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The chemical and pharmaceutical industry is fundamental to modern society. With an immense variety of products, from vital medicines and foods, the construction of buildings, to transport and leisure, the industry truly does have an impact on virtually every aspect of our daily lives.
Read moreAs it stands, the UK ETS is failing to promote industrial electrification. By following the EU’s swift and sensible actions on expanding relief from the indirect cost of carbon, revenue recycling, and amendments to the fuel-exchangeability rules, the UK can help to unlock investment in the electrification of UK ETS sites. But amendments to the CCA scheme are also required to ensure UK ETS participants are not penalised by that scheme, as and when they electrify.
The UK Emissions Trading Scheme (UK ETS) is one of the UK’s flagship decarbonisation policy instruments, expected to play an important role in meeting UK climate targets while supporting businesses through the net zero transition. Yet the scheme is failing to promote industrial electrification because of its impact on the price of electricity, the design of fuel exchangeability rules, a reluctance to recycle revenue, and its interaction with the Climate Change Agreements (CCA) scheme.
It is well understood that the UK ETS imposes a direct cost on manufacturers, by putting a price on emissions of carbon dioxide from on-site combustion. What is less well known is that the ETS also drives up UK electricity prices, adding an indirect carbon cost onto electricity consumption. This acts as a barrier to industrial decarbonisation because it increases the cost of switching a gas boiler for a heat pump.
The indirect carbon cost arises because the UK ETS imposes a direct cost on the burning of fossil fuels in the power sector, i.e. at gas-fired power stations. Unlike manufacturers, which trade on global markets and face competition from overseas, the power sector has a captured market which allows it to pass-through the cost of its carbon emissions to its customers.
The result is that UK manufacturers pay for emissions in the power sector over which they have no control, at an estimated cost to our sector of >£300mn per year or £21/MWh of electricity used. This is a cost that manufacturers in competing industrial countries do not face and is a part of the reason that the UK has the highest industrial electricity price in the IEA.[1]
In recognition of the impact of this indirect carbon cost, to the competitiveness of UK businesses, the Government established the EII compensation scheme for energy intensive industries. The scheme provides indirect carbon cost compensation to industrial processes in sectors at risk of carbon leakage. However, coverage is patchy and compensation is not comprehensive, with the subsidy intensity set at 75% of the indirect cost to manufacturers.
A similar scenario plays out in the EU owing to the EU ETS, and a comparable compensation scheme supports their energy intensive industries. But last year, due to a sustained rise of emission costs under the EU ETS, the EU adopted an emergency amendment to their scheme, to expand the list of eligible processes to cover the whole of the chemical sector (part of their European Chemicals Industry Action Plan). At the same time, they increased the subsidy intensity from 75% to 80% for a number of chemical sector processes.
The Department for Business and Trade must act now to level the playing field with our EU competitors, by urgently reviewing the subsidy intensity and scope of sectors in the EII compensation scheme.
In the UK ETS, free allocation of emission allowances is provided to sectors at risk of carbon leakage according to product benchmarks. These benchmarks are set for each product on the basis of the top 10% most emission-efficient installations and are regularly updated. Free allocation is a function of production and benchmark, providing effective carbon leakage mitigation for the lowest emitters. It also creates an incentive to exceed the benchmark, because sites that exceed the benchmark will generate surplus free allocation to sell.
For certain sectors the calculation of free allocation is more complex and special rules apply. For example, where products can be made using either fuel or electricity driven processes, the indirect emissions from electricity consumption are not eligible for free allocation.
The impact for sites in these sectors is that they receive less free allocation as their electricity use increases in proportion to their fuel use. If they switch their production entirely to electricity they lose all of their free allocation – a significant disincentive to electrify. In the chemical sector, products affected by fuel exchangeability include ammonia, aromatics, carbon black, ethylene oxide/ ethylene glycols, hydrogen, steam cracking, styrene and synthesis gas.
The EU has already identified this problem and moved to fix it within their ETS. The Commission makes clear that ‘in order to incentivise the electrification of industrial processes to significantly reduce emissions from such processes, it is necessary to remove the rules for the exchangeability of fuel and electricity… electrified processes covered by the EU ETS should benefit from free allocation in the same way as processes with high direct emissions.’
The Department for Energy Security and Net Zero must enact equivalent changes, to afford UK sites that would like to electrify the same opportunities as their competitors in the EU.
The UK ETS is a significant source of revenue for the Government - £3bn for the year April 2025 to March 2026 according to the OBR’s assessment. Yet despite this large transfer of funds from manufacturers to the Exchequer, there is no public support made available for the electrification of industrial sites.
In the EU, by way of contrast, auction revenues generated under the EU ETS system amounted to €38.8bn in 2024, of which €2.4bn went to the Innovation Fund, €6.3bn to the Modernisation Fund and €24.4bn went directly to Member States. The EU specifies that the money destined for these recipients is spent on climate and energy policy.
The EU’s Innovation Fund is one of the world’s largest funding programmes for low-carbon technologies. Just last month, 54 clean tech projects were selected for €2.7bn of grants under the Innovation Fund’s 2024 call, with individual project support ranging from €2mn to €216mn. Once operational, these projects will cut 210MtCO₂ in their first ten years. Alongside the Innovation Fund, the Modernisation Fund supports lower-income EU Member States with funding for renewables, hydrogen, energy efficiency and energy networks.
Of the €24.4bn that went to direct to Member States, those Member States are obliged to use 100% of the auction revenue collected from their EU ETS to support climate action. Member States can spend ETS revenues on industrial decarbonisation, energy transformation, clean tech, adaptation, decarbonisation of transport and actions to support a just transition.
In the UK, ETS revenue is not hypothecated for climate spending and there is no equivalent of the Innovation Fund that UK ETS participants could access to help them electrify. Since the axing of the Industrial Energy Transformation Fund last summer, there has been no comment from the Government on any replacement scheme that might help overcome the green premium associated with electrification.
HM Treasury must roll-out a competitive support package to overcome the higher cost of electrifying heat demand in a country with globally high electricity prices.
The UK’s CCA scheme is designed to support energy-intensive industries by providing relief on an energy tax - the Climate Change Levy (CCL) - in exchange for meeting energy efficiency performance targets. However, the design of the scheme, and how it interacts with the UK ETS, means that the CCA scheme can effectively block a UK ETS site’s efforts to decarbonise.
UK ETS participants report under both the UK ETS and the CCA scheme. To avoid double-reporting of energy use, and double-pricing of emissions, the energy reported under the UK ETS is not reported under the CCA scheme. Because the UK ETS is only concerned with the combustion of fuels on site, UK ETS participants report their on-site combustion under the UK ETS and their imported electricity use under the CCA scheme.
The result is that if a UK ETS participant were to switch its heat demand from natural gas to electricity, then all of its heat-related energy use would move from the UK ETS into the CCA scheme, causing it to fail its CCA targets and face a penalty ‘buy-out’ fee. The site would need to choose between paying a ‘buy-out fee’ in each compliance year or giving up valuable CCL relief.
The Department for Energy Security and Net Zero must provide guidance on how the CCA scheme will accommodate the electrification of heat demand at UK ETS sites.
To improve the business case for industrial electrification in the UK, the CIA is asking the Government to:
1. Remove the indirect carbon cost: The Department for Business and Trade must act now to level the playing field with our EU competitors, by urgently reviewing the subsidy intensity and scope of sectors in the UK’s EII compensation scheme.
2. Amend the fuel-exchangeability rules: The Department for Energy Security and Net Zero must change the rules governing free allocation to those on a fuel-exchangeability benchmark, to afford UK sites the same opportunities as their competitors in the EU.
3. Revenue recycling: HM Treasury must roll-out a competitive support package, to address international asymmetries in access to public support and help overcome the higher cost associated with electrification in the UK.
4. Fix the CCA scheme: The Department for Energy Security and Net Zero must provide guidance on how the CCA scheme will accommodate the electrification of heat demand at UK ETS sites, without penalty or loss of CCL relief.
[1] ONS (2025) The impact of higher energy costs on UK businesses: 2021 to 2024
A sharp look at why the Government’s new British Industry Competitiveness Scheme is a welcome step, but still falls far short of what UK manufacturers need to stay globally competitive.
The Chemical Industries Association is the organisation representing and advising chemical and pharmaceutical companies located across the UK. Our core membership is a diverse mix of chemical and pharmaceutical companies operating within the UK
