UK ETS Free Allocation Review – Final Business and Regulatory Impact Assessment

Section 1: Background, aims and options

Background to policy issue

Free Allocation of UK ETS allowances is the primary policy instrument through which carbon leakage risk is currently addressed in the UK. The Authority defines ‘carbon leakage’ as the movement of production and associated emissions from one country to another due to different levels of decarbonisation effort, through carbon pricing and climate regulation.

The Free Allocation Review considered how the Authority can use free allocations to better target carbon leakage mitigation and incentivise further decarbonisation across the next allocation period (2027-2030). The objective of the Free Allocation Review was to focus on changes to the methodology for distributing free allocations, ensuring that support is better targeted for sectors most at risk of carbon leakage, in the context of UK industry and within the bounds of the new net zero consistent industry cap.

Purpose

If the Authority does not intervene with changes to free allocation rules, there are notable implications:

• Incentives to decarbonise industrial production may not be sufficient to promote investments in green technologies, particularly in hard-to-abate sectors.
• Free allocation levels remain at current levels, resulting in a greater risk of exceeding the industry cap^[5] and drawing on the flexible reserve^[6] to avoid triggering a reduction in each sector’s share of free allocation through the Cross Sectoral Correction Factor (CSCF)^[7]. This would reduce production and investment certainty for industry.
• For those sectors covered by the UK CBAM, retaining free allocation at current levels would render the UK CBAM significantly less effective.
• As announced as part of the UK-EU Summit on 19 May 2025, and then set out in the shared Common Understanding^[8], the UK and EU have agreed to work towards linking their respective Emissions Trading Systems. As stated, any agreement should include dynamic alignment with European Union rules where relevant. Maintaining the status quo would likely be inconsistent with this position.

The Authority consulted stakeholders on a number of proposals to improve its approach to free allocations ahead of the next allocation period.

Options considered

The Authority examined a range of options for each of the policy proposals set out in the consultation. Below is an outline of the policy proposals consulted on. The Authority Response and the Authority Impact Assessment sets out in detail stakeholder views, assessment and rationale for options proposed and discounted, and all final decisions that will inform the calculation of free allocations in the next allocation period from 2027-2030.

Historical Activity Level (HAL)

Historical Activity Level (HAL) refers to the level of production or activity at an installation during a defined past period, which is used to determine how many free allowances that installation should receive.

The Authority consulted on 3 options in relation to HAL:

i. Option 1: Do nothing.

ii. Option 2: Dynamic allocation. Change to a dynamic allocation approach, with free allocation distributed on a provisional basis at the start of each scheme year and updated after the end of each scheme year to reflect actual reported activity.

iii. Option 3: Consider reducing the activity level changes (ALC) threshold. Maintain current HAL and ALC rules but lower the threshold at which ALCs are triggered (currently ALCs are triggered if activity increases or decreases by 15% or more in any two year period).

The Authority has decided to maintain the current approach to HAL and ALC and not to implement a dynamic approach or reduce the ALC threshold. This will provide continuity and certainty for operators and avoid increased administrative burden. Following assessment of all options, the Authority concluded that the current approach (Option 1) offers a reasonable balance between accuracy in reflecting activity, certainty to industry, and administrative burden.

Having heard stakeholder concerns about the impact of COVID-19 on activity levels during the baseline period, the Authority has decided that operators of UK ETS installations will be able choose to exclude activity data for the scheme year 2020 only, or 2020 and 2021, for the purposes of determining HAL for the 2027-2030 allocation period. Operators will be able to indicate whether they wish to exclude 2020 only, or 2020 and 2021, activity from HAL at sub-installation level during the second stage of the free allocation application process (1 April – 30 June 2026). Guidance on how to do this will be made available before the second stage window opens on 1 April 2026.

Benchmarks

Benchmarks are reference values that reflect the efficiency of specific sectors covered by the UK ETS. They are used to calculate the number of free allowances allocated to installations. The closer an installation’s performance is to the benchmark, the more efficient its processes are considered to be, and the higher the proportion of its emissions that will be covered by free allocations.

The Authority consulted on 3 options in relation to Benchmarks:

i. Option 1: No change to benchmarks

ii. Option 2: Use updated 2026 EU benchmarks

iii. Option 3: UK focused benchmark update

The Authority has decided to use updated 2026 EU benchmarks in the Free Allocation calculation for the 2027-2030 allocation period. Current benchmarks will be retained for 2027, with the in-principle intent to adopt updated EU benchmarks from 2028-2030. Following assessment of the options, the Authority has concluded that the EU ETS benchmarking methodology remains the most robust and representative framework for reflecting efficiency improvements made by industry and incentivising decarbonisation.

Carbon Leakage List

The carbon leakage list identifies sectors and sub-sectors that are deemed at significant risk of carbon leakage. Those sectors in the list are eligible to a higher level of free allowances.

The Authority consulted on 3 options in relation to the Carbon Leakage List:

i. The Authority presented two options for determining the Carbon Leakage List from the second allocation period:

1. A revised list based on updated UK-specific data and a new Carbon Leakage Indicator (CLI) methodology.

2. Retention of the existing list, based on historic EU wide data.

ii. Whether to introduce tiering of the Carbon Leakage Emissions Factor (CLEF)^[9] or CSCF.

iii. Bringing forward the phase out date for free allocation to sectors deemed not at risk of carbon leakage.

The Authority has decided to retain the EU ETS Phase IV Carbon Leakage List for the second UK ETS allocation period (2027–2030). This decision reflects a balanced judgement across policy intent, data robustness, stakeholder confidence, deliverability, and strategic alignment with wider decarbonisation objectives.

The Authority has decided not to pursue any of the tiering options consulted upon. Modelling indicates that free allocation will remain below the industry cap through to 2030, and the decision to retain the EU list avoids the increase in allocation volumes that would have resulted from adopting the UK list. Tiering of the CLEF is therefore unnecessary.

As the likelihood of levels of free allocation exceeding the industry cap in the next allocation period from 2027 is deemed very low, the CSCF is unlikely to be triggered, and any changes to the CSCF process would increase complexity without any of the benefits of better targeting free allocations. Therefore, the Authority will not be introducing tiering of the CSCF.

The Authority has decided that it will maintain the existing trajectory for phasing out free allocation to sectors not deemed at risk of carbon leakage, as defined by the EU ETS Phase IV Carbon Leakage List. Under this approach, installations operating in sectors not on the carbon leakage list will continue to receive a reduced level of free allocation until 2030, at which point it will be fully phased out. The Authority recognises that decarbonisation through the UK ETS requires long-term investment and that policy stability is essential to enable operators to make informed decisions. Maintaining the current phase out timeline provides the necessary certainty for sectors to prepare for the full exposure to the carbon price.

Additional Factors for Free Allocation Calculation – Access to Decarbonisation Technologies

The Authority consulted on 2 methods that could be used to consider any discrepancies in availability of decarbonisation technologies:

i. Option 1: disaggregate benchmarks on the basis of whether a sub-installation has access to large-scale decarbonisation technologies, putting installations with different access to decarbonisation technologies on different benchmarks so they would not be measured against each other.

ii. Option 2: Including low/no carbon production processes in benchmark calculations

The UK ETS Authority has decided not to disaggregate free allocation benchmarks or amend benchmark definitions to include low or no carbon production processes. This means that access to decarbonisation technologies will not be used for benchmark calculations for the 2027-2030 allocation period.

The Authority’s assessment concluded that there is no evidence of widespread deployment of large-scale decarbonisation technologies at UK industrial sites that could significantly affect benchmark values. Therefore, there would be no risk of early adopters setting unattainable benchmarks on the basis of use of UK data for the next allocation period.

Additional Factors for Free Allocation Calculation – Conditionality

The Authority consulted on 3 proposed designs of conditionality:

i. Option 1: Reducing free allocation to an installation by a pre-determined amount (for example 10%) if an installation has not made any emissions reductions or resource efficiencies over a certain period of time.

ii. Option 2: Exclude the most efficient installations from any potential application of a CSCF. This option could define most efficient installations as those who are operating at the benchmark level and then ensure that these installations would not see a reduction in their free allocation from a CSCF.

iii. Option 3: Require installations to have a decarbonisation plan in place or they will have their free allocations reduced by a pre-determined amount (e.g. 10%).

The Authority took on board feedback on the three conditionality options presented in the consultation as part of its assessment. The Authority is mindful of not increasing complexity or administrative burden as part of free allocation changes and therefore took account of the benefit of introducing conditionality in comparison to the burden and cost that would be imposed on operators and regulators to facilitate its introduction.

As a result of this assessment process, and stakeholder feedback, the Authority has resolved not to introduce conditionality for the upcoming free allocation period. The Authority notes the potential benefits of introducing conditionality and will continue to consider its merits for the future.

Free Allocation for Sectors Covered by the UK Carbon Border Adjustment Mechanism (CBAM)

The UK Government has signalled its intention to introduce a CBAM from 1 January 2027. As this measure is designed to address the risk of carbon leakage, the Authority has assessed how free allocations should be treated for sectors that will fall within the scope of the UK CBAM.

The Authority therefore consulted on 3 options for adjusting free allocations for sectors covered by the UK CBAM from 2027:

i. The adjustment of free allocation for UK CBAM sectors

ii. Parameters for adjustment

iii. Extent of adjustment i.e. a phase out or a phase down to account for export leakage

The Authority has decided to gradually phase out free allocations for sectors covered by the UK CBAM, the trajectory for this has been presented for 2027-2030, giving certainty on operator’s free allocations for the next allocation period. In order to provide further clarity, the Authority has also set out an indicative trajectory beyond 2030. This phase out will occur at sub-installation level to ensure only free allocations corresponding to products where a UK CBAM will be applied are affected. This phase out of free allocation will ensure a gradual transition for industries across the UK from free allocations to the UK CBAM as the primary carbon leakage mitigation.

The approach taken also mirrors the EU’s pace and scale of phase out for sectors covered by the EU CBAM. This will ensure consistency in the transition for UK and EU businesses, minimising competitive distortions.

Technical Changes

The Authority consulted on 5 technical changes:

i. Technical Change Three: Updating minimum content of the monitoring methodology plan

ii. Technical Change Four: Changes to Heat Metering Measurement Hierarchies

iii. Technical Change Five: Adjustment to Monitoring Principles with relation to Hierarchy.

iv. Technical Change Six: Updating the Unreasonable Cost Calculation

v. Technical Change Seven: Requirement of control system checks to be made at yearly intervals.

The Authority has decided not to introduce the changes proposed in the consultation.

In relation to technical changes three and five, the Authority considers that current legislation reflects the proposed changes.

In relation to technical change four, the Authority concluded that, based on the available evidence, there is insufficient confidence that the proposed equivalent accuracy of Non-automatic Weighing Instruments Regulations 2016 or Measuring Instruments Regulations 2016 compliant metering (e.g. for measurable heat ±3% of actual reads) is currently achievable by industries across the UK.

In relation to technical change six, the Authority has decided not to update the reference price figure used in the unreasonable cost calculation at this time. The Authority recognises that the current reference UK Allowances (UKA) price does not reflect recent UKA prices, which have been higher than the reference price throughout the current allocation period. However, given the scope of planned and possible changes across the scheme, the Authority considers that it would be prudent to wait until those changes have been finalised before determining any update to the reference price. The Authority may update the unreasonable cost calculation in future.

In relation to technical change seven, the Authority considers that the current industry practice of conducting regular checks in line with manufacturer guidance is sufficient to ensure measuring equipment continues to perform to the required standard.

Sectors/ Groups affected

In preparing this BRIA, we have conducted an assessment of the sectors which are expected to be affected by the policy.

The proposed changes to the UK ETS will primarily affect the sites and businesses which are covered by the UK ETS. On this basis, this BRIA focuses on the potential impacts of the policy for sectors covered by the UK ETS who receive free allocations.

By design, the UK ETS legislation applies across the whole of the UK to the same sectors (except for power in Northern Ireland which remains under the EU ETS). This means that there is no specific Scottish cap, or specific cap for any of the four nations in the UK.

This presents challenges when assessing the impact and costs of the UK ETS changes at the regional level. Abatement opportunities, such as access to decarbonisation technologies, carbon capture and storage and fuel switching, will vary across and within sectors and regions and depend on often site-specific key infrastructure and technological solutions being available. In addition, Scotland’s industrial profile is different from the UK when taken as a whole and, as a result, the solutions required in Scotland may be different from those in the rest of the UK. Abatement solutions may not be available or not delivered symmetrically across all parts of the UK. Overall, the rate of decarbonisation is therefore likely to differ across the UK nations. While we can draw some high level and aggregate conclusions around likely impacts, business responses to the proposed changes will be made on site or organisation-specific commercial decisions, which are difficult to predict on the basis of national or sector-level data and targets.

As the Authority agrees a shared approach to UK ETS changes, it is appropriate for the costs and benefits to affected sectors of this policy to be examined at a UK-level. This analysis was undertaken by the Department of Energy Security and Net Zero (DESNZ) with oversite and involvement from the Devolved Governments, and full details can be found in the Authority Impact Assessment attached to the Authority Response. The Authority Impact Assessment provides the overall economic impact across the UK of these changes.

Further detail is set out in section 3 (Costs, Impacts and Benefits).