Purpose, executive summary

This Annex provides an overview of the analysis underpinning the government Free Allocation Review: Carbon Leakage Consultation. This considers the potential adjustment to sectors covered by the UK carbon border adjustment mechanism (CBAM), in Chapter 2 of the consultation. We outline the 3 broad options as presented at consultation, and the analysis underpinning them.

The consultation outlines the approach and any adjustment to Free Allocation for industries covered by the UK CBAM, which government has committed to implementing by 2027. Additionally, the consultation explores interactions with the UK emissions trading scheme (ETS) more broadly, and the possible considerations in recalibrating Free Allocation policy for sectors covered by the CBAM compared to those that are not.

The objectives of the policy outlined at consultation are to mitigate carbon leakage, help UK industry decarbonise, and meet the wider objectives of the UK’s Free Allocation Review. While carbon leakage is affected by several factors, this consultation covers only the adjustment of Free Allocation for CBAM sectors and does not assess other carbon leakage policies. Key conclusions from evidence and analysis in this Annex include:

• A CBAM seeks to charge a carbon price on products in 5 sectors,^{[footnote 1]} when imported into the UK, comparable to the carbon price faced by UK producers. This aims to level the playing field, in terms of carbon costs, for these producers in the UK market, and therefore aims to prevent potential carbon leakage from the UK.
• Both policies aim to address carbon leakage but in different ways: a CBAM raises the carbon costs on imported goods, while Free Allocation lowers effective carbon prices for UK producers. The 2 will therefore have different ultimate impacts and implications for carbon leakage.
• A sectoral effective carbon price^{[footnote 2]} will be charged on embodied emissions for CBAM products. The effective carbon price is reduced by Free Allocation. Free Allocation may therefore be reduced, or fully removed, for sectors covered by a CBAM to allow the CBAM to become effective and as the CBAM provides carbon leakage protection to such sectors.
• We consider the key parameters for CBAM adjustment: start and end year, extent (reduction to zero or partial reduction), trajectory (curve) and sectoral variation. All options considered involve a phased reduction, to support gradual CBAM implementation, and to ensure impacts to business are gradual and therefore lower risk.
• We also explore key decisions necessary to implement the adjustment: where in the Free Allocation Methodology the adjustment will be applied, the precise industries covered,^{[footnote 3]} and whether the adjustment applies at installation or sub-installation level. These points were all considered in the consultation.
• In qualitative assessment, we outline the central trade-off: a faster phase out raises the price signal to both domestic and importers to decarbonise and increases the CBAM effect, but is a sharper cost increase and may create carbon leakage risks. The optimal option will depend on objectives, sectoral characteristics, and policy context.
• In quantitative evidence, we find that CBAM sectors currently receive high proportions of free allocation, meaning the effective ETS cost they face is lower, although this varies by sector and operator. The phased removal of Free Allocation would significantly reduce Free Allocation and increase their effective carbon price.

Introduction

In 2023, the UK Government published a government response to the consultation which confirmed that the government will implement a UK CBAM by 2027.^{[footnote 4]} The CBAM aims to address carbon leakage through charging a comparable carbon price on imported products covered by the CBAM. Carbon leakage is 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. As a result of carbon leakage, the objective of decarbonisation efforts – to reduce global emissions – could be undermined.

Currently, to mitigate the carbon leakage risk for sectors covered by the UK ETS, a proportion of UK ETS allowances (UKAs) are assigned to operators in exposed sectors for free. This reduces exposure to the carbon price for operators receiving this Free Allocation, while preserving the economic incentive for decarbonisation and the emissions cap across the ETS sectors. The UK ETS^{[footnote 5]} Authority committed to maintain current levels of Free Allocation for industrial sectors until 2026, subject to changes in activity.

The UK CBAM aims to ensure that highly traded goods^{[footnote 6]} face a comparable carbon price when imported into the UK. This seeks to increase decarbonisation incentives while protecting against carbon leakage from the UK. In advance of the introduction of the UK CBAM, Free Allocation remains the primary policy for mitigating the carbon leakage risk associated with the UK ETS. With the introduction of the UK CBAM, imports of covered products will be charged a comparable carbon price for embodied emissions, ensuring imports face similar carbon costs and incentives to UK producers. The UK CBAM will apply to the emissions embodied in imports of specified goods in 5 sectors: aluminium, cement, fertilisers, hydrogen, and iron and steel. Although the CBAM is a different approach to carbon leakage than Free Allocation, the 2 policies are closely related. The interaction between the 2 policies will be considered, and consideration will be paid to the wider UK Government carbon leakage policy context.

The liability applied by the CBAM will depend on the greenhouse gas emissions intensity of the imported good and the gap between the carbon price applied in the country of origin (if any) and the carbon price that would have been applied had the good been produced in the UK. CBAM liability will lie directly with the importer of imported products within scope of the UK CBAM based on emissions embodied in imported goods. This system will not involve the purchase or trading of emissions certificates.^{[footnote 7]}

The UK ETS Authority launched 2 consultations on 18 December 2023 on proposed changes to the UK ETS that will ensure it continues to support progress toward net zero across the UK. The Free Allocation Review explores how to better target Free Allowances for industries most at risk of carbon leakage.^{[footnote 8]} The UK CBAM will work cohesively with the UK ETS, including Free Allowances, to ensure imported products are subject to a carbon price comparable to that incurred by UK production, mitigating the risk of carbon leakage.

In this annex to the consultation document, we discuss the broad options for adjustment to Free Allocation for CBAM sectors and assess their carbon leakage risk, impact on ETS effectiveness, technical feasibility, and affordability to government.

Assessment criteria

Other analytical considerations

Consumer impacts and cost pass through:

We primarily assess the impact of options on carbon leakage. Free Allocation can significantly reduce the cost of the UK ETS for participants. The removal of this results in potentially marked increases in production costs. However, these increases to effective carbon prices do not necessarily lead to leakage. In cases where businesses and industries can pass a greater proportion of carbon costs on to final prices, there may be lower leakage risks but still negative impacts to consumers and producers, through higher costs, higher prices and reduced production.

The cost pass through rate refers to how much the market price of a product will increase if carbon pricing raises the marginal cost of production.^{[footnote 10]} If carbon pricing raises the marginal cost of production by £2, and final products increase by £1, there is a cost pass through of 50%. This rate of cost pass through will differ by industry, depending on product differentiation, market conditions, trade, and the presence of competitors. In general, the greater the cost pass through, the greater the potential consumer impact but the lower carbon leakage risk. This is one approach to considering the competitiveness implications of options and distribution of final impacts. While this Annex discusses these impacts qualitatively, the UK ETS Authority will consider these impacts comprehensively in a full Impact Assessment of options alongside the response to this consultation.

Long term vs transitional impacts:

The design of Free Allocation adjustment for CBAM sectors should consider both the long-term impacts (for example, carbon leakage risk when Free Allocation adjustment is complete) and during the transition (that is the period when Free Allocation support is being adjusted towards its long-term value). Both impacts, and their potential interaction, should be considered in the policy appraisal. For example, a relatively faster adjustment results in an earlier increase to effective carbon prices – this may increase the effectiveness of the ETS and raise effective carbon prices, but results in a sharper price shock and lessens the time for gradual business preparedness.

Analytical caveats:

• First, it should be noted that decarbonisation and carbon leakage depend on the package of policies and different mitigation measures in place. Policies should ultimately be assessed according to their wider context of decarbonisation and leakage policies.
• Second, carbon leakage risk is multifaceted and varies for individual industries and firms; variation in impact across and within sectors is likely, depending on market characteristics, cost pass through, competition, and abatement potential. While this Annex aims to highlight this where possible, it does not aim to consider detailed industry variation. Instead, we aim to assess the overall intent and impact of options, considering impact to all affected sectors.

Analytical approach and evidence used

We seek to utilise a range of analysis and evidence to assess the illustrative options and assess the policy context. We present 3 main types of evidence and analysis in this Annex:

Section 1: Adjusting Free Allocation for CBAM sectors

As outlined in the consultation, there are several broad approaches to the adjustment for CBAM covered sectors. We seek to build on this consultation by outlining the several parameters for Free Allocation adjustment, outlining how the adjustment could take place within the ETS and Free Allocation methodology, and illustrating these broad options in more depth.

Technical implementation of adjustment

Adjustment to Free Allocation may increase the effect of the UK ETS through raising the effective carbon price for UK producers.^{[footnote 11]} The UK CBAM subsequently supports the goals of the ETS, by mitigating carbon leakage risks of the ETS, enabling price incentives on domestic and foreign producers. The approach to determining CBAM liability will be calculated on the basis of effective carbon price: the price payable for embodied emissions for CBAM goods or the ‘UK CBAM Rate’. This approach intends to charge both UK and foreign producers equivalent carbon prices for embodied emissions in products sold in the UK domestic market.

As noted in Section 6.36 of the HMT and HMRC consultation of March 2024,^{[footnote 12]} the ‘CBAM Rate’ will be the effective carbon price applied to the embodied emissions, reflecting the explicit carbon price faced in the UK, and adjusting for Free Allowances and other reductions to the carbon price paid domestically.

The government has outlined that it intends to calculate a single CBAM Rate for each sector. This CBAM Rate will account first for the explicit carbon price faced, and then adjust for any policy provided to reduce the impact of the explicit price. This includes adjusting for both Free Allocation (on direct emissions) and Carbon Price Support (for indirect emissions). For this Consultation, on Free Allocation design and potential adjustment, we only consider the Free Allocation adjustment and its impact on the effective CBAM Rate.

Figure 1: Calculation of effective carbon prices for CBAM products

Source: HMT & HMRC CBAM Consultation

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Description of figure 1: Diagram describing the calculation of effective carbon prices for CBAM products:

Base x (CBAM Rate - Adjustment) = Liability

Where:

• Base: Embodied emissions
• CBAM Rate: Effective UK carbon price
• Adjustment: Effective overseas carbon price
• Liability: CBAM liability

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Figure 2: Determining the Effective UK carbon price (CBAM Rate) for a given sector^{[footnote 13]}

Source: HMT & HMRC CBAM Consultation

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Description of figure 2: Diagram showing the support rates and effective direct carbon prices faced by CBAM covered firms.

Indirect emissions price + Direct emissions price ÷ Tonnes of emissions for given sector = UK CBAM rate (for the given sector)

Where:

• Indirect emissions price: Indirect emissions x (ETS + CPS).
• Direct emissions price: (Direct emissions x ETS) x (1 - free allocation adjustment).
• Tonnes of emissions for given sector: Indirect emissions + direct emissions.

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UK Government is developing the methodology for the Free Allocation adjustment within the calculation of the CBAM Rate. We therefore do not outline the precise calculation by which Free Allocation and direct emissions in the UK ETS features in this calculation. Nonetheless, in general, negative adjustment to Free Allocation for CBAM sectors will increase the effective carbon price faced by covered sectors over time, all else equal.

Technical implementation – parameters for adjustment

There are also several options for implementing the Free Allocation adjustment. Some key parameters are discussed below.

Table 1: Free Allocation - CBAM adjustment parameters and options

Parameter	Description
A: Adjustment start year	Year of first adjustment to FA. This could be from first year UK CBAM is effective (2027) or could be delayed for a given period.
B: Adjustment period	The length of transitional adjustment period, from no adjustment to static, long-run value. Some proposals suggest a 10-year transition period, but this could be varied.
C: Trajectory of adjustment	Precise values of adjustment in each year of transition – that is whether decrease in Free Allocation is linear, initially slow and accelerating, or vice versa. Any form of curve is feasible to apply.
D: Extent of adjustment	The static, long-term value of Free Allocation for CBAM-covered sectors. This could be no adjustment (100%), the full removal of all Free Allocation (0%), or some non-zero value adjustment
E: Uniform or sectoral adjustment	The adjustment values could be applied equivalently to allocation for any sub-installation within scope, could be tailored to individual sectors, or varied for sectors in specific circumstances. Most proposals considered here imply a uniform (non-sectoral) adjustment.

We also consider the technical implementation of the adjustment. This would define where and how in the Free Allocation methodology the CBAM adjustment would take place.

Options analysed

This Annex assesses the options as outlined in the government consultation, detailed below. Options should be considered illustrative and could be varied by the above parameters.

The consultation primarily considers phased adjustment to Free Allocation for CBAM sectors over time. The introduction of a UK CBAM is a novel policy and may have significant impacts. A gradual adjustment to Free Allocation for CBAM sectors aims to support policy implementation and minimise risks to industry. The immediate removal of Free Allocation risks introducing a sharp change in incentives and costs to affected business, reducing preparedness and risking adverse impacts. An immediate removal of Free Allocation is therefore not considered here. A phased approach allows adaptation for both business and government and allows for the CBAM effect to increase over time.

Figure 3: Illustrative presentation of options 1 & 2 (excluding delayed 2029 starts)

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Description of figure 3: Line graph illustrating the presentation of options (excluding delayed 2029 starts). It shows the 3 options (linear, accelerated and slow) against 2 EU aligned options (EU aligned linear and EU aligned S-shaped). Detail in text.

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Option 1 – Do nothing

The ‘Do Nothing’ scenario entails no adjustment to Free Allocation to CBAM sectors, with no change to the current methodology for distributing FA. Although changes to the methodology are possible under the ongoing Free Allocation Review, this option excludes any active treatment or adjustment for CBAM covered industries.

Without an active mechanism to reduce Free Allocation for CBAM sectors, Free Allocation coverage may remain high, in some cases near 100%. By extension, the effective carbon price may be near-zero for CBAM sectors, reducing the effect of the CBAM. This may vary by sector, and Free Allocation may reduce through other factors.

Options 2 – Top-down Free Allocation adjustment for CBAM sectors

This option would involve the gradual adjustment of Free Allocation over the course of a given period. This would result in CBAM-covered sectors receiving reduced Free Allocation during and after the adjustment period, and facing higher effective carbon prices, all else equal. This would likely involve adding a Free Allocation reduction factor to preliminary Free Allocation calculation each year for each in-scope sub-installation.^{[footnote 14]}

We present several illustrative adjustment options under Option 2, varying the adjustment trajectory (speed) and the start year, but holding the length of the adjustment period constant at 10 years. These should be considered illustrative and other parameters could also be varied between the different adjustment options.

Option 2.1a and 2.1b (delay)

A top-down linear adjustment would result in a consistent removal of Free Allocation each year of the transition period. For a 10-year adjustment, each year the adjustment factor decreases by 10 percentage points (p.p.), either starting in 2027 for 2.1a (UK CBAM start) or 2029 for 2.1b. Each CBAM-covered installation would see its preliminary Free Allocation multiplied by the 10 percentage points (p.p.) adjustment factor each year, reaching zero by 2036 in option 2.1a and zero by 2038 in option 2.1b.

Figure 4: Linear adjustment implementation; 2027 vs 2029 (illustrative)

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Description of figure 4: Line graph illustrating the linear adjustment implementation: 2027 vs 2029. It shows the 2 options (2.1a linear and 2.1b linear). Detail in text.

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Option 2.2a and 2.3a

We also consider a faster and a slower adjustment scenario. As above, each in-scope sub-installation would have its Free Allocation multiplied by a pre-determined adjustment factor each year, reaching full adjustment by 2036. Delayed versions (not presented) would begin adjustment in 2029.

Broadly, Option 2.2 (accelerated) sees adjustment of 15 p.p. for 4 years, 10 p.p. for 3 years, and by 5 p.p. for 4 years. Option 2.3 (slower) is the reverse. The accelerated adjustment thus increases the pace of Free Allocation removal, increasing the effective carbon price more quickly. This option would present the greatest export risk, but it could potentially positively impact on the ambition of firms’ decarbonisation, due to the higher relative carbon costs.

Figure 5: Fast and slow initial Free Allocation adjustment options (illustrative)

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Description of figure 5: Line graph illustrating the fast and slow initial Free Allocation adjustment options. It shows the 2 options (2.2a accelerated and 2.3a slow). Detail in text.

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Option 2.4a and 2.4b

We also consider potential adjustment trajectories which broadly align with the announced FA adjustment of the EU for the implementation of its CBAM. This begins adjustment in 2026, the first year of EU CBAM, and reaches zero by 2034, as below. There may be advantages to broadly aligning the timing of the UK CBAM adjustment to FA to the EU’s FA adjustment trajectory for CBAM covered sectors.

We outline 2 illustrative approaches to achieve this goal, with each starting in 2027 but reducing more quickly to reach a comparable level to the EU FA CBAM adjustment. Firstly, Option 2.4a shows a linear reduction of equal reduction each year. Option 2.4b shows a ‘S-shaped trajectory, with gradual adjustment at the start and end but with faster adjustment in the middle, as below.

Figure 6: EU adjustment vs options 2.4a and 2.4b

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Description of figure 6: Line graph illustrating the EU adjustment vs options 2.4a and 2.4b. Detail in text.

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It should be noted that while these approaches aim to match the adjustment curve of the EU free allocation for CBAM sectors, several factors may determine the effective carbon prices of the individual ETSs, and the effective CBAM Rates. Therefore, seeking to align adjustment curves may not guarantee comparable carbon prices or scheme outcomes.

Option 3 – Top-down adjustment to non-zero

Option 3 involves phasing down the Free Allocation received by CBAM affected to a certain level, with some Free Allocation retained to mitigate potential carbon leakage risk, such as for exports.

Figure 7 examines an illustrative partial adjustment, with variations in the level of Free Allocation received by different CBAM covered sectors. This variation in the level of Free Allocation received by different CBAM sectors could, for example, be calibrated on their sectoral level carbon leakage risk. Figure 7 does not vary the transition period within which the adjustment factor is applied, or the pace of adjustment between sectors; however, this is purely for illustrative coherence.

Figure 7: Illustrative presentation of delayed Free Allocation adjustment options

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Description of figure 7: Line graph illustrating the presentation of delayed FA adjustment options. Detail in text.

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Section 2: Qualitative assessment of options

We aim to assess each of the broad policy options according to key criteria. This aims to capture the main objectives that Free Allocation adjustment for CBAM sectors aims to meet, and how options differ in terms of impacts. We therefore aim to consider both the rationale for intervention, and the key impacts of options.

While not a comprehensive assessment of all impacts, this section aims to highlight the key trade-offs when adjusting Free Allocation. Importantly, a faster reduction increases the (effective) carbon price signal to both domestic and importing firms, and raises the effect of the UK CBAM, more quickly. At the same time, a sharper cost increase may reduce business readiness and harm competitiveness relative to foreign firms (for example, on export markets), raising leakage risks.

This reflects the fact that a CBAM and Free Allocation address carbon leakage in different ways and are not perfect substitutes. As in Box A (Introduction), Free Allocation lowers the effective carbon price faced by UK producers regardless of destination market. In contrast, an import-only CBAM only covers products imported into the domestic market and (when combined with removal of FA) raises the effective carbon price to both UK and foreign producers. An import-only CBAM provides no protection against carbon leakage into export markets.^{[footnote 15]} Therefore, the removal of Free Allocation and replacement with an import-only CBAM means domestic firms face higher costs resulting from carbon emissions than competitors. As such, the 2 policies are not perfect substitutes and may differ in sectoral competitiveness and carbon leakage. While we identify these potential channels for carbon leakage, this may vary by sector and context.

It should be noted this appraisal does not assume changes to other carbon leakage policies, beyond Free Allocation and CBAMs. Nonetheless, a comprehensive approach may require a package of policies to address carbon leakage risk in future. UK Government will continue to explore alternative approaches to mitigate export leakage as it develops its carbon leakage and industrial decarbonisation measures. The UK ETS Authority will engage with UK Government as it develops approaches in this space to ensure the role of Free Allocations is considered.

Carbon leakage is 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. Carbon leakage is multifaceted, but we primarily consider the competitiveness channel, which acts as follows: a climate policy (such as an ETS) raises production costs above those in other locations; in some industries (typically competitive, traded, and emissions-intense), higher costs lead to lower competitiveness, which in turn may drive industrial relocation or import substitution to jurisdictions with lower carbon costs.

Table 2: Assessment of options against criteria^{[footnote 16]}

Criteria / Option	Do nothing – no adjustment to Free Allocation (FA)	Adjustment to zero (Linear / faster)	Adjustment to zero (slower or EU aligned, delayed)	Partial adjustment to non-zero
Carbon leakage mitigation	[Green] Continues comprehensive carbon leakage coverage for Energy Intensive sectors	[Amber] Faster reduction of FA, a comprehensive carbon leakage mitigation, means leaving potential risk of CL through other channels (if unaddressed) in short run	[Green] Relative to fast adjustment, more gradual adjustment means more time for adjustment and lower carbon leakage risks in transitional period	[White] In short run, similar to any adjustment, dependent on trajectory
Long-run carbon leakage mitigation	[White] As above	[Amber] Export carbon leakage is not covered as FA is adjusted to zero	[Amber] Export carbon leakage is not covered as FA is adjusted to zero	[Green] Potentially lower carbon leakage risks in long-run, if feasible and accurate
Impact on ETS effectiveness	[Red] Doesn’t actively lower FA (although FA may fall through other means): continues support for covered sectors but mutes price signal, lowering decarb incentive relative to adjustment and CBAM. Reduces effect of CBAM as Rate may remain near-zero	[Green] Compatible with broader ETS operation and FA rules. Increases decarbonisation signal through higher effective UK ETS prices initially	[Amber] Compatible with broader ETS operation and FA rules. Slower adjustment means reduced decarbonisation signal relative to a faster adjustment	[Amber] Compatible with ETS operation, but may reduce ETS effectiveness in long-run, and raise issues through the continuation of FA for CBAM sectors, through having 2 closely interacting carbon leakage policies indefinitely
Technical feasibility	[Amber] Feasible for ETS in the short-run, as no direct adjustment to FA required, but in long-run requires ongoing FA adjustment for CBAM	[Amber] Feasible to implement, through adjustment within FA methodology. Precise results to be developed	[Amber] Feasible to implement, through adjustment within FA methodology. Precise results to be developed	[Red] Some difficulties in accurately and clearly deriving adjusted Carbon Leakage Indicator values – see Potential Implementation of Option 3
Affordability & fiscal impact	[Amber] No difference in ETS revenue; implies zero/low CBAM revenues	[Green] Greatest impact to government affordability and revenue through fewer FA allocated and greater CBAM revenues	[Amber] Similar to any adjustment to zero; lower benefits relative to a faster adjustment due to slower CBAM effects and revenue	[Amber] This option is likely affordable to government, but raises lower revenues relative to a long-run adjustment to zero
Other impacts	[White] -	[White] -	[White] -	[Red] Potential risk to consistency with World Trade Organisation Rules and other trade related obligations.

Green: significant benefits or no risk; Amber: potential benefits or minor risks; Red: significant costs or risks; White: NA

Section 3: Quantitative evidence

Potential sector scope for adjustment to CBAM

In line with the prior consultation on the UK CBAM, we base this analysis on the 5 sectors in scope for the UK CBAM: aluminium, cement, fertilisers, hydrogen, and iron and steel.

CBAM scope is based on a set of CN (Combined Nomenclature) product codes, listed for each sector. Scope for the UK ETS, in contrast, applies to a set of ‘regulated activities’ where combustion exceeds a threshold.^{[footnote 17]} The 2 schemes are therefore based on different eligibility, and neither on the basis of specific industry (or SIC4) codes. However, it is possible, and likely necessary, to identify a set of affected industries in order to determine scope for adjustment for CBAM sectors. We identify a set of potential industries for CBAM sectors with any active installation in the UK ETS below:^{[footnote 18]}

Table 3: CBAM sectors aligned to UK ETS industries

CBAM sector	SIC4 / Industry
Aluminium	24.42 (Aluminium production)
Cement	23.51 (Manufacture of cement)
Fertiliser	20.15 (Manufacture of fertilisers and nitrogen compounds)
Hydrogen	20.11 (Manufacture of industrial gases)
Iron and steel	24.10 (Manufacture of basic iron and steel and of ferro-alloys) 21.20 (Manufacture of tubes, pipes, hollow profiles and related fittings, of steel)

Historic Free Allocation for CBAM sectors

We assess the characteristics of these ‘CBAM sectors’ by aggregating UK ETS data relating to the SIC codes within each sector, as in Table 4 below. First, we note that these sectors relate to a relatively small number of installations, between 1 and 20. This means only around 70 installations, at present, would see their Free Allocation adjusted under a UK CBAM. The relatively small numbers of installations underlines that there is a notable potential for annual volatility^{[footnote 19]} in emissions and Free Allocation – and therefore Support Rates – of UK CBAM sectors. We also note there are significant variations in size between the UK CBAM sectors, in terms of numbers of installations, emissions and Free Allocation.

Table 4: Number of installations, emissions and Free Allocation for combined CBAM sectors

	No. installations	Emissions 2021	Emissions 2022	Emissions 2023	FA 2021	FA 2022	FA 2023
Iron & Steel	20	11,870,000	10,110,000	9,380,000	10,320,000	10,280,000	8,640,000
Aluminium	4	160,000	160,000	130,000	140,000	130,000	130,000
Fertiliser	2	1,250,000	640,000	40,000	1,480,000	1,370,000	650,000
Cement	11	6,280,000	5,920,000	5,170,000	5,290,000	5,160,000	5,120,000
Hydrogen	1 [footnote 20]	220,000	170,000	160,000	160,000	160,000	120,000

Source: UK ETS Registry – Compliance Report

Export and downstream leakage risk

As above, the CBAM raises comparable carbon prices on the embodied emissions of imported, covered products, aiming to mitigate carbon leakage from ETS costs in the UK domestic market. However, UK producers face higher carbon prices through the reduction in free allocation, which may have complex impacts in export markets in which UK producers compete.

This impact depends, amongst other factors, on whether the increase in carbon prices improves or reduces competitiveness in the given export market. In some cases, when export markets are covered by a carbon border adjustment (the EU), the higher carbon prices for UK producers of CBAM goods may offer a competitive advantage, through reducing CBAM liability in these export markets, which some other competitors (with unpriced emissions) face. On the other hand, in the case of export market without CBAMs, UK producers may face reduced competitiveness as they face higher carbon costs compared to competitors. In the latter case, there is a potential channel for carbon leakage. By extension, different adjustment options may increase or decrease these effects, depending on the speed of adjustment of Free Allocation: a faster adjustment raises the effective carbon price more quickly and may have larger effects (both positive competitiveness and negative leakage risks) to export markets.

We consider the evidence on the export intensity of UK production in CBAM sectors. Export intensity to non-EU markets could be considered a proxy for potential export leakage risk, albeit as a simple ‘risk marker’ rather than confirmed modelling of expectations of export leakage in any given policy scenario. Nonetheless, those UK sectors with a higher producer share of exports to non-CBAM markets may constitute higher export leakage risks.

Figure 8 shows the export intensity of UK production for the UK CBAM subsectors (SIC4 codes as above).^{[footnote 21]} This compares the value of exported production to EU and Rest of World (ROW) markets, divided by UK domestic production. For example, around a third of basic iron and steel manufacture (34%) goes to export markets, the majority of which is to EU. We differentiate between EU and ROW markets because EU exports may face a lower export leakage risk compared to ROW given the expected implementation of the EU CBAM.

This indicates that some subsectors have very high export intensities (for instance, almost all UK production goes to foreign markets in aluminium production); other sectors have high export intensities (such as, tubes of steel, ), and most other sectors have an export intensity below 20% of total domestic production. This indicates that not all sectors are likely to have an equivalent carbon leakage risk due to their differing reliance on export markets. Nonetheless, all else being equal, we may expect that a slower adjustment may reduce the short-term risk of export carbon leakage, compared to a fast, steep increase in carbon costs. This is because a fast adjustment could lead to UK firms facing significant asymmetries in cost compared to foreign competitors in export markets.

Figure 8: Export intensity of UK industries potentially covered by UK CBAM

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Description of figure 8: Stacked bar chart showing the export intensity of UK production for the UK CBAM subsectors. It compares the value of exported production to EU and Rest of World (ROW) markets, divided by UK domestic production. For example, around a third of basic iron and steel manufacture (34%) goes to export markets, the majority of which is to EU.

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As above, it should be noted that an increase in effective carbon costs for UK producers may have positive and negative competitiveness impacts, depending on export market characteristics amongst other factors. This analysis should be considered as context but not projections of the impact of such policies.

However, the above export intensity figures highlight the EU as the predominant export market for most CBAM goods, and suggests that a CBAM may improve UK competitiveness relative to competitors (with unpriced emissions) into this market.^{[footnote 22]} Nonetheless, ROW markets represent a significant destination for UK exporters for many CBAM goods, suggesting the competitiveness and/or leakage to these countries should be considered, although noting export leakage is complex and dependant on many factors.

Downstream carbon leakage

A similar channel for leakage could be identified for ‘downstream’ products. This arises as UK CBAM products face increased carbon prices if combined with lower Free Allocation. This raises the production costs of UK goods compared to a scenario where full, unadjusted Free Allocation is retained. Any product which uses the CBAM sector as an input to downstream goods may therefore face these higher prices. For example, take a complex downstream product, such as cars, for which several CBAM products are required for intermediate production – such as steel . As in the export example, UK producers of CBAM products may face higher production costs than foreign producers (who do not face comparable carbon prices). These costs flow to firms purchasing CBAM goods, creating a potential asymmetry: producers of the downstream product face lower embodied carbon prices in foreign jurisdictions than in the UK. This creates a potential channel through which production moves to foreign jurisdictions (industrial relocation) or through which the UK imports more of these goods (import substitution). As a result, UK emissions fall while foreign emissions rise.

Potential implementation of Option 3 – adjusted Carbon Leakage Indicator (CLI)

To assess the feasibility and potential values for adjusted CLI values within Option 3 (the partial adjustment of Free Allocation to a non-zero long-term value), UK Government commissioned NERA to undertake an assessment of whether quantitative carbon leakage indicators for CBAM sectors could be constructed to quantify potential export and downstream leakage risk, using primarily public data and through a transparent methodology. This was undertaken as a hypothetical exercise to explore the feasibility of creating a methodology which may be used for Free Allocation adjustment, but should not be considered a full risk assessment, nor an assessment of the wider impacts of this option.

The analysis indicated that it is feasible to develop quantitative indicators for export intensity of UK production from public datasets (as above), using a modified version of trade intensity based on public trade and economic output data at a sectoral level. In contrast, the research found it is complex to build indicators which consistently capture potential downstream leakage risk for UK CBAM sectors with publicly available and transparent data. While further analysis and policy development could explore this, this initial study indicates that it may be difficult to reliably develop robust, clear indicators which comprehensively capture the remaining leakage risk in this scenario – in practice, such indicators may only be able to capture export leakage risk.

Annex A: Technical considerations for application of Free Allocation adjustment

A – Application in the Free Allocation methodology

There is a potential decision as to where in the Free Allocation methodology the adjustment is applied. As noted in the consultation, it is necessary to add or adjust a parameter in the Free Allocation methodology. Whilst it may be possible to adjust an existing parameter, a potentially clearer approach would be to add a new CBAM component to preliminary Free Allocation.

This would be used to calculate the allocation for each installation or sub-installation using an adjusted version of the following equation, with the change marked in square brackets:

FA_si,y = HAL_si,y x Benchmark_si,y x CLEF_si,y x [CBAM_si,y]

Where:

• FA_si,y: Preliminary annual Free Allocation for the sub-installation (si) in year (y) (expressed in UKAs/year)
• HAL_si,y: Historical activity level as determined and verified in the baseline data collection
• Benchmark_si,y: Emissions intensity benchmark
• CLEF_si,y: Carbon Leakage Exposure Factor for the process emissions sub-installation in year y.
• [CBAM_si,y]: Carbon Border Adjustment Mechanism Factor for the process emissions sub-installation in year y, if relevant

In this case, an additional parameter for the CBAM adjustment factor would be applied, only for installations or sub-installations deemed in scope.

The values for this parameter would be outlined precisely for each option, such as the following for the linear option. As a case study, we apply this calculation to an archetypal installation:

Table 5: Potential CBAM adjustment factor

	2026	2027	2028	2029	2030	2031	2032	2033	2034	2035	2036
CBAM adjustment factor	100%	90%	80%	70%	60%	50%	40%	30%	20%	10%	0%
Preliminary FA (before CBAM adjustment) [footnote 23]	1m	1m	1m	1m	1m	1m	1m	1m	1m	1m	1m
Preliminary FA (after CBAM adjustment)	1m	0.9m	0.8m	0.7m	0.6m	0.5m	0.4m	0.3m	0.2m	0.1m	0

If the Support Rate for a given sector started at exactly 100% (zero effective carbon price), and responded exactly to the Free Allocation adjustment, all else being equal (including Free Allocation and emissions), the Support Rate would also reduce linearly in line with the adjustment, with the effective CBAM Rate as the opposite. In this case, in 2030, the sector would face an effective carbon price (CBAM Rate) of 40%.

Figure 9: Support Rate / Effective direct carbon price faced by CBAM covered firms

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Description of figure 9: Stacked bar chart showing the effective direct carbon price faced by CBAM covered firms. Detail in text.

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This Figure outlines the effective direct carbon price in opposition to the Support Rate, for a hypothetical sector which receives an adjustment to its Free Allocation to zero (Option 2). It seeks to highlight the inverse relationship between Free Allocation levels and the effective carbon price faced within the CBAM Rate calculation.

There is also a potential decision as to when in the Free Allocation methodology the adjustment is applied. This primarily concerns whether it is applied as part of the preliminary calculation, and before any final adjustments (such as a Cross-Sectoral Correction Factor), or before. It is likely that the adjustment could take place within the preliminary Free Allocation calculation, as below. In the case of Option 3, an updated long-term value for Free Allocation may be required. The effective carbon price would then be calculated based on historic emissions and Free Allocation.

Figure 10: Broad approach for implementing adjustment

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Description of figure 10: Diagram showing the approach for implementing adjustment:

1. Updated preliminary free allocation calculation for CBAM sectors:
   
   A: Preliminary Free Allocation: calculated as normal through the FA Methodology, bottom-up at sub-installation level.
   B: CBAM adjustment: For installations within scope of the CBAM, FA is adjusted according to a given annual adjustment factor.

2. FA aggregated and confirmed: After adjustment, FA is aggregated, and Final FA is given to operators at the start of a scheme year.

3. Support Ratios > effective direct carbon price > CBAM Rate: calculated based upon historic emissions and FA at an industry level.

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B – Application: whether adjustment applies at an installation or sub-installation level

There is a potential decision as to whether the adjustment to Free Allocation takes place at the installation or sub-installation level. This would consider either that all activity within a given installation as CBAM covered and adjusted – likely by industry NACE4 code – or that activity should be disaggregated to sub-installation level, and CBAM coverage determined for individual products or processes – likely based on Benchmarks. The latter may involve creating 2 different versions of some Benchmarks to reflect that some sectors are CBAM covered and some are not. The UK ETS Authority is seeking further views at consultation.

C – Scope

Finally, there is likely to be a decision as to which specific sectors are considered ‘in scope’ of the UK CBAM and therefore will receive adjustment. This is discussed above in ‘Potential sector scope for adjustment to CBAM’. This section outlines one potential method and set of industries for CBAM scope and adjustment, but it should be noted that other potential methods and levels of application may be derived, such as determining CBAM coverage at the sub-installation or Benchmark level. The UK ETS Authority is seeking further views at consultation.