UK Emissions Trading Scheme: Business and Regulations Impact Assessment (BRIA)

2. Purpose and Intended Effect

2.1 Background

The UK Emissions Trading Scheme (UK ETS) was established on 1 January 2021 by the UK ETS Authority (the “Authority”) –formed by the Scottish, UK and Welsh Governments and the Department of Agriculture, Environment and Rural Affairs in Northern Ireland (DAERA) for Northern Ireland. When it was established, the Authority committed to increasing the climate ambition of the scheme and last year the Authority consulted on a number of proposals to strengthen the UK ETS and align it with net zero targets.

In August 2022, the Authority published an initial Government Response to the consultation covering proposals which had to be implemented by 2023^[1]. On 3 July 2023 the Authority published a final Government Response and associated impact assessment covering the remaining and more substantive policy changes.^[2] These documents considered stakeholders’ views throughout. This Business and Regulatory Impact Assessment (BRIA) builds on the UK Government’s Impact Assessment to provide an assessment of the impact of these changes on Scottish businesses.

This document is designed to be considered alongside the “Developing the UK Emissions Trading Scheme: Main Response” (referred to as ‘Government Response’) and its associated impact assessment (referred to as the “UK ETS Impact Assessment”).

In summary, the proposed changes in the UK will:

• Set the UK ETS cap to be consistent with a goal of reaching net zero. The net zero consistent cap will reset the total cap for the first phase of the UK ETS (2021 – 2030). This supports Scottish Government climate change plans and targets, and it goes further in reducing emissions than the previous cap.
• Set the Industry Cap (the proportion of allowances that are given for free to industries at risk of carbon leakage) at 40% of the overall cap.
• Smooth the transition to the new net zero consistent cap through releasing 53.5 million additional allowances (which are currently unallocated) to the market between 2024-2027.
• Retain 29.5 million of the unallocated allowances. This is equivalent to approximately 3% of the overall cap.
• Phase-out aviation free allocation.
• Expand the scope of the UK ETS to include the maritime, waste incineration and energy from waste sectors, as well as new activities within the traded sector^[3] (see Annexes A and B for more detail on these proposals).

These changes are set out in detail in the Government Response, along with definitions for some of the terms used in this document.

The Government Response to the UK ETS consultation also sets out a number of more technical policy changes. The Scottish Government has assessed these and deems their impact on business to be low; they are therefore not considered in detail in this document. See Annex A for more detail on each policy decision.

Lastly, a few policy positions outlined in the Government Response are subject to further consultation (see Annex B for more detail). The Authority will produce impact assessments as appropriate following consultations on these policy issues. The Scottish Government will also consider what Scottish specific impact assessments may be appropriate to support policy development.

2.2 Objectives

The changes to the UK ETS set out in the Government Response support Scotland’s decarbonisation objectives. The UK ETS plays an important role in meeting Scotland’s ambitious net zero target by incentivising emissions reductions in the power, oil and gas, heavy industry and short-haul aviation^[4] sectors of the economy. Together Scottish ETS emissions account for 18% of Scotland’s 2021 greenhouse gas (GHG) emissions^[5]. By setting a market-led price for carbon, the UK ETS incentivises least cost decarbonisation in these high-emitting sectors, whilst also mitigating risks of carbon leakage during the transition to net zero.

This section summarises the objectives of the policy changes covered in this BRIA:

1. Net zero consistent cap : The cap refers to the total number of allowances created within the scheme, which can be broken down by year. A lower cap represents a smaller number of emissions and greater climate ambition. The objective behind the new cap trajectory is to therefore support the decarbonisation of the ‘traded sectors’ (including industry, power and short haul aviation) in order to meet our net zero targets. The cap must be set appropriately to ensure the carbon price signal provided by the UK ETS is consistent with the level of traded sector ambition needed to meet our targets^[6]. If the cap is set too high (i.e. allows a greater number of emission allowances to enter the market), it is less likely the UK ETS price will incentivise sufficient decarbonisation. Similarly, if it is set too low, it will not align with a credible and low-cost decarbonisation pathway. We believe that the net zero consistent cap trajectory strikes the balance between incentivising decarbonisation and enabling industry to transition to net zero fairly, in line with our Just Transition objectives.

2. Industry cap: The industry cap is the upper limit on the number of free allowances that can be issued each year to sites that are at risk of carbon leakage. The objective for setting the industry cap at 40% is to mitigate the risk of carbon leakage as the traded sector decarbonises and lower the risk of triggering the cross-sectional correction factor (CSCF)^[7]. It also gives the Authority more flexibility for reviewing the scheme’s approach to free allocation distribution in the upcoming phase 2 Free Allocation Review. This is aligned with the Climate Change Committee (CCC) advice to the Authority on the industry cap^[8].

3. Unallocated allowances: In previous years, the number of free allowances allocated to industries was below the industry cap. The gap between the amount allocated and the cap has resulted in unallocated allowances that have no route to market. The objective for bringing some of these unallocated allowances to market is to smooth the transition to the net zero consistent cap. This supports Scotland’s Just Transition objectives by supporting businesses to plan for a managed transition to net zero.

4. Phase out aviation free allocation: Free allocation for the aviation sector will not be extended for the 2026-2030 allocation period as research has found that there is a minimal risk of carbon leakage for the aviation sector.^[9] Free allocations are used to mitigate against carbon leakage, therefore, continuing to allocate free allowances to the sector goes against the policy intent.

2.3 Rationale for Government intervention

Climate change targets: Both the UK Government and the Scottish Government have legislated ambitious net zero targets. One of the primary policy objectives in reforming the UK ETS was to align the UK ETS Cap to the UK's legally binding net zero targets by implementing a revised net zero consistent cap trajectory from 2024. The net zero consistent cap will reset the total cap for the first phase of the UK ETS (2021 – 2030). The CCC have stated that the proposed cap “ is appropriate, given the pathway set out in the [UK] Net Zero Strategy.”

Scotland's greenhouse gas emissions reduction targets are set out in the Climate Change (Scotland) Act 2009^[10], and subsequently amended in the Climate Change (Emissions Reduction Targets) (Scotland) Act 2019.^[11] Scotland's net zero target is consistent with the overall UK target and is based on advice from the CCC. The new cap goes beyond the level of reductions set by the previous cap, thereby providing greater support for Scotland's net zero targets.

Negative Externalities: The rationale for Government intervention is that there are a number of negative externalities associated with climate change, whereby the global costs of greenhouse gas emissions are not factored into the decision making of emitters and hence emissions will be too high. These externalities represent market failures, and as such warrant Government intervention in the market to correct them.

Alignment with National Performance Framework (NPF). These changes to the ETS support alignment with the National Performance Framework (NPF).^[12] The UK ETS contributes positively to four of the National Outcomes:

• We value, enjoy, protect, and enhance our environment;
• We have a globally competitive, entrepreneurial, inclusive, and sustainable economy;
• We are open, connected and make a positive contribution internationally; and
• We have thriving and innovative businesses, with quality jobs and fair work for everyone