New Proposals aim to address carbon leakage

The Government are consulting on a range of potential policy measures to mitigate future carbon leakage risk.

Carbon leakage means any movement of production and associated emissions from one country to another due to different levels of decarbonisation effort through carbon pricing and climate regulation. Decarbonisation efforts to reduce global emissions are undermined as a result of carbon leakage.

The Consultation seeks views to help develop proposals for policy measures that will mitigate future carbon leakage risk, and ensure the UK Government's climate policies support efforts to decarbonise and reduce emissions within the UK as well as globally.

Potential policies include:

• a carbon border adjustment mechanism (CBAM) applied on imports that would reflect both the carbon emitted in their production together with any gap between the carbon price already applied in the country of origin and the carbon price that would have been incurred had they been produced in the UK;
• mandatory product standards (MPS) that would set an upper limit on the embodied emissions of specific industrial products and could be designed to increase in stringency over time;
• demand side policies to help grow the market for low carbon goods, such as product labelling (based on voluntary product standards) and public procurement initiatives; and
• an embodied emissions reporting system which could support the implementation of carbon leakage mitigation policies.

So what would the two main policies being proposed by Government entail?

Carbon Border Adjustment Mechanism (CBAM)

Late 2022, the European Union agreed to the world's first CBAM, aimed at preventing carbon leakage. Carbon leakage occurs when companies based in the EU move carbon-intensive production abroad to countries where less stringent climate policies are in place than in the EU, or when EU products get replaced by more carbon-intensive imports.

It is effectively a tariff on carbon intensive products such as cement or fertilizer, designed to deter carbon-intensive processes and encourage carbon reduction by putting a fair proceed on the carbon emitted during the production of carbon intensive goods that are entering the EU. In practice it will confirm that a price has been paid for the embedded carbon emissions generated in the production of certain goods imported into the EU, so the CBAM will ensure the carbon price of imports is equivalent to the carbon price of domestic production.

A UK CBAM would operate in the same principle, and would apply to products imported into the UK to ensure they are subject to a comparable carbon price to that incurred by UK-based production. There are six key areas which would shape the design and implementation of a potential UK CBAM:

• sectoral targeting - which sectors would a UK CBAM apply to;
• emissions measurements - how should emissions be measured as part of a UK CBAM;
• emissions scope - which emissions should be in scope of a UK CBAM;
• price measurement - how should a UK CBAM price be calculated;
• implementation - how and when should businesses be required to comply with a UK CBAM;
• timing - when should a UK CBAM be introduced.

Sectoral targeting

As CBAM operate to mitigate the risk of carbon leakage by applying domestic carbon pricing on products, it is therefore likely that to begin with at least, only those products subject to carbon pricing frameworks under the UK Emissions Trading Scheme (UK ETS) would be subject to CBAM.

It is proposed that only sectors deemed to be at risk of carbon leakage, for example cement, chemicals, paper & pulp, glass, iron and steel, be subject to CBAM.

CBAMs are complex and may not be suitable for all products in all sectors governed by UK ETS and at risk of carbon leakage. Consequently CBAMs may only be introduced where the need for such measures is sufficiently compelling to justify their need on environmental grounds. One option would be introducing a CBAM for a limited number of sectors and products and expanding to new sectors or products in a phased way. 

A CBAM would apply to products in scope which are imported to the UK, to ensure that emissions embodied within products are priced. As the UK can't directly place a carbon price or reporting requirement on installations based abroad, any CBAM requirements such as liability or emissions monitoring and reporting, would fall on the importer of the products.

Emissions measurements

A UK CBAM would add a price to the relevant emissions embodied within imported products that reflects any difference between the carbon price paid by the trading partner where the goods were produced, and the carbon price which would be paid for the same goods produced in the UK.

It is likely that the Government will seek to introduce a CBAM that is based on the embodied emissions in a specific imported product. An importer of a product with a low emissions content would face a lower CBAM compared to an importer of the same product but with higher levels of embodied emissions.

In the Consultation the Government will consider the options of determining the emissions content of imported products through the use of:

• independently verified emissions data by a recognised body; and
• default values.

Emissions scope

The emissions embodied in imported products come from different sources, parts of the supply chain and production processes, and can be categorised into:

• scope one emissions - direct greenhouse gas (GHG) emissions attributed to a company, for example running vehicles or a boiler;
• scope two emissions - indirect GHG emissions, for example from the energy or electricity used to run buildings and heating, produced on behalf of a company;
• scope three emissions - all other GHG emissions associated with a product, both up and down the supply chain, including suppliers and consumers.

The Consultation will look into which scopes of emissions should be included in a UK CBAM.

• scope one emissions - as a minimum scope one emissions embedded within imported products are likely to apply to any CBAM. This will replicate the type of emissions covered by the UK ETS.
• scope two emissions - in terms of the UK ETS, scope two emissions aren't priced at the manufacturer because if we use the example of electricity, electricity generators are covered under UK ETS for their own scope one emissions. Applying a UK CBAM to scope two emissions would seek to ensure that if manufacturers in other jurisdictions produce products using more energy intensive processes, this is reflected in the CBAM liability for those imported products. This would be the equivalent then for domestic producers of the UK ETS applying to UK electricity generation. In order to apply a CBAM to scope two emissions it could be that the Government require importers to provide verified data on the emissions associated with electricity generation embodied in imported products. 
• scope three emissions - similar to scope two emissions under the UK ETS, some of these emissions are covered at source, particularly in respect of the supplier side. Potentially a CBAM could cover scope three emissions where equivalent emissions are covered under the UK ETS. Importers could be required to provide evidence of scope three emissions associated with an imported produced for the application of a CBAM.

Price measurement

Carbon pricing in the UK is based on the final emissions of production, and is not impacted by wider or non-pricing carbon reduction measures implemented to reduce those emissions, known as residual emissions. A UK CBAM would seek to treat imported products in an equivalent manner by applying a price only to residual emissions.

The price applied by a CBAM would be set on the basis of an explicit carbon price differential (£/tCO2e) between the UK and the country where the products were produced.

Measures in other countries to decarbonise production would be reflected n CBAM liability as those products would be produced with lower embodied emissions. As CBAM only applies to residual embodied emissions, imported products with lower embodied emissions would have lower cost liability than those with higher embodied emissions.

In relation to specific pricing, the Consultation looks into:

• calculating the UK's effective carbon price; and
• measuring the carbon price differential between jurisdictions.

Implementation

If a UK CBAM is to be introduced, the Government would need to consider how this would ft in with existing UK customs and border objectives, and ensure a CBAM is designed to facilitate the smooth flow of trade with minimal impacts on businesses.

Any UK CBAM would be closely related but a wholly different mechanism to the existing UK ETS, so the Government will look at ways of re-creating the degree of flexibility the UK ETS has in a CBAM. In the UK ETS participants can choose when to purchase allowances required for future surrender, with market processes setting the price being separate from the point of emissions production, and point of surrender. To achieve something similar with CBAM, it is proposed that liability would need to be split into three separate stages:

• point of emitting - when embodied emissions enter the UK a the point of import;
• point of payment - when the importer would pay the carbon price per tonne of C02e. Not associated with specific imported emissions at this stage;
• point of compliance - when the importer would reconcile the embodied emissions they have brought into the UK, against the emissions they have paid for, and the carbon price paid in the country of origin.

Timing

The UK ETS Authority stated that structural changes to the UK ETS would be implemented by 2024, and proposed that free allowances allocated to industry would not be reduced before 2026. With this in mind it is likely that the earliest the Government would consider the introduction of a UK CBAM would be 2026.

Mandatory Product Standards (MPS)

The second key policy option the Government are consulting on are MPS'. These would create a form of product regulation that would set upper limits on the embodied emissions of industrial products either produced in the UK or placed on its market, potentially including imports.

MPS would be different from other product standards, for example, minimum energy performance standards, because the standards would relate to the way the products are made rather than their characteristics.

Key aims of any MPS policy would be to:

• set a minimum expectation on the pace of decarbonisation of manufacturing operations in targeted sectors, supporting efforts in the UK and internationally to reduce global greenhouse gas emissions; and
• mitigate the carbon leakage risk in future by preventing the highest carbon products from being placed on the UK market, which could undercut lower carbon alternatives.

MPS would likely form part of a broader system of policies including voluntary product standards and product labelling. Having complimentary policies would help to:

• enable manufacturers to distinguish their products as lower carbon;
• reach new markets and potentially attract "green premiums";
• strengthen the case for investment in low carbon technologies;
• help the UK to reach net zero while supporting new jobs and positioning UK industry to access new low carbon export markets.

Before deciding whether to introduce MPS for specific sectors, the Government is seeking further views on:

• which industrial sectors should these MPS apply;
• the stage in the manufacturing value chain to which they are applied;
• emissions scope;
• when would be most effective to implement MPS;
• geographic coverage of MPS;
• setting of emissions thresholds.

UK Emissions Trading Scheme (UK ETS)

The Consultation relates to the UK ETS Authority's recent consultation on developing the UK ETS.

The UK ETS places a price on the carbon emitted by domestic producers in the sectors covered. Total carbon emissions under the scheme are capped, reducing over time to incentivise decarbonisation. The risk of carbon leakage risk is currently managed by at-risk sectors receiving a proportion of carbon allowances free of charge (free allocation).

There have been calls from industry to explore new proposals for mitigating the risk of carbon leakage alongside free allocation, including calls that action to tackle carbon leakage should be closely aligned with future changes to the ETS. At the end of this year there is set to be a further consultation looking to better target the remaining free allocations toward sectors considered to be at risk of carbon leakage, with measures expected to be implemented in 2026.

For more information, see:

• Addressing carbon leakage risk to support decarbonisation.