The benchmark European Union carbon emissions allowance has traded at a premium to its British counterpart for over a year, and upcoming trade policies like the EU’s carbon border adjustment mechanism (CBAM) could impact British industry.

Read more: CBAM 101: The EU’s Carbon Border Adjustment Mechanism Explained

That’s unless the United Kingdom’s emissions trading system (UK ETS) and the EU emissions trading system (EU ETS) are linked to create a single carbon price for both entities, say some analysts who think that it could gain more traction if the Labour Party forms the next British government.

Brexit led to the departure of the UK from the EU’s carbon market and the creation of the UK ETS in 2021. The two carbon schemes cover heavy industry, but the EU market is substantially larger and more liquid than the UK ETS, covering over 10,000 installations, while the UK ETS covers several hundred.

Navigating the UK-EU Relationship

Linkage between the two carbon schemes is a real possibility according to Mark Lewis, one of Europe’s best known carbon analysts and the head of climate research at commodities hedge fund Andurand Capital Management. Lewis thinks that in the case of a Labour victory in the upcoming general election, Sir Keir Starmer, leader of the opposition party, will navigate a more subtle, less confrontational relationship with the EU.

While Starmer is unlikely to pursue an agreement to re-enter a single market with the EU, Lewis suggested to OPIS in an interview last month that merging the two carbon markets would be a way to show goodwill towards the EU and, perhaps more importantly, level the playing field between British and European industries.

“I think it makes political sense, and…it makes economic sense…It’s too early for the market to really start pricing [linking] in, but as we get closer to the UK election, I think what you will see is the carbon markets [in both the U.K. and the EU] think harder about how this might work,” Lewis said. “This will be an interesting narrative in the second half of the year.”

Linkage between the two carbon markets would be straightforward, Lewis said, especially as the British government has laid down a carbon reduction policy that is more ambitious than the EU’s. The EU has legislated for a 55% reduction in greenhouse gas emissions over 1990-2030 and has proposed a 90% fall by 2040 based on 1990 levels, while the British government has written a 68% reduction into law by the same year and then a 78% cut by 2035.

Linking would also provide British industry with access to a larger pool of carbon allowances, easing concerns about higher prices in the UK ETS in the coming years, Lewis noted.

The gap between the December benchmark contracts of the EU carbon allowances (EUAs) and UK allowances (UKAs) peaked in the fall of 2023 with a spread of over €40 ($43.33). That difference has narrowed to around €18 as EUAs traded on Tuesday at €58.72/mt and UKAs at £34.93/mt ($43.90).

The British government is also considering ways to provide more market certainty with respect to the UK ETS, which has seen prices dip from all-time highs around £97.75/mt on August 19, 2022 to an all-time closing low of £31.48/mt on January 29 this year. The government announced in December that it was working on the development of a supply adjustment mechanism akin to the Market Stability Reserve (MSR), which has been active in the EU ETS since 2018. The MSR mechanism aims to maintain competitive prices by either hoovering up allowances from the market or releasing them into the supply pool.

“The real point here is much more that the prices [between the EU and UK carbon schemes] are out of sync because the U.K. like the EU is frontloading allowances, but [the U.K.] doesn’t have an MSR,” Lewis said. “It’s raining hard outside with U.K. allowances, but at some point the drought in the U.K. is going to be more severe than in the EU because of the more ambitious [U.K. carbon emissions reduction] target.”

Riham Wahba, a senior market analyst with Vertis Environmental Finance, told OPIS that unless the U.K. introduces a supply adjustment mechanism into its carbon scheme, the government’s ambitions, like zero emissions in the power sector by 2050, could “break” the UK ETS as it calls for the faster decarbonization of British utilities, lower hedges and a ballooning total number of carbon allowances in circulation. Based on the government’s projections, power sector emissions would need to drop by 75% by 2030, 83% by 2035 and 98% by 2050 based on 2021 levels.

An EU official told OPIS that linking different carbon schemes is beneficial for climate action as it would allow for more cost-effective emissions reductions. The same official said that any decision to proceed with linkage with the UK ETS “remains to be explored” and that this would be assessed in light of potential changes to the EU ETS.

The EU Commission would need to get a negotiation mandate from the EU Council and the EU Parliament would also need to be involved in the ratification process, the official explained.

“Should the parties decide to link their emissions trading systems, in practice they would negotiate an international agreement. This was done recently with Switzerland, for example,” the EU official said.

On the British side, the Department of Energy Security and Net Zero (DESNZ) maintains an open position to linking with the EU ETS under the terms of the post-Brexit Trade and Cooperation Agreement, a DESNZ spokesperson told OPIS.

“We are open to the possibility of linking the UK ETS internationally and will continue to work collaboratively with other jurisdictions to tackle shared challenges and learn from the experience of others as we develop the scheme,” the DESNZ representative said.

Ben Lee, an analyst with Energy Aspects, told OPIS that while linkage between the two carbon schemes would face better chances under a Labour government, it would still be far from certain due to political, legal and administrative barriers.

Lower Exposure to EU CBAM through Linked Schemes

Wahba said that linking the two markets would help consumers avoid the price differential between the two carbon schemes and any resulting cost being passed through to consumers in the U.K. The CBAM, according to the EU Commission, was implemented to prevent ‘carbon leakage’, or domestic industry decamping to countries without carbon pricing or taxes. The EU Commission believes that the CBAM will encourage other countries to decarbonize their domestic industries

The mismatch between UK ETS and EU ETS carbon prices would mean that British industry is exposed to higher European carbon prices, potentially affecting the flow of trade from the U.K. to continental Europe. The British government announced in December that it would consider implementing its own CBAM but that this would only go live in 2027, a year after the EU’s carbon tax has gone into effect, with potentially harmful effects for British industry, according to accounting firm KPMG.

The EU CBAM will initially cover imports of cement, iron, steel, aluminum, fertilizers, electricity and hydrogen. The U.K. carbon border adjustment mechanism will include the same sectors with the exception of electricity and will also cover imports of ceramics and glass products.

Certain sectors of British industry have called for linkage with the EU ETS. UK Steel, a trade association, called for linkage in December to keep British exports to the EU afloat as 75% of the country’s steel industry’s exports — around 2.5 metric tons — are delivered to EU ETS-covered markets.