The economics of the fourth carbon budget

What would be the economic implications of meeting the fourth carbon budget as set out by the Committee on Climate Change? Sophie Billington analyses some scenarios.

A report published last month by Cambridge Econometrics sought to identify the macroeconomic implications of the measures required to cut greenhouse gas emissions to the levels proposed by the Committee on Climate Change in the legally binding fourth carbon budget.

While many previous analyses have identified the cost of investment required to deliver a low-carbon energy system, this study used a macroeconomic approach to consider both the cost of climate change mitigation policies (in the form of higher electricity and product prices for consumers) and the benefits. For example, increased investment leading to an expansion of the low-carbon supply chain and associated output, employment and incomes.

The report is based on an econometric-based simulation model called “MDM-E3”. This was used to model three scenarios:

•    all climate change mitigation policies since the Low Carbon Transition Plan are abandoned and all future carbon budgets are not met;

•    the fourth carbon budget is met;

•    emissions cuts exceed the targets set out in the fourth carbon budget, due to additional low-carbon measures in the buildings and transport sectors.

The analysis does not assess the specific policies that would be required to bring about the low-carbon transition, but instead considers the macroeconomic impact if this transition did occur.

Specifically, the report considers the impact on households, businesses and the wider economy if the structure of the energy system included a highly decarbonised electricity sector in addition to efficiency measures in buildings, industry, transport and agriculture.

The analysis shows that overall, the measures and changes required to meet the fourth carbon budget will lead to a small positive impact on the UK economy, with a net increase in GDP of 1.1 per cent by 2030. However, it is important to note that despite net positive benefits overall, different sectors of the economy will be affected in different ways, with some benefiting more than others.

To consider the impact on the electricity supply sector, it is important to note Cambridge Econometrics’ assumptions about the structure of the power sector.

In the low-carbon scenarios, the carbon intensity of electricity generation reaches 50gCO2/KWh by 2030. In this scenario, onshore and offshore wind together account for around 40 per cent of total generation by 2030, and most of the remaining generation is from other renewables and low-carbon sources (see graph, The generation mix).

Cambridge Econometrics’ analysis shows that over the period 2014-30 there would be an additional £181 billion cumulative investment in the power sector, compared with the reference scenario in which current climate policies are abandoned. This increase in investment creates jobs in the electricity supply sector – both in the construction and installation and operation and maintenance of the additional low-carbon generation.

However, the investment must be paid for, and in this case the investment is assumed to be financed by an increase in electricity prices. In addition, there is a higher carbon price in this scenario, and together this leads to a 30 per cent increase in industrial electricity prices and a 14 per cent increase in domestic electricity prices by 2030, relative to the scenario in which climate policies are abandoned.

Despite a substantial reduction in total energy demand, the net impact on electricity demand for the economy as a whole is minimal. This is because reductions in electricity demand due to more efficient appliances are almost entirely offset by increases in electricity demand because of fuel-switching (predominantly more electric vehicles and the transfer from gas to low-carbon heat pumps for heating).

The analysis also shows that low-carbon policies in the power sector and households will lead to a 55 per cent reduction in gas demand. This is partially due to fuel-switching (from gas to electricity in heating and from gas to renewables in the power sector) and partially due to reduced demand (because of energy efficiency measures in households and industry).

Reduced reliance on gas leads to energy security benefits and reduced expenditure on imports. However, it also leads to a contraction of the domestic gas supply sector.

Implications for consumers

The analysis also considers the impact that meeting the fourth carbon budget would have on households. The net impact of meeting the fourth carbon budget on households’ energy-related expenditure is broken down in the report as follows.

If no energy efficiency measures were installed, there would be an increase in energy bills because of the higher electricity price (£127 a year). There is also the additional cost of the energy efficiency installations (£155 a year). However, the energy savings due to efficiency improvements would offset the upfront cost of the measures, and almost offset the effect of higher electricity prices (£260 a year)

Taking all of these factors into account, by 2030, households’ energy-related expenditure would increase, on average, by £22 a year in the scenario in which the fourth carbon budget is met.

Meeting the fourth carbon budget will entail challenges for utilities. Electricity will form an important part of the transition, and as the carbon intensity of electricity declines, the rationale for investing in low-carbon measures which rely on electricity (such as electric vehicles) improves.

Policies will be required to support low-carbon investment in the electricity sector and to ensure that domestic energy-intensive industry remains competitive. The analysis also shows that well-designed policies could lead to net benefits for consumers because of increases in employment and real incomes, and that, if the government is able to encourage households to take up cost-effective energy-efficiency measures, the net impact on household energy bills would be small.