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Carbon market faces Brexit deal or no-deal conundrum

Brexit uncertainty leaves carbon market and climate policy hanging fire

In only a matter of weeks, the United Kingdom is scheduled to leave the EU. The political atmosphere in London has reached fever pitch, while European partners await a decision from the UK regarding the terms under which it intends to quit the bloc.

Of the hundreds of EU-wide policy areas that stand to be thrown into turmoil by a no-deal outcome, it is climate policy that has arguably the greatest potential to highlight an isolated UK.

While politicians and economists talk of adopting WTO standards for trade and negotiating free-trade agreements to replace those lost by leaving the EU, there is no such remedy or replacement in the offing for climate. The UK will have to go it alone.

This will be acutely felt at the United Nations Framework Convention for Climate Change (UNFCCC), where the UK has been a stalwart of the EU delegation since 1992. British negotiators have been strong proponents of ambitious climate targets and robust mechanisms to underpin these goals. The UK played a prominent role in achieving the Paris Agreement in 2015.

When negotiators next meet this summer in Bonn, the UK may find itself isolated, not yet aligned with any like-minded countries, such as the Umbrella Group (which includes Australia, Canada, Iceland, New Zealand, Norway, the Russian Federation and the United States), or the Environmental Integrity Group (Mexico, Liechtenstein, Monaco, South Korea, Switzerland and Georgia).

The UK will not benefit from the integrated negotiating strategy that EU member states enjoy at the regular UNFCCC talks, nor will it have nearly as much weight in the negotiations until such time as it joins another group. And the task of developing a new role for Britain within global climate policy will be made all the harder by the current uncertainty over its domestic climate policy in the period after Brexit.

UK emissions down

The UK has its own, binding emissions reductions targets under the Climate Change Act, which currently calls for a reduction in greenhouse gases by 80pc from 1990 levels by 2050. While the country has enjoyed considerable success in lowering its carbon footprint—notably through the "dash for gas" policies of Margaret Thatcher in the 1980s—the UK has also benefited from its alignment with EU climate policies, and in particular the EU Emissions Trading System (EU ETS).

Statistics show that UK carbon dioxide emissions have fallen by 33pc between 2005 (the year in which the EU ETS started) and 2017. Most notably, the share of UK power generated from coal has fallen to less than 5pc in the past five years due to a domestic surcharge on carbon emissions from the power sector.

The growing likelihood of a no-deal exit from the EU means that UK industry will tumble out of the 14-year-old carbon market at the cost of potentially millions, and political uncertainty will mean companies face a policy vacuum in which they will need to carry out planning for a post-Brexit world.

A high price on carbon encourages power generators and industrial companies to switch from more carbon-intensive coal to natural gas, and from natural gas to renewables. The UK may well quit the EU ETS just when prices are reaching levels that would trigger widespread fuel switching.

According to the UK Department of Business, Energy and Industrial Strategy, if the UK leaves the EU with no agreement on a transition out of the bloc, "current participants in the EU Emissions Trading System who are UK operators of installations will no longer take part in the system".

This means that UK installations will no longer be required to acquire and surrender EU Allowances covering their annual emissions, and will lose access to the EU market in carbon allowances.

UK's options

In July last year, the UK government said that it was considering four different ways to proceed after the country leaves the EU ETS: remaining in the EU ETS; setting up its own internal, stand-alone carbon market; eventually linking this market to the EU ETS as a third-party country, as Switzerland has done; and finally, imposing a carbon tax. Officially, all these options remain on the table, BEIS staff have said, though observers are divided as to which is the most likely outcome.

If the UK is able to reach agreement with the EU on a transition period in which it negotiates its future relationship with the bloc, UK installations would continue to participate in the market until December 2020, when the current phase of the EU ETS comes to an end.

BEIS and the EU have agreed that UK installations must complete their compliance for 2018 no later than 15 March, thus ensuring that all the administration will be completed before the Brexit deadline.

Preparing for no-deal

In the event of a no-deal Brexit, however, UK installations may still find themselves holding surplus EU Allowances (EUAs) with no monetary or compliance value. The implication therefore is that these surplus EUAs should be sold before 29 March.

But because there is still no clarity on whether the UK will crash out of the EU ETS on March 29, or continue to be a member until December 2020, companies have thus far held on to their allowances.

"I think most operators holding surpluses are still waiting on a final decision," says Tim Atkinson of ETS Markets, which advises UK companies on EU ETS compliance. "The key message is to at least prepare for a no-deal scenario."

Atkinson adds that many UK companies are exploring options to shift their holdings of allowances to non-UK registry accounts, which would allow them to continue trading EUAs after Brexit.

In place of EU ETS membership, the UK government has proposed a new carbon-emissions tax to start on 1 April, payable on any emissions exceeding the quotas for each plant established under the EU ETS.

Companies will continue to monitor, report and verify their annual emissions as they currently do, while the tax itself is designed to "maintain carbon emissions at around the same level that would occur if the UK remained in the EU ETS." The new tax will be set at £16/t CO2, and for power generators it will be added to an existing levy known as the Carbon Support Price, currently set at £18/t CO2, which has been in place since 2013.

The combined cost of £34/t means that for utilities that exceed their emissions quota, the cost of compliance will be £12/t higher than the current EU ETS price of €25.20 (£22).

To be sure, the UK Carbon Price Support has meant that since 2013, UK generators have paid more for carbon emissions than their continental counterparts, and this state of affairs will continue under both a no-deal scenario and a transitional agreement.

Even at this late stage though, a no-deal Brexit is not guaranteed, particularly if parliamentary opposition has its way. Proposals to rule out a no-deal scenario have been tabled, and the 29 March deadline could be postponed.

This could potentially allow UK emitters to continue to participate in the market for the additional period, but there are numerous political considerations that would have to be resolved before such an outcome would be guaranteed.

As things stand, UK industry has no certainty that it will either continue in the EU ETS, or leave suddenly in a few weeks from now. Carbon prices, which might be expected to reflect the likelihood of one or the other outcome, reflect only the lack of clarity.

Traders say all outcomes, bar a no-deal exit, are priced in to the cost of EUAs, which currently trade at around €25.15 on London's ICE Futures exchange. If a no-deal scenario becomes the default, then prices are expected to drop sharply as UK industrials get rid of their surplus.

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