current economic signals for decarbonisation in the uk · 2019-02-11 · internalising...

This report forms part of the Energy Systems Catapult project ‘Rethinking Decarbonisation Incentives’ co-

funded by the Energy Technologies Institute.

Current Economic Signals for

Decarbonisation in the UK Rethinking Decarbonisation Incentives

William Blyth, Oxford Energy Associates

May 2018

Current Economic Signals for Decarbonisation in the UK

© 2018 Energy Systems Catapult

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Contents

1. Introduction .................................................................................................................................................... 3

Project Scope and Aims ................................................................................................................. 4

Current Economic Signals ............................................................................................................. 4

Implications for Policy – Why Do Variations in Carbon Price Matter? ......................... 5

2. Methodology ................................................................................................................................................. 8

Using Taxes and Subsidies to Calculate Incentives ............................................................. 8

Calculating Emissions Reductions from Low-Carbon Options ........................................ 9

Treatment of Other (Non-Carbon) Externalities ................................................................. 10

Defining a ‘Target Range’ ............................................................................................................ 10

3. Results ............................................................................................................................................................ 12

Price Signals by Sector ................................................................................................................. 12

Notes and Commentary ............................................................................................................... 14

4. Conclusions................................................................................................................................................... 19

Preliminary Conclusions ............................................................................................................... 19

Using the Results Priortise Policy Action ............................................................................... 19

Evidence Gaps and Areas for Further Work.......................................................................... 23

5. APPENDIX: Sectoral Analysis of Incentives ....................................................................................... 24

Upstream ........................................................................................................................................... 24

5.1.1. Electricity Generation .................................................................................................. 24

5.1.2. Other Upstream Energy: Oil, Gas & Solid Fuels ................................................ 31

Downstream ..................................................................................................................................... 35

5.2.1. Transport .......................................................................................................................... 35

5.2.2. Business and Industry ................................................................................................. 39

5.2.3. Residental ........................................................................................................................ 42

5.2.4. Public Buildings ............................................................................................................. 44

5.2.5. Agriculture, Forestry and Other Land-Use (AFOLU) ........................................ 45

5.2.6. Waste ................................................................................................................................. 49

6. References ..................................................................................................................................................... 51



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Glossary of Terms

Downstream sectors These are end-use sectors where fuels and electricity are finally consumed

(e.g. transport, households, businesses etc.).

Dynamic efficiency The efficiency of resource allocation taking account of the dynamic nature

of economic conditions, particularly likely changes in the future, and

balancing outcomes for current and future generations.

Externality During a transaction between two parties, an externality is a cost or

benefit that is incurred by a third unrelated party (or parties).

First best First best policy solutions will lead to optimal outcomes if other prevailing

conditions are also optimal (e.g. perfect markets and rational consumer

behaviour). In practice, if conditions are not optimal, then first best

policies may not lead to the best available outcome.

Internalising

externalities

Ensuring all costs and benefits of all third parties are reflected in the costs

of transactions between two parties.

Price discovery When the costs of transactions between two parties are revealed through

publicly observable price signals. This has benefits to the market since

costs data is a public good.

Static efficiency The efficiency of resource allocation given prevailing economic conditions

at a given point in time.

Upstream sectors These are sectors such as oil, gas and electricity that produce or process

energy vectors, before passing them on to final consumers

Wealth transfer Money or other assets are reallocated between different parties or sectors

in the economy, creating winners and losers, without changing the overall

level of activity or size of the economy. Potential losers may seek to avoid

such losses, creating inefficiencies in the system.



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1. Introduction

Project Scope and Aims

The “Rethinking Decarbonisation Incentives” project aims to develop and articulate a range

of policy options capable of improving the coherence of economic signals for

decarbonisation across the UK economy.

The project builds on the whole system analysis and perspective developed in recent years

by the Energy Technologies Institute (and now being carried forward by the Energy Systems

Catapult). The project will apply a whole system perspective, but within a policy context by

developing credible approaches to market and incentive design for emissions reduction

across the system.

In future stages of the project, policy options will be analysed in detail, taking account of the

range of policy objectives that exist in different sectors. This is intended to inform debate

about options to improve the feasibility and cost-effectiveness of meeting deep

decarbonisation targets, within a broader pragmatic context of industrial strategy, economic

competitiveness concerns and potentially competing policy objectives in different sectors.

This report provides a comparison of the current framework of economic signals for

decarbonisation in the UK. The aim is to explore and visualise the extent of variation in

decarbonisation incentives across different sectors, in order to provide a baseline from which

to assess in more detail the different sector drivers, and future options for policy reform.

Current Economic Signals

In an idealised policy environment, a single price signal across the whole economy would in

principle be the most efficient way to internalise the carbon externality, as long as it could be

combined with other instruments to address R&D market failures and other externalities

(Advani et al., 2013). In practice, ‘first-best’ policy options for other related externalities are

not practicable, and decarbonisation incentives become mixed with other policy objectives

such as raising revenue, supporting particular technologies, protecting industrial

competitiveness and addressing other externalities such as fuel poverty and other (related)

environmental impacts. Also, some sectors may be less responsive than others to carbon

pricing; for example, if there are relatively few affordable decarbonisation options, or where

carbon pricing is less salient to decision-making due to non-price barriers. These factors can

reduce the effectiveness of pure price signals and point to the need for other types of policy

intervention. Variations in economic signals have therefore often arisen for understandable

policy reasons.

However, not all sector variations exist for good policy reasons, and even when they do, they

will tend to lead to a reduction in the ability of the economy to adjust dynamically to



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progressively tightening carbon targets in the most efficient way. Given the very deep levels

of decarbonisation required in coming decades, it is timely to reassess the status quo, and

explore the options for reforming policy/ies in a way that enables carbon goals to be

delivered as efficiently and pragmatically as possible in future decades.

Implications for Policy – Why Do Variations in Carbon

Price Matter?

In a ‘first-best’ policy world, an economy-wide carbon price would in principle be more

efficient than the current patchwork approach to reducing emissions (Helm, 2017). However,

in the real world, carbon pricing does not exist in a policy vacuum, and a first-best world is

not always achievable. The main arguments and counter-arguments for a single carbon price

are set out below.

Arguments for single carbon price Counter-arguments

Short-term: static efficiency and behavioural effects

A single price minimises overall economy-wide

abatement cost because emissions reductions

will be made wherever they are most cost-

effective. Policy-makers do not necessarily know

where the lowest-cost options are, and these

can be exposed through an economy-wide

price.

The static efficiency of climate policies depends

on the extent to which carbon prices are

matched to sectors’ abatement opportunities.

For sectors with high costs of abatement, raising

prices would add to their costs (and lead to

wealth transfer), but deliver little in the way of

short-term emissions reductions. If abatement

costs are known to policy-makers, then

matching prices to sectors’ ability to reduce

emissions can recreate the efficient market

response (at least in the short-term), with less

wealth transfer effects.

A single price avoids policy fragmentation, and

improves efficiency because it avoids firms and

regulators having to manage complex

sometimes overlapping regulations.

However, a first-best policy framework for

carbon also requires a first-best policy

framework for the other externalities and market

failures.

If first-best policies for other externalities and

market failures are unattainable (e.g. due to

political unpopularity, or because the UK is

required to follow international policy

formulations), then it is likely in practice that

special arrangements get made in particular

sectors, and multiple policy objectives again

become clustered together, reducing the

benefits of simplicity of a single carbon price.

At the level of individual projects, a single price

provides more streamlined incentives for project

developers leading to better design particularly

for projects that cut across current policy silos

In some sectors, carbon pricing is not the salient

driver that affects the choices and investments

of individuals and firms. Other types of policy,

such as product standards or mandates are



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(e.g. projects incorporating renewable district

heating with CHP and building efficiency)

required to change behaviour and overcome

barriers.

Medium-term: technology development incentives

A single price mechanism helps price-discovery

which allows all market players to observe and

compete, allowing markets to deliver and

respond dynamically to technology ‘surprises’.

If the required technologies are known, then it

may be more efficient to set targeted incentives

for managing their development and

deployment because risks may be easier to

manage on a targeted basis compared to

economy-wide incentives. This approach is less

likely to lead to breakthroughs in unexpected

sectors / technologies.

Long-term: dynamic efficiency and structural effects

The economy will eventually reshape in

response to price signals, favouring sectors,

activities and behaviours with lower carbon

intensity. Achieving these benefits requires

economic flexibility to deal with the creation of

winners and losers, with some sectors increasing

and some sectors decreasing activity levels,

whilst being beneficial to the economy as a

whole.

Economic restructuring will have regional

growth and employment consequences that

may be difficult to tolerate politically and may

meet labour market constraints in terms of skills

and availability. Additional political pressure is

created by the fact that the rest of the world will

continue to operate with differentiated pricing,

creating competitive disadvantages in some

sectors for the UK. To the extent that political

reality may prevail, e.g. through exemptions and

special arrangements for ‘strategically important

sectors’, this will limit the extent to which a first-

best policy framework would in practice deliver

the expected dynamic efficiency gains.

As the next section shows, the UK currently experiences wide variations in carbon pricing

between sectors. It is beyond the scope of this report to estimate how much more efficient a

first-best policy world might be compared to the current policy arrangements. However, it

can be observed that both sides of the arguments and counter-arguments presented above

have considerable weight. This points to two preliminary conclusions about any possible

transition towards a more consistent set of carbon prices between sectors.

Firstly, such a transition will be disruptive. Some of this disruption will create new

technologies and value, but some of the disruption may be value-destroying, at least in the

short-term. Secondly, the biggest benefits of moving closer to a first-best policy world are

likely to emerge over medium to longer timescales, in response to new technology

development and structural adjustments. This suggests that moves to harmonise price

signals should evolve rather gradually. This report looks at mid-term price expectations (for

2030) as a guideline for the direction of travel of current policies.



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Finally, this report does not focus on specific policy design options, but it is worth

mentioning here some of the complexities involved in implementing a single carbon pricing

or incentive mechanism as these would likely impact on the effectiveness of such an

instrument in practice. The design of a carbon policy instrument requires careful

consideration of multiple, sometimes competing objectives.

In particular, there is a trade-off to be made between setting firm targets for carbon prices

vs. carbon emissions. A carbon tax provides certainty over the carbon price but does not

guarantee what the resulting emissions level will be, whereas a cap-and-trade scheme

controls emission quantities but loses control of the resulting price. If the purpose of climate

policy is to achieve a given level of emissions reduction by mid-century, then the latter policy

might be preferred, but investors may prefer a greater level of certainty over prices,

depending on the type of investment they are making. Hybrid policies, where quantity

targets are set in a cap-and-trade scheme, but with upper and/or lower bounds on prices

allow some of the benefits of both price and quantity mechanisms, but at the cost of greater

complexity. These will be important areas for policy-makers to consider when assessing

options for policy reform, which can draw on considerable body of previous literature.



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2. Methodology

Using Taxes and Subsidies to Calculate Incentives

The economic signals addressed in this report mainly comprise taxes or subsidies on fossil

fuel use or low-carbon alternatives. Specifically, positive carbon prices arise either from taxes

on emitting activities (such as fuel use in road transport), or from subsidies to low-carbon

alternatives (such as rail). Conversely, negative carbon prices arise either from subsidies for

emitting activities1, or taxes on low-carbon alternatives.

Some carbon-emitting sectors and technologies face direct taxes which are easily translated

into a positive carbon price based on the carbon intensity of the fuel. Examples include the

climate change levy, EU emissions trading scheme allowances, and the carbon price support

levied on producers of electricity. Subsidies to carbon-saving generation such as renewables

or nuclear also result in a positive carbon price signal.

Other end-use sectors receive a subsidy on energy use (e.g. reduced VAT on residential

energy use) which translate into a negative carbon price signal, again based on the carbon

intensity of the fuel.

The carbon intensity for direct combustion by end users is determined by the average

national values for each particular fuel concerned (natural gas and other fossil fuels). The

carbon intensity of electricity as far as end-users is concerned is taken to be the average for

the UK electricity system as a whole (this approach follows national emissions reporting

guidelines).

Some taxes and subsidies are explicitly applied with climate change policy goals in mind (e.g.

renewable energy subsidies in power generation), whereas in other cases they are in place

for historic reasons (e.g. reduced VAT rates on domestic electricity and gas consumption).

This report considers provision of a consistent approach across all sectors, by applying the

following principles:

As far as possible, all taxes and subsidies that affect the volume, the price or the carbon-

intensity of a particular sector activity or output should be included.

Incentives are evaluated at the point at which they influence behaviour and investment

decisions by different groups and sectors in the economy:

For upstream energy sectors (i.e. electricity generation and oil and gas

production), the analysis includes direct taxes, tax allowances, subsidies and other

direct pricing signals2.

1 Tax rates that are below general rates for the economy as a whole are also treated as subsidies and indicate a negative implicit carbon price. 2 For oil and gas, this includes allowances against the petroleum revenue tax for more difficult fields



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For downstream end-use sectors, the analysis includes both direct price signals

on downstream emissions, as well as indirect signals from the pass-through of

carbon prices associated with emissions from the upstream production of fuels

and electricity.

It is considered that sectors should in principle be self-sustaining financially, so therefore

tax receipts are calculated net of public expenditure in each sector. E.g. in road transport,

net public income is calculated as gross road tax receipts (mainly fuel duties + vehicle

excise duties), minus total public expenditure on road infrastructure. This net public

income is the quantity used to compare to the level of various externalities such as

congestion, carbon emissions and so on.

VAT at the standard rate (20%) is assumed to be neutral (neither tax nor subsidy) for

carbon. Reduced VAT rates (such as the 5% rate for household gas and electricity

consumption), are treated as a subsidy by OECD, but not by the UK government. Both

approaches are applied to show sensitivity to this assumption.

Prices are based on recent data, or where necessary adjusted for inflation to be

approximately consistent with 2016 or 2017 monetary values.

Electricity market prices are assumed to include feedthrough of the carbon costs of

fossil-based generators which includes both the carbon price support (CPS) at its current

frozen rate of £18/tCO2, plus the price of EU-ETS allowances (EUAs). In this analysis, EUAs

are valued based on average 2017 price of £5.10/tCO2. This total of £23.10/tCO2

represents a carbon price signal for end-users of electricity and producers of low-carbon

electricity, that is additional to the direct taxes and subsidies on those sectors.

Calculating Emissions Reductions from Low-Carbon

Options

Translating subsidies and taxes for low-carbon alternatives into an effective carbon price

requires an assumption about the amount of carbon that is reduced as a result of the low-

carbon activity. The following key assumptions are made:

For renewable and nuclear electricity generation, it is assumed that they are displacing

new CCGT plant which would otherwise be the long-run default plant3 that would be

built in the absence of a carbon price signal, giving an emissions intensity of 0.34

tCO2/MWh of electricity displaced4.

For end-users, energy price signals are assumed to lead to reductions in emissions by

incentivising the reduction of energy consumption through investment in greater energy

efficiency or switching to less energy intensive processes. The effective carbon price

3 This is a slightly conservative assumption. If the counter-factual was that coal plant would instead be built (in a world where there were was no carbon price signal), then a greater level of emissions reductions from these low-carbon sources would be achieved for the same subsidy, implying a lower effective price signal. 4 For data source, see page 5 https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/599761/Background_documentation_for_guidance_on_valuation_of_energy_use_and_greenhouse_gas_emissions_2016.pdf

https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/599761/Background_documentation_for_guidance_on_valuation_of_energy_use_and_greenhouse_gas_emissions_2016.pdf

https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/599761/Background_documentation_for_guidance_on_valuation_of_energy_use_and_greenhouse_gas_emissions_2016.pdf



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associated with a particular energy tax or subsidy is calculated using the carbon intensity

of each fuel. For electricity, it is assumed that current end-user reductions in

consumption will save the average current level of emissions per unit for the electricity

system, giving an emissions intensity of 0.352 tCO2/MWh5.

For rail transport, it is assumed that the displaced activity is the equivalent level of road

transport (either passenger-km or t-km for freight) at the relevant national average

carbon intensity. Further details are given in Appendix Section 3.

Treatment of Other (Non-Carbon) Externalities

In several cases, taxes or subsidies may address more than one externality. In the case of

transport, these other non-carbon externalities such as congestion have been quantified by

other studies (e.g. Johnson and Stoye, 2012). This allows a range of results to be presented

for the effective carbon price which depends on assumptions about the degree to which

these other externalities are priced into the particular tax or subsidy being considered.

In the case of renewables, subsidies could be considered to address climate externalities or

market failures relating to lack of investment in technology development (or a combination

of the two). In this case, it is not straightforward to assess the degree to which taxes or

subsidies should be attributed to each of the externalities involved, and the scale of R&D

externalities in the market is not readily quantified. In this case, the subsidy is attributed

entirely to carbon, but recognise that this will lead to an overestimate of the effective carbon

price that the subsidy represents.

Defining a ‘Target Range’

Whilst it is difficult to define exactly what the price of carbon should be, various estimates of

the social cost of carbon and other approaches to forecasting carbon prices have been

undertaken. These provide a useful benchmark for this analysis, helping to place discussions

of price harmonisation within a context of whether prices in different sectors are likely to

need to rise or fall over time.

IMF (2013) used a figure of $25/tCO2 for the present-day value of carbon, based on 2010

reports by the US Interagency Working Group (IWG) on Social Costs of Carbon. IWG

estimates for the 2020 value of carbon have since been revised upwards in 2016, with a 5%-

95%’ile range of $6-140/tCO2, average $42/tCO2 (approximately £30/tCO2) at 3% discount

rate6. Looking slightly further ahead, BEIS calculates a carbon price range of between

£40-119/tCO2 as being required by 2030 to be on track for mid-century decarbonisation

5 BEIS; UK Government GHG Conversion Factors for Company Reporting 2017 6 Estimates for the social cost of carbon are very sensitive to the discount rate because it is used to discount all future climate damages, and those that occur in the very long-term count for little at current value if high discount rates are used. The IWG uses three different discount rates, with 3% as the central case.



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targets. This relatively wide range reflects uncertainty over the cost of abatement and the

global pathway to 2050.

This analysis takes this latter 2030 BEIS price range as a ‘target’ range. Although the

timeframe for this analysis is to look at current subsidies, a medium-term comparator for the

target range is used because in practice it would take some time to achieve convergence of

economic signals across different sectors and a mid-term target helps identify where

subsidies or taxes may need to be raised or lowered to achieve greater consistency across

sectors and activities.



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3. Results

Price Signals by Sector

Figure 1 shows the range of carbon price signals within each sector / technology category.

The legend is as follows.

Orange bars represent sectors / technologies which are receiving a subsidy as a result

of policy interventions;

Purple bars represent sectors / technologies which are subject to a tax.

The blue diamonds show the level of emissions from each sector (in M/tonnes CO2e

pa), to show the importance of the sector as a component of total emissions.

The green horizontal shaded band indicates the ‘target’ range of carbon prices based

on BEIS projections for 2030 of £40-119/tCO2.

There are a number of different reasons for the ranges in estimates reflected in the following

colour-coding for the price ranges:

Solid shading: the range of prices faced by different projects or different companies

within a particular sector / technology category;

Striped shading: tax or subsidy may or may not qualify as a carbon price signal (e.g.

reduced VAT rates on domestic electricity consumption, or lack of VAT on air travel)

depending on assumptions;

Graduated shading: tax or subsidy is attributed to climate externalities as opposed to

other externalities (e.g. congestion externalities in road transport) depending on

assumptions.

The range of values for each sector shown in Figure 1 is explained briefly in the table in

section 3.2, (with further details in the appendix).



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Figure 1. Effective carbon prices and emissions by sector7. Source: author calculations, see Appendix for details.

7 Chart amended 18/07/2018: a) values corrected to 2016/2017 prices, b) low carbon power generation figures only include new or recently built plant, c) include feedthrough of CPS and EUA prices to electricity prices.



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Notes and Commentary

Upstream

Sector

Category Methodological note (further details in

Appendix)

Commentary on results

Renewables Solar, wind,

biomass CHP,

advanced

conversion

technologies8

and other

energy from

waste.

Renewables subsidies are based on the

Round 1 and 2 CfD strike prices adjusted for

inflation, plus the feedthrough of CPS and

EUAs to final electricity price. Carbon savings

are based on displacing long-term marginal

system plant, CCGT.

The entire subsidy is attributed to carbon

externalities. No attempt is made to separate

out those components of the subsidy which

could be attributed to R&D or early-market

barrier externalities. Doing so would reduce

the resulting effective C-price.

The results for renewables technologies span quite a wide range

because costs are generally coming down quite significantly over

time, and the range represents the difference between different

rounds of the CfD auction (see Appendix Section 1 for further

details).

The upper end of the subsidies for renewables projects for Round 1

are mostly above the target range, except for solar PV which falls

roughly within the target range. The range is based on different

prices received at auction. The most recent CfD auction results for

advanced combustion, biomass CHP and offshore wind are roughly

within the target range of carbon prices.

Other

Electricity

Nuclear Nuclear subsidies are based on the CfD strike

price for Hinkley Point C adjusted for

inflation, plus the CPS and EUAs. Carbon

savings are based on displacing long-term

marginal system plant, CCGT.

Decommissionng costs are included in the

CfD price, but are uncertain. No allowance is

made here to adjust for possible future

The effective carbon price for Hinkley Point C is above the target

range. The range shown underestimates the cost uncertainties

associated with new nuclear, see Appendix for further discussion.

8 Advanced conversion technologies are gasification and pyrolysis technologies, for treatment of residual waste as an alternative to landfill or mass-burn incineration



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Upstream

Sector


Appendix)


public expenditure liabilities that might arise

if these costs are higher than budgeted.

FiTs Feed-in tariffs (FiTs) apply mainly to smaller

renewables projects which attract widely

varying subsidies according to project size.

These are the published FiT prices, rather

than the prices at which projects are actually

built.

Prices span a wide range extending from well above to well below

the target range, although the lowest end of the range may be too

low to attract investment.

Coal, gas and

other fossil

The main tax for these technologies is the

CPS and EUAs.

Combination of CPS (£18/tCO2) plus EUAs at 2017 average values

(£5.10/tCO2) result in total effective price of £23.10/tCO2 is below

the target range for 2030. However, EUA prices have risen

significantly in the first half of 2018, which if continued, could start

to close the gap.

Other

Upstream

Oil and gas

E&P and

solid fuels

Upstream energy activities receive some

subsidies such as relief against the petroleum

revenue tax for some smaller oil fields.

The denominator is the emissions specifically

from upstream operations (rather than the

carbon content of the fuel produced).

Subsidies for emitting activities imply negative effective carbon

pricing.



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Downstream

Sector


Appendix)


Transport Road The main taxes are fuel duties and vehicle

excise. Subtracted from this income is the

level of public expenditure on road

maintenance to give a net public income. The

remaining tax income can be assigned to

externalities, of which congestion is the

largest but neither fuel duties or vehicle

excise are well targeted to address

congestion. Results therefore depend

strongly on assumptions about attribution of

taxes to congestion vs. climate externalities.

Road transport is a major emitter and may be either over-taxed or

under-taxed (relative to the target range) depending on how other

externalities (in particular congestion) are accounted for. Given the

importance of road transport, both in terms of its emissions levels,

and as a source of revenue from fuel and vehicle excise duties

(and the subsequent decline in revenues if there is a structural

shift to electric vehicles), this sector needs very careful

consideration.

Rail In terms of emissions reductions, the use of

rail is assumed in this report to replace road

transport. Carbon savings are based on the

average carbon intensity in the UK of

passenger and freight transport for each

mode. Subsidies for rail are based on total

public expenditure less total public income

from national statistics. As for road transport,

assumptions about congestion externalities

have a large impact on the results.

Rail transport is quite heavily subsidised in relation to its carbon

reduction impacts. The top end of the range assumes that public

subsidies are combined with foregone income from avoided road

journeys, and that no contribution is made to reducing road

congestion or any other social goals (e.g. regional development).

The lower end of the range excludes foregone tax revenue from

avoided road journeys and includes reduced congestion. A mid-

point estimate assuming both forgone tax revenue from car

journeys AND rail’s contribution to reducing congestion puts the

effective carbon price signal at £364/tCO2. This is based on annual

average congestion externality costs. Using peak congestion

calculations could give a very substantially lower figure.



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Downstream

Sector


Appendix)


Air Air travel attracts a passenger duty, but does

not include VAT. The upper end of the range

assumes that passenger duty is taken on its

own to represent an energy / carbon tax. The

lower end of the range assumes that the lack

of VAT is effectively a subsidy on air travel.

The assumption about whether or not the lack of VAT constitutes

a subsidy has a very large effect on the calculation of effective

carbon price. The lower end of the range indicates considerable

negative carbon price, whilst the upper end of the range indicates

that passenger duties per unit of fuel are equivalent in carbon

terms to the lower end of the target carbon price range.

Business

energy use and

industrial

emissions

The range of energy taxes paid by business

on gas and electricity is taken from CCC

analysis on energy pricing. The differentiation

of taxes is mostly by size and type of

business, with lower taxes levied on large,

trade-exposed companies receiving

compensation for the costs of low-carbon

support schemes in the upstream sectors.

Prices on solid and other fuels is based on

climate change levy rates for those fuels, and

the upper limit also includes EU-ETS

allowance prices paid by eligible sectors.

In the business sector, electricity use is taxed quite strongly for

small businesses, and lightly for large businesses due to concerns

about international competition. For all business types, gas use

appears to be relatively under-taxed. Likewise, there are a number

of non-combustion GHG sources from refrigerants which appear

to be under-taxed. Industrial process emissions of greenhouse

gases are included in the EU-ETS and incur the cost of EUAs.

Residential

energy use

Energy and carbon taxes are taken from CCC

analysis on energy pricing.

The key variable in the residential sector is

the assumption about whether or not

reduced VAT rates for electricity and gas (5%

rather than 20%) constitute a subsidy.

In the residential sector, electricity use is either appropriately

taxed, or under-taxed depending on whether the reduction in VAT

rate is considered as an effective carbon subsidy.

Residential gas and other heating fuels appear to be under taxed,

especially if the reduced VAT rate is taken into account, and this

constitutes an important source of emissions (circa 12% of total).



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Downstream

Sector


Appendix)


Public sector

energy use

Energy and carbon taxes are again taken

from CCC analysis on energy pricing.

The effective carbon price for electricity taxes are towards the

upper end of the target range, whilst for gas, it is below the target

range.

AFOLU Agriculture Two main types of subsidy are provided via

the EU common agricultural policy. The first

are single farm payments, which are not

linked to production, but based on farm size.

The second are rural development grants

which aim to incentivise environmental

improvements of agricultural land.

Agriculture is an important source of emissions (51mtCO2e direct,

plus 12mtCO2e from land-use change), but is excluded from the

EU-ETS and other pricing mechanisms, and therefore appears to

be significantly under-incentivised to reduce emissions at present.

Whilst agricultural subsidies are not directly tied to output (and

therefore arguably should not be treated as subsidising

emissions), they nevertheless help to maintain the financial

viability of farming activities, and therefore will tend to lead to an

increase in activity in the sector, which would effectively represent

a subsidy to emissions. The range of carbon prices shown in the

chart reflects simple metrics of sector subsidies and associated

emissions. The assumptions made in this initial analysis are set out

in the annex.

Waste disposal Landfill The main tax operating in this sector is tax on

land-fill gas (LFG), amounting to £987m 2015.

LFG emissions for this year were 12.1mtCO2,

giving an average tax rate of £81.5/tCO2.

The LFG tax is broadly within the target range.



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4. Conclusions

Preliminary Conclusions

The analysis in the previous section shows that the UK currently has quite wide variations in

carbon pricing, and suggests that the following sectors have prices that are in general below

the target range:

Agriculture

Coal and gas consumption in electricity generation

Some of the lowest-cost PV schemes

Natural gas consumption by all main end users (residential, business and public

sector)

Electricity consumption in residential sector and large businesses

Other sectors with relatively low prices which have smaller individual emissions, but which

are significant collectively include the upstream oil and gas sector, business and industrial

emissions from combustion of liquid and solid fuels and emissions of non-CO2 greenhouse

gases, and land-use change.

The analysis suggests that sectors which have prices above the target range in relation to

emissions reductions include:

Rail transport

Historical renewables projects9

Nuclear power

Possibly road transport (if congestion and other externalities are not valued

subtracted from the tax revenues received)

Sectors where current pricing is broadly aligned with expected target prices for 2030 include:

Solar PV and the most recent offshore wind bids of CfD auctions

Possibly road transport (if congestion and other externalities are valued and offset

against tax receipts)

Using the Results to Prioritise Policy Action

As noted in the introduction, carbon pricing has different impacts over different timescales.

Whilst in the long-run it would lead to dynamic efficiency improvements by encouraging

structural shifts to low-carbon activities, the short-term impacts will depend on the saliency

of pricing. Saliency is the extent to which decisions and behaviours that drive emissions in

each sector are sensitive to pricing. Saliency depends on the degree to which behaviours and

investments are sensitive to price signals in general, the degree to which a change in carbon

9 This conclusion assumes that the entire subsidy is attributed to carbon externalities rather than other externalities such as R&D externalities.



20

price will materially affect these price signals, the availability and cost-effectiveness of low-

carbon alternatives, and the timescale over which such investments are made (e.g.

depending on the lifetime of equipment / infrastructure being invested / replaced).

According to analysis by Michael Grubb (Grubb, 2014), three different economic domains

apply to energy transition:

Short-term economic processes driven by behavioural economics which can drive

behaviour away from equilibrium expectations (e.g. due to barriers, herding and

other effects).

Medium- to long-term economic processes that tend towards equilibrium based on

prevailing price signals

Long-term processes that respond to evolving economic and institutional structures,

as well as the physical infrastructure and environmental conditions.

Pricing effects tend to be dominant in the second of these, and less relevant or salient in the

other two. These issues of saliency therefore need to be taken into account when

considering options for policy reform.

Detailed analysis of saliency is beyond the scope of this report, but this section offers a brief

overview of some of the key drivers in different sectors to assess where action on pricing is

likely to have more effect, combining this with the results of Section 3 in order to help steer

further work on prioritising policy action. Based on the analysis of carbon prices and other

policy drivers set out in section 5.3, comparisons are drawn between sectors regarding the

level and salience of effective carbon-price incentives to investment and operational

behaviour affecting emissions in each sector. To aid comparison across sectors, Table 1 uses

the following colour coding:

Carbon pricing:

Below target range

Within target range

Above target range

Potential

Salience:

High salience

Moderate salience

Low salience

Partial or diagonal shading indicates the range of variation in the sector.

Blue or red shading in the C-price column indicates that policy action may be justified to

introduce or adjust the level of effective carbon prices in those sectors. The shading in the

salience column indicates how effective such policy action might be in directly influencing

emissions-related behaviour or decisions. Sectors with high potential C-price salience will

tend to see relatively strong carbon emissions impacts from a change in effective price.



21

Red shading in the salience column indicates that action might be expected to have

relatively strong effects, with less impacts for sectors shaded yellow or green.

Table 1. Summary conclusions and comparisons between sectors

Sector 2015

Emissions

mtCO2/yr

Sub-sector /

technology

C-price

relative

to target

range

Salience of carbon pricing (initial

assessment relative to other drivers)

Power

sector

105 Fossil fuels Investment and operational decisions highly

sensitive to fuel and carbon prices

Mature low-C Mature renewables starting to compete on

price, so future investments are sensitive to

feedthrough of c-price to wholesale elec.

price.

Emerging low-C Carbon pricing is relevant to the long-term

viability, but emerging technologies likely to

require other policy support, so other drivers

may be more important in the short-run

Other (UK-

based)

upstream

energy

34 Oil, gas & solid

fuels

Emissions levels from upstream UK energy

sectors relatively low compared to

downstream, so sector driven more by end-

use prices. Nevertheless, subsidies do affect

production decisions.

Transport 170 Road & rail

Higher fuel prices drive more efficient

transport choices, so C-prices are salient, but

transport externalities dominated by

congestion which are poorly targeted by

current policies.

Air Evidence on the impact of c-pricing on

demand for air travel is mixed. Air travel is

currently under-taxed, since tickets do not

attract VAT, though this is partly

compensated by passenger duty.

Business &

industry

157 Large energy

intensive

industries

Large energy intensive industries are

sensitive to energy and c-pricing. Process

emissions are often hard to mitigate. Key

driver in the sector is international

competition and pricing, making the sector

politically sensitive.



22

Sector 2015

Emissions

mtCO2/yr

Sub-sector /

technology

C-price

relative

to target

range

Salience of carbon pricing (initial

assessment relative to other drivers)

General elec use

Electricity and gas use is usually not a

significant proportion of overall business

costs, but companies are sensitive to energy

and carbon prices, and higher prices

incentivise efficiency & behavioural change.

General gas use

Residential 112 Electricity

Higher energy & carbon prices help

incentivise efficiency and behavioural change

& development of alternative technologies,

but many other barriers exist particularly in

tenant-landlord situations. Energy prices

politically sensitive.

Gas

Public 15 Electricity Electricity and gas use is usually not a

significant proportion of overall costs, but

higher prices incentivise efficiency &

behavioural change.

Gas

AFOLU 63 Agriculture Emissions uncertainties are high, but a new

reporting regime is being implemented

which could provide basis for future C-

pricing regime. Sector has various abatement

options available including potential land-

use choices with different emissions levels.

+7

-26

Other Land-use change has high levels of

uncertainty over emissions levels, making c-

pricing difficult.

Waste 18 Landfill Landfill tax driven by several externalities,

and waste management decisions driven by

multiple objectives on recycling policies &

targets etc. Uncertainties in emissions may

make carbon pricing impracticable.

Other Emissions relatively complex to measure and

uncertainties are high, making c-pricing

difficult.



23

Evidence Gaps and Areas for Further Work

This report provides an initial evaluation across the economy of effective carbon prices,

policy drivers and the salience of carbon pricing. The report identifies a number of areas

where more work is required, either because the results are very sensitive to a few key

assumptions, or because there appear to be evidence gaps. The most significant of these

areas include:

Road transport. Assumptions about the treatment of congestion externalities is a strong

swing item. Further work is required to assess the degree to which better targeted road-

use or congestion charging and charges for other externalities such as air quality, could

lead to a reduction in fuel duties, and the extent to which changes in how motoring is

paid for could affect carbon emissions. Longer-term sector transition scenarios away

from liquid fossil fuels also need to be investigated to explore further the relationship

between revenue raising and carbon pricing in the sector.

Rail transport. Congestion externalities are also a large swing item in calculating the

effective carbon price in the rail sector, as well as assumptions about what emissions are

avoided. A more detailed assessment is required of the true extent of rail’s contribution

to reducing congestion externalities in order to refine these assumptions.

Air transport. The treatment of VAT for air transport is the assumption with the biggest

impact on c-price estimates. Further work is required to achieve more accurate

accounting for the link between emissions, fuel use and passenger ticket values.

Agriculture. Further work is required to assess the extent to which farm subsidies act in

practice as a production subsidy, despite being formally de-linked from production

levels. In addition, the salience of carbon pricing in the agriculture sector needs further

assessment, to judge the extent to which increased carbon prices or other economic

instruments could help incentivise lower emissions, or whether other policies would be

more effective.

Relative cost of emissions reductions in all sectors. The short-term impact of carbon

price changes in a given sector will depend at least to some extent on the abatement

costs in that sector, and it would be useful to assess relative costs in different sectors to

see where the short-term gains / response may be strongest. A starting point for such

analysis would draw on work such as that undertaken by the Committee on Climate

Change (2015) in their sectoral analysis for the 5th carbon budget, which could be

extended through additional modelling work.

Long-term structural adjustments. In the long-run, the economy would adjust to a

harmonised carbon price through longer term technical and structural change, including

by changing output levels from different sectors. Further work on the likely impacts of

such adjustments would help inform the policy analysis, particularly helping to identify

where sectors are most exposed to international variations in the stringency of carbon

policies.



24

5. APPENDIX: Sectoral Analysis of Incentives

This section provides a brief summary of the decarbonisation incentives and other salient

economic drivers for each of the main sectors identified in Figure 1.

Upstream

5.1.1. Electricity Generation

Historically, there has been a relatively complex set of subsidies and decarbonisation price

signals in the electricity sector. However, for current projects, these now boil down to four

main policy instruments, carbon price support (CPS), EU emissions trading scheme

allowances (EUAs), contracts for difference (CfDs), and feed-in tariffs (FiTs), described below.

The CPS is a tax paid for combustion of fossil fuels in the electricity generation sector (Hirst,

2017), frozen in the 2014 and 2016 budgets at a rate of £18/tCO2. In addition, fossil fuel

generators have to purchase EUAs to cover their associated emissions. In the analysis

presented in Figure 1, this is included at average prices for 2017 (£5.10/tCO2), giving a total

tax rate of CPS + EUAs of £23.10/tCO2. In practice, this figure goes up or down according to

the EUA price, which has been rising in the early part of 2018. Both CPS and EUA prices are

assumed to feed through directly to the market price of electricity, since fossil fuels-fired

generation tends to be the price-setting marginal plant on the system.

Low-carbon generation sources receive an additional subsidy through CfDs which guarantee

a fixed payment per unit of electricity (the ‘strike price’) generated for large-scale generation

from low-carbon energy sources such as renewables and nuclear power. The subsidy

element of CfDs is a top-up over and above the market price for electricity. For the purposes

of these calculations, the current market price has been taken as £41/MWh, as used in the

CfD strike price methodology (BEIS, 2016a). Since the market price also includes the CPS and

EUA prices, renewables and nuclear see an effective carbon price signal equivalent to the

top-up level (strike price minus the market price), plus the CPS and EUA price. As noted

above, in order to convert the top level price expressed in £/MWh to carbon equivalent, low-

carbon sources are assumed (in the long-run) to displace new CCGT from the system. A

figure of 0.34 tCO2e is taken as the carbon saving for each MWh produced10. Table 2 shows

how the CfDs strike prices achieved in recent round 1 and 2 auctions have been converted to

a carbon price equivalent. The steps in the table are as follows:

A. Contracts for difference strike price

10 See page 5 https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/599761/Background_documentation_for_guidance_on_valuation_of_energy_use_and_greenhouse_gas_emissions_2016.pdf



25

B. Subsidy element is the strike price (A) less the wholesale market price (assumed to be

£41/MWh in the strike price methodology)

C. Inflate by 8% to convert from 2012 to 2016 equivalent prices

D. Convert to a carbon price equivalent by dividing the electricity price subsidy by the

assumed carbon intensity of displaced CCGT generation at 0.34 tCO2/MWh, then

adding on the combined CPS and EUA price at £23.10/tCO2 which is built into the

market price and therefore also received by low carbon generators.



26

Table 2. Effective carbon price arising from contracts for difference11

Round 1 Round 2

2015/

16

2016/

17

2017/

18

2018

/19

2020/

21

2021/

22

2022/

23

A. CfD Strike

price £/MWh

(2012 prices)

ACT 120 114 75 40

EfW with CHP

80

Biomass CHP

75

Onshore Wind

79 80 83

Solar PV 50 79

Offshore Wind 120 114 75 58

B. Subsidy

element of CfD

£/MWh

(2012 prices)

B = A - 41

ACT 79 73 34 -1

EfW with CHP

39

Biomass CHP

34

Onshore Wind 38 39 42

Solar PV 9 38

Offshore Wind 79 73 34 17

D. Effective

C-price £/tCO2

incl CPS +EUA

D=B/(0.34)*

108%+23.10

(2016/17

prices)

ACT CfD

269 252

126

EfW CfD

142

Biomass CHP

CfD

126

Onshore Wind

CfD

140 142 150

Solar PV CfD 47 140

Offshore Wind

CfD

269 252

126

11 2015-2018 figures from Round 1 https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/407465/Breakdown_information_on_CFD_auctions.pdf 2019-2021 figures from Round 2 auctions https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/643560/CFD_allocation_round_2_outcome_FINAL.pdf

https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/407465/Breakdown_information_on_CFD_auctions.pdf

https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/407465/Breakdown_information_on_CFD_auctions.pdf

https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/643560/CFD_allocation_round_2_outcome_FINAL.pdf

https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/643560/CFD_allocation_round_2_outcome_FINAL.pdf



27

Figure 2. Effective carbon pricing in CfD Rounds 1 and 2

For nuclear power, the same methodology was used as for large-scale renewables, taking the

CfD strike price range for Hinkley Point C as the reference point. This ranges from £89.5-

92.5/MWh depending on whether a follow-on plant is agreed at Sizewell C. This gives an

effective carbon price for Hinkley in the range £188-197/tCO2e when adjusted to 2016 prices

and the CPS and EUAs are included. This relatively narrow range significantly underestimates

the true uncertainty associated with new nuclear costs. For example, the CfD price includes

provision for decommissioning costs, so that the entire lifecycle costs of the plant are

intended to be included within this single subsidy figure. In practice however, estimating the

future costs of decommissioning is difficult given uncertainty over the final disposal options.

In recognition of this, the Government will eventually receive funds from the company to

take title to and liability for the operator’s spent fuel under the terms of the Waste Transfer

Contract12, and this payment is subject to a cap (set at £1,159,250/t uranium in 2012 prices).

This cap is necessary because uncapped future liabilities would be commercially impossible

to manage, and therefore in effect represents an additional subsidy.

On the other hand, if the build costs and/or profitability of Hinkley Point C turn out to be

better than was assumed when calculating the CfD strike price, there is a mechanism to

return funds to the public purse though various gain share mechanisms13. The cost of future

12 Waste Transfer Agreement relating to the transfer of spent fuel arising from Hinkley Point C https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/556776/6_-_Waste_Transfer_Contract_-_Spent_Fuel.pdf 13 See Fig 15 NAO report https://www.nao.org.uk/wp-content/uploads/2017/06/Hinkley-Point-C.pdf



28

plant are also expected to be lower than for Hinkley C if similar plant can be replicated. In

reality therefore, the true range of uncertainty in effective carbon prices for new nuclear are

wider than shown in Figure 1.

The third main policy instrument relates to FiTs, which are applied to projects below 5MW,

with a range of implied carbon price signals according to project size categories, as outlined

in the Table 3.

Table 3. Effective carbon price arising from feed-in tariffs14,15

Technology Size category

kW

Tariff p/kWh £/tCO2

Standard Solar photovoltaic

receiving the higher rate (see

footnote on different rates for PV)

0-10 4 118

10-50 4.22 124

50-250 1.89 56

Standard solar photovoltaic

receiving the middle rate

0-10 3.6 106

10-50 3.8 112

50-250 1.7 50

Standard solar photovoltaic

receiving the lower rate

0-10 0.38 11

10-50 0.38 11

50-250 0.38 11

Standard large solar photovoltaic 250-1000 1.54 45

1000-5000 0.38 11

Stand-alone solar photovoltaic 0-5000 0.23 7

Anaerobic digestion 0-250 4.99 147

250-500 4.72 139

500-5000 1.76 52

Combined Heat and Power 0-2 13.95

Hydro 0-100 7.78 229

100-500 6.24 184

500-2000 6.24 184

2000-5000 4.54 134

Wind 0-50 8.26 243

50-100 4.88 144

100-1500 2.58 76

1500-5000 0.8 24

14 Rates to 31st December 2017 https://www.ofgem.gov.uk/environmental-programmes/fit/fit-tariff-rates 15 Solar rates are in three bands. Higher rates apply to buildings that meet EPC energy efficiency standards of level D or above, and where owners do not have more than 25 installations. Middle rates apply to owners that have more than 25 installations, and lower rate applies to buildings not meeting the EPC level D standard.

https://www.ofgem.gov.uk/environmental-programmes/fit/fit-tariff-rates



29

Role of Carbon Pricing

Carbon reduction is a strong policy driver in the electricity generation sector. Low-carbon

policy has two interrelated goals:

1. Directly reduce emissions by incentivising investment in lower-carbon generation

2. Develop and/or reduce the cost of new low-carbon technologies

Carbon pricing primarily addresses the first policy goal. The UK government, and the UK

electricity generation sector itself was a strong proponent of carbon trading, and was

instrumental in the development of the EU-ETS. A carbon price floor was introduced,

originally intended to be a risk-reduction measure, designed to protect low carbon

investments from down-side carbon price risk. The rate was originally set at £9/tCO2, but was

set to rise rapidly on a pre-set trajectory. The original consultation document envisaged the

price floor rising to £30/tCO2 in 2020 and £70/tCO2 in 2030. The floor was to be guaranteed

by levying a new tax, the carbon price support (CPS), which would top-up the EUA price

when necessary to meet the floor price. However, in practice when carbon prices in the EU-

ETS collapsed after 201016, a decision was made in 2014 and 2016 budgets to freeze the CPS

at a level of £18/tCO2 in order to avoid creating an ever-larger gap in the price paid in the

UK relative to the rest of Europe17. The combination of CPS + EUAs at 2017 values is

£23.1/tCO2, below the BEIS forward view of £40-119/tCO2 by 2030, suggesting that fossil

fuels use for power generation in the UK is currently under-taxed, though EUA prices appear

to be rising in early 2018, which if continued could start to close the gap.

The experience with carbon pricing so far in the sector is that whilst the detailed design of

policy can be complex, and is not free of political risk (since EU-ETS caps and price floor

levels are essentially political decisions), the prices themselves feed transparently through to

electricity prices, and therefore provide a direct financial reward to low-carbon sources18. This

mechanism is generally well-understood in the sector, and is factored into routine

operational and investment decisions.

Regarding the second policy goal, the UK has introduced dedicated policies to stimulate

development of renewables, over-and-above direct carbon pricing. Most economists agree

that left to themselves, markets may underdeliver on research and development of new

technologies, which may justify additional policy interventions to support infant industries.

Though opinions differ on the extent to which UK renewable energy policies to date have

been cost-effective (Helm, 2017), the costs of renewable energy have come down

16 The price collapse was partly due to the financial crisis and subsequent reductions in economic activity and emissions, compounded by the impact of renewable energy being subsidised by other means 17 Since the CPF feeds through to wholesale electricity prices, and is not paid elsewhere in the EU, the CPF is politically exposed to problems of competitiveness for UK industrial users. 18 This is, however, judged to be insufficient on its own to drive investment in low carbon generation – hence the need for CfD mechanisms



30

substantially in recent years. For solar power, this is largely a result of international cost

reductions as well as the development of UK supply chains. For off-shore wind power,

economies of scale and improvements through learning-by-doing in the UK market itself

have also played an important role in cost reduction. Nuclear power has always required

strong policy support from the state, not only because of the need for technological

development, but also because of its large scale, heavy regulatory requirements regarding

safety and long-term waste disposal, and strategic links to nuclear weapons.

Although low-carbon policies often aim to address two or more different externalities with a

single policy instrument, all of the low-carbon policy costs are allocated to the carbon

externality. This means that the estimates made in this report could arguably overestimate

the effective carbon price because they allocate the entire policy cost to carbon, rather than

allocating the policy cost between the two externalities (carbon and R&D market failures).

This is mainly for reasons of transparency, (since there is no simple way to allocate costs

between the externalities). Recent CfD auctions indicate that some renewable technologies

(notably off-shore wind) are starting to become mature technologies in their own right, and

so the allocation of the policy cost to carbon reductions is reasonable in such cases, but for

newer technologies, it should be borne in mind that a significant part of the policy cost

would ideally be allocated to R&D market failure externalities.

Given that low-carbon technologies are at different stages of development, and given the

assumption that policy costs are all allocated to the carbon externality, it is therefore not

surprising that there is quite a wide range of effective prices calculated for different low-

carbon options.

In principle, it would be cleaner to have an economy-wide carbon price signal in the sector

to incentivise low-carbon investment, and then address research and development

externalities via different economy-wide policy instruments (e.g. patent protection and/or

public funding of some R&D activities). However, to the extent that supporting learning-by-

doing will tend to also result in emissions reductions or a reduction in the cost of lowering

emissions, there is no simple way to cleanly separate the two policy outcomes, meaning that

low-carbon-specific technology support programmes/interventions will always tend to

interact with carbon pricing mechanisms.

In practice, because of these multiple policy objectives, some pricing differentiation through

policy may still make sense in the power generation sector as new technologies are

supported through their development pathway, buying down their costs. However, to the

extent that several important low-carbon technologies are getting close to being cost-

competitive at target levels of carbon pricing, there is now a strong case that carbon pricing

could take a more central role in the policy structure.

A final point to bear in mind when interpreting the results in Figure 1 is that the carbon price

calculations for renewables and nuclear are sensitive to the assumed wholesale market price



31

of electricity, because the subsidy is taken as the difference between the CfD strike price and

wholesale electricity prices. The assumed market price value is taken as £41/MWh, based on

the government’s strike price methodology (see p12 BEIS, 2016a). However, this value is

arguably artificially suppressed by the effects of low-marginal-cost plant starting to

dominate the dispatch curve, combined with the effects of capacity markets providing a

portion of the income to thermal plant. A market price of £41/MWh is unlikely on its own to

stimulate investment in fossil-fired power generation, a fact recognised when the

government initiated capacity auctions as a way to ensure the maintenance of sufficient

supply margins. A fairer comparison of the subsidies for low-carbon generation might be to

compare their strike prices with the economic cost of new CCGT plant, the long-run default

plant which are assumed to be displaced, an assumption supported by the success of CCGT

plant in the capacity auctions (OFGEM, 2017). Figures from BEIS suggest that levelized cost of

electricity from CCGT, including carbon pricing, should be closer to £66/MWh (BEIS, 2016b).

If wholesale were up at this level, the implied subsidy to low-carbon alternatives would be

£25/tCO2 lower than indicated in Figure 1, though in reality, energy markets would unlikely

reach this level because some of the income to new CCGT plant will come from the new

capacity markets rather than the wholesale electricity markets.

5.1.2. Other Upstream Energy: Oil, Gas & Solid Fuels

The UK has progressively reduced subsidies to fossil fuels over the past 30 years in line with

EU and OECD guidelines. There are no end-user price controls, with all prices being set by

the market. The following analysis is based on OECD calculations of energy subsidies for its

member countries (OECD, 2013).

Producer Support

The main type of producer subsidy remaining in the UK is in the oil and gas sector and

relates to tax allowances to partially offset the petroleum revenue tax (PRT). The PRT is the

main tax levied at 50% of gross profits on oil and gas production in the UK. All oil and gas

producing countries levy some kind of tax or royalties on production which is how they gain

value from the resources being extracted. There is no common international standard for the

rate of such taxes and levies, the level is set by each country. The standard PRT therefore

defines the ‘normal’ baseline tax rate for oil production in the UK.

Various allowances which partially offset the PRT are available to companies which act as

subsidies. These include a new-field allowance that was introduced in 2009 for small,

ultrahigh-pressure and high-temperature oil fields, and ultra-heavy oil fields. Such subsidies

for high-cost fields are not uncommon (Global Subsidies Initiative, 2010). This allowance was

subsequently extended by the government to cover remote deep-water gas fields (March

2010), very deep fields with sizeable reserves (March 2012), and certain large shallow-water

gas fields (July 2012). Other measures to support certain types of production include



32

Promote licences, which allow small and start-up companies to obtain a production license

first and secure the necessary operating capacity and financial resources later through

reduced rent for the first two years. These PRT allowances added up to £159m in 2011 for oil,

and £121m for gas (Environmental Audit Committee, 2013). These translate into effective

emissions subsidies as shown in Table 4.

Table 4. Effective carbon price subsidies for fuel production. Source: Environmental Audit Committee,

(2013)

2011 Subsidy Emissions

from UK

production

Effective C-price

£m mtCO2 £/tCO2

Oil subsidies 159 13 -12.2

Gas subsidies 121 5 -22.7

Solid fuels 4 15 -0.3

The OECD considers that in the context of the UK tax system design, the ability of oil and gas

companies to write off exploration and production expenditures immediately does not

constitute a subsidy.

Producer support for coal-mining sector has been removed since 2006, with only inherited

liabilities relating to previous public ownership estimated by the OECD at a level of £4m in

2011. This includes management of abandoned mines and treatment of mine-water

discharges.

Looking ahead, shale gas is a potentially important new area of energy resource

development in the UK. HM Treasury is currently consulting with industry on a fair tax regime

for this new development (DECC 2012). The definition of a ‘fair’ tax in this context will have

to take into account whether special tax treatment is required for the sector given its

different pattern of capital investment and other differences compared to conventional oil

and gas fields. Given the normative nature of subsidies in the energy sector, a decision on

whether or not any special treatment given to shale gas vis-à-vis conventional sources would

have to take into account similar considerations. In the US which has the greatest experience

of shale gas development, emerging subsidy issues include the adequacy of bonds used by

oil and gas producing states to assure funding for reclamation of drilling sites, cover

regulatory costs and offset public infrastructure costs. Road damage from use of heavy

trucks on secondary roads, and payments for clean-up of fracking water are also emerging as

costs which will need to be accounted for.



33

Consumer Support

By far the largest subsidy for fossil fuels in the UK relates to the lower VAT rate of 5% for

domestic energy supplies (compared to 20% for the economy as a whole). Since VAT is a

general economy-wide tax, any reduction from the general national rate is considered by the

OECD to be a subsidy. Domestic energy supplies have always been taxed at a lower rate in

the UK, since being raised from zero to 5% in 1994, but this practice is unusual, as most

countries tax energy at the prevailing rate of VAT. In 2011, this tax was worth £81m for coal,

£380m for oil and £3,510m for gas. The reduced VAT-rate subsidy is considered further in

Appendix Section 5 on residential emissions.

Other than VAT, there are very few measures that support energy consumption in the United

Kingdom. Schemes such as winter fuel payments for the elderly or cold-weather payments

do not depend on the price of fuels and are provided in-cash to eligible households. Most of

the remaining measures target consumption technologies such as low-carbon vehicles and

hydrogen refuelling equipment rather than energy use per se, and are therefore not included

further in the analysis.

Discounts to the climate change levy CCL (an end-user energy tax) are offered for eligible

energy intensive users in return for committing to a climate change agreement to reduce

energy consumption, and are considered in Appendix Section 4 on Industrial emissions.

Missing Data

The OECD study points to a number of areas where data was not available to calculate

subsidy levels for fossil fuels19. These include:

Ring-Fence

Expenditure

Supplement

The Ring-Fence Expenditure Supplement (RFES) was introduced in

January 2006 to replace the former Exploration Expenditure Supplement

(EES). In its current version, it provides oil and natural-gas companies

with a yearly 10% increase in the value of unclaimed deductions for

expenses related to exploration and appraisal for a period of up to six

years.

Field Allowance This new allowance was first introduced in 2009 and later extended to

encourage the development of small or technically-challenging fields.

Before 2012, qualifying fields had to be small in size, feature ultra-high

pressure or temperature, possess ultra-heavy oil reserves, or be remote

deep-water gas fields. In 2012, it was then announced that new field

allowances would also be extended to very deep fields with sizeable

reserves, and large shallow-water gas fields. This extension is expected to

generate revenue losses of about GBP 20 million per year (HM Treasury,

19 The quantification of energy subsidies is the subject of ongoing research by a range of organisations including the OECD, World Bank, IMF and NGOs such as the Global Subsidies Initiative



34

2012). The field allowance provides companies with a partial exemption

from the Supplementary Charge. Relief is calculated at the level of the

field but is provided at the company-level. Unclaimed allowances can be

carried forward.

Mineral

Extraction

Allowance

The Mineral Extraction Allowance (MEA) was introduced in 1986 to

provide mining companies (including coal, oil, and natural-gas

producers) with faster rates of depreciation for qualifying capitalised

expenditures. The latter include the acquisition of mineral rights or

deposits and expenditures connected to access to the reserves.

Prescribed rates vary with the type of expenditure to which the provision

applies. Analysis of this provision is, however, complicated by the

interaction of the MEA with the general tax regime that applies to oil and

gas extraction. These caveats do not apply to coal though. Although this

provision applies to the mining sector as a whole, data from the OECD’s

STAN database indicate that mining of fossil fuels accounts for nearly

90% of total gross output for the mining and quarrying sector (as

defined in the standard ISIC Rev.3 sector classification).

Abandonment

Costs

This provision allows capital expenditures connected to the

abandonment of fields and mines to be deducted in full in the year in

which they are incurred. Deductions are coupled with a carry-back

provision which makes it possible for companies to use losses arising

from decommissioning costs against profits earned in earlier years. This

may therefore result in tax refunds. Although this provision applies to the

mining sector as a whole, data from the OECD’s STAN database indicate

that mining of fossil fuels accounts for nearly 90% of total gross output

for the mining and quarrying sector.



35

Downstream

5.2.1. Transport

Data from Department of Transport (2016) shows the breakdown of transport activity by

mode, which can be combined with information from national accounts showing tax rates

and from national emissions inventories to identify effective carbon prices for different

modes of transport. This section outlines how these calculations have been carried out.

Activity data is summarised in Figure 3. It should be noted that air transport in these charts

only includes domestic (intra-UK) flights.

Figure 3. Activity levels and emission by transport mode in the UK (2014 data)

Road Transport

The road transport sector is an important source of public revenue, including fuel duty of

£27.6bn and vehicle excise duty of £5.5bn together amounting to a combined tax revenue of

£33.1bn, comprising 5% of total UK tax revenue in 2017 (Institute for Fiscal Studies, 2016).

However, this revenue needs to be offset by direct public costs, including expenditure on

road building and maintenance, which in 2017 amounted to £9.5bn covering both central

and local authority spending (HM Treasury, 2017), so that net revenues (less expenditure)

from transport amounted to £23.5 bn. Total emissions from road transport (including

passenger and freight) amounted to 124 mtCO2, or 25% of the UK total in 2017.

If all of the net public revenues from road transport are assigned to carbon externalities, then

the effective carbon price would be 23,500 / 124 = £190/tCO2. This is included in the analysis

as an upper bound effective carbon price for road transport. This upper bound figure implies

that road transport is over-taxed relative to the expected carbon price range.

However, one complication is how to account for other externalities. A recent economic

survey of transport sector externalities (Johnson and Stoye, 2012) suggested that total non-

greenhouse gas emissions externalities amounted to around £20bn per year in the UK,



36

mostly attributed to congestion externalities. If these externalities are netted off, then

amount of public revenue attributed to climate externalities drops to £3.5bn, implying an

effective carbon price of 3,500/124 = £29/tCO2. This is included as the lower bound of the

effective carbon price for the transport sector. This lower figure implies that road transport is

under-taxed relative to the expected carbon price range.

Clearly, assumptions about congestion externalities are a swing item that dominate the

results. Whilst the principle is clear that public revenue from a sector should at least cover

public expenditure plus externalities, the case of congestion externalities is complicated by

the fact that transport fuel duties were never intended to address congestion, and are in fact

poorly designed to do so. Road charging and congestion charging schemes would be much

more appropriately targeted, but have been routinely seen to be unpopular with drivers,

even if they are substituted for fuel duties.

Another issue facing the design of road transport taxation is the risk of steeply declining

public revenues if and when road vehicles shift towards battery-powered or other low carbon

alternatives to fossil fuels (e.g. hydrogen). This suggests that in the medium to longer term,

there is the potential to significantly transfer the taxation burden from the fuel consumption

to road usage rates, potentially including a time-of-use or other congestion-related

component. These charges should in principle be set at a rate that is adequate to cover

public road spending, plus congestion externalities. The remaining road fuel tax rates could

significantly drop from their current level to help make these new taxes affordable, and still

adequately cover climate externalities, which would like fall in the medium-long term as a

result of fuel switching.

Rail Transport

Rail transport is less carbon intensive than road transport, so each km of passenger

transport, or t-km of freight transport will save some carbon emissions. Unfortunately,

emissions from rail transport are not broken down by freight and passenger transport.

However, rail transport is close to 10% of total UK transport activity levels across both

passenger and freight, but only accounts for 3% of total transport carbon emissions.

Therefore, the carbon savings in both freight and passenger transport are approximated by

assuming that emissions levels per unit of activity are approximately 3/10th of the level of

their road transport alternatives.

Average road transport emissions levels based on the activity levels and emissions identified

in Figure 3 are 0.118 tCO2/’000 passenger-km for passenger transport, and

0.275 tCO2/’000 t-km for freight. The assumed emissions levels for rail is 0.036 tCO2/’000

passenger-km, leading to total emissions savings of 6.35 mtCO2 for passenger transport, and

0.084 tCO2/’000 t-km, leading to emissions savings 3.44 tCO2 for freight. This leads to total

emissions saving from rail transport of 9.8 mtCO2.



37

Rail sector income and expenditure is summarised in Figure 4. Government subsidies are

£3.7bn per year, which divided by the annual carbon saving amounts to around £380/tCO2.

However, rail travel contributes significantly to reducing road transport congestion. If the

78 bn passenger-km currently travelled by rail were to be transferred to cars instead, car

usage would increase by around 12%. This implies that the contribution of rail to reducing

total congestion costs in the UK is around 12% x £20bn = £2.3bn per year. Netting this off

the public subsidy implies that the effective carbon price is (3,700-2,300)/9.8 = £140/tCO2.

This is taken as the lower bound of the carbon price in the analysis, though it is possible that

the contribution of rail to reducing congestion externalities has been underestimated since

the true value would depend on the relative proportions of rail and car journeys undertaken

at peak congestion times and locations.

Figure 4. GB Rail Industry: income, expenditure and government funding 2015-16. Source: (Office of Rail

and Road, 2017)

The upper bound of carbon pricing signals for rail transport considers the incentive that

applies to some passengers if they face a decision on modal shift between car and rail

transport. These passengers effectively see a double incentive, firstly through the direct rail

subsidies, and secondly from avoided payment of road fuel duty. The upper bound case

arises for passenger journeys undertaken during non-peak hours when there is no

contribution to reduced congestion externalities of shifting transport mode, and including

the foregone fuel tax revenues associated with the offset car journey. The lower bound case

arises when congestion is fully costed, and foregone tax revenues from offset car journeys



38

are not included. In this case, rail’s share of total journeys (approximately 10% of all

passenger and freight activity) is assumed to offset around the same share (~10%) of total

annual congestion costs.

A mid-point estimate for the rail sector is to assume that the foregone fuel duty tax revenues

from offset car journeys are included as part of the price signal for rail, but that the benefit of

reduced congestion costs are also factored in. This gives the following result:

A = public expenditure on rail = £3.7bn

B = forgone income from avoided road journeys = £2.2bn

C = contribution of rail to reduced congestion externalities = £2.3bn

E = emissions savings from switching from road to rail = 9.8 mtCO2

Effective carbon price signal = (A+B-C) / E

= £ 364/tCO2

Air Transport

Revenue from air transport arises mainly from air passenger duty which amounted to £3.2bn

in 2016/17 (Institute for Fiscal Studies, 2016). However, neither tickets nor aviation fuel for

international flights attract VAT. Obstacles to raising such taxes in aviation are discussed by

Seely (2012).

The upper bound estimate of the effective carbon price takes account of foregone VAT just

on the aviation fuel itself. Consumption of fuel for air travel from the UK amounts to

12.6 billion tonnes oil equivalent20, worth £6bn21 which implies foregone VAT income of

£1.2bn, reducing the effective public revenue to 3.2-1.2 = £2.0bn. The majority of air miles is

from international journeys, for which total emissions amount to around 41mtCO2 based on

government statistics22. This suggests that the effective carbon price arising from air

passenger duty is 2,000/41 = £49/tCO2.

In addition, air travel emissions are included in the EU-ETS, which adds £6/tCO2 at current

prices, raising the overall effective carbon price to £55/tCO2 putting it within the expected

range for 2030.

If the foregone VAT from the full price of passenger tickets is included in the analysis, this

results in the air transport sector shifting from a net source of revenue to a net source of

subsidy. UK passenger expenditure on flights totalled £44bn in 201623. Since international

20 Digest of UK Energy Statistics 21 Using global average aviation fuel price of $641 per metric tonne, data for December 2017 from http://www.iata.org/publications/economics/fuel-monitor/Pages/index.aspx 22 UK Department of Transport Statistics https://www.gov.uk/government/statistical-data-sets/env04-total-greenhouse-gas-emissions-from-transport 23 https://www.ons.gov.uk/peoplepopulationandcommunity/leisureandtourism/articles/traveltrends/2016

http://www.iata.org/publications/economics/fuel-monitor/Pages/index.aspx

https://www.gov.uk/government/statistical-data-sets/env04-total-greenhouse-gas-emissions-from-transport

https://www.gov.uk/government/statistical-data-sets/env04-total-greenhouse-gas-emissions-from-transport



39

flights are zero-rated, this amounts to foregone VAT income of £8.7bn, reducing tax revenue

from the sector from £3.2bn to -£5.5bn. Accounting for the EU-ETS allowance price, this

suggests that the effective carbon price for air transport is -5,500/41 + 6 = -£130/tCO2.

However, this overstates the carbon price effect because it is associated with undercharging

on the overall ticket price, not just the fuel element.

This analysis is subject to a number of important caveats. In particular, there is no agreed

international method for allocation of aviation emissions between countries, and there is not

a simple way to align the statistics for fuel consumed for international transport (which

covers both domestic and international transfer passengers) with the value of passenger

tickets. This is reflected in the differences in expenditure estimates from different sources.

Whilst the Department for Transport emissions data and DUKES energy consumption figures

both tally, implying consumption of around 13 mtonnes of aviation fuel worth £6bn, figures

on passenger ticket purchases £44bn would suggest a higher level of fuel consumption,

since fuel typically accounts for between 30-50% of airline costs. These estimates should

therefore be regarded as broad-brush figures, and further work on these is recommended.

Analysis carried out by the International Air Transport Association (IATA, 2008) suggests that

the demand for air travel is relatively sensitive to prices, with supra-national price elasticities

of -0.5 to -0.9 for intra-European, trans-Atlantic and Europe – Asia travel. This suggests that

carbon pricing could be effective in reducing overall emissions. On the other hand, when the

passenger transport duty was introduced, it was intended to be purely as a revenue raising

tax, and it was not expected to suppress demand significantly (House of Commons Library,

2012). Overall, the salience of carbon pricing may be assumed to be relevant, but not a very

strong driver of activity in the sector.

5.2.2. Business and Industry

The carbon pricing regime for business is relatively complex because a number of different

policies are applied, with different rates and exemptions for different types and sizes of

business meant to manage conflicts between the need to incentivise emissions reductions

whilst managing international competitiveness concerns.

This analysis follows the work of the Committee on Climate Change (2017) which estimates

the combined effect of the different policies on different types of business. The CCC estimate

that average electricity prices for the commercial sector and manufacturing sector were 11

p/kWh and 7.7 p/kWh respectively in 2016, comprising the following elements:

Wholesale, supplier and network costs. Wholesale costs for both commercial and

manufacturing consumers are lower than for households. Larger business consumers of

electricity may be able to negotiate lower prices through direct contracts with suppliers.

Network costs may also be lower, by connecting directly to the transmission network and

avoiding distribution costs. Businesses will also be cheaper to supply where their demand



40

includes more off-peak energy, and is more flexible. CCC estimate wholesale and

network costs were on average 7.7 p/kWh for the commercial sector and 5.3 p/kWh for

manufacturing in 2016, though this varies considerably depending on the quantity of

electricity consumed by the firm.

Carbon price. CCC estimate that the carbon price support mechanism and the

purchasing of EU ETS allowances by businesses cost around 0.8 p/kWh in 2016. However,

electricity-intensive firms in sectors deemed by government to be “most at risk” of

carbon leakage received compensation up to 80% of this cost (Box 2.1).

Support for low-carbon investment. Policies to support roll-out of low-carbon

generation increased the electricity price faced by businesses by 1.5 p/kWh, except for

certain electricity-intensive firms that receive compensation for some of this cost.

o Renewables Obligation (RO), micro-generation Feed-in Tariffs (FiTs) and Contracts

for Difference (CfDs) contributed 1.8 p/kWh. Electricity-intensive firms in sectors

deemed “most at risk” of carbon leakage received compensation of up to 85% of

these costs.

o ‒ Additional network costs from increased renewables deployment contributed

0.2 p/kWh, while CCC estimates suggest the merit order effect reduced wholesale

energy costs by around 0.6 p/kWh.

Climate Change levy (CCL). A tax on energy consumption which applies to all non-

residential consumers, the CCL was 0.6 p/kWh in 2016, although the majority of

manufacturing sectors have a Climate Change Agreement (CCA) and therefore receive a

90% discount from the levy, and metallurgical/mineralogical processes are exempt from

CCL (around 15% of electricity consumption).

CRC Energy Efficiency scheme. A mandatory carbon emissions reporting and pricing

scheme for non-residential organisations that consume over 6 GWh of electricity

annually and are not already covered by a CCA, the EU ETS or are

metallurgical/mineralogical processes. Participants must purchase and surrender

allowances for their emissions. CCC have estimated that the cost of the allowances for

electricity were 0.7 p/kWh in 2016.

To reflect the diversity of electricity costs and low-carbon policy impacts for businesses, the

CCC focus on five illustrative types of electricity consumption to show a range of prices.

Inevitably these do not cover all possibilities and the variety and complexity of businesses

may mean that different parts of operations are affected by different policies. However, they

give a reasonable picture of the most important differences.

Table 5 shows the CCC figures expressed in terms of an energy taxation in pence per kWh of

power consumed, and then converting these into an equivalent carbon price making

assumptions about the carbon intensity of the power based on methodology described in

Section 2.2.



41

Table 5. Effective Carbon Prices for different business types Source: Energy prices and policy costs from

CCC 2017 Tables 2.2 and 2.3. Final column, author’s calculation.

Business type Total

energy

price

(p/kWh)

of which,

low-carbon

policy cost

(p/kWh)

Effective

Carbon

price

£/tCO2

Ele

ctr

icit

y

Small commercial 12 2.9 82

Medium commercial 10.7 3.6 102

Large manufacturing 7.8 2.4 68

Large manufacturing (low-carbon support

compensation)

6.4 0.9 26

Extra-large manufacturing (low-carbon support &

carbon price compensation)

3.7 0.3 9

Gas

Small commercial 2.6 0.2 10.9

Medium commercial 2.6 0.5 27.1

Large manufacturing (ETS) 1.6 0.2 10.9

Large (metal/mineral) manufacturing (ETS) 1.5 0.1 5.4

In addition to these rates for gas and electricity, which are the primary source of emissions

from the sector, other sources of emissions include the following:

Combustion of liquid and solid fuels in the business sector accounted for emissions

of 34mtCO2 in 2015, of which 12mtCO2 is from the irons and steel industry. These

fuels attract tax from the Climate Change Levy. Taking the 2019 rate (which will

increase slightly to account for scraping of the CRC scheme by then), the CCL is levied

at a rate of £0.02653/kg of fuel, equivalent to a carbon price of approximately

£9/tCO2 when multiplied by the carbon intensity of the fuel. For larger industrial

users, including the iron & steel sector, this rate is discounted to around £2/tCO2 in

return for companies entering into a Climate Change Agreement.

Most of these large industrial users will also be subject to the EU-ETS. Currently,

allowances are priced at around £11/tCO2. This is in addition to the reduced CCL rate

for the fuels.

Industrial process (i.e. non-combustion) emissions of CO2 and other greenhouse

gases amounts to 13 mtCO2, plus an additional 13 mtCO2e from refrigerant gases.

These sources do not attract any taxes or subsidies.

In general, policy costs associated with electricity consumption in the business and industrial

sectors are adequately taxed, but emissions from fossil fuel combustion, refrigeration and

industrial processes to be under-incentivised. This is partly due to competitiveness drivers in

the sector which act as a political constraint on raising carbon prices. Some authors propose

border tax adjustment as a way to overcome these constraints (Helm, 2017; Mehling et al.,

2017).



42

5.2.3. Residential

The residential sector accounts for emissions of 112mtCO2 per year, 22% of UK total. Energy

consumption in the residential sector totalled 42 mtoe in 2016, 28% of UK final energy

consumption. The largest share 27 mtoe was from natural gas, and 9 mtoe from electricity

(DUKES, 2017). The majority of the energy is used for space heating, water heating and

cooking. The contribution of electrical appliances to bills is higher than the share of energy

consumption because of the higher unit cost of electricity, reflecting the efficient nature of

electricity end-use.

Figure 5. Breakdown of UK household energy consumption and bills by usage. Source: (Committee on

Climate Change, 2017)

Carbon prices in the residential sector arise mainly through the contribution of carbon policy

costs to energy prices, which are extensively covered by the CCC report on energy bills and

prices (Committee on Climate Change, 2017). The incentive is assumed in this work to be

mainly a price signal to switch fuel, reduce consumption, or increase efficiency.

The contribution of climate policies to residential energy prices is shown in Figure 6.



43

Figure 6. Contribution of climate policies to residential prices, electricity (top) and gas (below). Source:

(Committee on Climate Change, 2017)

In addition to these climate policies, included here is the subsidy represented by the

reduction in VAT rates for residential consumers of electricity and gas, and the effective

carbon price for other domestic fuels (i.e. oil products and solid fuels). These totals are

shown in Table 6, which indicate that for electricity, the carbon policy costs for electricity are

largely offset by the VAT subsidy, resulting a low effective carbon price of just £8/tCO2, whilst

for gas the result is an overall subsidy (i.e. negative carbon price) of -£33/tCO2 and other

heating fuels a subsidy of -£19/tCO2. This is significant, since decarbonisation of heat is

recognised as a difficult technical challenge, and the presence of a major price distortion in

this sector is already impacting the incentive to develop alternatives.

Electricity

Gas



44

Table 6. Calculation of effective carbon price for residential sector energy. Steps and assumptions shown

in black. Resulting carbon prices shown in red. Source: own calculations except where stated

Calculation steps and assumptions Units 2016 Source

Electricity

price

components

Total unit cost of electricity p/kWh 15.4 CCC

Climate policy costs p/kWh 2.6 CCC

Carbon intensity of purchased electricity kgCO2e/kWh 0.352 BEIS

Direct climate policy costs - electricity £/tCO2 74

Foregone VAT receipts on electricity p/kWh 2.31

VAT carbon subsidy - electricity £/tCO2 -66

Total carbon price - electricity £/tCO2 8

Gas price

components

Total unit cost of gas p/kWh 4.58 CCC

Climate policy costs p/kWh 0.08 CCC

Carbon intensity of gas

kgCO2e/kW

h 0.184

BEIS

Direct climate policy costs - gas £/tCO2 4

Foregone VAT receipts on gas p/kWh 0.69

VAT carbon subsidy - gas £/tCO2 -37

Total carbon price - gas £/tCO2 -33

Other

heating fuels

Value of energy traded £m 2005 DUKES

Energy value GJ 2.19E+08 DUKES

Calorific value GJ/t 45.3 DUKES

Weight kt 4,841

Carbon emissions per t kgCO2 / t oil 3190 DUKES

Total CO2 mtCO2 15.44

Foregone VAT receipts on heating oil £m 301

Total carbon price - other £/tCO2 -19

5.2.4. Public Buildings

Total energy consumption by the public administration sector amounts to 5,800 ktoe, or 4%

of UK total final energy consumption, whilst the sector is responsible for a slightly smaller

share (3%) of total UK emissions of greenhouse gases. Energy is predominantly used in

schools, hospitals, universities, offices and other buildings, as illustrated in Figure 7.

Public buildings such as schools and hospitals pay a commercial rate for electricity and gas

which includes the same carbon price support mechanisms as described in Appendix Section

4. for industry and business energy users. These include the pass-through to electricity prices

of the cost of low-carbon electricity support mechanisms (CfDs, FiTs, Carbon Price Floor etc.),

the Climate Change Levy, and for larger organisations, also the CRC energy efficiency

scheme. The upper bound is therefore taken from the CCC estimates of the carbon policy

component of energy bills (Committee on Climate Change, 2017). These replicate the values



45

shown in Table 5 for the medium commercial category, giving an effective carbon price of

£102/tCO2 for electricity and £27/tCO2 for gas.

The CRC Energy Efficiency scheme only applies to larger organisations, so that publicly-

funded schools for example have been removed from the scheme, which reduces the

effective carbon price for smaller public organisations. However, the CRC is to be phased out,

and replaced with an increased rate for the Climate Change Levy in 2019, which will close

some of the gap. The lower bound estimate therefore adjusts the CCC figures by removing

the CRC component, and substituting the higher CCL figure for 2019. This results in an

effective carbon price of £90/tCO2 for electricity and £18/tCO2 for gas.

Figure 7. Breakdown of energy use in the public sector. Source: (BEIS, 2017)

5.2.5. Agriculture, Forestry and Other Land-Use (AFOLU)

AFOLU sectors include important greenhouse gas emissions sources amounting to

72 mtCO2e/yr, as well as sinks of amounting to -28 mtCO2e/yr in 2015. Sector drivers are

discussed in some more detail in the subsections below. There is considered to be significant

potential to reduce emissions from these sectors, with up to 12% savings at zero or negative

cost, and up to 17% savings at a cost of below £34/tCO2 (Moran et al., 2009). Since all these

sectors face either a low or negative effective carbon price, they could be an important

source of additional effort under a more coherent decarbonisation policy scenario.



46

Emissions levels from these sectors are much less certain than for energy-related emissions

sources. According to National Physical Laboratory (2017), agriculture, land use and waste

contribute the largest sources of uncertainty to the UK inventory:

Agriculture accounts for only 9% of the total CO2 equivalent emissions, but

contributes to 36% of uncertainty in the total inventory emissions. Uncertainties

around the emission factors and activity data are high.

Land use change contributes 8% of the total emissions but is responsible for 32% of

the total uncertainty in the UK inventory. In this case emission factors are the main

sources of uncertainties.

The waste sector constitutes 3% of the total CO2 equivalent emissions yet contributes

18% to the total uncertainty. Emission factors are the main issues for the sector

uncertainties with activity data also playing a role.

This uncertainty makes it much more difficult to price carbon directly, because the amount of

tax to be paid would also be uncertain. However, according to a recent Parliamentary

question24 a revised agricultural greenhouse gas (GHG) emissions inventory model is due to

be completed this year and implemented as part of the 2016 National Atmospheric

Emissions Inventory. Data from the 2016 inventory is due for submission and publication in

2018. Details of the methodology and assumptions within the revised agricultural GHG

emissions model will be published in 2018 as part of the annual UK National Inventory

Report. It is expected that this revised methodology will bring much improved data and

accuracy to GHG measurements in the agriculture sector. Further work is required to assess

whether this could form the basis on which some form of carbon pricing incentive could

operate.

Agriculture

National emissions inventories are separated out into direct emissions from agricultural

production, with emissions associated with agricultural change of use being allocated under

the land-use change and forestry section.

This analysis groups together the direct agricultural emissions and the change of land use for

agricultural activities, in order to better align total sectoral emissions with the level of

subsidies allocated to the sector.

On this basis, total emissions in the agriculture sector comprise direct emissions of

51.1 mtCO2, and associated emissions from land-use and land-use changes of 12.2 mtCO2,

totalling 63.3 mtCO2.

Agricultural subsidies under the EU Common Agricultural Policy are complex, but the way

these have been implemented in the UK essentially boil down to two strands of subsidy:

24 http://www.parliament.uk/business/publications/written-questions-answers-statements/written-question/Commons/2017-04-18/71084



47

1. ‘Pillar 1’ payments, or single-farm subsidies. These are direct payments to farms

which are not connected to production levels, but are associated with the size of

individual farms.

2. ‘Pillar 2’ payments which are to support rural development and environmental

improvements

The total level of these payments is shown in Table 7

Table 7. UK agricultural subsidies covering the 7 year period 2014-2020. Source: (House of Commons

Library, 2014)

Pillar 1 Pillar 2

England €m 16,421 1,520

Northern Ireland €m 2,299 227

Scotland €m 4,096 478

Wales €m 2,245 355

TOTAL €m 25,061 2,580

Pillar 2 payments are intended to enhance environmental quality and rural development of

agricultural land, so it is assumed here that this is effectively carbon neutral, neither

incentivising or disincentivising emissions.

Pillar 1 payments are also in theory unlinked to production, so arguably, they could also be

treated as carbon neutral in the sense that they do not directly incentivise production. The

lower-bound case therefore treats the agriculture sector as un-subsidised with respect to

carbon emissions, leading to a zero lower bound for the effective price of carbon.

In practice however, Pillar 1 payments (totalling approximately £2,900 per year) help to

support farming in the UK by keeping farm incomes at sufficient levels to maintain

operations, although much of their impact may be capitalised in agricultural land prices. It is

likely therefore that agricultural activity levels are higher than they would otherwise be. The

upper bound case assumes the entire Pillar 1 payments act as a production subsidy. This

gives an effective carbon subsidy (negative price) of -2900 / 63.3 = -£45/tCO2.

It should be noted that this upper bound is an overestimate. The truth lies somewhere

between these two bounds, and further work is required to assess the degree to which farm

subsidies really act as a direct production subsidy.

Forestry and other land-use change

Forestry and other types of land use such as maintenance of grasslands are a fairly significant

sink of emissions in the UK, and amount in total to removals of 26 mtCO2 per year. The

detailed breakdown by sources is shown in Table 8.



48

Table 8. Emissions from forestry and other land-use change 2015. Source: UK National Statistics25

Source Emissions

mtCO2

Forest land Forest land remaining forest land -16.5

Biomass burning 0.0

Land converted to forest land 0.6

Direct N2O emission from N fertilisation of forest land 0.0

Drainage of organic soils 0.1

Direct N2O emissions from N mineralization/immobilisation 0.2

Grassland Biomass burning 0.3

Grassland remaining grassland -4.9

Land converted to grassland -4.6

Drainage and rewetting and other management of organic and

mineral soils

0.2

Direct N2O emissions from N mineralization/immobilisation 0.0

Wetlands Wetlands remaining wetland 0.3

Non-CO2 emissions from drainage of soils and wetlands 0.0

Land converted to wetland 0.0

Land converted to flooded land 0.0

Other

(LULUCF)

Harvested wood -1.9

Land converted to other land 0.0

Indirect N2O emissions 0.3

According to public sector accounts, the forestry sector received public income of £111m in

2016/17. It is not clear the extent to which, if at all, these public payments are related to

incentivising the sink function of forests, but if it is assumed that they directly act as a carbon

reduction incentive, then the effective carbon price for the forestry sector is -111/15.7 =

£4.2/tCO2. This is taken as the upper limit of carbon prices, on the basis that the payments

fully incentivise carbon emission reductions. The lower bound is taken as zero on the basis

that the public payments may not create incentives one way or the other on emissions levels.

In either case, the carbon price is low, and significantly below the expected range for 2030

suggesting the sector is under-incentivised.

Other subsidies (e.g. for grasslands etc.) are not listed in national accounts, suggesting that

any subsidies to the sector are small. The range calculated for the forestry sector is therefore

taken as indicative of the wider land-use change sector.

25 https://www.gov.uk/government/collections/final-uk-greenhouse-gas-emissions-national-statistics



49

5.2.6. Waste

Table 9. Emissions from waste management sector 2015. Source: UK National Statistics26

Sector Emissions mtCO2

Landfill 12.1

Waste-water handling 4.1

Waste Incineration 0.3

Composting 1.1

Anaerobic digestion 0.1

Mechanical biological treatment 0.5

TOTAL 18.2

Emissions from the waste sector are shown in

Table 9, though as noted in the previous section, uncertainties in emissions from waste are

high; the waste sector constitutes 3% of the total CO2 equivalent emissions yet contributes

18% to the total uncertainty (National Physical Laboratory, 2017). The biggest emissions arise

from landfill, which paid a total landfill tax bill of £987m in 2015. If this tax is assumed to act

as an incentive to avoid using landfill, and thereby reduces emission rates accordingly, then

the effective carbon tax rate facing landfill is 987/12.1 = £81.5/tCO2. This is taken as the point

estimate for the waste sector, suggesting it is in an appropriate range relative to expected

prices in 2030.

However, in practice, carbon emissions from waste management are complex. Firstly, waste

management is not a simple two-option process which compares an emitting option (e.g.

landfill) with a non-emitting option. Rather, there is a hierarchy of different waste

management options including recycling, energy recovery which respond in different ways to

price signals, and a single price for landfill cannot optimise for the whole hierarchy (DEFRA,

2011). Even within a single option such as landfill, determining the carbon price is complex

since the carbon content of landfill materials is dropping over time as other waste

management techniques are introduced (DEFRA, 2011), which also changes the economics of

landfill gas to power. Taking account of the lower carbon content of more recent landfilled

waste would tend to increase the effective carbon price using this methodology. On the

other hand, the landfill tax addresses other externalities than just carbon emissions (notably

constraints on the availability of suitable sites), so offsetting the tax income against these

other externalities would tend to decrease the effective carbon price. Some of the key issues

to address are set out in Box 1.

26 https://www.gov.uk/government/collections/final-uk-greenhouse-gas-emissions-national-statistics



50

Box 1. Excerpt from DEFRA ‘Economics of Waste and Waste Policy’ June 2011

Landfill tax cannot reflect the differences in environmental performance between all levels of the waste

hierarchy above landfill.

Firstly, for the treatment and disposal of waste:

-On the whole, those treatment options which reduce embedded emissions by reducing energy

associated with extraction, primary production etc., such as re-use and recycling, do not have

their full external benefits reflected in the price of disposal.

-The emissions from waste combustion of non-biogenic material (via any technology including

mass-burn incineration) are also not comprehensively reflected in the price of disposal. Unless

the installation in question is in the ETS (municipal solid waste incinerators are excluded) a

negative externality persists – such installations are creating GHG emissions without paying the

relevant price.

-Subject to proving its environmental performance, MBT-landfill does not have its environmental

benefits reflected in the price of disposal.

To supplement the landfill tax, the Waste Review has introduced measures to encourage recycling, such

as better accessibility to recycling for businesses and consumers, agreeing responsibility deals with

business sectors, and introducing new packaging targets. This is in addition to other non-market

instruments, such as the revised Waste Framework Directive requirement on separate collection. While

such measures help internalise market failures and barriers, they have some limitations; for example, in

incentivising/determining the optimal level of activity

As well as ensuring that the relevant instruments are in place to reflect the impact of treatment options,

it is also necessary to address barriers to efficient response. For example, the lack of direct pricing of

household waste collections – households pay for their waste collections indirectly though council tax

and general taxation, rather than paying directly for the amount and type of waste produced - means

that other instruments such as information policies may take more prominence, although they are

unlikely to achieve efficient outcomes. Funding announced in the Waste Review for trial reward-and-

recognition schemes is a step in the right direction and will help develop the evidence base on the effects

of pricing mechanisms on household waste.

Second, even if all the externalities of waste treatment options were covered by policy, there would still

be a need for additional intervention to ensure efficient production and consumption decisions, and the

optimal level of waste arisings (in the absence of these intervention, waste arisings will be inefficiently

high). This is an important policy area because the additional greenhouse gas benefits from waste

prevention are significant. In addition to the environmental benefits, there are financial savings for

businesses, consumers and government from waste prevention - through reduced material use and

reduced collection, treatment and disposal costs.

Information was not readily available from national accounts regarding public subsidies for

waste water, which is the second-most important source of emissions in the sector,

accounting for 4.1 mtCO2. This work assumes that costs are fully recovered from waste water



51

service users so the sector does not receive substantial subsidies, resulting in a zero value for

the effective carbon price incentive.



52

6. References

Advani, A. et al. (2013) Energy use policies and carbon pricing in the UK.

BEIS (2016a) ‘Contracts for Difference : An explanation of the methodology used to set CFD

strike prices’, (November). Available at:

https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/566337/CO

NTRACT_FOR_DIFFERENCE_STRIKE_PRICE_METHODOLOGY_final.pdf.

BEIS (2016b) Electricity Generation Costs.

BEIS (2017) LEADING BY EXAMPLE : CUTTING ENERGY BILLS AND CARBON EMISSIONS IN

THE WIDER PUBLIC AND HIGHER EDUCATION.

Committee on Climate Change (2015) Sectoral scenarios for the Fifth Carbon Budget Technical

report.

Committee on Climate Change (2017) Energy Prices and Bills - impacts of meeting carbon

budgets.

DEFRA (2011) The Economics of Waste and Waste Policy.

Department of Transport (2016) Transport Statistics Great Britain 2016.

DUKES (2017) DIGEST OF UNITED KINGDOM ENERGY STATISTICS.

Environmental Audit Committee (2013) Energy Subsidies in the UK: written evidence

commissioned by the Committee. Available at:

https://publications.parliament.uk/pa/cm201314/cmselect/cmenvaud/61/61we03.htm.

Global Subsidies Initiative (2010) Tax and royalty-related subsidies to oil extraction from high-

cost fields.

Grubb, M. J. (2014) Planetary Economics. Routledge.

Helm, D. (2017) ‘Cost of Energy Review Dieter Helm’, (October).

Hirst, D. (2017) ‘Carbon Price Floor ( CPF ) and the price support mechanism’, House of

Commons Library, (5927).

HM Treasury (2017) Public Expenditure Statistical Analyses.

House of Commons Library (2012) ‘Air passenger duty : introduction’.

House of Commons Library (2014) ‘CAP Reform 2014 –20: EU Agreement and

Implementation in the UK and in Ireland’, (October).

IATA (2008) Air Travel Demand: Measuring the responsiveness of air travel demand to changes

in prices and incomes. Available at:

https://www.iata.org/whatwedo/documents/economics/air_travel_demand.pdf.

IMF (2013) ‘ENERGY SUBSIDY REFORM : LESSONS AND IMPLICATIONS’, (iii). Available at:

file:///C:/Users/Will/Downloads/_012813.pdf.



53

Institute for Fiscal Studies (2016) A survey of the UK tax system.

Johnson, P. and Stoye, G. (2012) Fuel for Thought The what , why and how of motoring

taxation.

Mehling, M. et al. (2017) ‘Designing Border Carbon Adjustments for Enhanced Climate

Action’, (December).

Moran, D. et al. (2009) ‘Marginal abatement cost curves for UK agriculture , forestry , land-

use and land-use change sector out to 2022’, Paper presented at the Agricultural Economics

Society 83rd Annual Conference, Dublin, (31 March-1 April), pp. 1–27.

National Physical Laboratory (2017) ‘UNDERSTANDING THE UK GREENHOUSE GAS

INVENTORY’, NPL REPORT CCM 2.

OECD (2013) Inventory of Estimated Budgetary Support and Tax Expenditures for Fossil Fuels.

doi: http://dx.doi.org/10.1787/9789264187610-en.

Office of Rail and Road (2017) ‘UK Rail Industry Financial Information 2015-16’, (February).

Available at: http://orr.gov.uk/__data/assets/pdf_file/0020/24149/uk-rail-industry-financial-

information-2015-16.pdf.

OFGEM (2017) ‘Annual Report on the Operation of the Capacity Market in 2016 / 2017’,

(June), pp. 1–40.

Seely, A. (2012) ‘Taxing aviation fuel’, House of Commons Library Standard Note SN00523.

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current economic signals for decarbonisation in the uk · 2019-02-11 · internalising...

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