Energy use policies and carbon pricing in the UK

Headline issue

This policy paper summarises research by the Institute for Fiscal Studies and the Grantham Research Institute on the UK energy policy landscape for both households and business. The paper explores the potential for policy reform, and provides a number of recommendations for improving business and household energy policies.

Key points

• The UK has a complex framework of over 20 taxes and levies on energy use that aim to reduce carbon emissions and other pollutants, ensure cheap and reliable supply, avoid fuel poverty, and raise revenue. This has made UK energy policy inconsistent and in places inefficient.
• The layering of policies over time has led to a substantial variation in carbon prices across users and fuel types: gas has a much lower carbon price than electricity; residential consumers pay lower carbon prices than business; and, among businesses, big energy-intensive firms face a lower price than smaller, less energy-intensive ones.
• The divergence in carbon prices between electricity and gas will continue grow and businesses will continue to face considerably higher prices than households.

Business energy tax reforms

• The European Union Emission Trading System (EU ETS) should be reformed, introducing a price floor and ceiling in allowance auctions and a tighter emissions cap. This would help to reduce the risk for investors arising from present uncertainty about the future price of allowances.
• To simplify an increasingly complicated policy landscape and eliminate inconsistencies, we suggest merging the Carbon Reduction Commitment Energy Efficiency Scheme, Climate Change Levy and Climate Change Agreements into one single instrument, in the form of a Climate Change Ley-style carbon tax (this is discussed in more detail in our paper ‘Climate Change Policies and the UK Business Sector: Overview, Impacts and Suggestions for Reform’)
• This reform is intended to be tax neutral. Any additional revenues raised should be recycled, with a focus on mitigating the effect on trade-exposed, energy-intensive industries.
• The identification of businesses vulnerable to competitiveness impacts as result of policy has generally been too broad. Compensation should be better targeted and more need to be done to determine which sectors are genuinely at risk of significant carbon leakage.

Household energy tax reforms

• Households face lower carbon prices than businesses in large part because of the reduced VAT rate on residential energy consumption. Once this subsidy is taken into account, effective carbon price on household electricity consumption is only £7/tCO2, while for gas the figure is negative.
• There is a strong case for imposing VAT at the full rate on domestic energy consumption, and an additional carbon tax on gas use which would bring the carbon price into line with that on electricity.
• Should the carbon price of households’ gas and electricity be set close to the Government’s shadow carbon price of £59, over £8 billion additional revenue would be generated. Such reform would reduce household emissions by around 8 million tonnes of CO2 per year in the short run, and more than 22 million tonnes of CO2 per year in the long run
• Raising households’ energy prices can be regressive and unpopular. Such a reform therefore will need to be introduced gradually and accompanied by a substantial compensation package, which benefits the poorest.
• Other policies aimed at supporting energy bills, like the Warm Home Discount and the Winter Fuel Payments, could be further reformed to increase their transparency and fairness.