Emissions Trading Schemes (ETS) put a cap on emissions, while allowing market participants to trade emission allowances
UK emission allowances (UKAs) initially traded at a premium to the EU carbon market
Gas and coal prices, the availability of low carbon energy, and sentiment play a crucial role in short-term price formation
Investment in decarbonisation, particularly the industrial sector, coupled with the availability of UKAs will determine the longer-term outlook for UKA prices
The UKA price must move higher if the UK government is to meet its net zero strategy

The UK Emissions Trading Scheme (ETS) is one of the most important policy tools to guide the country towards net zero by 2050 by setting carbon prices. Cap-and-trade schemes such as the UK ETS involve a cap on emissions that gradually decline each year to meet a predetermined emissions reduction target.

Obligated emitters are then allowed to trade emission allowances (a permit to emit 1 tonne of CO2) amongst themselves. Allowing the market to put a price on carbon means that companies can cut emissions in the most efficient way possible. This directs investment to the best decarbonisation opportunities.

Following the UKâ€™s exit from the European Union, the UK government launched its own separate ETS at the start of 2021.

Sectors currently covered by the scheme include power generation, energy intensive industries and aviation. Itâ€™s not surprising that the UK took its inspiration from the EU ETS when designing its own carbon market.

The UK had been a member of the EU ETS since its launch in 2005. Before this, it had operated a pilot scheme that informed the development of the EU ETS.

2021 relaunch

The first auction of UK emission allowances (UKAs) took place in May 2021. Throughout the first 18 months or so of its existence, the UKA price typically traded at a 5-10 euro (Â£4.3-8.6) per tonne premium to the EU emission allowance (EUA) price.

Three factors contributed to this: weak levels of trading liquidity, a 5% lower emissions cap than existed under the EU ETS, and more ambitious cuts in UKA supply through to 2030. The UKA price peaked at over 120 euros (Â£103) per tonne in the summer of 2022.

High carbon prices have already had a significant impact on the North Sea. Evidence suggests that the seven-fold increase in carbon prices between 2018 and 2022 contributed to the one-quarter decline in UKCS emissions during that period.

Research published in Energy Economics suggests that carbon prices eroded the economic value of a sample of 21 new fields by an average of 28%. This makes them less attractive as investments and accelerates the early cessation of production at several fields.

Short-term UKA prices

In the short term, the supply of UKAs is essentially fixed. The UK ETS Authority auctions a fixed number of UKAs every two weeks at a schedule determined before the start of the compliance year and in line with the overall cap on emissions. Inelastic supply means that changes in demand can have a significant impact on the price of UKAs.

The absolute and relative price of power, natural gas and thermal coal in Europe are the main short-term factors that affect the demand for UKAs. An increase in electricity prices might encourage a utility to hedge more of their forward power generation, while hedging the carbon exposure through purchasing UKAs â€“ either physical or via the futures market.

Meanwhile, a decline in the price of natural gas relative to thermal coal could encourage a power generator to switch to burning natural gas. As gas has a lower carbon intensity, this would reduce the demand for UKAs.

Hinkley Point C. Source: EDF — *Delays at Hinkley Point C will drive a need for more UKAs, driving up carbon prices. Source: EDF*

Heating and cooling demand can play an important in determining short-term energy and carbon price movements.

The share of low or zero carbon energy generation is also an important factor in determining UKA demand.

How the wind blows

In theory, as the share of wind and solar generation increases, the demand for fossil-fuel fired generation will decline, pressuring demand for UKAs. However, as its share increases, demand for UKAs will become even more reliant on the weather outlook.

Weaker than expected wind speeds, for example, will lead to unexpected demand for gas-fired generation. Meanwhile, if a nuclear or biomass generation facility goes offline for unplanned maintenance, fossil fuel generation is likely to fill the gap. This would increase demand for UKAs.

Finally, interconnectors and natural gas pipelines have an impact. The supply of low carbon electricity â€“ such as French nuclear or Norwegian hydro â€“ can have an impact here.

Sentiment can also have a significant impact on the price of a UKA. Itâ€™s important to remember that the carbon price is built on trust. If market participants start to doubt the UK governmentâ€™s commitment to net zero then the carbon price is likely to fall. As this price falls, the signal to industry to decarbonise begins to fade into the shadows.

This is exactly what happened in the UK starting in the autumn of 2022.

Over the following 12 months, the UK government consistently sought to water down its net zero commitment. This culminated in Prime Minister Rishi Sunakâ€™s speech in late September 2023.

The upshot is that the UKA price has plunged by over two-thirds over the past 18 months. It has fallen to below 40 euros (Â£34) per tonne. Over the same period, EUAs have dropped 40% to 60 euros per tonne (Â£51.4).

Longer-term outlook

Overall power demand is likely to increase over the next decade. Supporting this move is growth in EVâ€™s, demand from data centres and broader electrification of the economy. The relative balance between fossil fuel and clean energy generation will continue to be an important driver of UKA price trends.

As utilities typically hedge their carbon exposure at the same time as their power is contracted, changing sentiment regarding the outlook for clean energy generation growth can have an immediate impact on UKA prices.

France’s EDF recently announced delays in the construction of the 3.2 GW Hinkley Point C nuclear power plant. The company said it might not complete the facility until 2031. Previously, it had expected to complete this work in 2028.

Assuming a two-year delay, Aurora Energy Research estimate that the Hinkley Point C delay is likely to result in an additional 6.2 million tonnes of CO2e emissions across the period 2028-30. Any delay could have a significant carbon cost, especially if gas-fired generators are called upon to fill the gap, resulting in higher-than-expected demand for UKAs.

End of the free pass

Nevertheless, power generation carbon intensity is likely to become less important over the next five to 10 years. This is partly because free allocations of UKAs to industrial emitters are expected to be gradually phased out as the UK introduces a carbon border tax (known as the UK CBAM), likely to be in 2027.

It also reflects the incorporation of other industrial sectors within the UK ETS, for example the waste management and maritime sectors. It means that expectations of industrial demand, and by extension the pace at which heavy industry decarbonises, is likely to become a more important factor in determining UKA demand.

In January 2023, Tata Steel UK, announced that it would close its two blast furnaces by the middle of 2024. It will wind down its remaining heavy assets over the course of the year. Tata is the UK’s largest industrial emitter.

In their place, it will commission new electric arc furnaces in 2027. The transformation is expected to cut overall UK emissions by about 1.5%, reducing demand for UKAs.

Tata Steel at Port Talbot. Source: Tata Steel — *Tata Steel plans will have an impact on the UK’s carbon prices. Source: Tata Steel*

While demand side factors are cloaked with uncertainty, there is more clarity as to how supply will develop. The availability of UKAs is expected to become progressively tighter between now and 2030, as the cap on UK ETS emissions decreases.

This should push the UKA price higher and in turn make decarbonisation technologies, currently too expensive, more attractive to implement. The only way that power generation and other industries can prevent the price of UKAs increasing is if they cut their emissions at a faster rate than the cap declines.

Policy moves

Last year, the UK government outlined how it would tighten the emissions cap. This aims to bring it into line with the target of net zero by 2050. The cap on emissions for the entire Phase 1 of the UK ETS (2021-2030) was set at 936 million UKAs. It came into force at the beginning of 2024. The revised cap represents around a 30% reduction in emissions over the course of Phase 1 compared with the original cap.

Policy reforms are also likely to squeeze UKA supply. As outlined previously on E-FWD, in December 2023 the government invited industry to comment on proposed changes to the UK ETS. All five of the proposals detailed in the consultation document refer to policies that could stabilise the market.

The measures either look to prevent UKA prices from falling too low (and too rapidly), weakening the incentive to decarbonise, or manage excessive volatility to the upside, ensuring that carbon prices donâ€™t become a burden for industry.

SAM I am

One of the most important proposals is the Supply Adjustment Mechanism (SAM). The description of this closely mirrors the EUâ€™s Market Stability Reserve (MSR). This began operating in 2019. It mops up excess allowances on the market.

Finally, the outcome of the UK General Election later this year could have important long-term implications for the UK ETS. If UKA prices continue to trade at a significant discount to the EUA, there will be increased calls to link the two.

There are historical examples of this occurring. For example, Switzerlandâ€™s ETS established a link to the EU ETS from 2020 after several years of negotiation. The indication from UK manufacturers is that the current UKA/EUA discount is deterring low carbon investment in the UK. It could also put the UK at a competitive disadvantage once the EU launches its carbon border levy â€“ known as the CBAM â€“ in 2026.

If a link does occur, itâ€™s likely that UKA prices will move towards the EUA price.

Net zero targets under threat

The price of carbon has been a crucial factor in driving the decarbonisation of the North Sea. It is vital that carbon prices rebound from their recent lows and continue to move higher. This would drive the North Sea to secure its future as Europeâ€™s low carbon leader.

Leveraging the investment necessary to meet the North Sea Transition Deal (NSTD) â€“the commitment to the North Sea becoming a net zero basin by 2050 â€“ depends on it.

Failure to achieve high carbon prices threatens the economic viability of carbon capture and storage (CCS), low carbon hydrogen, carbon removal (e.g., BECCS, DAC), the growth in offshore renewables, and the electrification of the North Sea. In the absence of a sufficiently high carbon price, the UK government â€“ and by extension the UK taxpayer â€“ will need to step in to fill the funding gap.

Itâ€™s therefore in the governmentâ€™s interest to ensure that the UKA price reaches an economically sustainable level.

Tighter carbon prices

A recent report from Macquarie analysed the impact of recent adjustments to UK ETS policy, coupled with the changing outlook for UK power generation and industrial demand. These included the Hinkley Point C delay and Tata Steelâ€™s new furnaces.

This analysis indicated the supply-demand balance was likely to tighten sharply towards the end of this decade.

The Total Number of Allowances in Circulation (TNAC) will move into deficit during 2027-30 by 20-23 million per year. This will see demand for UKAs exceeding the available supply.

Macquarieâ€™s analysis projects that the UKA price will almost triple by 2030, rising from Â£55 per tonne (65 euros) in 2023 to Â£152 per tonne (180 euros) in 2030.

The researchers noted the analysis did not take into account the impact of the UKâ€™s proposed SAM. Should the government implement this, it is likely to put further upward pressure on UKA prices.

Related Content

Methane law brings UK into EUâ€™s orbit

Industry and politicians talk at cross purposes on future of energy