A post-budget guide to the carbon price

Utility Week presents a handy guide to the carbon price, the debate over its future and reaction to the budget.

In his autumn budget, chancellor Philip Hammond has revealed that the government will seek to maintain the total carbon price at the current level until the phase out of unabated coal is completed.

“This will deliver a stable carbon price while limiting cost on business,” he announced.

The update has provided some long-awaited visibility over its fate during the 2020s, meaning new build bidders in the upcoming capacity auction will finally know what price they face when delivery is scheduled to begin 2021/22.

Utility Week presents a handy guide to the carbon price, the debate over its future and reaction to the budget.

Emissions Trading System

The total carbon price paid by generators in Great Britain is made up of two parts – the European price provided by the EU Emissions Trading System (ETS) and a top-up tax called the Carbon Price Support.

The ETS is the flagship climate change policy of the EU, representing the largest carbon market in the world.

The mechanism operates under the ‘cap and trade’ principle. An annual cap on emissions is set for participating industries, which is reduced over time. Allowances for these emissions are either auctioned off or allocated for free. Once allocated they can then be traded.

For most of its existence the ETS has been plagued by a surplus of allowances.

When the scheme was introduced in 2005, the caps were determined at a national level. A mix of industry lobbying, national interest and genuine error meant the caps were set too high, exceeding actual emissions. From a starting point of almost €25 per tonne, the price of allowances crashed to zero in 2007 – the final year of the trial phase.

The caps were tightened for the second phase (2008 to 2012) to reduce the surplus and the price recovered to an all-time high of nearly €30 per tonne. However, the problem was exacerbated by the slump in economic activity following the 2008 financial crisis and the carbon price dropped back down into single digits.

For the third and current phase (2013 to 2020), national caps were replaced by a single EU-wide cap and auctioning became the default method for allocating allowances.

In 2014, the auctioning of 900 million allowances over the following three years was postponed – a process referred to as ‘backloading’. Proposals were adopted the following year to transfer any unallocated allowances to a Market Stability Reserve (MSR) at the end of the third phase. The MSR will be created in 2018 and become operational the year after.

Despite the changes, the price of allowances has remained in single digits.

Following lengthy negotiations, draft reforms for the fourth phase (2021 to 2030) were finalised earlier this month. The package includes an increase in the rate at which the cap is reduced from 1.74 per cent to 2.2 per cent per year; a doubling of the rate at which surplus allowances can be absorbed into the MSR from 12 per cent to 24 per cent per year; and the introduction of a new mechanism to completely cancel unallocated allowances from 2024.

The government revealed in October it would seek to remain part of the ETS for a two-year transition period following Britain’s departure from the EU.

Allowances are currently trading at almost €7.50 per tonne.

Carbon Price Support

The Carbon Price Support (CPS) was introduced in April 2013 to supplement the European carbon price and ensure generators in Great Britain face a minimum price for carbon emissions called the Carbon Price Floor (CPF). The top up took the form of a tax on fossil fuels used for generation and was implemented via the existing Climate Change Levy.

The price signal being sent to generators through the ETS was, by itself, too weak to drive substantial decarbonisation, the government argued. From a starting point of £16 per tonne, the total carbon price as set by the CPF trajectory was meant to rise to £30 per tonne by 2020 and £70 per tonne by 2030.

Just a year after its introduction the chancellor George Osborne announced in his 2014 budget that the CPS rate would be capped at around £18 per tonne from 2016 to 2020 to reduce upwards pressure on energy bills and keep British businesses competitive with their European peers.

In his 2016 budget, Osborne extended the cap until 2021 and promised to set out the long-term direction for the carbon price in the autumn budget statement.

However, the statement was delivered by his successor Philip Hammond who merely said that the government would continue to consider its options. It wasn’t until his spring budget in March that Hammond revealed his intention to target a total carbon price starting in 2021, with fuller details coming in this week’s autumn budget.

The chancellor has now announced that the total carbon price will kept at the current level until the government has completed its pledged phase out of unabated coal generation by 2025.

Pre-budget debate

Although there has been a widespread consensus on the need for visibility over the future of the carbon price, opinions have been more divided over what its fate should be.

The Energy Intensive Users Group (EIUG) and the manufacturers’ organisation EEF both criticised the CPS for putting British businesses at a disadvantage, with EIUG director Jeremy Nicholson telling Utility Week that the mechanism has only led to emissions being exported to elsewhere in Europe.

The free market think tank Centre for Policy Studies warned that the “unfair advantage” enjoyed by European generators and the rapid growth in interconnector capacity will not only lead to the “offshoring” of emissions but also undermine investment in domestic generation, jeopardising security of supply.

Appearing on a panel at Energy UK’s annual conference, RWE Supply and Trading chief commercial officer Tom Glover said the CPF “doesn’t make any sense”.

“I optimise power stations across Europe and I know that when I turn down my gas station in the UK, we turn on a coal station in Europe because of the carbon tax,” he remarked. “If that is sensible carbon reduction, then it doesn’t make any sense to me.”

Glover said he supported a sturdier Europe-wide carbon price. However, fellow panellist and former energy secretary Ed Davey raised concerns over whether that could be achieved following Brexit given the key role that the UK has played in driving forward reforms, usually in the face of stubborn resistance from Eastern European members such as Poland.

Conservative MEP and peer Ian Duncan, who has led the phase four reforms of the ETS, told delegates “the challenges are very clear for anyone who pays attention.”

Researchers from University College London urged the government not to “cave in to lobbyists” by scrapping the CPS, saying this would undermine confidence in low-carbon investments and raise the cost of decarbonisation.

Consultancy firm Cornwall Insight cautioned that scrapping the CPS would “shake up the power market”and lead to “one last hurrah for coal” which has seen a drastic decline over recent years.

Analysis by Aurora Energy Research found that even keeping the CPS at its current rate may allow coal to experience a “revival” during the early 2020s due rising gas prices. Without further government intervention, a total carbon price of at least £40 per tonne would be needed by 2025 to prevent a comeback. If the CPS was scrapped, there would be a “surge”.

Earlier research by the company also concluded that once the coal phase out has been completed the CPS will become “irrelevant”.

On this basis, Policy Exchange argued for the CPS to be gradually removed following the phase out to harmonise the carbon price with the rest of Europe. Modelling by Arup indicated that this could save consumers around £12.5 billion between 2019 and 2030 through lower energy bills.

Drax, SSE and climate change think tank Sandbag recently wrote to the chancellor to plead with him to commit “strong and robust” carbon price in the autumn budget. They hailed the the CPS and its impact on power sector emissions as “a striking example of what can happen when a meaningful carbon price is imposed on fossil fuel generation.”

In his cost of energy review, Oxford economics professor Dieter Helm proposed a more radical solution to the carbon price conundrum – create a single economy-wide carbon tax and apply an adjustment at the border to prevent emissions being exported.

A report published earlier this week by the Grantham Research Institute at the London School of Economics backed Helm’s proposals and urged the government to strengthen the carbon price. It warned that the freeze on the CPS rate at £18 per tonne is inconsistent with the goals of the Paris climate change agreement.

Post-budget reaction

The Renewable Energy Association (REA) said there is still no clarity over the long-term trajectory for the carbon price as was expected before the budget. REA head of policy and external affairs James Court said the lack of additional support for new projects and the carbon price freeze, suggested that the government was turning its back on renewables.

“This could see a hiatus in much needed infrastructure development,” he added. “Considering this is coming only a couple of months after the much-vaunted Clean Growth Strategy, it’s hugely disappointing.”

Leonie Greene, head of external affairs at the Solar Trade Association said lack of an increase means there is “no clear long-term signal for investors”.

Energy and Climate Intelligence Unit energy analyst Jonathan Marshall said: “Despite warm words from the dispatch box, Philip Hammond has failed to deliver on low carbon energy.

“Keeping the carbon price unchanged was the bare minimum expected before the budget and does not make up for the hat-trick of freezing new low-carbon support, throwing North Sea oil and gas another lifeline, and shying away from fuel duty changes that would both encourage lower-carbon transport and tackle the air pollution crisis.”

“All in all, it suggests that the recognition that green growth is good for UK plc, clearly on display with the launch of the Clean Growth Strategy, has failed to permeate through to the treasury,” he added.

Association for Decentralised Energy director Tim Rotheray said the statement of confidence in the existing carbon price “sends a clear signal to business energy users on the benefits of efficient onsite generation and energy efficiency”.

However, he added, the government must also “continue to develop its longer-term carbon taxation arrangements to ensure energy users have clear long-term signals to invest in cutting carbon in cost effective ways.”

Drax Group chief executive Dorothy Thompson said: “Having this clarity from the chancellor on the CPF will help to unlock further investment in low-carbon and renewable technologies ensuring that, together, we can continue creating a cleaner economy for future generations.

“Reducing carbon in our energy system is the fastest way to deliver a low-carbon economy. The CPF has enabled the UK to half the amount of carbon emitted through electricity generation since 2012.”

Bob Ward, policy and communications director for the Grantham Research Institute at the London School of Economics said: “The current combined carbon price of about £24.50 per tonne of carbon dioxide, created by the CPS rate of £18 per tonne and the market price in the European Union ETS of about £6.50 per tonne, may be sufficient to complete the removal of coal from UK power generation, which only supplied 9 per cent of electricity in 2016.

“However, this price is likely to be too weak to create enough shift from gas-fired power stations to low-carbon sources, such as renewables and nuclear. We pointed out in our report earlier this week that such a shift is required if the UK’s power sector is to reduce its emissions by at least 60 per cent by 2030, as required by the UK’s overall target.”

Based on a total carbon price of £23 per tonne, Aurora Energy Research has forecast that the price freeze will lead to a doubling of annual coal output from 17TWh in 2017 to an average of 32TWh between 2021 and 2025.