What does the October 2018 Budget mean for UK carbon pricing in a no-deal Brexit?

To tax or to trade – that is the question. This carbon pricing conundrum has raged among academics and policymakers alike for several decades now. As the UK is poised to leave the European Union, difficult – and enforced – contingency planning about the future direction of UK carbon pricing is beginning to crystallise. The recently published no-deal guidance on meeting climate change requirements, and yesterday’s Budget announcement, are beginning to give clarity on the future of carbon pricing in the UK if there is no Brexit deal.

To take the first of these: the technical guidance notice on climate change has – for the first time – put forward the implications of a no-deal Brexit in terms of carbon pricing, stating: “In a ‘no deal’ scenario, the UK government will initially meet its existing carbon pricing commitments via the tax system, taking effect in 2019.” Such a move would represent a significant departure from current UK policy. Details are scant as yet, and the notice reports that, “The UK government will publish more details of how it will initially apply a carbon price in a ‘no deal’ scenario at Budget 2018 and legislation will be included in the Finance Bill 2018–19.”

This brings us to the second. The Budget announcement states that if the UK departs from the EU emissions trading system (ETS) in 2019, the Government would introduce a Carbon Emissions Tax to replicate the ETS component. The announcement states that, “The tax would apply to all stationary installations currently participating in the EU ETS from 1 April 2019. A rate of £16 would apply to each tonne of carbon dioxide emitted over and above an installation’s emissions allowance, which would be based on the installation’s free allowances under the EU ETS.”

In the short term, the Government’s notice and budget indicate that a tax rather than an emissions trading system has prevailed. This is a victory for pragmatism as the institutional architecture for a carbon tax already exists. However, given the current price of ETS permits, extrication from the EU ETS has significant implications for carbon prices in the UK. This raises important questions about the efficacy of a future UK carbon tax.

Current carbon prices

The UK has a domestic carbon tax in the power sector, known as the Carbon Price Support, introduced to augment the low carbon price signal UK power emitters would have had to pay under the EU ETS.

The Carbon Price Support was introduced in 2013 at a rate of £16 (€18.05) per tonne of carbon dioxide-equivalent (tCO2e), and was set to increase to £30 (€33.85) by 2020. However, the Government recently decided to cap the Carbon Price Support at £18.08 (€20.40) till 2021 and this was reiterated in yesterday’s Budget. But the Carbon Price Support is just one constituent of the Total Carbon Price, which the Government has indicated it wishes to be around £24/tCO2e.

The Total Carbon Price that power sector emitters face is comprised of the Carbon Price Support plus the price of EU ETS permits, which currently stands at approximately £16.80 (€19). Therefore the Total Carbon Price amounts to approximately £35 tCO2e – £11 higher than the Treasury’s stated target price.

The high price has been instrumental in driving a switch from coal to gas: Aurora Energy Research suggests that the UK Carbon Price Support policy alone caused 73% of the reduction in coal generation from 2012 to 2016. UK power emissions halved in that period, with coal-fired generation’s contribution reducing from 40% to 9% of the total.

Implications for carbon pricing in a no-deal Brexit – and for ‘clean growth’

In essence, the intentions set out in the Budget would maintain the current Carbon Price Support of £18/tCO2e but create an additional new carbon tax of £16/tCO2e. While the power sector would be exposed to both taxes, the new £16/tCO2e tax would only apply to EU ETS sectors. But crucially, the new £16/tCO2e tax is only payable above an installation’s emissions allowance, therefore replicating free allowances from the current ETS and transposing them into a new tax arrangement.

Leaving the ETS will reduce the price of UK carbon emissions by the current value of ETS permits (£16.80/tCO2e) back to the price of the Carbon Price Support  (£18.08/tCO2e). This presents two related questions: will this be high enough to keep coal off the system, and, if not, to what extent would this be reflected in the Budget?

Research by Sandbag has indicated that if the UK’s Total Carbon Price falls from the current level to the Government’s target level (£24/tCO2e), winter 2021 will see 2.5 times more coal burn, making it much harder for the UK to achieve its 4th and 5th carbon budgets. Aurora Energy Research also makes this point, stating that the revival of coal due to increased gas prices and low carbon price could increase gas-to-coal switching and result in 46 million tonnes more CO2 emissions in 2018–27 (to the end of the 4th carbon budget).

What does industry say?

If the UK remains in the EU ETS, it has been mooted that the Chancellor may reduce the carbon price floor in order to hit the target carbon price and mitigate against the loss of industrial competitiveness – a move that would almost certainly be supported by the Manufacturers’ Organisation EEF. EEF previously advocated for “a complete scrapping of the carbon price floor”, which they considered “a business-unfriendly concept in terms of international competitiveness”. Although this has not happened yet, it may in the future, as the Budget stated that from 2021/22 the Government “will seek to reduce the [Carbon Price Support] rate if the Total Carbon Price remains high”. Defining ‘high’ remains an arbitrary exercise and will surely be subject to significant political wrangling.

Given the UK’s leading role in the Powering Past Coal alliance, as well as the fact that the country recently held its first ever ‘Green Great Britain’ week, the optics of reducing ambition could be damaging for prospective investors and to the UK’s reputation on the global stage.

Pre-empting any announcement, three of Britain’s largest power generators – SSE, Drax and Ørsted – wrote to the Chancellor Phillip Hammond in mid-October saying that a carbon tax “will be the cornerstone of delivering the ambition set out in the Government’s clean growth strategy, while providing billions of pounds in revenue to HM Treasury”. Meanwhile a coalition of non-governmental organisations, including WWF, Greenpeace, E3G and Green Alliance, also wrote to the Chancellor, to urge the continuation of the Carbon Price Support mechanism.

While a no-deal scenario could eliminate the need for this difficult and contentious decision, it would simultaneously present another challenge: whether or not to increase ambition for the Total Carbon Price (currently £24/tCO2e) to prevent a coal resurgence. The Treasury appears to have recognised this, as evidenced in the Budget. By indicating that the Carbon Emissions Tax will be set at £16/tCO2e it effectively raises the Total Carbon Price to £34/tCO2e – £10 higher than the Government’s original target price of £24/tCO2e and, significantly, probably high enough to prevent a resurgence of coal in the early 2020s.

This is a welcome move as it has put forward not only a stronger price signal, but also indicates a stronger commitment to achieving the UK’s mandated decarbonisation targets. However, the details are yet to be decided: in 2019 there will be consultations on how the Carbon Emissions Tax will work – but implementation will also begin that year and finalised in 2020. This short termism certainly raises longer term questions over the bankability of the intended tax, given the time period for investment decisions can be much longer than the two year period allocated.

BEIS and the Treasury at odds?

Energy Minister Claire Perry has frequently reiterated her commitment to carbon pricing should there be a no-deal Brexit. Despite the no-deal notice indicating that the UK will rely on carbon taxation as a fall-back, it appears this is seen as a short-term solution – at least within the Department for Business, Energy and Industrial Strategy (BEIS).

Minister Perry recently indicated that there are four long-term carbon pricing options on the table – staying in the EU ETS, implementing a standalone UK ETS, launching a carbon market that is linked to the EU’s, or imposing a carbon tax. She has shown a preference for setting up a standalone ETS that could be linked to the EU market: during Perry’s evidence session to the EU Energy and Environment Sub-Committee, she said that “The intention is, and conversations [within BEIS] are about how do we set up a ‘mirror’ system that is linked to the EU ETS, with current operators in the UK having the same requirements to monitor, report and verify their emissions, as per exit day.” This stance would seem to put BEIS and the Treasury on opposing sides of the carbon pricing debate, with the latter widely seen to favour a tax.

In the event that the UK cannot participate in the EU ETS, the Minister’s preferred option presents a number of questions, which are yet to be answered.

First, is it possible to link a domestic ETS with the EU’s carbon market? Evidence from Switzerland, which has taken this route, suggests this could be a long and drawn-out process. The Swiss have been negotiating for over 10 years and the process is still not complete.

Second, if a domestic scheme cannot be linked with the EU, will there be enough liquidity in a UK-only scheme?

There is a high likelihood that the answer to both questions is no. Therefore, in the long term and in opposition to the Minister’s advocated linked ETS solution, this author concludes that a domestic tax would be more advantageous than establishing a domestic trading system with a view to linking it with Europe’s carbon market.

Considerations for a no-deal carbon tax

The Budget only briefly touches upon the design of a no-deal carbon tax in two key areas:

  • How to extend the existing carbon tax – which is only applied to the power sector – to other sectors that are covered by, and currently trade, ETS permits.
  • How a no-deal carbon tax can replicate the free allocation of permits to at-risk sectors.

However, more details of how this will work in practice will be outlined in the 2018/2019 Finance Bill which will provide details on the following:

  • Provision for the level of the emissions allowance
  • Amending existing emissions reporting requirements to adapt them for the tax
  • The payment and tax collection arrangements

To provide further evidence to the debate, at the Grantham Research Institute we will be examining the relative merits of implementing a carbon tax or a linked ETS to help achieve net zero, building on its previous work on how to make carbon taxes more acceptable.

The views in this commentary are those of the author and not necessarily those of the Grantham Research Institute on Climate Change and the Environment.