HC 742 Electricity Market Reform

UK Electricity Market Reform

Evidence to the

Energy and Climate Change Select Committee

Sam Fankhauser*, Alex Bowen* and Simon Dietz*

24 January 2011

* Grantham Research Institute and Centre for Climate Change Economics and Policy, London School of Economics. The Institute and Centre are supported by the Grantham Foundation for the Protection of the Environment, the UK Economic and Social Research Council and Munich Re.

Introduction

The Energy and Climate Change Committee of the House of Commons has issued a call for evidence for its inquiry into Electricity Market Reform (EMR).  The Grantham Research Institute at the London School of Economics is happy to respond to this call.

We welcome the EMR package as an important and necessary step to decarbonise Britain’s electricity sector, which in turn is essential for the UK to meet its statutory greenhouse gas emission targets. The reform package recognises that a sound policy environment, including a strong and reliable carbon price, is crucial to unlock the investments needed over the coming decades and that the regulatory economics of low-carbon electricity are different from those for traditional electric power. It is important that the reforms go ahead.

The EMR proposals rest on four pillars:

1. A capacity-based market

2. An emissions performance standard (EPS)

3. A carbon price floor

4. Revision of the Renewables Obligation and the Feed-in Tariff system 

This response primarily deals with the third pillar, the question of a carbon floor price. However, we begin our response with two brief observations about pillars two and four.

As far as the second pillar is concerned, the key issues are whether the EPS applies to all generation or only new-build and whether the standards are consistent with the fall in the carbon intensity of power generation required by the UK’s long-run emissions targets. There is a danger that the EPS will be superfluous if the carbon price signal is strong enough. And if it does have an effect at the margin, it may give incumbent firms and existing plants an unfair advantage over new entrants and give insufficient incentive to improve the efficiency of existing plants.

With respect to the fourth pillar, work by the European Commission has suggested that the UK system of renewable energy support has not been as cost-effective as the feed-in tariff systems used in several other countries. The complexity of the Renewables Obligation and the price volatility of Renewables Obligation Certificates (ROCs) may discourage new entrants in the power supply market. But the risks facing potential renewable energy suppliers can be reduced without switching to a feed-in tariff scheme. In this respect the EMR is right to focus on providing longer-term contracts as a way to reduce price uncertainty. Also, it would be helpful to carry the burden of grid expansion management centrally and to make it easier for new suppliers to connect to the National Grid. ROC allocation rates or FIT premia can usefully be differentiated to give a higher rate of support to less commercially mature technologies, but with the rate declining over time (rather than setting the rates for different technologies arbitrarily or in an attempt to ‘pick winners.’ It is also worth noting that a price incentive for the output of renewable energy does not tackle the problem of inadequate energy (and energy efficiency) R&D.

Turning to the third pillar, we wholeheartedly agree with the government’s objective of setting a strong and predictable carbon price. As already set out in the Stern Review, putting a price on carbon (or "internalising the carbon externality") is absolutely necessary, although not sufficient on its own, to tackle climate change successfully. However, we would argue that in setting a carbon price floor the policy context (especially, interaction with the EU Emissions Trading Scheme) needs to be taken into account more carefully.

In particular, we make the following four observations on the question of a carbon floor price:

· The first-best approach to supporting the carbon price would be an EU-wide tightening of the EU Emissions Trading (ETS) cap, supported by an auction reserve price to protect against price drops

· The proposed extension of the climate change levy and fuel duty to power generators is second-best, because (unlike a tighter EU cap) it will depress the EU allowance price and will not reduce EU-wide emissions.

· The measure will succeed in strengthening the long-term carbon price signal for UK electricity investors. However, investors may discount the price signal in the absence of more policy credibility.

· The proposal is relatively straightforward administratively by removing existing tax exemptions. However it does not noticeably simplify Britain’s relatively complex climate change incentive structures, although this is an explicit (and laudable) objective of the legislation.

To strengthen the carbon price floor regulation, government and Parliament may therefore want to consider:

· working more determinedly with EU partners to tighten the EU emissions cap;

· ensuring the policy credibility of the carbon price floor; and

· exploring further opportunities to simply Britain’s climate change incentive structures (CCL, CCA, EU ETS, CRC and the new floor price).

The rest of the note briefly elaborates on these points.

Further elaboration

The first-best approach to supporting the carbon price would be an EU-wide tightening of the EU ETS cap (e.g. a move from a 20% to a 30% emissions target), combined with an EU-wide reserve price for allowance auctions.

A tighter cap is the best and most direct way of supporting the carbon price. In addition to sending a long-term price signal it leads to predictable and immediate EU-wide emission reductions (something the EMR carbon floor proposal does not, see below). Moreover, the market mechanism ensures that these are achieved at the lowest possible cost.

However, a rigid cap can lead to unnecessary price fluctuations because the regulator is unable to adjust the supply of allowances (the cap) to changes in demand. We have seen the effect of this during the recession over the past two years, when reduced economic activity led to lower emissions and a fall in the carbon price. The price could have been supported through a reduction in the cap, but EU ETS rules did not allow this.

There is a fairly broad agreement in the economics literature that a good way to address the problem is a reserve price on the auctioning of EU allowances (auctioning will become the norm in the EU ETS from 2013). A reserve price provides clear rules for how the supply of allowances responds to the price. It is an intervention that the market understands. Most auctions have reserve prices. (If there is a symmetric concern about price spikes the reserve price may be combined with a "safety valve" to create a cap-and-collar system).

However, we recognize that moving to a 30% EU target is difficult politically and that the current auctioning proposals do not foresee a reserve price. The UK should continue to push for these reforms, but in the meantime it is rational to explore second-best options.

Subjecting British power generators to the Climate Change Levy, as proposed in the EMR, is a second best solution, if EU ETS reform is not possible.

The proposal is second-best because of certain side-effects not currently acknowledged in the EMR proposal. Three side-effects stand out:

· First, any additional emission reductions in the UK will be fully offset by higher emissions elsewhere in the EU, since the EU-wide emissions cap has not changed. Under emissions trading the only way to reduce EU-wide emissions is by tightening the EU-wide cap.

· Second, the price for EU Allowances (the European carbon price) will fall because of reduced demand from UK power generators. This will reduce the intended effect of the new floor price and lower the carbon price signal (the incentive to reduce emissions) in the rest of the EU. As a very rough indication, a £10 carbon tax in Britain might reduce the EUA price by perhaps 5% (or about £0.65). [1]

· Third, the British floor price will reverse some of the gains from trade that the EU ETS offers. Compliance costs will go up and rise non-linearly with the level of the floor. The costs of meeting the UK’s carbon target will still be acceptable, but it does mean a loss in emission reduction efficiency.

The carbon floor proposal would be strengthened if complemented by serious attempts to tighten the EU-wide emissions cap.

For example, if it were replicated by a group of like-minded countries, Britain’s price floor legislation could be used to soften opposition to a tighter EU-wide cap. Since a unilateral carbon tax reduces the EU-wide allowance price it is possible to construct a package where the effect of a tighter cap (which increases the carbon price) and the impact of unilateral action by some member states (which decreases the carbon price) cancel each other out, so that non-participating member states face the same carbon price as today.

The carbon price floor will succeed in strengthening the long-term carbon price signal for UK electricity investors. However, investors will discount the price signal in the absence of policy credibility.

Against the drawbacks of the carbon price floor (in terms of EU-wide side effects) have to be put the positive effect of giving UK investors a strong long-term signal to invest in low-carbon generation. This long-term signal is important.

However, the strength of the long-term signal will depend not only on the level of the floor price but also on the long-term credibility of the measure. One reason why the current carbon price is so low is that the market discounts what it perceives to be non-credible commitments to tighten the emission caps. The EMR underestimates the importance of policy credibility in the carbon floor proposal.

In other contexts, policy credibility is strengthened by giving a bigger role to independent bodies like the Bank of England (on interest rates), the Committee on Climate Change (on carbon budgets) and the Office of Budget Responsibility (on macroeconomic forecasts). Such institutional options may not be justified for a measure that is politically sensitive and has direct revenue-raising implications (although the CCC is already required to advise on new trading schemes, which also raise revenue, and the Bank of England receives revenue from its lending activities and liquidity operations).

In the absence of (or in addition to) such institutional options the government needs to maintain policy credibility through consistency and deeds. In that context, it is a concern that the proposed Energy Performance Standards (pillar one of the EMR) are to be set at a level that is wholly inconsistent with Britain’s carbon targets and several times higher than the actual carbon intensity required by 2030. At best, an EPS at that level is redundant (since other policies will push actual emissions further down). At worst, it is counter-productive by sending a mixed signal and creating doubts about Britain’s decarbonisation commitment among investors.

The EPS should therefore be strengthened and made consistent with the emission performance standards required by Britain’s decarbonisation targets, as recommended by the Committee on Climate Change.

The proposal does not noticeably simplify Britain’s relatively complex climate change incentive structures, although this is an explicit (and laudable) objective of the legislation.

Britain’s carbon policy landscape is relatively complex. It includes the Climate Change Levy, Climate Change Agreements, the EU ETS and the CRC Energy Efficiency Scheme. Hydrocarbon duties are also partly justified as climate-related carbon taxes. These policies overlap and tax carbon at very different rates. The Renewables Obligation, although designed primarily to promote renewable energy, also pushes up the price of carbon-intensive energy, as does the Renewable Transport Fuel Obligation. Some entities are taxed several times (e.g. the service sector will feel the impact of the carbon price floor, the EU ETS and the downstream CCL). Other parts of the framework, like the CCAs, are known to have been ineffective or even counterproductive. [2]

Government and Parliament may be missing an opportunity not just to strengthen but also to simplify Britain’s climate change incentive framework fundamentally, for example by imposing a broad, single and consistently set carbon tax.