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, gas) where they then contribute to global warming and climate change. The most common of these GHGs is carbon dioxide (C02) with the others being methane, nitrous oxide, hydrofluorocarbons, perfluorocarbons and sulphur hexafluoride.
For comparison and for reporting purposes, GHG 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 or carbon.
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. Later, 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.
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 2, 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 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 around 11,000 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 sectors covered by the scheme include electricity and heat generation, oil refineries, steel works, aluminium production, paper mills, and bulk chemicals.
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”, that is where the cost of a company buying sufficient EUAs it would otherwise have needed would make it consider relocating to a country outside the EU ETS scheme to avoid the cost of buying carbon emission permits. It is in place to avoid 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 just passed or be fined €100 per excess tonne of CO2e. For those organisations who then end up with allowances that exceed their emissions, this surplus can either be retained to cover its future needs under the scheme or it can be traded for cash on the carbon market to buyers in need of additional permits to meet their legal requirements and to 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 end of the transition period. However, groups with headquarters in any of the four nations of the UK, but also having subsidiaries with significant activities located in EU states and in the qualifying sectors (such as an oil refinery or a large manufacturing plant), will still be subject to the EU ETS. In addition, Northern Ireland electricity generators still remain in the EU NTS due to the Northern Ireland Protocol.
UK ETS
With the UK finally leaving the EU on 31 December 2020, the UK ETS (United Kingdom Emissions Trading Scheme) replaced, as from 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 which together comprise the UK ETS Authority.
The UK ETS is based upon the latest EU ETS scheme (their Phase 4; 2021 to 2030) 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 and there will be interim reviews in 2023 and 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 (MtCO2e) of 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 2021 it is set at 155.7 MtCO2e with the amount of the annual cap reducing each year by 4.2 MtCO2e.
SEPA (Scottish Environmental Protection Agency) is responsible for regulating the UK ETS within Scotland and will cover stationary installations and aircraft operators there. 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, Natural Resources Wales, the Northern Ireland Environmental Agency, and the Department of Energy and Climate Change.
Who is covered by the UK ETS?
It covers energy intensive industries (regulated activities) which are listed in Schedule 2 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 (except for installations for incineration of hazardous or domestic waste).
- Power generation.
- Manufacture of glass.
- Production of bulk organic chemicals.
- Aviation – UK domestic flights, flights from UK to the European Economic Area, flights to Gibraltar.
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 also be bought at auction or by trade in the carbon market. Auctions are hosted by ICE Futures Europe and will be held every fortnight starting in May 2021.
Reporting requirements by participants
The UK ETS has essentially adopted the EU ETS approach to MRV (Monitoring, Reporting, and Verification) which is an annual procedure.
- Reporting frequency: This is covered by each participating organisation in the ETS carrying out annual self-reporting to the regulator (in Scotland, this would be to SEPA). The compliance period is for one year (1 January to 31 December) and organisations have until 30 April of the following year to surrender allowances to the regulator and, if needed, buy further allowances in the market.
- 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 and reporting their annual emissions and 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 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
