How could the UK ETS be adapted and aligned with a market framework for zero carbon power?

Published: 13 May 2021

By Dr. Danial Sturge, Practice Manager – Carbon Policy and George Day, Head of Markets, Policy and Regulation

Electricity is seen as a shining beacon of how to decarbonise a sector. Coal is all but pushed off the system and last year renewables generated over 40% of our electricity. A combination of policy interventions including carbon pricing, feed-in-tariffs, and regulation have progressively driven down the carbon intensity of the grid over the last decade.

The key question now is how do we get to zero carbon power? And given its importance for the decarbonisation of other sectors, including road transport, buildings (i.e. heating), and industry, how do we achieve this by 2035 (as recommended by the Climate Change Committee)?

The UK ETS already covers power generation, but it also covers industry and parts of aviation; arguably the two sectors – save agriculture – that are going to be the hardest and perhaps take the longest to decarbonise. In recent years to overcome this tension, the effective carbon price the ETS yields has been bolstered by the carbon price support (currently £18/tCO2e), which is paid by power generators only. In addition, free allowances are allocated to the trade-exposed industry as well as aviation to reduce their overall liability. Our work, however, suggests that the electricity policy mix will need substantial strengthening and reform to deliver a fully decarbonised electricity grid in the required timeframe. The room for manoeuvre in tightening the cap (i.e. the total amount of certain greenhouse gases that can be emitted by installations covered by the system and is reduced over time) in the near term so that it yields a carbon price high enough to drive full decarbonisation by 2035 is limited by the potential impact of a much tighter cap on other sectors covered by the ETS.




What is the UK ETS?

The UK Emissions Trading System (UK ETS) came into operation on 1 January 2021 following the UK’s departure from the European Union’s ETS – covering electricity generation, heavy industry, and domestic flights.
Under the ‘cap and trade’ principle, an upper limit of emissions is set – the cap – for all participating installations. Allowances for emissions within the system are auctioned off or allocated for free. Trading of allowances between installations can occur if an installation exceeds or outperforms its limit. In this way, installations are able to achieve emissions reduction in the most cost-effective way that meets their business needs. Government have said the emissions cap will soon be aligned with the UK’s 2050 Net Zero commitment.

In our recently published Rethinking Electricity Markets report, we proposed that an outcome-based policy mandate, such as a decarbonisation obligation could complement the UK ETS to achieve the urgently needed change in pace. Such a policy mandate can internalise the decarbonisation imperative into the demand for electricity (by suppliers and large offtakers) and therefore, wholesale electricity prices, driving investment to decarbonise the power sector at a faster pace than the rest of the economy.

An outcome-based decarbonisation policy mandate, aligned with what is required to meet Carbon Budgets (i.e. zero carbon power by 2035), will create a credible, investable market signal for investors in portfolios of zero carbon generation and flexibility/DSR assets. It could take the form of carbon intensity performance standards, obligations or targets – with the option of trading carbon credits (that are equivalent to UK ETS allowances), to meet the obligation.

The design and phasing in of an electricity decarbonisation policy mandate will need to be carefully managed. For example, policy design would need to ensure that a new decarbonisation obligation would not act to exacerbate the imbalance in ‘effective carbon price’ between electricity and natural gas use in heating (see chart below). There are options around who a mandate (or the obligation) applies to – in our Rethinking Electricity Markets report we propose a mandate on suppliers and large offtakers of electricity – while the ETS currently obliges generators to surrender ETS permits to cover their emissions.

An electricity decarbonisation policy mandate could in fact be designed to function in a way that delivers an outcome very closely equivalent to an ETS cap applied to electricity generation. Thus the introduction of such a policy mandate would come with opportunities to closely align it with the structure and functioning of the UK ETS. This could potentially enable it to become the means by which the UK ETS cap is applied for electricity while helping to resolve the inherent tension in the stringency of cap setting across different sectors where the pace of decarbonisation and other policy pressures are likely to differ.

We have discussed the role of an outcome-based policy mandate for electricity decarbonisation as part of a wider package of market reforms in our Rethinking Electricity Markets report. In a future blog, we will be considering in more detail the options around designing and phasing the electricity sector policy mandates (specifically a decarbonisation obligation) so that it provides a strong investible signal (e.g. to investors in low carbon generation assets) and can be integrated within a broader economy-wide carbon policy (including the new UK ETS).

Such an approach could also enable the transition from subsidy supported generation (e.g. through CfDs) to a decarbonisation obligation (potentially in the form of a carbon intensity standard), that is linked to the UK ETS market for carbon allowances.

Fundamentally, we believe that a sector-led approach can be used to construct an integrated economy-wide carbon policy framework. Sectoral policy instruments can be designed to integrate over time with the development and expansion of the UK ETS as a world-leading system of carbon markets.

This can be done in a way that enables and incentivises rapid progress of electricity sector decarbonisation, while also creating measured decarbonisation incentives for other sectors (such as industry and aviation) that may decarbonise over a longer timeframe and that need to manage impacts on the competitiveness of trade-exposed industries.

NEXT WEEK:

How the UK ETS could be developed to support the uncovered sectors of the economy, beginning with the role it might play in decarbonising buildings.