REUTERS | Mike Hutchings

Linked emissions trading schemes: opportunities and risks

This blog describes some of the risks that are emerging as a result of the proliferation and linking of emissions trading schemes. It begins by providing an overview of the development of emissions trading schemes and the creation of links between them. It then considers the dispute risks that may arise from these developments and briefly explores the availability of relief under investment treaties for market participants that lose out when a scheme is altered, cancelled or delinked from another.

Background

Emissions trading schemes have become a popular tool in global efforts to tackle climate change. There are more than 20 schemes currently in operation and many more are scheduled for implementation or are otherwise under active consideration at both national and sub-national levels. In theory, the schemes operate by fixing the economic problem that the environmental impacts of greenhouse gases are not appropriately priced in traditional markets.

The most popular schemes utilise a “cap-and-trade” model. By this method, an overall cap is set on emissions within chosen industry sectors. The cap reduces over time. Participants are allocated a limited number of allowances (that is, rights to emit certain amounts of greenhouse gases within the cap), or acquire them at auction, and can then trade the allowances. It may also be possible to offset emissions by earning or buying credits through emission-reduction projects. Participants must then surrender the allowances or credits to cover their emissions during the reporting period (generally in units such as tonnes of CO2). This mechanism means that emissions are likely to be reduced where it is most cost-effective to do so.

Generally, when two or more schemes are linked, allowances in one scheme can be used for compliance in another. This creates larger and, arguably, more robust markets, leading to a more cost-efficient reduction in emissions. However, linking can also cause imbalances between jurisdictions and, naturally, diminishes a jurisdiction’s ability to manage and control the market. Such imbalances may make it politically expedient to alter, delink, or cancel a scheme. A change in political leadership may also result in one scheme being hastily delinked from another (or revoked altogether). Linking thus expands the reach and effectiveness of emissions reduction policies, but also produces complexity and heightens the risk of disputes (particularly where politics intervenes).

Developments

New UK ETS and plans to link it with EU ETS

The EU emissions trading scheme (EU ETS) was the first large emissions trading scheme in the world. It became a bit smaller on 31 December 2020. This date marked the end of the Brexit transition period and the UK’s participation in the EU ETS (with legacy compliance obligations extending to 30 April 2021). The near-identical UK ETS commenced on 1 January 2021. The first auctions for UK ETS allowances are set to begin in Q2 2021, with the government clarifying the eligibility criteria for participation in late April. Many questions remain about how the UK ETS will operate and whether it will be linked with any other schemes.

The UK and the EU have agreed that they will cooperate on carbon pricing and give “serious consideration” to linking the UK ETS and the EU ETS (Title XI, article 7.3(6) of the EU-UK Trade and Cooperation Agreement, the UK-EU TCA). The UK Government has also stated that it is “in principle” open to linking the UK ETS internationally, albeit that no decisions have been made. The longer the delay, and the greater any subsequent divergence, the more complicated a future UK-EU ETS link will be.

Implementing legislation provides that the UK ETS’ allowances cap will be reduced annually by approximately 4.2 million allowances (article 22, Greenhouse Gas Emissions Trading Scheme Order 2020/1265). However, an explanatory memorandum produced by the Department for Business, Energy and Industrial Strategy describes this cap as “temporary”, with consultations to follow. To the extent that the actual rate of decrease is not clearly set out in advance, this increases the risk for market participants.

Established links

Negotiators of any future link between the UK and the EU ETS will have a growing number of examples to draw from:

Switzerland and the EU agreed to link their ETS schemes in 2017. Following ratification in late 2019, the EU-Switzerland Agreement entered into force on 1 January 2020. There is now mutual recognition of allowances between the Switzerland ETS and the EU ETS (pursuant to article 4(1) of the EU-Switzerland Agreement). However, the fact that it took over ten years of negotiations to agree upon the integration of a relatively small scheme with the EU ETS is perhaps indicative of the risks involved in linking schemes. They are inherently complex and political.

Links have also been created at sub-national level, for example, between cities and regions in Japan and between states in the USA and Canada. The sub-national schemes in the USA and Canada are also instructive of how politics can affect linked programmes:

  • In July 2018, a new government in Ontario revoked its short-lived emissions trading scheme and all trading of allowances was then prohibited. This effectively led to Ontario’s withdrawal from its newly created link with the California and Québec schemes without notice.
  • The Regional Greenhouse Gas Initiative (RGGI) is a combined market originally constituted by ten states in the US northeast. New Jersey withdrew in 2011 but, after the election of a new governor, later officially re-entered the RGGI on 1 January 2020.

Dispute risk

The growing complexity of emissions trading markets, linked or otherwise, will inevitably lead to more commercial and regulatory disputes. However, what options may be open to market players that lose out if a scheme is abruptly cancelled or delinked?

Typically, linking agreements only provide for a mechanism for the resolution of disputes between the parties to the agreement and not for market participants. Given the framework of the UK-EU TCA (and the model of the EU-Switzerland Agreement), it is likely that this will also be the case for any future UK-EU linking agreement. Market participants will therefore have to look elsewhere if things go wrong.

Where relief is not available in the relevant state’s judicial system, it may be possible to seek recourse under an investment treaty, as exemplified by a recently announced dispute arising out of the cancellation of Ontario’s cap-and-trade scheme. In December 2020, Koch Industries and Koch Supply & Trading commenced proceedings against Canada under NAFTA, arguing that Ontario’s cancellation (without compensation for market participants) constituted an unlawful expropriation and breached NAFTA’s minimum standard of treatment. The case will be closely monitored.

The growth and internationalisation of emissions trading schemes offers significant opportunities for those involved. However, it also requires participants to navigate complex and overlapping regimes. While climate policy remains in a state of flux, market participants will be wise to structure their investments in a manner that provides for a possible right of recourse if regulations are unfairly changed or if schemes are abruptly delinked or cancelled.

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