A cost-effective balance between taxes on fossil fuel pollution and support for cleaner alternatives

The UK’s new Conservative Government has embarked on a major bout of reform of elements of its energy and climate policies. Although the aim, according to the Secretary of State for Energy and Climate Change, Amber Rudd, is to decarbonise the economy at least cost, there is a danger that the current tinkering with subsidies and taxes affecting renewables will result in incoherence that will hinder efforts to reduce greenhouse gas emissions.

Since the election, the Department of Energy and Climate Change taken the controversial steps of removing subsidies through the Renewables Obligation for onshore wind farms, reducing them for biomass, and consulting on whether to cut them for small-scale solar power.

These sudden changes to policy seem to have been precipitated by new figures published by the Office for Budget Responsibility alongside the Summer Budget which appear to show that the Levy Control Framework, which caps the total level of subsidy for renewables that can be charged each year through electricity bills, is projected to already be at the upper limit of its ‘headroom’ in 2020-21.

At the same time, the Chancellor of the Exchequer announced in the Summer Budget that the Climate Change Levy is being extended to apply to renewable power, effectively turning it into an energy levy. This suggests that Her Majesty’s Treasury may believe that reducing greenhouse gas emissions can be achieved simply by trying to decrease energy demand by raising taxes on consumption, without further policies to encourage a shift to low-carbon sources.

The Budget indicated that the Government will “review the business energy efficiency tax landscape and consider approaches to simplify and improve the effectiveness of the regime”, beginning with a consultation in the autumn.

Ahead of this review, it is essential that Her Majesty’s Treasury and the Department of Energy and Climate Change remind themselves of the overall policy objectives, and understand in particular the complementary relationship between taxes on fossil fuel pollution and subsidies for cleaner alternatives.

At the very heart of the economic analysis is that the price of fossil fuels does not reflect their true costs, including the externalities they create because greenhouse gases and other air pollution damage the health of others through climate change, heart disease, asthma, etc.

The failure to price fossil fuels properly means that the real costs are hidden, and manifested, for example, through climate change impacts and deaths due to air pollution, which kills millions of people around the world each year, and 29,000 annually (PDF) in the UK alone.

These market failures can be corrected through policies that increase the price of fossil fuels to reflect the damage that they cause, hence internalising the externalities. In the case of greenhouse gases, this means introducing a carbon price, either through a cap and trade system or a carbon tax. Further measures may be needed to internalise the other externalities, such as local air pollution.

While pricing these externalities helps to level the playing field for alternatives to fossil fuels, there are other market failures holding back new technologies, hindering, for instance, research and development and infrastructure finance. Some initially expensive, but potentially low cost and profitable, technologies need support to become commercially viable and benefit from learning and experience associated with scaling and deployment.

For this reason, taxing pollution is a necessary but not sufficient policy response and other measures are needed. In many cases, this means subsidies for the development and deployment of low-carbon energy, so that businesses can ‘learn by doing, and by copying emerging best practices. These subsidies are most effective when applied transparently and phased out when the market failures have been overcome, allowing the new technologies to compete with the old incumbents, fossil fuels.

It is not clear that onshore wind and solar have overcome all of the market failures and are now able to compete on a level playing field with fossil fuels. The Contracts for Difference auction earlier this year guaranteed a price of £79.23 per megawatt-hour for electricity generated in 2016-17 by new large-scale onshore wind and solar photovoltaic installations, still well above the market rate, which is artificially depressed by the weak carbon price applied to fossil fuel generators.

This is what the Department of Energy and Climate Change and Her Majesty’s Treasury need to bear in mind. The demand for subsidies from renewables at the moment has been elevated by the low carbon price.

About half of the UK’s emissions of greenhouse gases are covered by the European Union Emissions Trading System. Although Member States have agreed to much-needed reforms from 2019-20, including a new Market Stability Reserve, the carbon price is still less than €10 per tonne of carbon dioxide, and is likely to remain weak for the foreseeable future.

The central scenario projected by the Department for Energy and Climate Change assumes that the carbon price in the traded sector will remain at about £5 per tonne of carbon dioxide until 2020, before rising steeply towards about £78 per tonne in 2030.

The current low carbon price in the EU ETS is considered by the UK Committee on Climate Change and the UK Government to be too low to be consistent with a cost-effective pathway to the goal of the 2008 Climate Change Act of reducing the UK’s annual greenhouse gas emissions by at least 80 per cent by 2050 compared with 1990.

For this reason, the Coalition Government introduced a Carbon Price Floor in April 2013, but announced in the 2014 Budget that the Carbon Price Support Rate would be capped at no more than £18 per tonne of carbon dioxide between 2016-17 and 2019-20.

This means that the carbon price for emissions in the traded sector in the UK is likely to remain inconsistent in the near term with the objective of reducing greenhouse gas emissions cost-effectively. It will also place too much of the burden of adjustment on the rest of the economy – the latest central estimates published by the Department of Energy and Climate Change show that if the carbon price in the traded sector in 2015 is £5 per tonne of carbon dioxide, it should be £62 per tonne in the non-traded sector to be consistent with the long-term emissions reduction target.

A weak carbon price is considered by the International Monetary Fund to be a form of subsidy for fossil fuels. The Fund expects unpriced externalities to contribute significantly to subsidies for fossil fuels, which are projected to be more than $5 trillion globally this year alone.

And the International Energy Agency pointed out that the $548 billion spent worldwide on consumption subsidies for fossil fuels in 2013 was more than four times the $121 billion in subsidies for renewables.

In the UK, the weak Carbon Price Support Rate, together with the reduced rate of VAT on electricity and gas heating for households, artificially lowers the price of consuming fossil fuels. The carbon price is also being undermined by other UK Government policies that are promoting the production and consumption of fossil fuels.

The subsidy for pollution benefits not just consumers but also suppliers of fossil fuels, at the expense of citizens affected by climate change and air pollution. Much of this subsidy goes to overseas companies. For instance, 85 per cent of the UK’s demand for coal in 2014 was met through exports, nearly half of which came from Russia.

As a report published in November 2013, by the Institute for Fiscal Studies, ESRC Centre for Climate Change Economics and Policy and the Grantham Research Institute on Climate Change and the Environment, pointed out, the UK’s carbon pricing system is too complicated and inconsistent, and needs to be made more uniform and simpler.

Therefore, it would be far better if Her Majesty’s Treasury and the Department for Energy and Climate Change considered significantly increasing the Carbon Price Support Rate over the next few years, and extending it to all sectors covered by the European Union Emissions Trading System, not just electricity generators. In addition, it should introduce a single instrument for applying a carbon price to the rest of the economy, at a similar level to that in the traded sector.

These changes would create a stronger and more consistent carbon price across the economy, and lower the implicit subsidy for fossil fuel pollution. They would also reduce the need for subsidies for low-carbon alternatives to fossil fuels and relieve pressure on the Levy Control Framework.

This might create pressures on a small number of UK companies competing with overseas businesses for which energy costs are a determining factor of their location. However, some of the revenue from the increased Carbon Price Support Rate could be used to partly compensate those companies. It is important to note that such companies, while perhaps being of local and regional economic importance, represent only about two per cent of the UK’s GDP and two per cent of the work force, according to the Committee on Climate Change. Therefore the risks to the UK’s economy from taxing greenhouse gas pollution should not be overstated.

Of course, the UK Government should also push for quick and more effective reform of the European Union Emissions Trading System to make it function better and boost the carbon price, which would also help to alleviate potential competitiveness pressures experienced by the UK’s energy-intensive companies.

The UK’s five-year carbon budgets under the Climate Change Act, and associated emissions reduction policies, provide new business opportunities and generate income for investors in the UK by tapping into growing demand for renewable power and energy efficiency investment. The green sector is a vibrant part of the global economy at the moment. The UK Department for Business, Innovation and Skills valued sales in the UK low-carbon and environmental goods and services sector at £128.1 billion in 2011–12, 4.8 per cent higher than the previous year despite the global slowdown. Overall, the UK is a substantial net exporter of green goods and services, including to Germany and China.

As Professor Sir Brian Hoskins and Professor Lord Stern of Brentford pointed out in a recent article, the UK reduced its annual emissions by 36 per cent between 1990 and 2014, while increasing its GDP by 60 per cent over the same period.

If the UK wants to continue to cut its emissions in a cost-effective manner over the next few years, it will need a coherent set of policies that achieve the right balance between taxes on fossil fuel pollution and measures to support cleaner alternatives.