Extending the UK Emissions Trading Scheme to heating and road transport fuels: what role can it play in decarbonising the UK economy?

The UK Emissions Trading Scheme (ETS) entered into operation on 1 January 2021, following the country’s departure from the European Union’s ETS. It is the primary policy to directly reflect the cost of emissions and is integral to achieving the UK’s net zero target.

This report focuses on the potential role the UK ETS could have alongside existing policies were it to be expanded to cover the domestic heating and road transport sectors, two sectors that are hard to decarbonise. The report aims to inform government criteria for assessing UK ETS expansion, including practicality, suitability and distributional impacts across different income groups.

The authors have modelled the impact of extending the UK ETS to heating, road transport, and to a combination of both sectors, using illustrative carbon prices of £40/tCO₂ (low) and £80/tCO₂ (high), to show how different carbon prices may affect emissions from domestic heating and road transport, economic growth, inflation and household consumption. The model also considers an option in which revenues raised from the UK ETS extension are redistributed to households and firms in order to at least partially offset disproportionally greater effects on lower income households.

Main messages

• The modelled contributions to emissions reduction under both low and high carbon price scenarios demonstrate that carbon pricing alone will not be sufficient to reduce emissions to meet the legislated target to reach net zero greenhouse gas emissions by 2050.
• Any expansion of the UK ETS to domestic heating and road transport must be developed as part of a wider package of complementary policies that address specific challenges, including fuel poverty and regressive distributional impacts, as well as investment in infrastructure and supply chains to make low carbon options more attractive for consumers.
• The revenue that could be raised if the high carbon price were applied to both sectors is potentially significant – up to 0.62% of GDP – and sufficient to mitigate distributional impacts for the poorest 50% of households, with surplus to spend on other priorities.
• The modelling shows a bigger impact on emissions reduction from applying a carbon price to domestic heating than road transport. This is because there is currently no carbon price on gas heating, while road transport already sees an effective carbon price via fuel duty.
• However, while carbon pricing has potentially higher salience (a measure of the support towards and effectiveness of a policy) in the heating sector, it results in a disproportionate impact on lower-income households.
• Redistribution of revenues raised from the UK ETS extension to households and firms was shown to significantly increase the ‘fiscal multiplier effect’ (i.e. the impact on GDP), yielding a ‘double dividend’ whereby carbon pricing and revenue redistribution lead to a boost in GDP. Importantly, redistribution to households has very limited rebound effects on emissions (i.e. it does not unintentionally boost them).
• The UK ETS has the potential to assist efforts to decarbonise domestic heating through a phased extension over time, beginning with natural gas and eventually extending to cover other heating fuels, which could also be an effective part of an approach to rebalance electricity and gas prices in the sector.
• In road transport, there is an argument to strengthen existing policies that have already started to enable the decarbonisation of road transport as the most effective approach in the near term.
• Regardless of the decision taken on the UK ETS, revenue collection from road transport is in need of urgent reform, to address the expected erosion of revenues from fuel duty due to the continued electrification of vehicles.