Essar Oil (UK) Limited

The Role of UK Policy in Preventing Carbon Leakage

As the UK advances towards net-zero emissions, the future of the UK Emissions Trading Scheme (UK ETS) remains a critical policy issue. Recent Government consultations, including “Extending the UK ETS Cap Beyond 2030” (February 2025) and “UK Emissions Trading Scheme: Free Allocation Review: Carbon Leakage Consultation” (December 2024) have highlighted the need for a long-term emissions cap trajectory, a robust Carbon Border Adjustment Mechanism (CBAM) and a recalibrated Free allocation (FA) system. These decisions will significantly influence industrial decarbonisation and the competitiveness of UK industries in a low-carbon economy.

Balancing Decarbonisation and Industrial Competitiveness

The UK ETS has played a crucial role in reducing emissions across energy-intensive industries by capping emissions and gradually tightening allowance supply, encouraging investment in cleaner technologies. However, carbon leakage—where production shifts to regions with weaker emissions policies while imports of high-carbon goods persist—remains a major concern.

Aligning UK ETS and CBAM                                                 

The Free Allocation Review proposes updating carbon leakage risk assessments using UK-specific trading and emissions data rather than EU legacy data. In principle, this shift allows for a more accurate assessment of domestic carbon leakage risks based on real import-export dynamics.

Meanwhile, the UK Government has outlined its initial stance on CBAM, set to apply from 2027 to a limited number of industrial sectors. However, CBAM is currently designed to cover only imports, leaving domestic manufacturers with considerable exports at a competitive disadvantage in global commodity markets, particularly in sectors like oil refining, where carbon costs cannot be passed on. To mitigate this, a revised FA framework ought to retain some level of free allowances for export-oriented sectors. Ensuring CBAM and FA work in tandem will enable decarbonisation without deindustrialisation, preventing emissions from simply shifting overseas while undermining UK manufacturing.

A More Comprehensive Carbon Leakage Risk Assessment

The consultation’s proposal to revise the Carbon Leakage List (CLL) is a positive step, but it lacks a long-term sectoral analysis.

Relying on snapshot figures risks misrepresenting carbon leakage exposure, as trends vary over time. A more effective approach would assess multi-year trends to capture industries with significant and rising carbon leakage vulnerabilities.

“Ensuring CBAM and FA work cohesively—addressing both import and export leakage risks—will help prevent the UK from offshoring emissions while weakening its own industrial base”

This approach would reveal that sectors like oil refining have faced increasing carbon leakage exposure due to shrinking UK production while imports keep rising. Without a refined assessment, some highly exposed industries may remain inadequately protected, while others receive disproportionate allocations.

Recalibrating Free Allocation Beyond 2027

The second phase of UK ETS, beginning in 2027, coincides with CBAM implementation. At this stage, a strategic redistribution of free allowances will be essential, prioritising sectors most at risk of carbon leakage and not covered by CBAM.

A blanket reduction in free allowances would likely accelerate de-industrialisation, shifting production abroad and increasing overall emissions. Instead, allowances should be reallocated to vulnerable industries critical to the UK economy, such as oil refining. Additionally, export-intensive sectors should continue receiving FA beyond 2027 to counterbalance export-related carbon leakage. Under World Trade Organization (WTO) rules, maintaining a level of export-linked FA is justifiable, as it would simply offset a self-imposed carbon levy applied to domestic industries.

A dual approach—CBAM for imports and FA for exports— could offers a pragmatic, WTO-compliant strategy to support decarbonisation while preserving industrial competitiveness. This would also encourage trading partners to implement similar carbon pricing mechanisms, fostering greater global alignment in climate policy.

Ensuring Policy Certainty Beyond 2030

The long-term trajectory of UK ETS remains uncertain. While the consultation proposes extending the scheme into a second phase, crucial details such as cap trajectories, allowance banking and sectoral implications remain unclear. Greater policy certainty is necessary for industries planning major decarbonisation investments, particularly in Carbon Capture, Utilisation and Storage (CCUS) and hydrogen infrastructure.

Conclusion: A Coherent Policy for Industrial Decarbonisation

The UK ETS stands at a critical juncture. Extending the scheme beyond 2030 is essential for maintaining progress towards netzero, but policies must ensure industrial decarbonisation does not compromise economic competitiveness.

A recalibrated Free Allocation system, underpinned by robust carbon leakage risk assessments, is necessary. High-risk sectors not covered by CBAM should receive targeted support rather than facing indiscriminate cuts in free allowances. Moreover, if the UK aims to address carbon leakage effectively, the most vulnerable industries should be prioritised for inclusion in the next phase of CBAM implementation.

Furthermore, ensuring CBAM and FA work cohesively— addressing both import and export leakage risks—will help prevent the UK from offshoring emissions while weakening its own industrial base. Policymakers must adopt a long-term, data-driven approach, avoiding simplistic solutions that fail to account for sectoral nuances. The decisions made now will shape the UK’s industrial landscape for decades, making it imperative to strike a balance between climate ambition and economic resilience.