition, the government will explore the inclusion of other sectors – including waste, maritime and heat – and the incorporation of greenhouse-gas removal options. The government has also shown willingness to use revenues raised through the ETS to provide relief to consumers and industries exposed to high energy costs.  

The government has also launched a consultation on a carbon border-adjustment mechanism that would apply a carbon price on imports and limit potential ‘leakage’ of emissions to overseas producers. As a complementary step, commitments to support the development of high-integrity voluntary carbon markets, including private investments in nature-based solutions.

‘Strong guarantee’ on decarbonisation

The power of an ETS is that it establishes a pollution limit and lets market forces determine a price for emissions. This spurs innovation that determines where, how and when emissions reductions can be most cost-effectively achieved across the economy, without having to regulate exactly how this activity is carried out.

To the extent that other policy measures and subsidies also work to unlock, or even hinder, climate action, this means the carbon markets may have a smaller or larger role to play in reducing emissions – but the caps established under the ETS must still be respected.

As the UK Government notes, even though the impact of the ETS is unquantified in its modeling, the system provides a “a strong guarantee that [a] traded sector’s emissions will not exceed its decarbonisation pathway.”

UK carbon-investment opportunities

Based on even the most conservative assumptions given the range of caps the government announced in a consultation last year, our analysis indicates the UK’s carbon price needs to rise significantly higher from the approximate GBP 76 per tonne at which it trades today. And if the ETS is extended beyond 2030 and expanded to include more sectors of the economy where emissions are hard to abate, the price of carbon must appreciate even further. 

While the media and investors were closely following the European Union’s (EU’s) Fit for 55 policy reform processes last year, we believe investors have yet to wake up to the opportunity presented by the UK carbon market, which is poised to move higher with strengthening policy certainty, even as the EU has already reached its comparative policy equilibrium.

As global investors in carbon markets, we see opportunities to invest directly in the UK ETS market, as well as in natural climate solutions, technology-based removals, and other carbon-credit generating activities within the UK.

‘Big bazooka’

The government’s recent commitments to the future of the ETS should begin to provide greater confidence for investors – but this will need to be backed up with action, starting with the tightening of the emissions caps scheduled for this year.

Combined with broader climate actions, a strong ETS is essential in the effort to achieve the UK’s net-zero goals: this is a lever that environmentalists, policy analysts and the finance community should be paying much more attention to, and for which the government must be held to account as a guarantee of its climate commitment.   

The UK was the first G7 country to establish, in law, a commitment to achieve net zero by 2050, along with legally binding five-year emissions budgets. It also shepherded a major increase in global climate ambition as host of the COP26 climate summit in Glasgow in 2021.

Alok Sharma, Conservative Party MP and former President of COP26, has been calling on the government for a “big bazooka moment” akin to the US IRA. But the race to net zero is also a long campaign, in which sending the right long-term market signals to investors is essential.

While the UK’s carbon market may not make as loud a bang, it may well be the secret weapon in securing the country’s global leadership in achieving net zero.

To learn more about our Global Carbon Opportunity strategy, please click here.

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