By Baran Doda, Research Officer and Luca Taschini, Assistant Professorial Research Fellow

As the UK prepares for Brexit, its future participation in the European Union Emissions Trading System (EU ETS) has yet to be decided. Ian Duncan, Conservative MEP for Scotland and Conservative spokesperson on energy and climate change in the European Parliament, has said he does not think there is a future for the UK in the EU ETS after Brexit as the rules are governed by the European Court of Justice. The UK Department of Business, Energy and Industrial Strategy (BEIS) says the issue is still part of Brexit negotiations.

The evidence we submitted to Parliamentary consultations on the effect of Brexit on UK climate policies concludes that, on balance, the best option for the UK is to negotiate to stay within the EU ETS. But what alternatives does the UK have?

The EU ETS incentivises firms to cut down greenhouse gas emissions and aims to ensure that these reductions are achieved at the minimum cost possible. Cost-effectiveness of policy is important for the Member States of the European Union, including the UK, to meet the ambitious promises made in the Paris Agreement and to comply with national policies.

Though the EU ETS has been a cost-effective tool – helping to both reduce emissions and drive low-carbon innovation (PDF) – it has not been working perfectly. Interactions with other EU-wide and domestic climate change and energy polices, and a huge drop in demand following the financial crisis and economic downturn, have created a large surplus of permits (1.78 billion surplus permits in 2015). Since 2011 the permit price has struggled to exceed €6 (at the time of writing in February 2017 the price is €5.12). Several Member States and various EU ETS stakeholders consider this price to be too low to create a strong enough incentive for polluters to undertake the required investment in low-carbon technologies and to drive low-carbon innovation. As a consequence many have layered on additional domestic policies, such as the Carbon Price Support Rate in the UK.

Leaving the EU ETS might offer the UK the opportunity to implement a more coherent carbon pricing system across the UK’s economy, for instance, by replacing the EU ETS, Carbon Price Support Rate and Climate Change Levy with a single carbon tax across all sectors. However, despite its simplicity and revenue-raising potential, a tax could be unpopular and possibly unworkable if there is stiff resistance from stakeholders.

So if the UK does leave the EU ETS but wanted to keep emissions trading as its primary policy tool, what options does it have? After extracting itself from the EU-ETS, the UK would need to formally set up its own emissions trading system. It could then go it alone or attempt to link it with other emissions trading systems.

Going it alone

An isolated trading system covering only UK-based facilities would be expensive for the firms operating those installations. The EU ETS offers a large potential for cost savings for UK firms because of its size – currently, the largest emissions trading system in the world. It covers  greenhouse gas emissions from over 11,000 installations (PDF). By comparison, a UK-ETS would cover only 780 installations which currently account for around 10.5% of the 1.67 billion cubic tonnes of emissions which the EU ETS regulated across all Member States in 2015.  The size of the EU ETS creates lots of opportunities for UK businesses to buy and sell permits.

In the UK it is at times expensive to reduce emissions compared to other Member States. But participation in the EU ETS effectively allows UK businesses to pay for emissions reductions, through the purchase of permits, in other European countries where the emissions reductions can be achieved more cheaply. At other times, European firms may face higher abatement costs and value the permits more than their UK counterparts. Then, it makes economic sense for the UK firms to sell their permits and increase their emissions reduction efforts instead.

In both cases, the targeted emissions reductions for the Europe Union as a whole can be achieved at the lowest cost only if the UK remains part of the EU ETS.

In an isolated UK ETS firms in the UK could only trade with each other. This could mean, for example, that in a time of UK economic expansion, permit prices on the UK ETS rise steeply, increasing the overall costs for UK businesses.

Finding a new match

The UK could seek to make a match with another partner and link to their emissions trading systems. A national ETS in China is expected to be set up this year, and is expected to become the largest in the world. Emissions trading systems are currently in operation in California and Quebec which are already linked together, and Ontario is currently contemplating joining as well. There are emissions trading systems in South Korea, New Zealand, and many other countries, so there would be no shortage of potential partners for the UK.

To pair up with one of these markets, however, the UK would effectively need to negotiate a carbon ‘trade deal’ which may be challenging. A recent Grantham Research Institute Working Paper, soon to be published in a peer-reviewed journal, set out some of the factors that need to be considered to make a good match between emissions trading systems.

Size matters
In the EU ETS between 2013 and 2015, the UK was responsible for only 11% of all the regulated emissions. The study by the Grantham Research Institute found that, in a link between emissions trading systems, the smaller country tends to benefit the most from cost savings. So whilst these big markets are attractive for the UK, the UK’s relatively small size may mean it is not such a tempting prospect for larger potential partners. The large EU ETS market could be a more attractive prospect for China than a UK ETS. Conversely, the gains that the UK could expect by linking with the smaller emissions trading systems in New Zealand are likely to be minute compared to those we currently enjoy as a participant in the EU ETS.

Making a new match will cost the UK
The UK has already incurred the costs of negotiating and setting up the EU ETS. These costs are sunk and cannot be recouped. There would be further costs to link a future UK ETS to a new partner. These might be large when linking with China or South Korea, which are institutionally, legally and culturally more different from the UK than the UK is compared with the EU. This is less true for the North American emissions trading systems in California, Quebec and Ontario. However, negotiating with two, or potentially even three, sub-national partners at the same time, while ensuring the negotiations do not interfere with the UK’s post-Brexit relationship with the federal governments in the US and Canada, could be tricky.

Let’s stay together…

So, divorcing the EU ETS and finding a new partner would be expensive for the UK and for its businesses. Finding a suitable new partner could also be challenging. The alternative, and the best on balance, would be to stick with the EU ETS. The EU ETS is far from perfect even though it has recently undergone structural reforms which could help address some of the problems. In addition, revisions for Phase 4 of the EU ETS (2021-2030) are being voted on by European Parliament.  If the UK does continue to participate in the EU ETS, it should seek to retain its positive influence over the ongoing efforts to strengthen the system.

This commentary was originally posted on the Grantham Institute’s website and is part of the LSE-Statkraft Policy Research Programme: “‘Fit-for-Purpose’ Energy and Climate Change Mitigation Policies for the European Union”, and it represents the views of the authors and not those of the Brexit blog, nor the LSE, nor Statkraft.