Where should the Chancellor focus his attention for a low-carbon transition?

Joshua Burke

Senior Research Fellow, Energy and Environment

Policy Exchange Energy and Environment Research Fellow Joshua Burke has written for Business Green with some recommendations for how the Chancellor, Phillip Hammond, should focus his attention for a low-carbon transition. The article is reproduced below.

There has been a growing need for Chancellor Phillip Hammond to set out his vision for a low carbon transition – a vision unshackled by the ambitious Clean Growth Strategy (CGS). The CGS provided a flurry of energy policy announcements and deferments – the latter to be dealt with in the Budget. Now, as it looms, this presents an opportunity for the Chancellor to address and reform a number of policies that will drive an affordable, secure and low carbon transition.

But where should the Chancellor focus his attention?

  1. Reform the Levy Control Framework and place affordability at the heart of energy policy

Conceptually at least, the ‘Levy Control Framework’ (LCF) is not a bad piece of policy as it sets a clear limit on costs and gives longer Budgetary visibility than most other departments are gifted. However, in its current form the LCF is not fit for purpose. Indeed, spending caps governed by the LCF have been breached in all of the past three years, leading some to blame this for the early closure of the Renewables Obligation and cuts to the Feed-in-Tariff.  Clearly the Government lacks a framework to manage the cost of all policies on bills in a holistic manner. As it stands, the majority of energy and climate change policies are funded through levies on consumer bills, rather than through taxation. This means that they fall outside normal departmental spending plans, and the high level of scrutiny that this entails.

Moreover, the LCF does not include policy costs such as the Energy Company Obligation, Renewable Heat Incentive, Capacity Mechanism, or Smart Meter programme, because HM Treasury classifies these as ‘regulations’ rather than ‘levies’. A previous report from Policy Exchange entitled The Customer is Always Right recommended that if the LCF is continued, it should be expanded in scope to include all policy costs levied on consumer bills as this would better reflect the total policy cost that is deemed acceptable and affordable.

Recent analysis from Aurora further illustrates the difficulty the Government has in controlling spend under the LCF. They concluded that the Government has underestimated subsidy cost of the latest offshore wind sites by almost 50% – the equivalent of £80m per year. BEIS forecasts that the subsidies to the 3.2GW offshore wind recently awarded a CfD will be £176m per year- based on the difference between the strike price and baseload price- estimated by the Government to be £50/MWh. However, Aurora Energy Research believes that the offshore wind capture price is actually £45/MWh. This increase in subsidy payments by £5/MWh will increase the total forecast subsidy from £176m per year to £261m per year. Therefore, unless BEIS changes its allocation methodology, it risks breaching the LCF once again, further inhibiting the future deployment of renewable technologies. This is likely to have a particular effect on the CfD scheme – the only long term support mechanism for renewable energy in the UK. The interesting question is whether there is then a conflict between maintaining the LCF Budget and meeting targets for renewables or carbon.

  1. Reform the Renewable Heat Incentive and develop a new cost-effective strategy to decarbonise heating

Nearly half (48%) of all energy consumed in the UK is used to provide heating, with domestic heating accounting for 28% of total energy used in the UK. The 2015 autumn Budget announced that the Renewable Heat Incentive (RHI) would be extended to 2020–21 in order to deliver the European renewable heat target and the annual Budget will increase to £1.15 billion by 2020–21, making it a relatively expensive policy. Evidently, decarbonising heat and doing so cost effectively remains a big challenge.

Previous analysis by Policy Exchange has shown that the domestic RHI has provided an average tariff of around £120/MWh, compared to a cost of around £30/MWh or less for energy efficiency schemes or mature renewables technologies under the new Contract for Difference scheme. The Government should pursue the lowest cost solutions to decarbonise heat, and be more open-minded about the range of options available. If energy efficiency measures can be delivered more cost-effectively than renewables, then this should surely be a higher priority.

In addition to this the price of heating fuels needs to reflect their relative carbon intensity, allowing the market to drive out lower carbon solutions rather than higher carbon solutions. To facilitate this, the Government should consider adjusting taxes and levies on electricity, gas and other heating fuels to better reflect their carbon content. For example, Government could increase VAT on carbon intensive fuels (gas, heating oil, coal) – currently at 5%- to the standard rate of 20%.

  1. Provide clarity about the future of the Carbon Price Support mechanism beyond 2021

The Chancellor’s 2017 spring Budget put off changes to the UK’s carbon price until his autumn 2017 Budget. But will he finally set out a long-term trajectory for the Carbon Price Support and give businesses and industry the certainty they desperately need? Calls for clarity extend beyond the vacuum of policy wonks, although opinion is mixed. SSE and Drax recently urged the Treasury to deliver a “robust and strong carbon price”. This came just days after Aurora concluded that because of changing fuel price dynamics, maintaining the carbon price at the current level risks a revival of coal generation in the early 2020s.

Although the CPS has historically been the key driver behind the rapid decline of coal, particularly since 2013, the current price is no longer high enough. To achieve the Government target of phasing out coal generation by 2025, using price signals alone, this would require CO2 prices to rise above £40/tCO2 by 2025 – nearly twice the current price which has been frozen at £18 per tonne of CO2 until 2021. This provides a strong rationale to retain the CPS at least until the early 2020s, to support the Government’s ambition to phase out coal generation.

In contrast, some stakeholders such as the Manufacturers’ Organisation – also known as the EEF – have called for the Government to remove the CPS now. Whilst this would result in an immediate saving to consumers, it would significantly undermine investor confidence as well as the credibility of the Government’s decarbonisation plans.

Clearly a credible future carbon price is needed, but will this be addressed in the upcoming Budget? How the Chancellor responds will be determined by how the Government prioritises affordability, carbon, security of supply, and fiscal considerations. There are no scenarios that tick all of these boxes, so inevitably policymakers will need to choose.

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