By Ruben Lubowski, Callum Lee, and Lorenzo Bernasconi, Lombard Odier Investment Managers

In the EU, investor and media interest have grown along with the landmark reforms to the Emissions Trading System (ETS) as part of the Fit for 55 climate package, provisionally agreed in December and formally approved in Parliament this week, as a core strategy to achieve net zero by 2050.  Similarly, strengthening – and potentially expanding – the UK ETS is instrumental in achieving the country’s net-zero goals and enhancing opportunities for carbon investors. But the commitment to implementing reforms necessary for a robust ETS, confirmed recently in Whitehall’s “Powering up Britain” net-zero growth strategy, has been overlooked amid the mainstream media’s focus on the lack of green-industry incentives.

Need to know

• In a positive move, government commitments will extend the UK ETS to 2050 and could see sectors beyond energy and industry be included
• But these plans, part of the UK government’s relaunched net-zero strategy, have been overlooked amid criticism of the absence of green-industry subsidies relative to US and European policies
• To meet the UK’s aim of aligning ETS emission caps with net-zero levels by 2050, in our view the domestic carbon price needs to rise significantly, providing a structural support for the market

Drawing fire

The much-awaited relaunch of the UK government’s net-zero strategy, announced in late March on the eve of the legally mandated deadline, met widespread criticism for two main reasons.

First, its lack of a grand package of green subsidies to rival those of the US Inflation Reduction Act (IRA), drew fire. Second, its continued support oil and gas development, necessitating a reliance on unproven, large-scale carbon capture and sequestration technology to achieve the UK’s net-zero goals, saw the strategy dubbed an inconsistent “mish-mash” of policies.

There is also continuing uncertainty about whether the government’s policies will curb emissions in line with the successive five-year carbon budgets it aims to meet. Official modeling of what the new measures will achieve shows that, without relying on unquantified measures, they fall short of driving the decarbonisation targeted by 2030 and staying within the legally established carbon budget for 2033 to 2037.

Indeed, scepticism is warranted. But the news isn’t all bad.

Backing carbon markets

What policy watchers and commentators are missing is the strengthening role of market forces, based on a compliance carbon-market system, in meeting the UK’s net-zero ambition. The government is doubling down on its commitment to the UK ETS: a cap-and-trade system which sets declining annual emission limits for the country’s energy and industrial sectors, and a corresponding amount of carbon allowances that can be traded among businesses.

The UK’s ETS Authority committed in 2021 to aligning the ETS caps with net zero by January 2024 at the latest and ran a consultation last year proposing a range of potential cap decline trajectories, as well as a step change reduction in 2024. The proposals would reduce the Phase 1 (2021-2030) emissions budgets to 887-936 MtCO2e, a 31-35% reduction over this period compared to the current legislation, as well as a 57% reduction in the annual cap to 50 Mt in 2030.

As part of the relaunched strategy, the government confirmed its position that this range of cap alignment options remains compatible with achieving the UK’s carbon budgets and indicated that a full response to last year’s consultation is forthcoming.  It also affirmed its commitment for 2023 to work with the ETS Authority to not only establish a pathway for the ETS consistent with net zero through 2030, but also legislate a net-zero-consistent extension of the programme to at least 2050 to provide certainty to the market. These announcements significantly reduce policy uncertainty regarding the ETS cap revision.  It is now a matter of the details of implementation in the coming months.

In addition, the government indicated it will explore the inclusion of other sectors – including waste, maritime and heat – and the incorporation of greenhouse gas removal options. The government has also shown willingness to use revenues raised through the ETS to provide relief to consumers and industries exposed to high energy costs.

Furthermore, the government has launched a consultation on a carbon border adjustment mechanism that would apply a carbon price on imports and limit potential ‘leakage’ of emissions to overseas producers. Complementary commitments entail support for the development of high-integrity voluntary carbon markets, including private investments in nature-based solutions.

‘Strong guarantee’ on decarbonisation

The power of an ETS is precisely that it establishes a pollution limit while letting market forces determine a price for emissions. This determines where, how and when emissions reductions can be most cost-effectively achieved across the economy, without having to regulate exactly how this activity is carried out.

To the extent that other policy measures and subsidies also work to unlock, or even hinder, climate action, this means the carbon markets may have a smaller or larger role to play in reducing emissions – but the caps established under the ETS must still be respected.

As the UK government notes, even though the impact of the ETS is unquantified in its modelling, the system provides a “a strong guarantee that [a] traded sector’s emissions will not exceed its decarbonisation pathway.”

UK carbon-investment opportunities

Based on even the most conservative assumptions given the range of caps the government announced in the consultation last year, our analysis indicates the UK’s carbon price needs to rise significantly higher from the approximate £65 per tonne at which it trades today (down more than 15% since the end of March). And if the ETS is extended beyond 2030 and expanded to include more sectors of the economy where emissions are hard to abate, the price of carbon must appreciate even further.

While the media and investors were closely following the EU’s Fit for 55 policy reform processes last year, we believe investors have yet to wake up to the opportunity presented by the UK carbon market, which is poised to move higher with strengthening policy certainty, even as the EU has already reached its comparative policy equilibrium.

As global investors in carbon markets, we see opportunities to invest directly in the UK ETS market, as well as in natural climate solutions, technology-based removals, and other carbon-credit generating activities within the UK.

We expect rising policy certainty to support prices in other markets as well.  Various programmes – across North America, Asia-Pacific and Oceania – are at a policy inflection point, with reforms scheduled this year and next to align caps and programme features with ambitious climate commitments.  For instance, on March 30, Australia’s Parliament approved a major reform of its carbon market – known as the Safeguard Mechanism – to help achieve net zero by 2050.

‘Big bazooka’

The UK government’s recent commitments to the future of the ETS should begin to provide greater confidence for investors – but this will need to be backed up with action, starting with the tightening of the emissions caps scheduled for this year.

Combined with broader climate actions, a strong ETS is essential in the effort to achieve the UK’s net-zero goals: this is a lever that environmentalists, policy analysts and the finance community should be paying much more attention to, and for which the government must be held to account as a guarantee of its climate commitment, even if there are still questions over the impact of other measures.

The UK was the first G7 country to establish, in law, a commitment to achieve net zero by 2050, along with legally binding five-year emissions budgets. It also shepherded a major increase in global climate ambition as host of the COP26 UN climate summit in Glasgow in 2021.

Alok Sharma, Conservative Party MP and President of COP26, has been calling on the government for a “big bazooka moment” akin to the US IRA. But the race to net zero is also a long campaign, in which sending the right long-term market signals to investors is essential.

While the UK’s carbon market may not make as loud a bang, it may well be the secret weapon in securing the country’s global leadership in achieving net zero.

Lorenzo Bernasconi is Head of Climate and Environmental Solutions, Ruben Lubowski is Chief Carbon and Environmental Markets Strategist, Callum Lee is Portfolio Manager, at Lombard Odier IM.

In November, Lombard Odier Investment Managers created a Global Carbon Opportunity Fund that aims to capture yield in emissions trading schemes worldwide.

Any opinions published in this commentary reflect the views of the author and not of Carbon Pulse.