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Key points

• We estimate that the phasing out of free allowances under the ETS that will accompany the introduction of the UK’s CBAM will raise UK government revenue from between £50 million in 2027 to £1.5 billion in 2034. This is a tiny sum in comparison to the government’s current financial gap for 2022-23 of £131 billion.
• Any estimate of the revenue from selling previously free allowances clearly depends on their price, which is highly uncertain. We have taken an estimate of the EU carbon price by Standard and Poor.
• We believe that it would be sensible, and have also assumed, that the UK will adopt the same schedule as the EU to phase out free allowances and phase-in payment of CBAM charges. From the recent consultation document released by the Government, though, this seems far from assured.
• Despite the considerable uncertainty around our estimates of the revenue raised from phasing out free allowances and charging CBAMs on imports, we can be confident that it will not contribute much to filling the UK’s fiscal gap. But then, that is not the aim of those policies.

Introduction

After the UK exited the European Union (EU), it introduced the UK Emissions Trading Scheme (UK ETS), replacing its participation in the EU Emissions Trading System (EU ETS). The UK ETS sets a total amount of certain greenhouse gases that can be emitted by sectors covered by the scheme – energy-intensive industries, the power generation sector and aviation.2 At the end of each compliance period, firms in these sectors must surrender enough allowances to cover their emissions over that period. One allowance represents the right to emit one tonne of greenhouse gases in CO₂-equivalents. Firms in sectors considered at risk of carbon leakage receive free allowances and all participants in the ETS can purchase allowances at auction or trade them among themselves.3

In December 2023, the UK Government announced that a UK Carbon Border Adjustment Mechanism (CBAM) will be implemented by 2027. With coverage based closely on the EU’s CBAM, this regulates imports of iron, steel, aluminium, fertiliser, hydrogen, ceramics, glass, and cement sectors, which from that date will have to pay a comparable carbon price to that paid by goods produced in the UK.4 The CBAM covers only a subset of the sectors included in the ETS. Documents by the European Commission, which laid out the EU’s reasoning, argued that the included sectors were the most exposed to carbon leakage and that extending to other ETS sectors added technical complications. Given the Commission’s aim of minimising the diplomatic pushback on the CBAM, starting simply while the policy bedded in seemed a sensible way to proceed. The UK Government sees the matter in the same light.5

The CBAM is an alternative solution to the problem of carbon leakage for the UK. It could render free allowances redundant so far as avoiding leakage associated with the UK market is concerned, and this is the EU’s intention for its market, but in the UK consultation document (see footnote 4) the Government has studiously avoided making such a commitment. Rather it ‘is minded’ to introduce a hybrid system that mixes ETS free allowances and CBAM levies.6 With responses to a consultation on free allowances still under analysis,7 it is difficult to know where the policy will end up, so, in this exercise, we assume that the UK does abolish free allowances for CBAM products and that it will follow the same timetable as the EU. It is important to note that the CBAM does not solve the problem of carbon leakage in the export market, and neither the UK nor the EU has revealed (worked out?) how to treat that issue. In terms of revenue from removing free allowances, we return to this issue below.

Potential Revenue

In a recent briefing paper, Will the CBAM fill the UK’s fiscal gap?, we discussed the potential revenue raised by the UK’s CBAM. Although the latter is currently less well defined than the EU’s CBAM, comparing the trade of the UK and the EU suggests that the UK will be unlikely to raise more than 10 percent of the revenue that the EU does – a relatively small amount. However, as free allowances are abolished, firms may replace them with purchases of allowances at auction and this will increase the revenue raised by the ETS. In this paper, we ask how large this increase in government revenue will be.

The EU has already decided that when the EU CBAM becomes fully operational from 2026, the obligation to pay will be phased in gradually, at the same speed as EU ETS free allowances will be phased out. The schedule is shown in Table 1.

Table 1: The EU timeline for phasing out free allowances and phasing in the CBAM

Data is obtained from Climate change: Deal on a more ambitious Emissions Trading System (ETS).

In the absence of any other guide, and in accordance with our own belief about what would be sensible, we assume that the UK adopts the same schedule to phase out free allowances as the EU, except for 2026, during which the UK CBAM will not be operational. This implies that firms in UK CBAM-regulated sectors would lose 5% of free allowances in 2027, etc.

To set a reference of the level of UK ETS free allowances, we use data from its free allocation table that lists 470 UK eligible installations (i.e., plants) with their numbers of free allowances in 2025.8,9 For each of the installations, we tried to identify their industry via their Standard Industrial Classification (SIC) codes.10

We then identified the number of free allowances given to the UK CBAM-regulated sectors.11 Among 470 installations, 45 fall within the sectors covered by the UK CBAM. In total, the CBAM-regulated sectors receive 16.3 million free allowances (around 49% of the total, 33 million free allowances), suggesting that they are the sectors most exposed to carbon leakage.

Although firms will presumably make more effort to economise on their emissions once they lose their free allowances, we assume that they will seek to replace them one-for-one via the auction. It seems likely that the allowances will continue to be issued, but for sale rather than offered for free, so we would expect the total number of allowances to remain the same as already planned under the net-zero path. In this case, the abolition of free allowances should not impact the carbon price. That is, we are effectively treating the allocation of free allowances as a simple income transfer to the recipients because the marginal cost of allowances (or benefit from selling them) will remain the same.

We note that the total number of allowances will decline year by year to meet the net zero target and that the number of free allowances will decrease with it because the number of free allowances is capped as a share of total allowances.12 However, this does not necessarily imply that free allowances for CBAM-regulated sectors will decline, although we would certainly not expect it to increase. Consequently, and very positively for the estimate of additional revenue, we assume that the CBAM sectors require the same level of allowances as they received free in 2023, and that as they lose free allowances according to table 1, they purchase them on the market. We return to this issue below.13

The estimate of the revenue from the ETS, and hence the additional revenue that could be derived from selling previously free allowances, clearly depends on the price of allowances. We used S&P’s forecast of the European carbon price for the UK.14 Table 2 presents the potential revenue of phased-out free allowances and the estimated revenue raised by the UK CBAM from 2027 to 2034.15

With all these assumptions, the potential additional revenue increases from £50 million in 2027 to £1,473 million in 2034, which is not a substantial number in terms of UK Government revenue.16,17 Our estimates are proportionate to the price so that if the price were 50% higher, so would be revenue. The potential revenue is clearly less than the estimated revenue flow from the UK CBAM, and the sum of these two revenue sources is still pretty small compared to the government’s current financial gap for 2022-23, amounting to £131 billion.18

Table 2: Potential revenue from UK ETS free allowances for UK CBAM sectors

The ratio is obtained from Climate change: Deal on a more ambitious Emissions Trading System (ETS). The price data comes from S&P. The CBAM revenue estimate comes from Winters and Zhang ‘Will the CBAM fill the UK’s fiscal gap?’ CITP Briefing Paper No 10. Other figures are the authors’ computations.

The estimates are hugely uncertain and can be affected by many factors. These include the definitions of UK CBAM-regulated products; the extent by which the UK CBAM’s scope is extended to include more ETS sectors; the methodology for computing free allowances; the level of UK ETS free allowances; firms’ own efforts to economise on their emissions; the trajectory of the UK carbon price; allocations of free allowances within eligible installations and the treatment of exports. We explore each in turn below.

The extent by which the UK CBAM’s scope is extended to include more ETS sectors

If the UK’s CBAM included all current ETS sectors and all free allowances were phased out, over £3 billion in revenue would be generated in 2034 based on S&P’s carbon price prediction. And, of course, the coverage of the ETS itself may be extended, making more products ‘eligible’ for the CBAM.

Computing the need for free allowances

The need for free allowances is determined through a computation that takes into account historical activity levels (measuring the production during a specific baseline period), product benchmarks (denoted as reference values for emissions), and a carbon leakage exposure factor (indicating the risk of carbon leakage for a specific sector).19 Altering the configuration of these three factors or exploring alternative methodologies may yield a different, and almost certainly lower, ‘need’ for total free allowances for the UK CBAM-regulated sectors than we have assumed. If the UK Government did adopt a reduction policy similar to Table 1, it still remains unclear whether the reduction factors would apply to our assumed base level of free allowances or to the lower base resulting from changes to the calculation. Either way is likely to indicate a reduced ‘need’ relative to our assumption to purchase additional allowances.

The level of UK ETS free allowances

The government states that, in line with its net-zero target, it will reduce the overall level of allowances by 45% by 2027 relative to 202320, and it may well decide that, within that process, the level of free allowances will be reduced. In addition, the benchmark levels of free allowances will change. The benchmark comprises a firm’s output during a base period multiplied by an emissions standard derived from the 10 percent most emissions-efficient UK installations producing the relevant goods. This standard is likely to decline over time, as these firms become more efficient, and potentially bring further downward pressure on the number of free allowances.

Firms’ own efforts to economise on their emissions

Because they can sell any excess allowances, firms already have an incentive to economise on emissions and this seems likely to be reinforced once they lose the free allowances and have to pay real cash for them. Thus, firms may very well not wish or need to replace all the lost free allowances relative to 2025, leading to a potential overestimation in our revenue calculation.

The trajectory of the UK carbon price

The UK carbon price is very uncertain and is susceptible to fluctuations influenced by external events and related policies. For example, DESNZ forecasts the UK carbon price in four scenarios which depend on many factors, including fossil fuel prices other policies, and economic growth. The predictions are very different across scenarios.21 However, historical data suggests the UK carbon price is unlikely to exceed the EU’s.22 Moreover, if the UK ETS is linked to the EU’s, as we recommend, the UK carbon price would align with the EU’s. This case is consistent with our calculations above, although, of course, the projection for the EU price remains uncertain.

Allocations of free allowances within eligible installations

Installations which produce goods in more than one sector receive only one aggregate allocation of free allowances to cover all products. In calculating the free allowances absorbed by CBAM-regulated products, we assume that all the allowances that go to an installation we allocate to a CBAM sector, go to CBAM-regulated products. Clearly, some may not be so used (in which case the government would presumably let them keep some, reducing the number that had to be replaced) or some may be issued for CBAM products but to installations which we have not classified to a CBAM sector.

The treatment of exports

If, as with a full border adjustment, where a levy is applied to imports and rebated on exports (as is VAT), some of the ETS revenue would be returned to producers. Given that around 7% of the gross output in the UK CBAM-regulated products is exported, about 7% of the revenue we have estimated might be returned.23

Conclusion

While the uncertainties listed above tend towards reducing the additional revenue below our estimate, we cannot, unfortunately, be totally confident that the latter is an upper bound. Overall, however, it seems quite certain that the combined ETS and CBAM revenue will not contribute much to filling the UK’s fiscal gap. But, of course, neither of these policies was formulated with revenue generation in mind; instead, their purpose is decarbonisation, which, if perfectly achieved, would cut revenue to zero.

Footnotes

1. Data access statement:
   All the data used in this work are third party data which are publicly available. The data of EU timeline for phasing out free allowances comes from European Parliament, available at Climate change: Deal on a more ambitious Emissions Trading System (ETS) | News | European Parliament (europa.eu); the data of EU carbon price forecast and estimated revenue raised by the EU Carbon Border Adjustment Mechanism comes from S&P Global, available at EU Carbon Border Adjustment Mechanism to raise $80B per year by 2040 | S&P Global (spglobal.com); the data of free allowance allocations comes from the UK Government, available at UK ETS Allocation Table for operators of installations – GOV.UK (www.gov.uk); the data of UK’s export and production in UK-CBAM sectors comes from HM Revenue and Customs, and Office for National Statistics, more detail can be found in The economic significance of the EU CBAM in the UK | CITP.
2. More detail can be found in Participating in the UK ETS.
3. Carbon leakage refers to the movement of production from one country to another due to the different carbon costs.
4. Compared with the EU CBAM’s coverage, the UK excludes electricity and adds glass and ceramics. The UK imports electricity only from the EU, so presumably, there would rarely be any need to levy an additional border charge, and glass and ceramics are sectors of greater political sensitivity in the UK than in the EU.
5. See Consultation on the introduction of a UK carbon border adjustment mechanism.
6. If the CBAM were levied while free allowances were also offered for UK sales in the UK, there would be over-compensation for the ETS charges and the CBAM would just be pure protectionism. The Government is therefore clear that where free allowances pertain, the CBAM is reduced accordingly.
7. See UK Emissions Trading Scheme: free allocation review.
8. This list records the number of free allowances set for each eligible installation from 2021 to 2025, UK ETS Allocation Table for operators of installations. The government have committed to maintain the current levels of free allowances until 2026, Developing the UK Emissions Trading Scheme.
9. The determination of eligibility for free allowances is structured to address the risk of carbon leakage by diminishing a firm’s exposure to the carbon price. It hinges upon the evaluation of a firm’s trade exposure and emission intensity. The greater the trade exposure and the emission intensity within a production process, the greater the probability of encountering carbon leakage and thus of receiving free allowances. UK Emissions Trading Scheme: Free Allocation Review.
10. In the official document, there was no data about firm SIC codes. Based on Jensen et al. (2021), UK Policy on Carbon Leakage, we have manually searched for their SIC codes and tried to match the codes to the installation.
11. We identified SIC codes related to UK CBAM-regulated sectors as the identification for EU CBAM-regulated sectors in another CITP briefing paper, The economic significance of the EU CBAM in the UK, plus the industries ceramics (SIC code 23200, 23310, 23320 and 23420) and glass (SIC code 23110, 23120, 23130 and 23140). We identified the SIC codes for ceramics and glass industries manually by checking the definitions from Consultation on the introduction of a UK carbon border adjustment mechanism and the SIC code descriptions. The mapping may not be very accurate due to the substantial differences between the two coding systems. Limited by data, we identified UK CBAM-regulated sectors at 3- or 4-digit SIC code levels, which could cause potential risks of overestimation.
12. The government has raised the so-called industry cap (which refers to the share of allowances that is given for free) from 37% to 40%, from 2024, Developing the UK Emissions Trading Scheme.
13. The number for CBAM sectors will decline according to Table 1; this discussion is whether the base to which the table’s schedule is applied will decline, which is unknown at present.
14. For S&P’s forecast of the European carbon price, they did not reveal many details about how they made the predictions. It might depend on the EU’s schedule for reducing total allowances.
15. As our paper, Will the CBAM fill the UK’s fiscal gap? suggests, the UK CBAM is unlikely to raise more than 10 percent of the EU’s revenues. To be consistent with the price used, we presented 10 percent of S&P’s estimated revenue from the EU CBAM and converted them from US dollar to sterling at 2023 average exchange rate of 1.24.
16. We converted prices and values from euro to sterling at the 2023 average exchange rate of 1.15.
17. We note that the carbon values estimated by the Department for Energy Security & New Zero (DESNZ) in Traded carbon values used for modelling purposes, 2023, exceed these estimates significantly. We use S&P’s predictions in order to keep comparability between our previous estimates of the revenues raised by the CBAMs in the UK and the EU.
18. Although the DESNZ’s estimates are higher, the potential additional revenue increases from £56 million in 2027 to £1,809 million in 2034 based on their ‘market carbon values’ scenario, and the estimated revenue raised by the UK CBAM will also increase accordingly. Nonetheless, our conclusion still holds: the sum won’t contribute much to filling the fiscal gap.
19. More detail about the methodology can be found in UK Emissions Trading Scheme: Free Allocation Review.
20. More detail about the calendar for the UK’s ETS can be found in Emissions scheme to reduce sale of carbon allowances on path to net zero.
21. Traded carbon values used for modelling purposes, 2023.
22. More discussion about the UK and EU carbon prices can be found in our briefing paper, Will the CBAM fill the UK’s fiscal gap?
23. We estimated the gross output in UK CBAM-related sectors following our briefing paper, The economic significance of the EU CBAM in the UK. We computed these industries, including ceramics and glass defined in Consultation on the introduction of a UK carbon border adjustment mechanism. To keep data consistency (export data and production data), we used all the data in 2021.

Dongzhe Zhang

Researcher

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L. Alan Winters CB

Centre Director

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Zhang D, Winters A (2024) The revenue potential of phasing out the free allowances received by UK CBAM sectors, CITP Briefing Paper 13