House of Commons - Electricity Market Reform

Electricity Market Reform - Energy and Climate Change Contents

6 Carbon Price Support (CPS)

Carbon Price Support in EMR

136. Putting a price on "carbon" is a way of charging polluters for the costs of greenhouse gas emissions which contribute to dangerous climate change. Applied to the electricity sector it is, in effect, a differentiated tax which discourages CO₂-producing technologies and rewards low-carbon generation. A Carbon Price Support (CPS) (or "carbon floor price") will improve incentives for investment in low-carbon electricity generation by setting a minimum price for carbon emissions, which would increase the price paid for generation by fossil fuel fired power stations.[159] Low-carbon generators, on the other hand, would have to pay relatively little. A CPS would also reduce revenue uncertainty. According to HM Treasury, the level of the carbon price and its uncertainty is one of a number of factors affecting investment in low-carbon generation.[160]

137. The EMR consultation proposed to introduce a Carbon Price Support (CPS) mechanism from 1 April 2013 to support investment in low-carbon generation. CPS featured in all the proposed EMR packages. The consultation explained that it would be achieved by the Climate Change Levy (CCL) and fuel duty being levied on all fossil fuels used to generate electricity in the UK.[161]

Carbon Price Support in the 2011 Budget

138. On 23 March the Chancellor, George Osborne, announced a Carbon Price Support in the Budget, with a floor price of £16 per tonne of carbon dioxide in 2013, rising to £30 by 2020 in 2009 prices. The starting price would be equivalent to £19.16 in estimated 2013-14 prices. The Treasury estimates that the new tax will raise £3.2bn in the three tax years from 2013.[162]

139. HMRC estimates that the CPS levels the Government has set for 2013 will be equivalent to £4.94 per tonne of carbon dioxide "extra" tax, on top of the forecast price of carbon established by the EU Emissions Trading System in 2013-14. Indicative rates for 2014-15 and 2015-16 will be equivalent to £7.28/tCO₂and £9.86/tCO₂respectively.[163] This is significantly more than the £1-3 modelled as part of the Treasury's consultation.[164] We have heard no justification for the departure of the final proposals on Carbon Floor Price from those modelled in the consultation. We would welcome such a justification from HM Treasury.

140. According to media reports, the Carbon Price Support is already influencing the market, as the shares of Drax Group Plc, owner of the UK's largest fossil-fuelled power station, dropped for three days in a row on 24 March 2011 based on concern the Government's carbon tax would erode earnings.[165]

141. Some witnesses were concerned that the CPS was being considered separately from the EMR process. For example, Mark Hanafin (Centrica Energy) has said that "It is [..] important that [the CPS] is seen in the broader context of the forthcoming electricity market reform proposals".[166] International Power pointed out that the introduction of FITs may obviate the need for a CPS at all, saying that with a FIT "the economics of low carbon generation is assured and we believe it is no longer necessary to create a carbon floor price".[167]

142. The Carbon Price Support was introduced as one of the four "pillars" of Electricity Market Reform and will interact significantly with other measures. We are disappointed that the Government chose to introduce the Carbon Price Support before the Electricity Market Reform process is complete.

Creating a price for carbon

143. We strongly support the creation of a reliable price for carbon. Greenhouse gas pollution is an "externality", which means that the environmental, social and economic damage caused by the pollution is not reflected in the price. The Committee on Climate Change identified the establishment of a global carbon price as "the first essential element of climate change policy".[168]

144. Since 2005, a price for carbon has been created in the power generation sector and energy intensive industries by the EU Emissions Trading System (EU ETS). The requirement to hold enough EU Allowances (EUAs) to cover CO₂ emissions has created a market price for carbon which emitters factor into their business decisions. From 2013, the EU ETS emissions cap tightens each year, which provides some certainty in relation to the environmental benefits of the system. However, because of the excessive number of "allowances" issued, to date the carbon price has not been stable, certain or high enough to encourage large-scale investment in low-carbon electricity generation in the UK, although it has on occasion encouraged short-term switching to less polluting fuels (for example coal to gas). At the end of April 2011 the price of an EU Allowance was just less than €17 or about £15/tonne of CO₂.[169] The CPS "tops up" the EU ETS price to a pre-defined level and reduce volatility.

145. We heard from several witnesses who felt that the EU ETS should be the primary instrument for putting a price on carbon because a UK-only carbon price will not result in additional carbon savings and could undermine the EU-wide system.[170] Scottish Power argued that since emissions from power stations are capped at a European level, any additional savings made in the UK as a result of a CPS simply allow greater emissions elsewhere in Europe.[171] In other words, the CPS would only affect UK emissions—other countries in the EU will be able to increase their emissions by the same amount under the ETS cap. There would be no net environmental benefit.

146. However, it was also acknowledged that the EU ETS is unlikely to deliver a strong enough investment signal in the near future.[172] In this case, given the UK's statutory climate change targets, introducing a UK CPS is the next best option. National Grid said: "We believe the carbon floor price will be a welcome interim measure in the medium term to provide certainty for UK investors in the absence of an EU wide carbon floor price".[173] Professor Grubb told us:

174

147. This does not mean that efforts should not continue to try to improve the effectiveness of the EU ETS. Ian Marchant (SSE) told us:

175

148. A UK Carbon Price Support is a necessary compromise to support low-carbon electricity generation in this country. The Government must continue to push for a European greenhouse gas emissions reduction target of 30% by 2020 in order to strengthen the effectiveness and credibility of the EU Emissions Trading System. The White Paper must include a persuasive strategy for achieving this aim.

The effectiveness of a unilateral Carbon Price Support

149. Responses to our inquiry showed support for the principle of a unilateral CPS from the CCSA, Centrica, DONG Energy, EDF Energy, GE, Good Energy, the Grantham Institute, Intergen, National Grid, RES, SSE and Professor Helm.[176] Others, including the Association of Electricity Producers, Drax, E.ON, Friends of the Earth, Greenpeace, International Power, RWE npower and Swanbarton expressed some reservations about the proposals.[177]

150. The Government stated that "the purpose of this change is to encourage additional investment in low-carbon power generation by providing greater support and certainty to the carbon price".[178] HM Revenue and Customs has estimated that that a £30 carbon price should drive £30-40 billion of new investment in low carbon, increasing low carbon capacity to 7.5 to 9.3 GW by 2030.[179] On 29 March the Chancellor of the Exchequer told the Treasury Select Committee that "the rationale behind this policy is primarily it is an environmental policy and it is designed to try and provide some stability in the price of carbon".[180]

151. As part of its consultation, HM Treasury calculated the difference in the generation mix that a carbon price support would make from now to 2030. In these scenarios, nuclear energy increased significantly in the capacity mix compared with business as usual, renewables increased a small amount and there was a small effect on CCS investment. According to HM Revenue and Customs, the price floor announced in the Budget will reduce emissions from electricity generation by a total of 263 million tonnes of CO₂ to 2030. Over this period the power sector will reduce purchases of EU ETS allowances by around £7.2 billion by changing the merit order of existing plant and reducing carbon emissions.[181]

152. Despite these projections, the main objection to the CPS proposals was that they would not reduce carbon emissions or hasten the deployment of renewable generation. Reaction to the announcement in the Budget has mirrored responses to our inquiry.

153. Among the Big Six and independent generators, we note that those with existing low-carbon plant seem to favour the CPS, while those without do not. For example, Vincent de Rivaz, CEO of EDF which has a large nuclear business, said that "it will support the economics of renewables and carbon capture and storage, and can reduce the need for specific measures to support those technologies".[182] On the other hand, generators with more fossil-based assets and less nuclear disagreed. Drax Power told the Committee that "the carbon price support mechanism is unnecessary as it is an economically inefficient tool that supports specific technologies whilst simultaneously distorting the wholesale market".[183] RWE npower chief executive Volker Beckers said that the CPS "will not encourage investment in new low carbon generation, which will not be commissioned until 2018, and yet will hasten the closure of current fossil fuel plant that are vital for security of supply".[184]

154. A carbon floor price is intended to increase investment in low-carbon technologies and encourage short-term switching, but even at £27/t the carbon price would constitute only a small portion of the cost of electricity. The gas price is a much larger source of uncertainty. Gas prices have historically been more volatile than carbon prices. The gas price accounts for over 75% of the operating costs of gas-fired plants (and therefore typically wholesale electricity prices), while the carbon price makes up around 20% of the wholesale electricity price.[185] It is therefore uncertain how much difference a carbon price support will make to investment decisions. Swanburton told us that the CPS would have little effect on peaking plant because of their relatively low hours of operation. They calculated that a £20/tCO₂ increase in the carbon floor would add only £1500/MW/pa to the operating costs of a carbon-emitting oil-fired generator in the reserve power market.[186]

UNCERTAINTY

155. One of the main reasons we heard for doubts about the environmental effectiveness of the CPS was scepticism about the long-term reliability of the price signal. To make large investment decisions in low-carbon generation capacity, investors require a degree of certainty about future revenues. Carbon price certainty is particularly important given the long life of low-carbon generation investments, but volatility in the price of EU ETS Allowances means that the carbon price is currently a risky factor. If there were more certainty over future carbon prices, this would increase future profitability and rates of return and reduce the cost of capital for investors.

156. We are aware that some investors have little confidence in the reliability of HM Treasury's tax assurances. This introduces an extra element of political risk. Shaun Mays (Climate Change Capital) said that "the way the carbon tax is in the energy market reform at the moment looks like it is a bit too able to be adjusted at short intervals".[187] SSE told the Committee that a particular concern for investors is the fact that the chosen model is a carbon tax, which can be readily changed at the Treasury's discretion.[188] E.ON said:

189

157. On the other hand, Centrica was less concerned about political risk and told us:

190

158. The Welsh Power Group (WPG) questioned how the Government would manage the link between the CPS and carbon prices in the EU ETS. The price of EU Allowances varies from day to day. WPG said that they "do not believe that linking the price on a daily or weekly basis is either feasible or desirable given the volatility it will add to generation costs for marginal plant" and argued that this volatility would be highly likely to feed into electricity prices as generators seek to hedge the carbon risk.[191] They suggested that setting the new CCL rate annually, while creating some stability, risks over or under achieving on the target price. On the other hand, a fixed escalator may create uncertainty, with the expectation that the Government would alter the costs if it can see that the target value is going to be missed.[192]

159. SSE suggested that the CPS must be set to deliver a "bankable" carbon price trajectory.[193] This would require a long-term trajectory for the carbon price, consisting of the CPS plus the EU ETS carbon price, with a narrow range to allow for short term changes. They suggested that this would move away from a tax which could be changed every year at the discretion of Treasury, which is not a viable basis for investment and is not bankable.[194]

160. We acknowledge the contribution to decarbonisation that a high and reliable carbon price could make in the long-term. We also recognise the good intentions of the Government in attempting to underpin the carbon price. However, we are aware that when it comes to low-carbon investment, the effect of the Carbon Price Support will depend on the confidence of investors in the long-term reliability of the Carbon Price Support.

WINDFALL PROFITS

161. The introduction of a Carbon Price Support would lead to costs being passed on to consumers through the wholesale cost of electricity. According to HMRC, around 40% of the total cost of the CPS is likely to be borne by households.[195] Based on the market prices of fossil fuels and carbon, the economic determinants published at Budget, and assuming full pass through to the wholesale electricity price, average household electricity bills will increase by around one per cent (£6) in 2013 and around four per cent (£17) in 2016 solely because of the Carbon Floor Price proposals. Other measures such as the Energy Companies Obligation would separately add costs to electricity bills. However, in the late 2020s electricity bills will be between 2-4% lower than would otherwise have been the case.[196] This increased wholesale price would also benefit (low-carbon) generators that do not have to pay the tax, who would therefore enjoy a windfall profit. For instance, Greenpeace and WWF have suggested that the CPS announced in the Budget will lead to a £3.43bn windfall profits for existing nuclear.[197] We note that existing renewables also stand to benefit from this windfall.

162. Windfall profits could damage the political acceptability of the EMR package. RWE npower told us that there is a danger that if the CPS raised electricity prices in the short-term it would risk "resulting in windfalls for existing low carbon generators and being seen simply as a further revenue raising measure for the Government".[198]

163. Several witnesses suggested that these windfalls could be negated by timing the introduction of the Carbon Price Support so that it only benefited new generation, for example by introducing the tax around 2018 when the first new nuclear plant is likely to be built.[199] Drax agreed that a CPS would only be feasible if it "only benefits new low carbon investments, i.e. it does not provide a windfall to plant that is already operating".[200] SSE suggested that the CPS should be at a notional level (e.g. £1/tonne) until 2020, because it would be unlikely to influence low-carbon investment before that date.[201]

164. Dorothy Thompson of Drax Power was sure that "if you do have a carbon floor and that is introduced now, it will provide a windfall to existing renewables, to existing nuclear and, to an extent [...] to existing gas. That windfall will be paid for by the consumer".[202] Alistair Buchanan, CEO of Ofgem, accepted that "if certain decisions were to be taken and were not co-ordinated [...] there is a danger of a windfall gain to particular parties. That is not good news for consumers, and we would want our voice to be heard if that was the case".[203]

165. A way to avoid windfalls for renewables is to ensure that the CPS is factored into the forthcoming banding review. This would allow the level of support offered through the RO to existing renewables to be adjusted downwards so that there is no overall additional profit as a result of introducing the CPS. Simon Less (Policy Exchange) told us:

204

166. An alternative approach is to impose a windfall tax on those generators benefiting from the CPS.[205]

167. We recommend the Government explains how it plans to deal with the problem of potential windfall profits arising from the introduction of a Carbon Price Support in its White Paper. The White Paper should set out under what circumstances the Government would take action to address windfall profits resulting from the introduction of the Carbon Price Support. If such measures involved a tax, then any revenues should be matched by an increase in the budget of the Green Investment Bank.

IMPACTS ON COMPETITIVENESS

168. Following the Budget, a number of stakeholders in the electricity sector warned that the CPS would have considerable impacts on their businesses.[206] The Carbon Price Support also poses difficulties for electricity-intensive, trade exposed industries. F&C Asset Management said that in the longer term, the rising floor price could disadvantage UK companies, as current forecasts for EUAs under phase III of the Emissions Trading Scheme (ETS) are estimated at €25/tonne, which would suggest a premium supplement for UK companies based on the current EU cap.[207] Around 150 fossil fuel electricity generators embedded into the National Grid and around 1,000 CHP plants and a large number of small electricity generators will incur the carbon price support rates upon their fuel input.[208]

169. On the generating side, Drax warned that a CPS "could lead to investment being redirected to other [EU] Member States, with GB becoming more reliant upon imports of energy in order to meet national demand".[209] SSE believed that a substantial differential between UK carbon prices and EU carbon prices would penalise UK generators and therefore increase interconnector imports. They suggested that "a carbon price differential of around £5/tonne would theoretically make it more cost-effective to build a CCGT abroad with a corresponding interconnector, rather than build a CCGT domestically".[210]

170. Interconnectors enable the trading of electricity between countries. At the moment, the UK uses just three interconnectors: one of 2,000 MW with France, one of 600 MW with Ireland, one of 1,000 MW with the Netherlands (which first opened on the day of the our visit to National Grid). This compares with a total of 85.3 GW electricity generating capacity in the UK.[211] Interconnection can increase security of supply by drawing on a more diverse set of electricity generators. In particular, an interconnector is quick and flexible to operate, so can fulfil a balancing role and help to meet peak demand. During our visit to the National Grid Control Centre we heard that the levels of imports and exports along the interconnectors are fairly well balanced. However, a unilateral carbon price support system could skew the balance, so that the UK could become more reliant on cheaper imports of electricity from abroad. This could encourage imports of electricity that will displace the need for and lower the price of electricity in the UK, reducing our domestic reserve margin and somewhat reducing our flexibility. This in turn could lead to considerable capital transfers and to energy security issues.

171. Simon Skillings (E3G), noting that EMR was written "in the context of an island system", was concerned that a lack of harmonisation could lead to different situations across the EU.[212] However, this is not a problem of immediate concern given the current low level of interconnection with other European countries and the long construction times involved in building new connectors. In addition, the Treasury's consultation document envisages the UK and EU ETS carbon prices converging in 2030, which would remove this potential problem.

172. "Carbon leakage" occurs when instead of reducing emissions, a carbon price in one jurisdiction simply shifts the emissions (along with the business) elsewhere, where there is no carbon price. Carbon leakage can occur as a result of either direct emissions (an installation's own process and combustion emissions) or indirect emissions (the carbon cost that passes through to consumers in electricity prices). The carbon price support scenarios might increase average non-domestic retail electricity prices by 1-2 per cent in 2013 and 1-6 per cent in 2020. According to HM Treasury, this is likely to have a significant impact on a small, but important number of energy intensive sectors in the UK.[213]

173. The Committee also heard from Professor Helm about the wider problem of measuring carbon emissions. He told us "we should measure carbon consumption, not production, for setting our targets in Europe, so that we Europeans pay the true cost and take the true steps to address our impact on global warming".[214] Reporting carbon consumption figures alongside production figures would help provide greater transparency about the UK's impact on climate change. We recommend that the Government should consider this option.

174. The sectors most affected by the CPS are likely to be: aluminium; calcium carbonate; cement and slag grinding; chemicals (fertilisers, basic inorganic, industrial gases); glass; kaolin and ball clay; lime; malt; non-woven textiles; paper; steel; and wood panel manufacture.[215]The increased electricity cost as a percentage of Gross Value Added (GVA) ranges from between 1 per cent to 5 per cent for the most electricity intensive sectors.[216]

175. We believe that the Carbon Price Support will not influence investment decisions until 2018 at the earliest. We would have preferred the Government to establish a nominal Carbon Price Support level until 2018 and then set a long term trajectory based on advice from the Committee on Climate Change. Until then, the Carbon Price Support represents little more than an additional energy tax, which will be passed on to consumers.

176. We suggest that Carbon Price Support tax revenues should be matched by increased budget for the Green Investment Bank.

177. The Carbon Price Support must not systematically distort electricity prices between the UK and other countries. In an increasingly interconnected market, this could mean significant transfers of capital abroad and the "offshoring" of UK generation.

178. Carbon Price Support is a short-term solution to the failure of the EU Emissions Trading System to deliver a meaningful carbon price. It poses risks to UK energy security and the UK economy more widely. The White Paper needs to justify its costs and benefits and provide a persuasive plan for its integration with the EU Emissions Trading System.

159 DECC, Electricity Market Reform Consultation Document, Cm 7983, December 2010, p 42 Back

160 HM Treasury and HM Revenue & Customs, Carbon price floor: support and certainty for low-carbon investment, December 2010, p 5 Back

161 DECC, Electricity Market Reform Consultation Document, Cm 7983, December 2010, p 44 Back

162 HM Treasury, Budget 2011, March 2011, HC 836 Back

163 HMRC, Carbon Price Support, Tax information and impact note, 23 March 2011, http://www.hmrc.gov.uk/budget2011/tiin6111.pdf Back

164 HM Treasury and HM Revenue & Customs, Carbon price floor: support and certainty for low-carbon investment, December 2010, p 30 Back

165 "EU carbon falls as UK tax pushes costs above Osborne's 'floor'", Bloomberg, 24 March 2011, www.bloomberg.com/news Back

166 "UK generators at odds over carbon price floor impacts, ICIS Heren, 25 March 2011, www.icis.com/heren/ Back

167 Ev 153 (International Power), section 29 Back

168 Committee on Climate Change [CCC] [2008] Building a low-carbon economy-the UK's contribution to tackling climate change', First Report of the Committee on Climate Change [December] [London: The Stationery Office], p 155 Back

169 Point Carbon, EUA OTC Price, www.pointcarbon.com/ Back

170 Ev 137 (Statoil), Ev 143 (E.ON UK), Ev 216 (RenewableUK) Back