Select Committee on Environmental Audit Second Report


It is hard to isolate the impacts of the Levy

11. The Climate Change Levy is simple in principle: as its architect, Lord Marshall, put it, taxes like it "work through the price mechanism, incentivising reductions in the emitting activity by raising its cost."[10] Working out how much emissions reductions the Levy has delivered in practice, however, is complicated. The first reason for this is that organisations do not necessarily respond to rises in energy costs by reducing their energy use by a proportionate amount. This can be because of a variety of reasons, for instance:

  • improving an organisation's energy efficiency may require an initial investment of resources that has to compete with other business priorities, especially given that major capital investment tends to be made in periodic cycles—meaning that if a firm has recently invested in new machinery, it is unlikely to replace it immediately even if more energy efficient alternatives become available;

Box 2 Report by the National Audit Office: The Climate Change Levy and Climate Change Agreements

Source: National Audit Office, The Climate Change Levy and Climate Change Agreements, August 2007

  • for most companies energy is a relatively minor component of their business costs; and
  • for most users energy demand is relatively inelastic (i.e., they are committed or simply habituated to practices and activities that consume a certain amount of energy, almost irrespective of the cost).

12. The second reason why its impacts are hard to measure is that the Levy is only one factor among many others which affect the amount of carbon emitted by the business sector. Notably, movements in the underlying price of different fuels will be a major factor, often outweighing the changes to energy costs made by the Levy itself. Another significant complication is the changing 'carbon profile' of electricity. Leaving to one side electricity generated from renewable or combined heat and power sources, businesses have little control over the fuels used by their suppliers to generate the electricity they use. Since the Levy has come into effect, gas has become more expensive relative to coal, meaning that electricity generators have increasingly switched from one fuel to the other. Since burning coal emits more CO2 than burning gas, this has led to electricity becoming more carbon intensive. This in turn means that even where businesses have responded to the price signal of the Levy by becoming more efficient in their use of electricity, the impact on their carbon footprint will necessarily have been reduced by the rise in the carbon intensiveness of the electricity they purchase. Given the intrinsic difficulties involved in calculating its effects, and in order to improve transparency, we recommend that the Government should give an estimated range of uncertainty for its projections of the Levy's impacts.

Most of the Levy's impacts were established before it came into operation

13. Before the Levy came into effect, the Treasury estimated in 2000 that it would reduce annual emissions by some 7.3 MtCO2 by 2010, based on projections of its effects on energy prices and hence demand.[11] The most important attempt so far, however, to tease out the effects of the Levy from other factors and estimate its impacts on carbon emissions was carried out in 2005 by Cambridge Econometrics (CE)[12] for HM Revenue and Customs, and published alongside Budget 2005. This study drew on actual energy and emissions data in the period since the Levy had been announced, comparing this with projections of what business as usual (BAU) energy use would have been if the Levy had not existed. These projections were made using what the NAO describes as "one of the most sophisticated macroeconomic models of the UK economy available", built up using historical data on energy use and intensity across different economic sectors.[13]

14. The study's conclusions were that the Levy itself (i.e., independent of other factors, including the impacts of the Climate Change Agreements) led to a reduction in annual emissions of 11.4 MtCO2 in 2002 from business as usual projections; and that by 2010 these annual savings would increase to 13.6 MtCO2. In reaching this latter conclusion the study assumed that the Levy would be raised in line with inflation from 2005, rather than from 2007 as has actually happened: accordingly, this estimate has since been revised downwards to an annual saving from BAU of 12.8 MtCO2 in 2010. This is the savings estimate endorsed and relied on by the Government.

15. These estimated carbon savings were attributed by Cambridge Econometrics to two separate factors: the 'announcement effect' and the 'price effect'. The second of these is straightforward; as the NAO paraphrases, the price effect "recognises that from 2001 the Levy made energy more expensive and should therefore have reduced demand. Higher prices affect decisions regarding output and investment." The announcement effect is more interesting; this "assumes that simply the announcement of the Levy in 1999 focused the attention of businesses on achieving energy efficiencies. The result was a reduction in energy demand even before the Levy raised energy prices in 2001."[14] On this, Professor Paul Ekins, one of the lead authors of the Cambridge Econometrics study, told us:

    From looking at both the negotiation process for the Climate Change Agreements and the very long lead-time that went into the actual implementation of the Climate Change Levy—a full two years between the report of the Marshall Commission and when the tax was actually levied (during which time the CBI waged an absolutely relentless campaign against the Climate Change Levy, which I remember very well)—there was an enormous information effect, such that with this issue of energy prices, […] we found boards taking an interest in this issue for practically the first time in their lives. It was no surprise to me to find that, in the event, they discovered they could actually save quite a lot of energy in a cost-effective way, and they then went about and did that.[15]

16. The NAO explained that the carbon savings estimated by Cambridge Econometrics are different to those in the Treasury's 2000 study for essentially two reasons. First, the Treasury only took the price effect of the Levy into account, whereas CE in addition estimated the impacts of the announcement effect. Second, CE gave a different weight to the price effect than the Treasury. Most interestingly, Cambridge Econometrics attributed most of the impact of the Levy to the announcement effect rather than the price effect. In other words, according to the evaluation of the Levy relied on by the Government, most of the impacts of the CCL were already established before the policy actually came into effect in 2001, and have only marginally increased since then.

17. The National Audit Office report on The Climate Change Levy and Climate Change Agreements presented some evidence which supported the basic premises behind Cambridge Econometrics' findings. On the evidence for an announcement effect, the NAO stated that a majority of the businesses it surveyed had said that the imposition of the Levy had refocused their attention on energy use; and drew attention to a business survey carried out in 2002 by Green Alliance, which reported similar findings.[16]

As for the relative insignificance of the price effect, the NAO analysed the impact of the Levy on energy prices as a whole (Figure 1). This showed that when first introduced the

Figure 1 Fuel price indices for the industrial sector in real terms1 including the Climate Change Levy

1 Deflated using the GDP implied deflator at market prices.
2 Indices based on a survey of the prices (excluding VAT) of fuels delivered to industrial consumers in Great Britain, with the inclusion of an estimation of the
amount of Levy paid.
3 Indices based on the average unit value (excluding VAT) of sales to industrial consumers.

Source: National Audit Office, The Climate Change Levy and Climate Change Agreements, August 2007

18. Levy's impact "was not that great a change in the context of historic prices". On top of this, the Levy is set at a flat rate rather than as a percentage of energy prices; given that market energy prices have increased since 2001 while Levy rates have not been adjusted upwards proportionately (and indeed were completely frozen until April 2007), this means the proportion of energy costs made up by the Levy has been declining since it was first introduced. In other words, in terms of its impact on energy prices, the Levy was introduced at a relatively low level, and has only declined since then. The NAO backed up these findings by citing the results of their survey, which revealed that "companies do not recognise the Levy as a major decision driver":

    All of the Levy-only organisations we surveyed indicated that the Levy currently has no discernible material effect on investment decisions. Those that had invested in energy efficiency were unable to quantify how much of an influence the Levy was in such decisions, if any.[17]

This led the NAO to conclude: "These results suggest that the Levy was not set at significant rates initially, and has become less significant over time."[18]

Other views on the size of the Levy's impacts are more sceptical

19. The headline conclusion of the Cambridge Econometrics study, that the CCL had been responsible for significant emissions savings, has received criticism from a number of business groups; although, in making this argument, they have tended to concentrate on the impacts claimed for the announcement effect, while endorsing the finding that the price effect has been very limited. The NAO, for instance, found that of the seven Levy-only businesses it surveyed only one believed the Levy had driven emissions reductions. The UK Emissions Trading Group (UK ETG) told us that while business sector emissions may have fallen below business as usual projections after 2001, this could partly be explained by factors other than the Climate Change Levy, not least the weather (more temperate weather reducing demand for heating or air conditioning). Ray Gluckman of UK ETG argued: "it is believed there were a couple of very mild winters after the announcement of the CCL and that that weather effect was not properly taken into account [by Cambridge Econometrics]."[19] EEF and UK Steel also suggested that an economic downturn in the British steel sector in the early years of this decade contributed to the reduction from BAU projected emissions, and that a failure to properly take this into account also skewed Cambridge Econometrics' findings.[20] These broad sentiments of business groups towards the effectiveness of the Levy were shared by Andrew Warren, director of the Association for the Conservation of Energy, who told us: "I really am very dubious as to whether the arrival of what was not a very heavily publicised Levy upon ordinary businesses' bills […] has made more than a marginal difference."[21]

20. A strong theme to emerge from the evidence we received was that, whatever the impacts of the Levy have been overall, its impacts on small and medium-sized enterprises (SMEs) and larger but less energy-intensive organisations (for instance, retail chains) have been less significant. According to the NAO:

    The saving brought about by the announcement effect is likely to have been concentrated amongst large rather than small businesses. This is because small businesses generally have fewer resources with which to monitor government policy so are less aware of new announcements. […] Outside of energy-intensive sectors, there is little evidence of the price effect having led to a significant improvement in energy efficiency.[22]

On this theme, the Federation of Small Businesses drew our attention to research it carried out in 2002 and 2004, which showed that "For small companies, technical problems and the cost of changing production processes are barriers to increasing efficiency but so too is a lack of quality information and advice", and thus that "uptake of energy efficiency measures [among SMEs] in response to the levy have been negligible."[23] These findings were substantiated by a major study published in 2005 by the Carbon Trust, The UK Climate Change Programme: Potential evolution for business and the public sector. As Professor Michael Grubb, Chief Economist at the Carbon Trust, told us:

    [I]n the course of our study we received a lot of indications that for the less energy-intensive parts it was not a very effective instrument. It was better than nothing but essentially the price signal of the CCL on its own for organisations which were either very, very small SMEs or which were not energy intensive and totally focused on other things was pretty modest.[24]

21. Significantly, Professor Grubb explained that this study not only found that the Levy was essentially ineffective for smaller and less energy intensive firms, but that:

    [I]n a way the bigger finding in our study or the more, if you like, newsy item was that about half of total emissions associated with business and public sector use were from non-energy intensive sectors—light industry, the commercial sector, the public sector, also many SMEs […][25]

As a result, the Carbon Trust's report recommended the creation of a new mandatory auction-based trading scheme to target these sectors (excluding smaller organisations, falling below a certain threshold for energy use); and in response the Government is planning to introduce the Carbon Reduction Commitment from January 2010.[26] This represents a considerable evolution of Government thinking, given that the Marshall Report had specifically justified implementing a tax such as the CCL because it would be more applicable to the majority of businesses than a large carbon trading scheme:

    Even when the international trading scheme is fully developed, it is unlikely that all businesses will be involved. Indeed, I doubt whether it will ever be practical for the majority of small and medium sized enterprises (SMEs) and less intensive users in industrial and commercial sectors to participate in the international trading scheme. Taken together, these firms account for around 60% of total carbon dioxide emissions from business, and may offer scope for significant improvements in energy efficiency and reductions in emissions.

    Hence, my conclusion is that there probably is a role for a tax if businesses of all sizes and from all sectors are to contribute to improved energy efficiency and help meet the UK's emissions targets.[27]

22. Overall, it seems that the Climate Change Levy has not worked as originally planned —particularly for less energy intensive firms and SMEs. Before the Levy was implemented, the Treasury expected that its effect on the cost of energy would drive significant emissions reductions, and that a tax such as this would be especially suited to being applied to small businesses and larger but non-energy intensive firms; but neither appears to have been the case. The Treasury did not make an estimate of the impacts of the 'announcement effect' prior to implementing the CCL, but it now accepts that the majority of the Levy's impacts came from it. We are left with the impression that the Levy's reported impacts on carbon emissions have been to an extent unforeseen and serendipitous.

23. While concerned by the weaknesses of the Levy, we welcome the fact that the Government has not ignored these problems. In responding to the recommendations of the Carbon Trust by bringing forward plans for the Carbon Reduction Commitment, the Government is targeting some of the sectors for which the Levy has proved less effective. This shows a commendable flexibility of approach and ability to learn through doing.

10   HM Treasury, Marshall Report, para 40 Back

11   National Audit Office (NAO), The Climate Change and Climate Change Agreements, August 2007, p 14 Back

12   Cambridge Econometrics (in collaboration with the Policy Studies Institute, Westminster University, and the Department of Applied Economics, University of Cambridge), Modelling the Initial Effects of Climate Change Levy, March 2005 Back

13   NAO, The Climate Change and Climate Change Agreements, p 14 Back

14   NAO, The Climate Change and Climate Change Agreements, p 15 Back

15   Q192 Back

16   NAO, The Climate Change and Climate Change Agreements, p 15 Back

17   NAO, The Climate Change and Climate Change Agreements, p 17 Back

18   NAO, The Climate Change and Climate Change Agreements, p 17 Back

19   Q60 Back

20   Q3 Back

21   Q91 Back

22   NAO, The Climate Change and Climate Change Agreements, p 16, p 17 Back

23   Ev 132 Back

24   Q 142 Back

25   Q142 Back

26   The Carbon Reduction Commitment (CRC) is a mandatory auction based emissions trading scheme for the large non-energy intensive business and public sectors. Emissions that are covered under Climate Change Agreements and direct emissions included in the EU Emissions Trading Scheme will not be covered by the CRC. In addition, firms with more than 25% of their energy use emissions in CCAs will be completely exempt. Participants will be required to purchase allowances corresponding to their emissions from energy use, and then surrender them at the end of the year. Government will cap the total energy use emissions by setting a limit on the number of allowances available for auction at the beginning of the year. The auction revenue will be recycled to participants, so the scheme will be broadly revenue neutral to the Exchequer. The earliest the CRC will come into force is January 2010. Back

27   HM Treasury, Marshall Report, p 2 Back

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