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UK leaving EU emissions scheme in hard Brexit could boost coal burn

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European Energy Insights October 2021


UK leaving EU emissions scheme in hard Brexit could boost coal burn

The U.K. government's contingency plans to replace the EU's cap-and-trade emissions scheme under a no-deal Brexit would likely incentivize coal burn over gas in the country and dampen the investment case for greener alternatives. Exiting the scheme could also lower long-term carbon price support in the rest of the EU.

In a planning paper to prepare businesses for a so-called hard Brexit, the government on Oct. 12 said the U.K. would be excluded from the EU's Emissions Trading System, or ETS, if the country leaves the bloc without a deal in March 2019 and would switch to meeting its carbon pricing commitments via a tax system in that case.

Britain currently has its own carbon price mechanism that taxes power generators £18 per ton on top of the ETS, where prices have recently hovered around €20 per ton. Approximately 1,000 U.K. installations participate in the ETS, which covers power stations and energy-intensive industrial plants, among others.

Working in tandem, the two schemes have prompted power generators to shut down coal-fired plants in the U.K. and encouraged greener alternatives. But several carbon market analysts said the U.K.'s likely target for a total carbon price would be significantly lower than what generators currently pay, which could lead to gas-to-coal switching rather than the other way around.

SNL ImageBurning coal for power could become more attractive again in the U.K. if carbon prices plummet.
Source: Thinkstock

"In that case, you will see a significant increase in coal burn in the coming winters, purely based on the economics," said Charles Moore, an analyst at climate policy think tank Sandbag. "The carbon price support is [supposed to be] targeting the right level until coal is phased out of the system. It’s not going to achieve that goal if we lower the carbon price."

Since the government said it would target a total carbon price similar to the one in the fall of 2017, when ETS prices were only at €6 per ton, this implied that a future tax would be significantly lower than the current total carbon price, he explained.

If large-scale coal generation becomes more profitable, it will make sense for coal generators to bid more aggressively in future capacity market auctions, Moore added, which would crowd out investment in cleaner alternatives, including building new small gas generators, demand-side response and battery storage.

Following the global financial crisis, a glut of allowances drove down prices under the ETS to a range of €5/ton to 8/ton in 2016 and 2017. But recent reforms, which will remove surplus allowances from the market from 2019, have lifted prices to around €20/ton.

Uncertainty bad for generators, renewables investment

Experts said that for companies that participate in the ETS, the uncertainty around what will replace the scheme has been a major issue in itself. The government said it will publish more details on how a carbon price in a no-deal scenario will be applied in its next budget at the end of October.

"The big signal that they're sending is we don't know, and there will be a period of uncertainty," said Silke Goldberg, a partner at law firm Herbert Smith Freehills specializing in European energy law. "If I’m a generator, that’s not a comfortable position to be in, if you don’t know what the impact on the power price is going to be. That can't be very good for the market."

Three of the U.K.'s largest generators that have made large investments in switching from coal urged the government on Oct. 18 to maintain a strong carbon price to reach the U.K.'s clean growth targets and provide security for the industry.

"This is crucial whilst there is still uncertainty about the U.K.'s future participation in the EU ETS as maintaining a no-change position in [carbon price support] would provide much-needed certainty to power generators over the coming period," executives at Ørsted A/S, SSE PLC and Drax Group PLC wrote in their letter to Philip Hammond, the head of the country's treasury.

"The U.K.'s carbon price has been fundamental to delivering a 75% reduction in coal use since 2013 by providing an economic incentive for lower carbon and renewable generation to replace coal-fired generation on Britain’s power system," they wrote.

The U.K. currently has approximately 6 GW of coal capacity in use, with power stations operated by Electricité de France SA, Uniper SE, RWE AG, AES Corp., SSE and Drax. The government wants to phase out coal plants that don't use carbon capture technology by 2025.

Large-scale renewable developers are unlikely to be turned off by a lower carbon price alone, since they rely on the country's Contract for Difference auctions to provide investment security, analysts said. But a robust carbon pricing mechanism would still provide a stronger environment for renewables overall, according to Moore. "Those incentives will be much sharper aligned with robust carbon pricing," he said. "It definitely sends a strong investment signal."

SNL Image

The European perspective

EU carbon prices could also see a short-term bearish impact from the U.K.'s exit.

EU Allowance futures contracts fell after the U.K.'s contingency announcement, which could be due to traders fearing a sell-off of allowances ahead of the March deadline to report emissions savings under the scheme, said Alex Jones, a policy adviser at energy consultancy Ecuity. "The sheer number of generators that are part of the scheme in the U.K. means there will still be a sell-off to some degree," she said.

Even though participants will still have to cover their 2018 emissions, they could be tempted to get rid of surplus allowances in the short term. British utilities are some of the largest buyers of carbon permits in the ETS and, since power generators will have bought allowances to cover some of their future power sales, "there is a risk of flowback to the market as hedges are unwound," Mark Lewis, the head of research at the Carbon Tracker Initiative, said. Lewis expects ETS prices to reach €35 per ton next year, as the market stability reserve tightens supply, and average €35 per ton to €40 per ton until 2023.

The EU has already passed legislation that will invalidate any allowances issued by the U.K. in 2019 to protect the scheme from the dumping of millions of unused permits. The reporting deadline for 2018 was also moved forward to bring it ahead of Britain's scheduled departure date from the EU.

But there is also concern that Britain's exit from the scheme could lower appetite for a tighter carbon price regime among remaining participants in the future since the U.K. is generally seen as having pushed for higher targets.

"If the U.K. leaves the scheme, the system's cap [for allowances] would have to be adjusted," Debbie Stockwell, Sandbag's managing director, told a committee in the U.K.'s House of Lords in March. "There is a real risk that that is an opportunity for ambition to be decreased within Europe."

Still working towards a deal

U.K. Energy Minister Claire Perry said earlier this year that the government intends to remain part of the ETS until at least 2020, when the scheme's current trading phase ends.

But European Council President Donald Tusk warned in a letter to council members ahead of Brexit negotiations last week that the chances of a no-deal scenario had risen to an all-time high. "We must prepare the EU for a no-deal scenario, which is more likely than ever before," he wrote.

Negotiators are currently working overtime to reach a deal on Brexit, which has remained at an impasse largely over an EU "backstop" proposal for Northern Ireland to remain in the customs union to avoid creating a hard border between the country and the Republic of Ireland.

If the country leaves without a deal, the U.K. wants generators and other participants to keep monitoring their emissions, even though they won't have to surrender allowances for them under the ETS anymore.