Carbon emissions trading schemes

This article summarises the key features of the various established carbon emissions trading schemes.

The term carbon emissions refers to the greenhouse gases (GHGs) discharged into the atmosphere through human activity (largely through the burning of fossil fuels namely oil, coal and gas) where they then contribute to global warming and climate change. The most common of these GHGs is carbon dioxide (CO2) with other naturally produced gases being methane, nitrous oxide and water vapour. Hydrofluorocarbons, perfluorocarbons and sulphur hexafluoride are man-made GHGs from industrial processing and are extremely potent.

For comparison and for reporting purposes, GHG (greenhouse gas) emissions are measured in terms of a standard unit of carbon dioxide equivalence (called CO2e) which allows other GHGs mentioned above to be expressed in terms of CO2, based on their relative Global Warming Potential (GWP) hence the use of the overall term carbon emissions.

What is carbon trading?

The concept of carbon emissions trading schemes was pioneered in the late 1960s by the Canadian academic and environmental economist John Dales (1920-2007).

Their objective is to decrease the pace of climate change by progressively reducing the amount of carbon emissions made by large organisations.

An emissions trading scheme (an ETS for short) is established through legislation and is then binding upon certain industries - usually manufacturing, aviation and power generation - that are known to discharge significant amounts of carbon into the atmosphere. The scheme will typically set an overall limit or cap on GHGs that can be emitted by that industry over a set period. Each firm will then be required to have a permit allowing it to emit “x” tonnes of CO2e over that period. At the start of this period, these permits are either issued free by the government or are auctioned in a carbon market. If an individual firm’s emissions exceed the limit, it must then buy extra permits, again in the carbon market, to cover this excess or face being imposed with penalties and fines by the scheme regulator. Excess capacity can be sold to those over their targets.

A key feature of an ETS scheme is the progressive reduction in the size of the overall cap either each year or over a set period in order to drive down total GHG emissions. For example, let’s say the overall cap for a particular industry in year 1 is 1.8 million tonnes of CO2e; in year two, it is then reduced by (say) 5% and similar reductions will continue each year.

Notable emissions trading schemes in use are the European Union Emissions Trading Scheme (EU ETS), the UK Emissions Trading Scheme (UK ETS), as well as similar schemes in Japan, in New Zealand and in parts of the USA.

EU Emissions Trading System (EU ETS)

Established in 2005, this was the world’s first major ETS scheme and is still the largest international emissions trading scheme. It operates in all EU countries and in Iceland, Norway and Liechtenstein and covers emissions from around 10,000 installations throughout the EU representing approximately 40% of the EU’s GHG emissions. The EU ETS is now in Phase 4 which covers years 2021 – 2030.

The EU ETS is a mandatory emissions cap-and-trade scheme which sets an EU-wide cap on the total amount of GHG emissions from energy intensive sectors. The emissions covered are carbon dioxide (CO2), nitrous oxide (N2O) and perfluorocarbons (PFCs). The cap decreases over time in order to reduce the overall emissions.

The scheme covers the energy sector and manufacturing industry (including electricity and heat generation, oil refineries, steel works, aluminium production, paper mills and bulk chemicals) as well as aircraft operators, and, from 2024, maritime transport.

Under this scheme, for each year, companies either receive EU allowances (EUAs) free from the EU Commission or purchase them at auctions. Each individual allowance unit gives the company the right to emit one tonne of CO2e. A proportion of the total EUAs are given free to energy intensive industries where there is the risk of “carbon leakage”.

This is where the cost of a company buying sufficient EUAs would make it consider relocating to a country outside the EU ETS scheme with laxer emission constraints which could lead to an increase in total emissions. The policy to provide free allowances to such sectors avoids placing these industries at a competitive disadvantage.

After the end of each year, a company must surrender sufficient allowances to fully cover its emissions during the year or be fined €100 per excess tonne of CO2e. Organisations with allowances that exceed their emissions can keep the surplus allowance to cover future needs or trade it on the carbon market to buyers in need of additional permits to meet their legal requirements and avoid a penalty. The total number of allowances available is limited which gives them a monetary value in the market.

The UK was included in the scheme up until it left the EU on 31 December 2020 at the end of the transition period. However, groups with headquarters in the UK but also having stationary installations (such as power plants, industrial plants and other large energy users) will still be subject to the EU ETS. In addition, the EU ETS still applies to electricity generation located in Northern Ireland under the Protocol of Ireland and Northern Ireland.

UK Emissions Trading Scheme (UK ETS)

With the UK finally leaving the EU on 31 December 2020, the UK ETS replaced, as of 1 January 2021, its previous participation in the EU ETS. The new scheme was created through legislation called The Greenhouse Gas Emissions Trading Scheme Order 2020 by the UK government and the devolved administrations (Scottish and Welsh Governments and Northern Ireland Department of Agriculture, Environment and Rural Affairs) which together comprise the UK ETS Authority.

The UK ETS is based upon the latest EU ETS scheme (their Phase 4; 2021 to 2030) to provide continuity for UK businesses but, with the cap on UK carbon emissions being set at 5% less than what would have been our allocation of EUAs if we had been part of the EU scheme (Phase 4).

The first phase of the UK scheme runs from January 2021 up to December 2030, with an initial review conducted in 2023 and a further review due in 2028 to measure how the UK ETS is performing.  Within this first phase, the gross cap set for the duration of the 1st allocation period (2021 to 2025) is 736 million metric tonnes (Mt) CO2e and for the 2nd allocation period (2026 to 2030) it is 630 MtCO2e. There is also an annual cap for each year from 2021 to 2030 and for 2023 it is set at 147.2 MtCO2e with the amount of the annual cap reducing each year by 4.2 MtCO2e.

Scottish Environmental Protection Agency (SEPA) is responsible for regulating the UK ETS within Scotland. Participation is mandatory for the power sector, energy intensive industries and aviation. The scheme will cover approximately 100 participants in Scotland who in total produce about 28% of Scotland’s GHG emissions. SEPA will have powers to enforce compliance with the UK ETS.

The scheme regulators for the rest of the UK are the Environment Agency (EA) in England, Natural Resources Wales (NRW) in Wales, the Northern Ireland Environment Agency (NIEA) in Northern Ireland, and the Offshore Petroleum Regulator for Environment and Decommissioning (OPRED) for offshore oil and gas.

Who is covered by the UK ETS?

It covers energy intensive industries, the power generation sector and aviation. In-scope activities are listed in Schedule 1 (aviation) and Schedule 2 (installations) of the Greenhouse Gas Emissions Trading Scheme Order 2020. These include:

• paper mills
• oil refineries
• production of pig iron or steel
• production or processing of ferrous or non-ferrous metals
• combustion of fuels at installations with a total rated thermal input exceeding 20 megawatts
• manufacture of glass
• production of bulk organic chemicals
• aviation activity – UK domestic flights, flights from UK to the European Economic Area (EEA), flights from the UK to Gibraltar and from Gibraltar to the UK, flights from the UK to an offshore structure in the UK or EEA.

Allowances

Participants in the ETS must obtain sufficient allowances in total to cover the amount of their GHG emissions. A proportion of free CO2e emission allowances will be made to operators in industries at risk of carbon leakage and who applied for an allocation of allowances for the 2021-2025 allocation period. The UK ETS Authority will then decide on the validity of these applications. The legislation covering the free allocation of UK ETS allowances is in The Greenhouse Gas Emissions Trading Scheme (Amendment) Order 2020.

As per the EU ETS, allowances can be bought at auction or by trade on a secondary market. The auction platform and secondary market services are provided by ICE Futures Europe. Auctions are held every fortnight based on the auction calendar and began in May 2021.

Reporting requirements by participants

The UK ETS has essentially adopted the EU ETS approach to Monitoring, Reporting, and Verification (MRV) which is an annual procedure.

• Reporting frequency: The compliance period is for one year (1 January to 31 December) and organisations have until 31 March of the following year to submit their annual emissions and verifications report. Organisations have until 30 April of the following year to surrender allowances equal to their reportable emissions.
• Verification: Verification, by independent, accredited verifiers, of each participant’s annual return to the regulator of its GHG emissions is needed for each year by the following 31 March. Monitoring: The same provisions apply as in the EU ETS. Participants must have a plan for monitoring their reportable emissions from 1 January to 31 December of each year which has been approved by the regulator.
• Excess emissions penalty: The penalty levied on an organisation for making emissions exceeding its permit amount is £100 per tonne of CO2e (GBP100/ tCO2e) but this rate will be adjusted for inflation over time. The penalty will still apply even if allowances are surrendered in full after 30 April. The names of defaulting organisations will also be published by the regulator.

Further details on the UK ETS scheme can be found on the UK government website.