A chaotic patchwork of inconsistent incentives

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Government fiscal policy plays a vital role to play in determining the path towards net zero. Greenhouse gas (GHG) emissions result in a negative externality, using up the available carbon budget and contributing to climate change. In theory, governments should look to mitigate this by introducing an appropriately sized and uniform carbon price, incorporating the cost of the externality. In practice states use a combination of taxes and subsidies to affect the relative price of carbon intensive goods, and through doing so, influence individual behaviour — whether that is good for the environment or not.

In A uniform global carbon price is unworkable, and unnecessary, I explained that there are explicit (or direct) carbon prices such as carbon taxes and emissions trading schemes, implicit carbon prices including fuel excise duties, and finally fossil fuel subsidies that act as a sort of negative carbon price. The OECD’s Effective Carbon Rate (ECR) aggregates the overall impact of these policies into a single price.

The average net ECR among the 78 countries covered by the OECD (~80% of global GHG emissions) was estimated to be €14 per tonne of CO2e in 2023. The country with the highest ECR was Switzerland (almost €160 per tonne of CO2e), while the lowest was Sri Lanka (minus €60 per tonne of CO2e).1

Nevertheless, the average hides a multitude of sins.

Let’s take the United Kingdom as an example. With an ECR close to €30 per tonne in 2023, the UK is around the middle of the OECD league table.

In 1910 it became the first country to introduce a fuel excise duty on gasoline. Early this century it was the first jurisdiction to introduce an emissions trading scheme, launching a pilot scheme that became the basis for the EU ETS. In response to concerns that the EU carbon price was too low the government introduced a top-up carbon tax on power generators in 2013, helping the UK become the first major economy to phase out coal generation (see Britain makes coal history: Unique approach to carbon pricing instrumental to securing coal's fate).2

It maybe a pioneer in carbon pricing, but peering beneath the surface quickly reveals a ragtag of implicit carbon prices applied unevenly across the UK economy, depending on the source of emissions and the end user. The patchwork approach to pricing carbon results in some perverse consequences that instead of accelerating the UK towards net zero, is actually holding the country back.

A recent report from the Institute for Fiscal Studies, an independent research outfit based in London reveals the scale of the disparity between the implicit carbon tax on electricity and gas depending on whether you are a household or a business (both energy intensive and non-energy intensive firms).3

For example, while households effectively receive a £55 (€64) subsidy per tonne of CO2 emitted from consuming gas for cooking or heating, they also face a carbon tax of almost £120 (€138) per tonne of CO2 on their electricity consumption. This disparity arises partly because of the reduced rate of VAT on household energy use (5% versus the baseline rate of 20%), but also because the taxation levied to pay for renewable subsidies falls squarely on electricity.

As the IFS explains, one unintended consequence of this is that it makes it much more difficult to persuade households to switch to heat pumps. Three to four times as energy efficient as conventional gas furnaces, heat pumps are crucial to decarbonising buildings:

“By taxing emissions from households’ electricity use more than emissions from their gas use, the current tax structure makes it more expensive to switch from a gas boiler to a heat pump. This means that some households that would find it easier to switch to a heat pump than to undertake costly reductions in electricity usage nevertheless make the costly cuts because of the tax – driving up the overall cost of net zero.”

The average spark-spread including taxes and levies (the price differential between electricity and gas) in 2023 in the EU was a little less than 3, i.e. the cost of electricity was around three times higher than natural gas on a kwh basis. In the UK it was nearer 5. The higher the spark spread, the lower the incentive to switch to heat pumps, something that is borne out in the UK’s slow rate of heat pump installation (see Hot property: The long-term outlook for the ETS2 carbon price is tethered to heat pumps).

Non-energy-intensive businesses experience an even more extreme gap in tax rates. Each tonne of CO2 emitted attracts a tax of £52 if it comes from gas, and £249 if it comes from electricity, a gap of £197. As with households, the spark-spread reduces the incentive for businesses to pursue electrification. And as such limits the adoption of one of the key instruments by which the UK can make itself more energy efficient. But according to the IFS, as the share of electricity coming from renewable sources increases, the tax differences shown in the chart will only get worse, not better.

“The government plans to achieve a green grid, in part, by expanding the amount of subsidies on offer for renewable electricity producers, with the cost of these subsidies forecast to more than double by 2029–30. Because of the government’s choice to fund these subsidies through taxes only on electricity, this will mean higher taxes on gas-based electricity with no change to taxes on gas.”

A large variation in carbon tax rates is inefficient, resulting in heavily taxed emission sources being prioritised for carbon abatement, even if they are more challenging to reduce. As the IFS explains, the government could achieve lower-cost emission reductions by funding subsidies through a uniform tax on all energy sources, gas and electricity alike. Relatively speaking the price of electricity will go down, while the cost of gas will increase, resulting in a narrowing in the spark-spread.

It’s no use simply comparing one country’s average carbon price (i.e., the Effective Carbon Rate) to another. As the UK’s chaotic patchwork of inconsistent incentives makes clear, things are often a lot more complex. Far from the ideal of a uniform carbon price, the UK’s knotty fiscal mess makes it more difficult to allocate resources efficiently, and in doing so, increases the overall cost of meeting net zero.