Last week, after months, which to some felt like years, of protracted Brexit negotiations, the EU has given the green light to move on to Phase 2 of the process. Phase 1 was focussed on three integral issues namely, citizens’ rights, the Irish Border and the Brexit Bill. The EU and the UK have managed, with an impending deadline, to reach an agreement that is satisfactory to both parties (provided we discount recent comments from the Brexit Secretary on the legal status of the agreement). This allows the talks to progress into the new year, with Phase 2 centring on negotiations over the shape that the future EU-UK relationship will take. The biggest concern for the UK, and candidate for the most over-used buzzword of 2017, is ‘trade’. In fairness, this is a legitimate concern given the vast amount of tariff free trade that currently takes place between the UK and the EU. However, whilst figuring out a trade deal concerning physical goods is of paramount importance to the UK, it also needs to determine, along with the other 27 EU members, what to do when it comes to emissions trading.
What is the Emissions Trading System?
Currently, the UK is part of the European Union Emissions Trading System (EU ETS). There are 31 members including all the EU member states. The system covers aviation and energy intensive installations, such as power stations and industrial plants. As part of the EU ETS, the total amount of certain greenhouse gases that can be emitted by covered installations is capped. Within this cap, companies can buy, sell or trade allowances. The limit on the total number of allowances available ensures that they have a value. The system covers ‘roughly’ 45 percent of the EU’s greenhouse gas emissions. After each year, companies must report their emissions and ‘surrender’ their allowances. There must be enough allowances surrendered to cover the total amount of emissions from the company (one allowance is equivalent to one ton of carbon dioxide). Otherwise, companies will face paying hefty fines. Any left-over allowances can be retained by the company for future use. The idea is that the amount of allowances available on the market is reduced over time, thus lowering the amount of emissions. So, this is all well and good but what position will the UK take following Brexit?
Participation in 2018
The working assumption of the EU is that the UK will cease to participate in the system immediately on exit from the organization. This was borne out in their concern that the UK would not honour its obligations for the 2018 calendar year. This is because the UK’s stated intention is to leave the EU on 29 March 2019, one day before emission reports for 2018 are due and a month before the deadline to surrender allowances on 30 April 2019. The EU worry was that the UK would fail to enforce the system, as it would no longer be legally obliged to by the time the deadlines came around, leading to companies selling all their allowances which would artificially inflate the amount available and distort the market. In fact, the level of concern at this scenario was so high, that it was proposed to distinguish UK allowances from other allowances and restrict them from being used for compliance in 2018. In response, the UK offered to bring forward the compliance deadlines. On 30 November, the EU Climate Change Committee approved this approach and the following week the UK enacted these earlier deadlines in law. The deadlines to report emissions and surrender allowances for 2018 emissions have been brought forward to 11 March 2019 and 15 March 2019 respectively. The UK Government has also committed to punishing any companies that do not comply with these deadlines, even if this action has to be taken after Brexit.
Although the UK succeeded in averting what would effectively have been an early exit from the EU ETS and provided assurances to the EU and affected UK businesses for 2018, this doesn’t give any clues to the UK’s plans beyond Brexit. Where the UK finds itself with regards to the EU ETS on 30 March 2019 will depend on a number of factors, most significantly the terms of the final overall deal (if there is indeed a deal reached in time). However, at this point, it appears that there are 4 (or 5) possible paths that the UK could take.
1. Withdraw from the EU ETS on Brexit day
This is the outcome that would be most likely if the Government sticks to the ‘Hard Brexit’ approach which was the line when the Brexit negotiations began. Although it appears that this stance may have softened recently, this would satisfy the ‘Brexit means Brexit’ rhetoric and judging from the earlier mentioned concerns, may be what the EU27 still expects. In this event, the UK would no longer be allocated allowances and any left-over allowances from 2018 could not be traded with installations based elsewhere in the EU. This would probably require an adjustment from the EU27 of the allowances made available on the market, however it would be unlikely to have any significant or destabilising affect. In terms of how this would affect the UK, it is likely that an alternative system would be introduced. The Climate Change Act 2008 commits the UK government by law to reducing greenhouse gas emissions by at least 80% of 1990 levels by 2050, so the UK will need to find some method of reducing its carbon output. Also, the Greenhouse Gas Emissions Trading Scheme Regulations 2012, which implement the EU ETS in UK law, will remain in force following Brexit. It may be that they are adapted to copy the EU system into a UK only one. If not, something will need to be done to avoid it becoming a dead letter piece of legislation. If the UK does leave the system on Brexit day, it may take this as an opportunity to implement more innovative instruments and policies.
2. Remain part of the EU ETS after Brexit
This is an option that may still be available to the UK, particularly after it appears to have softened its stance in recent weeks with talk of implementing ‘regulatory alignment’ with the EU. Also in the UK’s favour if it wants to go down this route is the fact that Iceland, Liechtenstein and Norway participate in the scheme, despite not being EU member states. However, what these states also have in common is that they are members of the European Economic Area (EEA) which allows them to be part of the EU’s single market. It is unclear if membership of the EEA, or at the very least, the single market would be a requirement for continued participation in the EU ETS. Although staying in the single market does not appear to be on the agenda for the current Brexit negotiating team, 15 months is an awful long time in politics, and a lot could change.
3. Withdraw from the EU ETS at the end of Phase 3
Currently the EU ETS is in Phase 3of operations. Phase 3 runs from 2013-2020 with Phase 4 beginning in 2021 and running up until 2030. The EU has agreed to reforms which will enter into operation during Phase 4 after criticism that Phase 3 prices were too low. Phase 4 will attempt to combat this by tightening the amount of surplus allowances on the market and raising prices. It may be tempting for both parties to maintain the status quo and see out Phase 3 before the reforms kick in. This type of transitional period would ensure a smooth ending to Phase 3 and give each party time to get its house in order. The EU would be given time to prepare the Phase 4 reforms knowing that the UK will no longer be a part of the system and it would also prevent a regulation gap in the UK itself. If used correctly, the UK could benefit from the transitional period as a chance to develop its own regulation and policy which could then be implemented from 2021. This option would be attractive to both parties as it minimises any potential disruption and ensures that both sides continue to work towards their environmental targets.
4. Integrate the UK’s system within the EU ETS
Once the UK establishes its own system integrating it within the EU ETS may be an option. In this respect the UK would be following the lead of the EU and Switzerland who recently came to such an agreement. The EU-Swiss link, once ratified, will allow EU ETS participants to use allowances from the Swiss system for compliance, and vice versa. If the UK does establish its own system, integration could appeal to the EU in terms of co-operation and working towards the shared objectives of the Paris Agreement. Of course, if the UK and EU were to go down this path it would probably take even longer than the Brexit negotiations. After all, the EU and Switzerland took 7 years just to sign an agreement. And it would also be dependent on the UK establishing a similar cap and trade system that could fit back in with the EU ETS framework. If the parties do eventually choose to go down this road, it will be a long one.
5. And a bonus fifth… Cross-continental co-operation?
If the UK really wants to get creative, could it try and establish some sort of cross-regional emissions trading scheme to rival the EU ETS? Especially with the current UK Government so keen to emphasise the strength of its ties with North America. And if the UK were to leave the EU on bad terms, could Theresa May and Donald Trump hold hands and lead us into a brave new world of emissions trading? Well, in a word, no. Ignoring the high probability that neither will be in charge by the time such talks could come around, it would be impossible to overcome the logistical, political and administrative nightmares that this would create. Not to mention the questions over political sovereignty it would raise. Although this scenario is not credible and maybe seems a tad flippant, it can be used to illustrate the point that the UK would be well advised to co-operate with the EU27 on emissions and should stick to more traditional trade with the rest of the world.
Which Route Will the UK Go Down?
Looking at these options, perhaps the most sensible path that the UK should take is option 3, provided a transitional deal is also struck up for other aspects of Brexit. If a transitional phase is implemented, where the UK continues to have access to the single market for some time after 30 March 2019, it would make sense to see out Phase 3 and then have both parties start with a clean slate in 2021. Once the UK has its own system up and running, it could then enter into negotiations on the type of agreement proposed in option 4, following the EU-Swiss model. This way, it would satisfy both the Brexit hardliners who are calling for a total exit and those who want to continue co-operation with the EU. It would also avoid uncertainty for UK businesses over their obligations for 2019 and 2020 and allow them to at some point in the future, benefit from the reformed EU ETS. Although I would advocate this as the best course of action, we have seen from the way the Brexit talks have gone so far that it’s impossible to confidently predict the UK’s next move.