UK ETS Extended to 2040: Long-Term Carbon Price Signals for Industrial Decarbonisation Investment

Key Takeaways

• The UK ETS Authority has confirmed extension of the scheme into Phase II (2031–2040), providing long-term regulatory certainty for carbon-exposed industries
• The annual emissions cap will continue to reduce through 2040, consistent with the UK’s Sixth Carbon Budget (2033–2037) and net zero 2050 trajectory
• Current UK ETS allowance prices (£40–55/tCO₂) are expected to rise as the cap tightens, making early decarbonisation investment more attractive
• Energy-intensive industries — steel, cement, glass, ceramics, chemicals, refining — can now plan 15+ year capital programmes with greater confidence in the carbon price trajectory
• Free allocation will continue but at declining rates, increasing the effective carbon cost for installations that do not decarbonise

The Phase II Announcement

In December 2025, the UK ETS Authority announced the formal extension of the UK Emissions Trading Scheme into Phase II, covering the period 2031–2040. Phase I (2021–2030) had been established as the initial operating period following the UK’s departure from the EU ETS on 1 January 2021.

The Phase II announcement provides three critical elements of certainty:

• Cap trajectory: The annual emissions cap will reduce linearly through 2040, consistent with the UK’s legally binding carbon budgets and net zero 2050 target
• Scheme scope: Phase II will include existing sectors (power, industry, aviation) plus the additions confirmed during Phase I (domestic maritime from 2026, waste incineration from 2028)
• Free allocation: Transitional free allocation for trade-exposed industries will continue but will reduce over Phase II, with the pace of reduction linked to the availability of decarbonisation technologies

Why Long-Term Certainty Matters

Industrial decarbonisation investments typically have payback periods of 10–20 years. A steel producer considering hydrogen-based direct reduction (H2-DRI), a cement manufacturer evaluating carbon capture and storage (CCS), or a glass manufacturer assessing electric furnace technology needs confidence that the carbon price will remain sufficiently high throughout the investment’s economic life to justify the capital expenditure.

Without Phase II certainty, companies faced a regulatory cliff-edge at 2030. Investment appraisals had to make assumptions about post-2030 carbon pricing that were inherently speculative. The Phase II announcement converts those assumptions into a policy-backed trajectory.

Carbon Price Implications

UK ETS allowance prices have traded in the £30–65 range since scheme launch, with the current price around £40–55/tCO₂. The tightening cap through Phase II is expected to put upward pressure on prices, with most market analyses suggesting £80–120/tCO₂ by 2035 and potentially higher thereafter.

For compliance buyers, this price trajectory has direct financial implications:

• A cement plant emitting 500,000 tCO₂/year with 80% free allocation faces a net cost of 100,000 × £50 = £5 million today. At £100/tCO₂ with 60% free allocation, that becomes 200,000 × £100 = £20 million
• A steel plant emitting 2 million tCO₂/year faces proportionally larger exposure. The business case for H2-DRI or CCS becomes compelling at carbon prices above £80–100/tCO₂
• Gas-fired power generators already face full auctioning (no free allocation). Their carbon cost is directly passed through to wholesale electricity prices, affecting all electricity consumers

Comparison with EU ETS

The UK ETS was established as a standalone scheme after the UK’s departure from the EU ETS on 1 January 2021. While the two systems share a common design heritage — both are cap-and-trade mechanisms using auctioned allowances — they have diverged in several important respects since separation.

Price trajectory. UK ETS allowances (UKAs) have consistently traded at a discount to EU ETS allowances (EUAs) since scheme launch. As of late 2025, UKAs trade at approximately £40–55/tCO₂, while EUAs trade at approximately EUR 65–95/tCO₂ (roughly £55–80 at current exchange rates). The UK ETS discount reflects the smaller market size, lower liquidity, and the UK economy’s relatively smaller industrial base compared to the EU-27. Whether this price gap narrows during Phase II depends on the pace of UK cap tightening relative to the EU’s own cap reduction under the Fit for 55 package.

Cap stringency. The UK Government tightened the UK ETS cap in 2023, reducing it by approximately 30% from the original Phase I trajectory to align with the Sixth Carbon Budget. The EU has similarly tightened its cap through the revised EU ETS Directive (2023/959), increasing the annual linear reduction factor from 2.2% to 4.3% from 2024. Both schemes are on accelerated trajectories, but the EU’s larger economy and broader sector coverage mean the absolute cap remains substantially higher.

Free allocation. Both schemes are phasing down free allocation to industrial installations, but at different rates and using different benchmarking methodologies. The EU ETS is implementing a full phase-out of free allocation for CBAM sectors by 2034, with other sectors following a declining benchmark approach. The UK ETS Authority has indicated continued free allocation through Phase II but at declining rates linked to technology availability — a less prescriptive timeline than the EU approach.

Sector scope. The EU ETS expanded to cover maritime shipping from 2024 (under MRV from 2018) and will include building and road transport emissions through the new ETS2 from 2027. The UK ETS is adding domestic maritime from July 2026 and waste incineration from 2028, but has not announced plans for a building/transport equivalent. This means the UK carbon market remains narrower in scope than the EU’s, which affects overall market liquidity and price formation.

For UK businesses that operate across both markets — or that compete with EU producers — the price differential creates strategic considerations. A UK steel producer competing against a German counterpart faces a lower domestic carbon cost but potentially higher CBAM-related costs when exporting to the EU, since no automatic UK ETS cost deduction applies under the EU CBAM.

Sector-by-Sector Impact Assessment

Phase II affects different sectors in different ways, depending on their current UK ETS obligations, free allocation status, and decarbonisation options.

Power generation. Electricity generators have faced full auctioning (zero free allocation) since the UK ETS launch, mirroring the EU ETS approach. Carbon costs are passed through to wholesale electricity prices, adding approximately £20–25/MWh at current UKA prices for gas-fired generation (at a typical emission intensity of 0.45 tCO₂/MWh). Phase II reinforces the price signal for continued displacement of unabated gas by renewables, nuclear, and gas with CCS. Generators with long-term power purchase agreements should model UKA prices of £80–120 when assessing contract economics through 2040.

Industry (steel, cement, chemicals, ceramics, glass, refining). Industrial installations currently receive declining free allocation based on product benchmarks. As free allocation rates fall through Phase II, the net carbon cost for these installations rises even if the headline UKA price remains flat. The combined effect of a rising price and falling free allocation creates an accelerating cost curve. For example, a cement plant receiving 80% free allocation at £50/tCO₂ pays an effective carbon cost of £10/tCO₂ on total output. At 50% free allocation and £100/tCO₂, the effective cost rises to £50/tCO₂ — a fivefold increase. This is the dynamic that makes early investment in CCS, hydrogen switching, or electrification economically rational.

Aviation. Free allocation for airlines ended in January 2026, meaning airlines now purchase 100% of their UK ETS allowances for domestic flights and UK-Gibraltar flights. The full auctioning regime increases the per-passenger carbon cost by approximately £2–8 per domestic flight. Phase II confirms that aviation will remain in scope through 2040, with the cap continuing to tighten. Airlines that invest in sustainable aviation fuel (SAF) blending and fleet renewal with more efficient aircraft will reduce their exposure. Corporate travel managers should treat carbon as a structural cost component in air travel budgets, not a temporary surcharge.

Maritime (from July 2026). Domestic maritime shipping enters the UK ETS from 1 July 2026, covering voyages between UK ports. This is a new compliance obligation for ship operators, who must monitor, report, and verify CO₂ emissions and surrender corresponding allowances. The initial approach is expected to include transitional provisions similar to the EU’s phased introduction for maritime (40% of verified emissions in year one, rising to 100% by 2028). Ship operators should begin emissions monitoring now and model the allowance cost impact on voyage economics. Low-carbon fuels (LNG, methanol, ammonia) provide compliance pathways but require significant capital investment.

Waste incineration (from 2028). Energy-from-waste and municipal waste incineration operators will enter the UK ETS from 2028, following a monitoring, reporting, and verification (MRV) preparatory period. Waste incineration produces approximately 0.9–1.1 tCO₂ per tonne of residual waste processed, with fossil-derived CO₂ (from plastics and synthetic textiles) forming the compliance obligation. Biogenic CO₂ from food waste, paper, and natural fibres is excluded. This creates a direct financial incentive for local authorities and waste management companies to increase upstream source separation and recycling rates, reducing the fossil carbon content of residual waste streams sent to incineration.

Strategic Implications for Business

Investment appraisals: Companies should incorporate a carbon price trajectory of £50–120/tCO₂ (2025–2040) into all major capital expenditure decisions. Projects that are marginal at £50 may become essential at £100.

Allowance procurement: Companies with ongoing UK ETS obligations should consider forward purchasing, hedging, or banking strategies. The scheme allows allowance banking (carrying surplus allowances forward), which means allowances purchased at today’s prices can be used against future obligations at potentially higher spot prices.

Free allocation decline: Companies currently receiving free allocation should model scenarios with 50%, 30%, and 0% free allocation to understand their exposure as free allocation phases down. This analysis should inform the business case for decarbonisation investment.

UK CBAM interaction: The UK CBAM (effective January 2027) is designed to prevent carbon leakage by imposing equivalent carbon costs on imports. As the UK ETS cap tightens and allowance prices rise, the CBAM provides a competitive safeguard for domestic producers — but only for products in CBAM scope (aluminium, cement, fertiliser, hydrogen, iron/steel). Other energy-intensive products remain exposed to import competition from unregulated jurisdictions.

What You Should Do Now

• Update your carbon price assumptions in all long-term capital planning and investment appraisals
• Model free allocation decline scenarios to quantify your future compliance cost exposure under different phase-down rates
• Review your decarbonisation roadmap against the Phase II timeline — does the investment timing align with the policy trajectory?
• Engage with CCUS/hydrogen development programmes — Phase II strengthens the business case for carbon capture and fuel-switching, particularly with the industrial decarbonisation support schemes available
• Integrate UK ETS costs into product pricing to ensure carbon costs are reflected in commercial decisions and customer pricing
• Benchmark against EU ETS exposure — if you compete with EU producers, understand how the UK/EU price differential and CBAM dynamics affect your competitive position

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