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Inconsistent and inefficient UK carbon prices

Observation

The United Nations Climate Change Conference will take place in Durban, South Africa, between 28th November and 9th December 2011. Representatives from governments and international organisations will meet to try and agree on ways to reduce global greenhouse gas emissions.

Emissions reduction is like a form of investment, with upfront costs for an expected long-run benefit. Agreeing on who should bear the costs, in what form, and by when, is one of the most complex issues for global politics today. One principle, though, is clear: minimising the total cost of achieving lower emissions requires that it is done in the most efficient way possible. Failing to do this risks resulting in greater costs than need be or even a consequent loss of confidence in carrying through policies to combat climate change. As we describe the UK's current policies leave plenty of scope for improvement.

The damage caused by an individual's emissions affects everyone through climate change effects, but this 'externality' is not taken into account in the private decision of how much to emit. One way for policy to address this is to set an appropriate carbon price and so shift the cost back to the polluter.

A single, consistent carbon price across different sources of carbon emissions (and ideally across countries as well), is a necessary condition for minimising the cost of emissions reduction. To see why, suppose there were a carbon price of £20 per tonne applied to all emissions. This would give firms and households an incentive to carry out measures to reduce their emissions that cost less than this for each tonne of carbon saved. Suppose instead that firms faced a price of £30 while households faced a price of £10. Firms would now engage in more costly measures to reduce emissions, and households would do less. The total cost of reducing emissions by the same amount as before would rise.

Reducing the cost of carbon for households relative to firms might be done with distributional concerns in mind. But it is not at all clear that distributional objectives are best met through variable carbon prices rather than other parts of the tax and benefit system. Furthermore, higher carbon prices for firms may well ultimately fall on households through higher prices or lower wages, but in ways which are much less transparent (and thus harder to compensate for) than direct carbon charges on the household sector.

Existing policies impose both explicit and implicit prices on carbon emissions, which vary greatly across energy sources and energy users. In the UK all electricity produced by burning fossil fuels is subject to the EU Emissions Trading System. Layered on top of this, businesses face the Climate Change Levy (CCL) and the Carbon Reduction Commitment (CRC). The CCL charges firms on the basis of their use of gas or non-renewable electricity. Companies in some industries also get discounts of up to 80% in exchange for making a Climate Change Agreement. The CRC is a trading scheme, which requires firms that exceed a particular threshold of electricity use to purchase allowances for each unit. It has some interaction with the EU ETS, and this layering of trading schemes creates particular complexities. Households are not subject to the CCL or CRC. Indeed, household use of gas for cooking and central heating attracts no carbon tax at all. The figure shows the total carbon prices faced by households and businesses across a number of emissions sources in 2011-12 and 2013-14.

 

There are some things we exclude from the chart below. First, domestic energy is also subject to the reduced 5% VAT rate, so it is effectively subsidised by the tax system. Second, there are additional effects on energy bills of various cross-subsidies for efficiency measures and green energy production, such as the Carbon Emissions Reduction Target and the Feed-In Tariff.

It is not really possible to determine what the effective carbon price is for vehicle fuels. If we assume that all the tax levied on these fuels were there to capture the cost of carbon, then the effective carbon price would be a massive £251.74 per tonne for petrol, and £219.43 for diesel. In reality, most of the social costs imposed by driving take the form of congestion costs, so we should think of much of the tax as capturing these costs rather than emissions.

 

Implicit Carbon Prices

Carbon prices

Note: Only the CCL, Renewables Obligation, CRC, Carbon Price Support Rate, and EU Emissions Trading Scheme are included here. The business rate assumes participation in the CRC.

As can be seen from the figure, taking the current set of policies, for which we can straightforwardly estimate the carbon price, it is clear that households are charged much lower carbon prices than firms, and that gas used for heating is charged a lower price than electricity.

In addition, all users face lower implicit carbon prices on coal-fired electricity relative to gas-fired electricity. Businesses pay £22.20 more, and households £6.90 more, for a tonne of carbon emitted from gas-fired rather than coal-fired electricity. This is because neither the CCL nor the Renewables Obligation (RO) discriminate between non-renewable fuels on the basis of their carbon content, raising the implicit carbon price for the relatively less polluting gas compared to coal.

This inconsistency in carbon prices will continue in the coming years, with the gas-coal differential for business electricity rising slightly to £22.70 in 2013-14. The introduction of the Carbon Price Support Rate (due to be implemented in April 2013) will help ameliorate the dispersion of carbon prices because it depends explicitly on carbon content and applies to domestic and non-domestic sectors alike. But this effect is small, and is offset by the expansion of the Renewables Obligation, which does not depend on the carbon content of non-renewable fuels.

The current system is not the uniform carbon price necessary for emissions reduction to be done in the least costly way, but rather a complicated tangle of policies. Other interventions, such as targeted subsidies and product regulations are likely to be needed to achieve emissions reductions. But there is no reason these should substitute for, rather than complement, a uniform, transparent carbon price.