Liquidity could be issue in standalone UK carbon market

11 June 2020 | Trading

Disconnected UK market could experience sharp price spikes

Utility hedging requires operational surplus of allowances

Coal-to-gas fuel switching no longer available in UK

The UK's planned carbon emissions market set to start in 2021 could cause issues linked to utilities' need to hedge forward power sales, a senior carbon trader said June 9.

Potential problems around liquidity and hedging could arise if the UK's carbon market is not linked to the EU Emissions Trading System, according to senior carbon trader at UK-based market advisory company Redshaw Advisors, Tom Lord.

"I think a link is in everyone's best interest. The main risk is that if we don't get a link, the UK will have a small, thin market, and liquidity could be a real issue," Lord said.

"They will have to take great care when designing this system," he said.

The UK government June 1 outlined a proposal for a domestic carbon market that would closely align with the EU ETS, with a potential for linking the two systems. The UK's proposed ETS is designed to ensure a seamless transition for the period when the country leaves the EU scheme in just over six months' time.

The proposed system differs from the EU market in two key respects: it would include an auction reserve price of GBP15/mt (Eur16.55/mt) for allowances sold by the government; and the UK's cap would be 5% lower than it would have been under the EU ETS.

The two systems could be linked if the UK and EU agree that it would be in their mutual interests.

However, failure to link the systems could cause issues for UK-based companies, Lord said.

"The danger with the UK ETS is that we're already fuel switched [from coal to natural gas], so there is no obvious and immediate emissions reduction response to higher prices. There is an interesting potential for price spikes and volatility in the first one to two years," he said.

"With the UK market, not only do you have a smaller and less liquid market, but you also have a situation where you have buyers but not necessarily people willing to sell. And that could mean prices going higher and higher. It almost becomes a self-fulfilling prophesy," Lord said.

Surplus needed for power hedging

Some indications suggest that even with an annual carbon cap that is 5% below where it would have been under the EU ETS, the UK carbon market would still end up oversupplied because the country has sharply reduced its CO2 emissions in recent years as natural gas and renewables have replaced coal-fired plants.

However, such an analysis does not factor in utilities' need to hedge forward power sales up to three years ahead, Lord said. An operational surplus of allowances is therefore an important part of the UK market's functioning, as is the case with the EU ETS, because of the way power generators buy fuel and carbon on a forward basis to cover expected future power generation.

Aside from issues around the annual cap, liquidity and hedging, the tight timeline left before 2021 should not be a problem for the UK, Lord said.

"I do think there is enough time left before 2021 to get this up and running," he said.

"From our discussions with BEIS [Department for Business, Energy and Industrial Strategy], they are already building the architecture for the UK ETS. It's going to be tight, but I don't see any reason why they can't do it," he said.

"The UK government already runs the EU ETS in the UK through the Environment Agency -- overseen by the European Commission. They have the monitoring, reporting and verification systems in place. So they know how to do it," said Lord.

The UK is open to linking the UK ETS with the EU system, and this is subject to the ongoing trade negotiations between the UK and EU, the government said when outlining the plan June 1.

Once the UK's system is up and running, the government intends to go even further by amending the carbon cap again in line with its 2050 net zero emissions target, it said.

Source: S&P Global