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Carbon pricing in the United Kingdom

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Nick Stern argued in his influential review that action to mitigate climate change could be carried out at modest cost but that:

"costs will be higher if ... policy-makers fail to make the most of economic instruments that allow emissions to be reduced whenever, wherever and however it is cheapest to do so."

One of the key instruments – but not the only one – is of course the imposition of a carbon price.

An effective carbon price which minimizes costs would have a number of important features:

1) The carbon price should be consistent across different forms of emissions;

2) Policy should be stable and predictable to allow producers and consumers to plan their investments and consumption appropriately;

3) Many would argue that the carbon price should rise over time as the marginal cost of each unit of carbon emitted rises.

Ideally the carbon price should also be consistent internationally since it doesn’t matter where the emissions take place. That’s why international trading schemes such as the EU Emissions Trading Scheme (ETS) ought to have a prominent role to play. The way in which pricing interacts with a range of other policies will also matter. This is not an issue that can be solved by pricing alone.

Almost needless to say, UK policy on carbon pricing doesn’t come close to meeting these basic prerequisites for effective policy. Prices vary dramatically according to the source of emissions and the nature of the consumer. Policy has been notably unstable, providing little certainty for either consumers or industry. In the case of road fuel the effective carbon price has been falling rather than rising. The failure of the EU ETS to bind has made these domestic policies, and policy failings, especially important.

Consistent pricing

The proceeds of environmental levies such as the renewables obligation, contracts for difference, and feed-in tariffs are forecast by the Office for Budget Responsibility to double from about £6 billion in 2015/16 to over £12 billion in 2020/21. In addition, receipts from the Climate Change Levy (CCL) are due to rise from £1.8 billion to £2.2 billion. These are increasingly significant economically. But they do not add up to a consistent carbon price. There are numerous policies, for example, which add to the cost of electricity consumption, but few of these costs are imposed on gas consumption – for which the effective carbon price is close to zero. In fact once one accounts for the fact that VAT for domestic  fuels (both gas and electricity) is charged at only 5 per cent, rather than at the standard 20 per cent rate, gas consumption by households is effectively subsidized. There is a negative carbon price.

The treatment of gas and electricity is becoming more unequal over time as new market arrangements designed to subsidize renewable electricity generation result in a rising price of electricity. Ignoring the implicit VAT subsidy, work by researchers at the Institute for Fiscal Studies, published in 2013, suggested that by 2020 the implicit carbon price faced by households would be well over £100 per tonne of CO2 for electricity consumption – ten times the implicit carbon price for gas consumption. Given the relatively rapid rate of decarbonization of electricity production the price signals are increasingly worrisome – favouring use of carbon-emitting gas over the use of non carbon-emitting electricity.

There are differences in prices also according to end user, with businesses facing a range of additional pricing policies and significantly higher carbon prices than households. It is hard to see any rationale for this beyond a view that it is politically easier to increase charges on business energy consumption than on households. There are also differences between businesses of different sizes and types. Like households, businesses face higher implicit taxes on electricity than on gas, though the Budget 2016 announcement that the ratio between CCL rates for electricity and gas will be rebalanced from 2.5:1 to 1:1 will be a small movement in the right direction.

Even without going through the alphabet soup of different taxes, charges, and initiatives that make up these different carbon prices it is clear that pricing policy is not consistent. The priority for change should surely be to narrow the differential between the treatment of gas and electricity by finding a consistent basis for taxing gas use.

Consistent policy

Policy is not coherent in the way it treats carbon in different forms of energy consumption, and nor is it consistent over time. This inconsistency creates costs and reduces incentives to respond to price signals given uncertainty over how long they will persist for.

Take for example the carbon price support rate. This was introduced in April 2013 specifically to top up the EU ETS carbon price to meet the carbon price floor set by the government. It was intended both to raise the carbon price faced by those covered by the ETS and to create certainty over the carbon price. To do that it set a carbon price floor going forward to 2018. In the face of ETS prices well below intended levels this was, arguably, a defensible policy. There is, of course, the question of its relationship with the ETS itself and the fact that, to the extent that it reduced emissions in the tradable sector in the UK, it would allow more emissions elsewhere in Europe. But as a domestic policy it had some merit.

In the Budget just one year later the plans for a rising price floor were shelved, and a new floor level, not increasing over time, was announced. This sort of reverse clearly undermines the purpose of the policy.

More recently, in Budget 2015, the government announced that the CCL exemption for renewably sourced electricity would be removed. Self-evidently this removes the price incentive for businesses to source low-carbon electricity as well as representing a sudden change in policy direction. That it appeared in the Budget ‘scorecard’ as rectifying an ‘imbalance’ in the tax system, and hence counted towards achieving £5 billion in revenue from ‘avoidance and tax planning, evasion and compliance, and imbalances in the tax system’, may tell us something about the policy making process.

A more welcome change, though a change nonetheless, will be the abolition of the Carbon Reduction Commitment energy efficiency scheme announced in Budget 2016, to take effect from 2019, with revenue recouped from a higher CCL. This will simplify an horrifically complex set of policies – themselves a testament to earlier policy failure.

Taxes on motorists

While most of the policy action has been on energy it remains the case that the biggest environmental tax by far is that on petrol and diesel. From a fiscal point of view this brings in nearly £30 billion a year – far more important than all other environmental taxes and levies combined. Of course this is not just a carbon tax since much the biggest externality created by driving is congestion, and the rates of tax are well in excess of anything that could be justified by carbon emissions alone. 

This is another area of inconsistent pricing policy though. The real tax rate per litre of fuel – and hence per unit of emission – has been falling since 2010 and is currently at its lowest level in 20 years, but given the changes in petrol prices and fuel efficiency, the cost of driving now is lower than it was even longer ago than this. This is a policy choice that looks odd in the context of growing congestion and carbon costs. It is hard to know what the right tax level should be on road fuel, but it should certainly be rising over time. This is also a policy choice which has not been made explicitly or on a long-term basis. Tax increases have been announced and subsequently abandoned with monotonous regularity.

Taxes on car ownership have also been reformed substantially; increasing Vehicle Excise Duty (VED) in the first year of registration for high emitting vehicles, but with a flat rate VED payment in each subsequent year at a level unrelated to CO2 emissions. In part, the reform reflected the extent to which an increasing fraction of new cars were falling into zero and lower-rated VED bands as emissions levels have fallen. Policy needs to adapt to such change. It also reflects a belief in the importance of up front incentives. 

In conclusion

Carbon emissions in the UK are on a downward path. Electricity decarbonization is happening relatively swiftly. Average emissions from vehicles are falling. The first two carbon budgets on the route to the UK’s 2050 target will be more than met. The lack of coherence in pricing, though, risks stalling this progress and making future progress more expensive than it need be. Following policies which subsidize gas consumption, penalize business over households, and reduce the cost of petrol consumption are hard to square with a commitment to reduce emissions at minimum economic cost.

Find out more

This report examines the effect of UK government policies on energy use and carbon pricing.