The CIA recognises that carbon pricing can incentivise decarbonisation, but only where there is also effective carbon leakage mitigation. Because clean manufacturing comes with a ‘green premium’, until there is a global carbon price, or comparable decarbonisation ambition elsewhere, placing a higher carbon cost on UK manufacturers will only increase the risk of carbon leakage. Industry needs carbon leakage mitigation that reflects the UK’s industrial decarbonisation pathway.
Our sector is the foundation of a net zero economy. We provide the advanced materials used to make batteries, wind turbine blades and solar panels, novel fuels like hydrogen and ammonia, lightweight materials for transport, and insulation to keep homes warm. An innovative and competitive UK chemical sector will make us a contender in new low-carbon industries.
The CIA recognises that carbon pricing is an effective tool for incentivising decarbonisation, where the following conditions apply:
1) There is policy certainty. Investment requires reward. Knowledge of, and trust in, the policy framework is key to building a business case. As it stands, there are over 10 outstanding consultation responses on the design of the UK Emissions Trading Scheme (ETS), putting aside the uncertainty raised by linking negotiations with the EU.
2) There are ready alternatives. Amongst chemical UK ETS participants, investment in energy efficiency and emission abatement measures is mature. To take the next step, we need access to clean and competitively priced electricity, biogas and hydrogen, as well as carbon capture and storage (CCS) infrastructure. But these technologies are currently inaccessible or uneconomic.
3) There is meaningful support. The Climate Change Committee (CCC)’s Seventh Carbon Budget puts costs for industrial decarbonisation at ~£0.5-3 billion per year, up to 2050. This significant cost cannot be borne by trade-exposed manufacturers, where they cannot pass it through to consumers. Yet the Government has axed support for industrial decarbonisation investment.
4) There is effective carbon leakage mitigation. Because clean manufacturing comes with a ‘green premium’, until there is a global carbon price, or comparable decarbonisation ambition elsewhere, placing a higher carbon cost on UK manufacturers will increase the risk of carbon leakage. This will increase both the UK’s reliance on imports and global carbon emissions.
Free allocation as carbon leakage mitigation
Effective and sustained carbon leakage mitigation is needed whilst UK manufacturers face a higher cost than their overseas competitors. This protection can come in the form of free allocation, or policies that help pass through the green premium to the consumer, like carbon border adjustment measures (CBAM) or low carbon product standards.
Free allocation is a carbon leakage mitigation measure intended to shield UK ETS participants from the carbon price related to the portion of their emissions that cannot immediately be reduced. It is designed to allow a site to continue to operate in the UK while it looks to invest to decarbonise. Free allocation also rewards investment in decarbonisation because unused free allowances can be sold within the carbon market, reducing the need for Government support.
Importantly, because free allocation applies to production, regardless of the end market, it provides carbon leakage mitigation for UK manufacturers wherever their products end up, unlike the incoming UK CBAM. As currently proposed, the UK CBAM would provide no carbon leakage mitigation for UK manufacturers selling to overseas markets – a critical issue for an export-intensive sector like ours.
Yet the Government’s trajectory for free allocation reduction - the ‘industry cap’ – is misaligned with its industrial decarbonisation policies, creating a significant (and increasingly evident) risk of investment leakage and carbon leakage. Even with the most optimistic assumptions, there is a clear mismatch between the industrial emission reduction pathway established by the cluster sequencing process and the free allocation industry cap. Meanwhile high electricity prices and long grid connection times effectively block the electrification of industry. To ensure free allocation remains an effective tool against carbon leakage, it must reflect the availability and affordability of low-carbon infrastructure.
With this in mind, establishing any cap on free allocation undermines its intended purpose of providing effective carbon leakage mitigation. Rather than setting an arbitrary and declining cap on free allocation – that bears no relation to widely understood emission abatement pathways – the industry cap should instead be set from the bottom up, according to the level of free allocation that a UK site requires to protect it from carbon leakage. The timeline for accessing viable decarbonisation options must be front-and-centre of this process.
As it stands, if the industry cap falls below the total level of free allocation that manufacturers should be entitled to, then a cross-sectoral correction factor (CSCF) would apply (subject to consultation). A CSCF would curtail free allocation to all recipients to ensure the industry cap is not exceeded, regardless of the impact to their competitiveness. The CSCF is an arbitrary tool, which fosters uncertainty and thereby discourages investment. If used, it has the potential to be another major driver of carbon leakage.
We are currently in the first allocation phase of the UK ETS, stretching from 2021 until 2027. This means that for the time being, industry has a clear idea of its free allocation and the Government has stated it’s intention to guarantee free allocation using allowances from the reserve. Nonetheless, after 2027 industry has no clarity regarding free allocation. Those without free allocation, or whose free allocation does not cover all of their emissions, will likely be subject to a very high carbon price owing to the lower liquidity anticipated in the market. For multinational businesses that compete in global markets, this creates uncertainty which will undermine investment in key industrial decarbonisation technologies here in the UK.
Free allocation must not be undermined in any way, whether through the introduction of a CSCF or the arbitrary reduction of an industry cap. This can be done by getting rid of the industry cap entirely and amending the auction process, so that allowances are only auctioned once free allocation has been made. This would also allow for the abolition of the New Entrant Reserve, since there would be no need to ring-fence free allocation for new entrants.
Industry needs carbon leakage mitigation that accounts for the UK’s industrial decarbonisation pathway, as laid out in the CCC’s Seventh Carbon Budget and DESNZ’s Industrial Decarbonisation Strategy. The level of free allocation available must recognise international competitiveness and the availability of abatement options. The goal should be to nurture a thriving low carbon industrial base in the UK, which can outcompete carbon-intensive equivalents on global markets. The alternative is the shifting of carbon emissions overseas, the loss of jobs, skills and manufacturing capability, and the loss of revenue for the Treasury.
