Is Brexit an opportunity to rethink UK carbon pricing?

The UK’s exit from the European Union will make changes to UK carbon pricing unavoidable. Given the complexities and inefficiencies of the current policy mix, could Brexit be viewed as an opportunity for radical policy change in this area? And, if so, what is likely to be the best outcome?

The UK played a critical role in establishing the EU Emissions Trading System (EU ETS), the EU’s flagship climate policy. The UK has also provided an important and influential voice in the repeated attempts to reform the scheme and to tighten the overall cap. Despite the continuing problems of oversupply and low carbon prices, the EU ETS remains the EU’s flagship climate policy, and looks likely to retain that status for quite some time. In this context, Brexit creates two important challenges. It creates uncertainty about the future development of:

  • UK carbon prices with potentially negative implications for low-carbon investment in the UK
  • EU carbon prices, including the risk that Phase 4 of the EU ETS will be less stringent as a result of the UK’s withdrawal. If EU allowance prices continue on their downward trajectory, the limited incentives provided by the EU-ETS will be further undermined.

The timing of any changes in the UK’s involvement in the EU-ETS is important and will depend upon the broader timing of the Brexit process, and in particular when Article 50 is triggered. The preferred breakpoint for changes to the UK’s involvement would be end-December 2020 when Phase 3 comes to an end. If, however, the breakpoint comes earlier during Phase 3 or (more likely) later during Phase 4, it is likely to create messy difficulties in managing the transition which will only add to the burden on civil servants – as well as increasing the uncertainty for investors.coal_power_plant_datteln_2_crop1

The nature of the UK’s future involvement in the EU-ETS is likely to be critical for the success of UK climate policy – and early guidance on this will be important for investor confidence. At present, there appear to be three options for UK carbon pricing post-Brexit, namely the Norway model, the Linking model and the Unilateral model.

The Norway model would involve the UK joining the European Economic Area (EEA) and thereby gaining full access to the single market. This would require the UK to fully adopt EU standards and regulations, including the EU ETS. This model currently applies to Iceland and Liechtenstein, as well as Norway, and, since it allows full participation in the EU ETS, would involve the minimum of changes to UK legislation. The critical drawback of this model is that it gives the UK little or no influence on the content of relevant EU legislation, including future targets in the EU ETS. Since this runs counter to the intent of the ‘Leave’ campaign, full participation in the EAA seems unlikely to be politically feasible, thereby ruling out the ‘Norway model’ for the EU ETS.

The Linking model would involve the UK establishing its own emissions trading scheme and then negotiating a bilateral link with the EU ETS under the terms of Article 25 of the Directive. This approach is currently being followed by Switzerland – although the agreement has not been finalised. Switzerland is one of four members of the European Free Trade Association (EFTA) and, although joining EFTA may bring some benefits to the UK, it should not be a precondition for establishing a link to the EU ETS. Creating a separate emissions trading scheme and negotiating the terms of linking is likely to be a time-consuming process, although it could be greatly simplified by modelling the UK scheme as closely as possible on the current rules of the EU-ETS.

The main benefit of linking would be to reduce UK compliance costs through EU-wide allowance trading. But if the EU allowance price continues to be extremely low throughout Phase 4, this could also be considered a drawback. Oversupply in the EU ETS led the UK to impose a Carbon Price Floor (CPF) on the fuels used for electricity generation as a second-best means of encouraging domestic low-carbon investment. But while this may facilitate the low carbon transition in the UK, it provides no additional environmental benefit. Any additional abatement in the UK simply ‘frees up’ EU allowances that can be either sold or banked, and hence used for compliance elsewhere within the EU ETS, with the result that the CPF achieves no additional reduction in carbon emissions.[1] In addition, while the CPF raises the net carbon price faced by UK installations, it lowers the EU ETS allowance price. This means that any additional incentive to low carbon investment in the UK is offset by a reduced incentive for low carbon investment in the rest of the EU.

Identical comments apply to policies encouraging renewable electricity generation or improvements in the efficiency of electricity use. Hence, if the UK continues to participate within EU-ETS – either directly, or indirectly via a link – the ultimate environmental benefits of any policies that affect the ‘trading sectors’ in the UK will be contingent on the stringency of the EU-ETS cap. And post Brexit, the UK will no longer have any influence on the negotiation of that cap.

A third way: the UK establishes its own carbon pricing scheme

These problems point to the potential benefits of a third Unilateral model in which the UK establishes its own domestic carbon pricing scheme, but does not – at least at this stage – seek a link to the EU-ETS. This could take the form of a domestic emissions trading scheme, or it could be a revenue neutral carbon tax that either covered the same sectors or extended more widely throughout the economy. For example, such a tax could apply downstream to the public, commercial and industrial sectors, or upstream to fossil fuel producers – thereby encompassing the entire economy.

Of these two options, a carbon tax with a broad tax base has much to commend it. At present, the UK has a complex and overlapping mix of policies, including the Climate Change Levy, Climate Change Agreements, Carbon Price Floor and (until 2019) the Carbon Reduction Commitment. These policies  distort the incentives for emission reduction between sectors and fuels, increase the administrative burden for industry and regulators, and create opportunities for rent seeking and regulatory capture. As demonstrated by this report from 2002, this problem goes back many years.

Withdrawal from the EU ETS could provide the opportunity to rationalise and simplify this policy mix, while at the same time replacing the low and volatile carbon price from the EU-ETS with a higher and stable carbon price that gave confidence to investors and underpinned the UK carbon budgets. In the absence of a link to the EU-ETS, such a tax would also ensure that low carbon investment in the UK led to real emission reductions. With a wide base, such tax could also generate substantial revenue that could be used to reduce distortionary taxes, compensate losers or fund other low carbon investments.

As ever, the major political obstacles to such a tax would be the potential impact on low-income households and on energy intensive industries. These obstacles also apply to the EU-ETS, but the low carbon prices observed to date have made them less salient. Although these obstacles are challenging to resolve, potential solutions are available for both. For example, unlike the levies used to fund schemes such as the Renewables Obligation, the revenue raised from a carbon tax may be used to compensate low-income households. Similarly, energy intensive industries could potentially be protected through a system of border carbon adjustments (BCAs). While this would be challenging to establish, the UK’s exit from EU may make the process more straightforward.

In addition, a domestic carbon tax would not rule out the benefits of international carbon trading, since it should be feasible to develop some form of link in the future – either to the EU ETS, or to the broader international scheme that may evolve from the Article 6 of the Paris Agreement. For example, companies could be allowed to pay taxes at a higher level than their obligation and thereby receive tax credits that could be sold into an ETS. A robust carbon pricing scheme in the UK may also have an indirect but potentially positive influence upon future negotiations of the EU ETS, through encouraging agreement on a more stringent cap.

The political and practical challenges of redesigning UK carbon pricing should not be underestimated. Moreover, given the current political climate and the multiple difficulties created by Brexit, the political will to do so may not be there. Nevertheless, the UK’s exit from the EU makes significant changes to the current system unavoidable. Given the drawbacks of the Norway and Linking models, and the complexities and inefficiencies of the current policy mix, Brexit could be viewed as an opportunity (a policy window) for radical policy change in this area.

[1] The resulting allowance surplus and low carbon price may encourage the negotiation of a more stringent cap in subsequent phases, but this indirect impact is highly uncertain.

*Image by Arnold Paul cropped by Gralo shared under Creative Commons licence (CC BY-SA 3.0)