Memorandum submitted by Grantham Research
Institute and Centre for Climate Change Economics and Policy*|
* 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
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
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
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
- 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
- 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
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
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
- 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).
- 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
The carbon floor proposal would be strengthened if
complemented by serious attempts to tighten the EU-wide emissions
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
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
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.
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.
27 Fankhauser, S, C Hepburn and J Park (2010). "Combining
Multiple Climate Policy Instruments: How not to do it", in:
Climate Change Economics, 1(3): 209-225. Back
See Martin, R and U Wagner (2009), "Econometric analysis
of the impacts of the UK climate change levy and climate change
agreements on firms' fuel use and innovation activity", Contribution
to the OECD project on Taxation, Innovation and the Environment,
COM/ENV/EPOC/ CTPA/CFA(2008)33/FINAL and Martin, R., L. de Preux
and U. Wagner (2009), "The impacts of the Climate Change
Levy on business: evidence from microdata", Grantham Research
Institute on Climate Change and the Environment, London School
of Economics, Working Paper No. 6, August. Back