Navigating carbon compliance: Key shifts in Emission Trading System CO2 allowances for supply chains

8 minute read | September.28.2023

A clear trend has emerged for CO2 allowances: dwindling availability coupled with escalating prices. At Orrick, we are seeing two key events which promise to further intensify this trajectory. Firstly, the upcoming regulatory changes by the EU for the second allocation period of the fourth trading period (2026-2030), and secondly, the reduction in allowances available under the UK Emissions Trading System (“UK ETS”). The result? An increase in competition for allowances, which is leading to more frequent legal and distribution challenges, inevitably requiring adjustments of supply agreements and potentially resulting in disputes.

Companies reliant on the allocation of free allowances for sustaining their international competitiveness, as well as those involved in the trading market, need to take heed of these evolving dynamics. In this blog post, Orrick unpacks the forthcoming deadline and most critical amendments under the EU scheme. We also briefly note the reduction in allowances under the UK ETS and consider some of the potential implications of these changes from a dispute’s perspective.

Understanding the ETS Framework

The EU Emissions Trading System (“EU ETS”) is one of the world's most robust carbon pricing mechanisms and a cornerstone of Europe's strategy to combat climate change. By setting a cap on greenhouse gas emissions across various industries affecting thousands of companies, the EU requires companies to hold allowances that mirror their carbon footprint. Free allowances are allocated to eligible entities specifically to prevent so-called "carbon leakage", i.e., the relocation of CO2 emissions to non-European countries. This support limits the risk of European businesses becoming uncompetitive in the low-carbon economy transition, thereby preventing CO2-intensive production from shifting to regions outside of the EU.

Although the EU ETS is well-known throughout Europe, following Brexit, the UK introduced its equivalent UK ETS. This works in a very similar way to the EU ETS, albeit that it only applies to the UK.

2024 application deadline for free CO2 allowances under the EU ETS

For the beneficiaries of free allowances under the EU ETS, a critical but easily overlooked deadline is drawing closer: they must file their applications for free CO2 allowances before a deadline that can deviate between each member state. The default EU cut-off date is 31 May 2024, but the EU also grants each member state a latitude to deviate from this deadline by up to a month. Thus, contingent upon respective national implementation, the cut-off dates may range from 30 April to 30 June 2024, making individual assessments indispensable. Missing this deadline could have substantive financial ramifications, underscoring the urgency of timely action.

Reduction in quantity of CO2 allowances under the UK ETS

In July 2023, the UK Emissions Trading System Authority reduced the number of allowances available under the UK ETS.  The intention of reducing this cap from around 1,365 million allowances to between 887-936 million allowances was to increase the pace at which emissions are being reduced.

Notwithstanding the reduction, the relevant authorities will release 53.5 million additional allowances until 2024, so as to mitigate any risks of sudden drops in supply.

Effect on the supply chain beyond the eligible industries

The ripple effects of these changes will spread much wider and impact far more than just the companies directly impacted by the EU ETS and free allowances or by the UK ETS. For example, while the cement clinker industry is one of the beneficiaries of free allowances in Europe and the UK, the subsequent construction industry is not. Yet, while the construction industry is dependent on the cement clinker, the entire supply chain is affected by the costs of the relevant ETS regime. Similar effects apply to other beneficiary industries, such as the chemical, iron and steel, or paper industries. One common denominator for these beneficiaries is that they are at the upper end of their supply chains. Accordingly, supply contracts with downstream business-partners will need to take the upcoming costs and uncertainties into consideration and existing, often long-term supply contracts may require re-evaluation and renegotiation should the increased costs be passed down to business-partners and consumers. Where this process (and the strategy of the EU or UK) proves unsuccessful, the exodus of certain industries from the EU or UK could disrupt the current supply chains and necessitate a reorientation of business models and partners.

Effect on trading within the market

Aside from those using the allowances to cover their own CO2 emissions, both the deadline for applications under the EU ETS and the reduction in allowances under the UK ETS will also impact those trading such instruments.

Although it is impossible to predict the fluctuations of the markets, basic supply and demand economics would suggest that if supply reduces whilst demand remains the same, then the market trading price of these instruments would increase.

A high market trading price of these instruments could lead to increased energy production costs which may then be passed on to the consumers through increased consumer prices. Given the already high energy prices, there will come a point where such price inflation will become unsustainable.

The bigger picture

Against this background, the 2024 application deadline serves as a reminder of the upcoming changes in the regulation of the EU ETS. While the amendments for 2026-2030 are still in deliberation, the proposed regulation is likely to exacerbate conditions for beneficiaries of free allowances. As part of the “Fit for 55” policy framework, the EU’s ambitious strategy to reduce greenhouse gas emissions by at least 55% by 2030 compared to 1990 levels, the reduction not only of the overall cap, but also of the number of free allowances will be accelerated. In addition, the criteria for eligibility will become more stringent.

For the time being, the fundamental principle of free allowances is intended to remain untouched. However, the EU has already held out the prospect of lowering the allowances more quickly than previously planned, until they are expected to be completely phased out in the middle of the next decade. Industries less prone to relocate production will be hit even harder. The EU plans to conclude their access to free allowances as early as the end of the current trading period in 2030.

While the EU ETS mechanism has historically been successful in reducing carbon emissions without offshoring production, the real challenge still lies ahead. The increasing CO2 allowance prices coincide with the return of inflation and the highest energy costs yet. Further reduction in carbon emissions will often require never-before-seen transitions away from fossil fuels, gas, coal and other combustibles to newer, mostly energy-reliant technologies. The associated costs will lead many companies to closely evaluate the feasibility and their cost and price structure.

Looking Ahead: Strategizing for a carbon-constrained future

As the approaches to CO2 allowances becomes increasingly strict and reduced in number and the carbon pricing mechanism becomes more stringent, businesses must be aware of the changes to come and proactively review their strategies. From the perspective of users of allowances, businesses along with their partners, should proactively evaluate and safeguard the robustness and resilience of their supply chains and contractual commitments to ensure that both remain adaptive and sustainable in the face of these regulatory and technological transitions. This will not only ensure compliance but also bolster their international competitiveness and avoid legal conflicts in an increasingly changing carbon emission economy. Meanwhile, those trading allowances should be aware of the implications that these changes will have on the market and factor in these considerations when agreeing prices under such trades.

Disputes which may occur

Although proactive and rigorous planning from both commercial and legal perspectives should help to minimise the risk of legal conflicts, there will inevitably be some disputes.

From our experience, the most obvious types of disputes which may emerge include:

  • Disputes arising as a result of carbon market transactions – in particular if trades were concluded at one price but the market moves to such an extent that one party gets what it deems is a “bad deal”. Notably, the master trading agreement for the EU ETS provides for arbitration before the Permanent Court of Arbitration, whilst the UK equivalent agreement provides for disputes to be resolved before the English courts.
  • Disputes arising out of contractual renegotiation. As mentioned above, to ensure that costs are fairly allocated, it may be necessary to renegotiate elements of contracts. These renegotiations could cause issues, especially in construction if a party holds its work hostage to the negotiations. This could hold up the entire project and create a litany of satellite issues.

The coming years will be pivotal for industries under the EU ETS and UK ETS frameworks. Being well-prepared and agile can turn regulatory challenges into opportunities for sustainable growth.

If you have any questions about your CO2 allowances or any other points raised in this post, feel free to contact one of the Orrick team.