UK Carbon pricing: A taxing issue

A new UK carbon tax goes live this week to encourage low carbon investment from the country’s biggest energy users. Jonathan Grant and Jayne Harrold examine the law of unintended consequences in the latest round of national environmental regulations.

When a US president once said “Governments tend not to solve problems, only to rearrange them”, he could have applied the same thoughts to carbon pricing in the UK.

The Carbon Price Support Mechanism was launched in 2011, to provide a stronger carbon price signal to investors to encourage investment in low carbon power generation. This sounds very sensible, if we want to accelerate the transition to a low carbon economy. But the collapse in European carbon prices since 2011 means that consumers in the UK now face much higher carbon prices than elsewhere in Europe. So the focus of the attention has shifted from investment incentives for renewables to the impact of this mechanism on UK competitiveness.

The Carbon Price Support Mechanism is an additional tax, payable by power generators on the carbon content of fuels used in energy generation including gas, Liquefied Petroleum Gas, coal and oils. The support level is determined two years in advance, and is the difference between the government-set ‘carbon price floor’ and the price of EU Allowances (carbon permits) in the EU Emissions Trading Scheme futures market. Carbon price support, payable from 1 April 2013, will be collected through the UK’s climate change levy regulation.

The initial level of the carbon price floor was fixed at £16 per tonne of carbon dioxide, broadly in line with the EU Allowance price at that time, rising incrementally to £30/tonne by 2020 and £70/tonne by 2030. But Allowances are now trading at a fraction of that level, at around €5 (roughly £4 at current exchange rates).

This dramatic fall in EU carbon prices, together with the incremental increases built into the UK price floor, has led to a sharp increase in the level of ‘carbon price support’, from £4.94 per tonne of CO2 in 2013 to £18.08 per tonne in 2015. 

Coal, which currently accounting for around 40% of the UK’s generation needs, attracts the highest levy. A series unusually severe weather events in the UK has increased demand for energy, and provisional statistics for 2012 show a 31% rise in coal use at power stations since 2011.  

Critics of the support mechanism argue that this incremental tax on fossil fuel fired-generation in the UK represents an undue burden for energy users in the UK – consumer groups are rounding on anything that could add to already rising energy bills - and that the competitiveness of energy intensive industries will be particularly affected. On average, government estimates suggest an energy company could face an additional bill of £130,000 in 2013, rising to £1.1 million in 2020.

Critics also argue that there will be no overall environmental benefit from the mechanism, at least in the short term, because of so-called “carbon leakage” to continental Europe. Because of the way the EU Emissions Trading Scheme works – the overall number of Allowances is fixed in advance – any Allowances not used in the UK as a result of energy savings here will be available for use elsewhere in Europe.

At the same time, whilst everyone understands the wider economic pressures on government and the scale of the low carbon investment challenge, the projected revenues from the scheme - £0.8bn in 2013/14, £1.3bn in 2014/15, and £1.8bn in 2015/16 - are hardly going to touch the sides of what’s needed to fill the funding gap.

Calculating the impact of the support mechanism on energy prices is complex, because generators tend to hedge future commitments. But one thing is clear. If Brussels manages to push through anticipated reforms to the EU Emissions Trading Scheme and we see a recovery in carbon prices in Europe, the combined impact of the two schemes  would burst through the Carbon Price Floor trajectory set by the government in 2011, potentially putting UK business at a double disadvantage.

The answer in theory lies with action at a European level, to address the oversupply in the carbon market that has pushed down prices, not just by individual nations. Higher carbon prices across the board should be good for investment and good for the environment.

In practice, however, it remains to be seen whether there is any appetite in Europe for the sort of prices envisaged in the longer term by the UK price floor. To achieve the emissions targets of an 80% reduction by 2050, many analysts believe that a carbon price of €60-€100 is needed, to drive the level of investment needed in large scale renewables, nuclear and carbon capture and storage.

No matter what your view on the appropriate price, or the policy implications, with an EU Allowance trading today at around €5, you don’t have to be an economist to do the maths.

Read PwC’s quarterly review of global environmental tax and regulation