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UK budget freezes carbon tax to cut energy bills

In the 2014 UK budget announcement, George Osborne said that tax on carbon would not increase from 2016 to 2020

The UK government has announced a freeze on the carbon tax for electricity generation in an attempt to lower energy bills. The finance minister, George Osborne, said on 19 March that the country's carbon price support (CPS) - the tax electricity generators pay for carbon - would remain at the 2016-17 level of £18 ($29) per megawatt-hour (MWh) until 2020. This is instead of original plans to increase it to £30/MWh in the same period.

The tax freeze is designed to reduce power costs for energy-hungry industries, such as manufacturing, and combined heat and power plants. The government said capping the CPS until the end of the decade could save British businesses up to £4 billion by 2018-19 and cut typical annual household energy bills by £15 by the same date. Total savings across the UK could add up to £7bn by 2018, the government said.

Last year the government set a minimum level that British electricity generators must pay for carbon allowances, called the carbon price floor (CPF). Starting from £15.70 per tonne in 2013 then increasing by around £2 each year until it reaches £30 in 2020. Then it was to climb by £4 per year until it reached £70 by 2030. The government imposes this floor price for carbon on electricity generators by charging a price support mechanism - the CPS - on top of the EU Emissions Trading System (ETS) carbon price.

The CPF came into effect on 1 April 2013 as a top-up charge if the EU market price for carbon fell below £16 per tonne. As European carbon prices averaged around £4 per tonne last year, UK businesses have had to pay the CPF, increasing their power costs.

The aim of the CPF was to provide an incentive for UK businesses to invest in low-carbon energy by making fossil fuel generation more expensive. The UK needs up to £200bn of investment by 2020 to reach its decarbonisation targets. It was introduced to help provide certainty for investors by providing a floor price for future carbon costs which would be reflected in the wholesale power price.

A recent report published by the UK's Environmental Audit Committee, a parliamentary body, said low-carbon investment is less than half of the £200 billion needed in energy infrastructure funding alone by the end of the decade. It left the UK unlikely to reach its national carbon emissions reduction targets, the committee said. The UK wants to cut carbon emissions by 80% by 2050, relative to 1990 levels.

Tim Yeo, a member of parliament and chairman of the of the Energy and Climate Change Committee (ECCC), another parliamentary body, said the CFP had failed to cut carbon emissions and freezing it would boost UK manufacturing. "The decision to introduce a unilateral tax to top-up the EU carbon price actually did very little to reduce emissions overall, despite penalising British energy consumers with higher costs," Yeo said. "As the price of carbon was so low in the EU, any emissions reductions the CPF delivered simply allowed other member states to emit more. It was seen by many as a revenue raiser for the Treasury that damaged public trust in taxes on pollution."

The ECCC said in Jan 2012 that the decision to set a unilateral CPF could have a devastating effect on UK industry and artificially raise electricity prices for consumers, while having no overall impact on emissions. The government will review the CPF for the 2020s and look at whether a continued cap on the CPS will be necessary once it becomes clear how the EU ETS will be reformed.

The ETS has been also been a failure. EU carbon emissions have risen since its introduction in 2005, and low carbon prices provide little incentive to cut coal use. Coal use has rising in Europe since the financial crisis, displacing some of natural gas in generation. The UK government said it was vital to reform and strengthen the ETS by agreeing an ambitious EU climate and energy package for 2030. But the carbon tax freeze is a canny political move by the government, too.

The UK's opposition Labour party said last year it would 'reset the broken energy market' by pledging to freeze UK energy bills for 20 months from June 2015. This was in response to public anger at soaring consumer energy bills, which have risen by almost 40% since 2010. In response Ed Davey, the UK's energy minister, said in December the government would cut energy bills by around £50 per year by reducing some green levies that energy companies must pay to support the government's decarbonising targets. The cost of these levies is then passed onto the consumer.

Phil Grant, a partner in Baringa Partners, a management consultancy, said the tax freeze would lower UK power prices by around £2/MWh compared with prices under the original CPF targets, which would have made coal more expensive than gas-fired generation from 2016. "The freeze is potentially good news for coal-fired generators, who will remain competitive with gas-fired generation longer into this decade," Grant said. "Conversely, this creates more uncertainty for owners and developers of gas-fired generation, as they are now less certain about future operating levels." Grant added that it also creates more uncertainty for green power developers, opting to develop plants under the government subsidies for renewables.

Bank of America Merrill Lynch said that UK natural gas prices would remain high throughout 2014 as domestic production continued to fall, despite demand being low. UK gas prices could be boosted by any temporary supply disruptions from Russia if tensions with Ukraine continue to escalate, the bank said. However tensions between Russia and Ukraine are unlikely to boost coal prices because of oversupply in Europe, which will keep the fuel much more cost-competitive than gas.

Environmentalists were angry with the government's about turn on the CPF. Greenpeace said the tax freeze showed a "lack of ambition in connecting the economy with the environment". RenewableUK, a lobby group for the renewable energy industry, said even if the tax freeze does not divert support from the government's renewable energy targets it would remove the financial incentive to invest in them.

Capacity market

The government also announced on 19 March its plans to develop a capacity market for electricity generation, a core part of the government's electricity market reform strategy. This aims to encourage power producers to provide a stable supply of electricity to UK consumers even at times of peak demand.

New capacity is needed to replace retiring coal, nuclear and older gas power stations to ensure secure electricity supplies. Gas-fired plants will eventually run less frequently as the UK attempts to move to low-carbon forms of power. The compensation power producers in the capacity market will receive will be set through a competitive auction process. Successful bidders must commit to deliver energy when needed or they will face penalties. The Government will run the first capacity market auction in December 2014. First power delivery will be from the winter of 2018-19.

Key points from the 2014 UK budget 

  • The government will extend the compensation for energy-intensive industries (EII) for the cost of the CPF and EU emissions trading system to 2019-20;
  • It will introduce a new compensation scheme, to help EII with higher electricity costs resulting from the renewables obligation and small-scale feed in tariffs for renewable generation, from 2016-17;
  • The combined cost of these compensation measures is expected to be around £500m a year from 2016-17. EIIs will be compensated for all government policy designed to support low carbon and renewable investment up to 2019-20, saving the average EII up to £19m by 2018-19;
  • Fuel used in combined heat and power (CHP) plants for electricity generated to supply manufacturing firms will be exempt from the CPF;
  • These measures will reduce energy costs for UK businesses by up to £7bn by 2018-19, according to the government;
  • These will benefit the most energy intensive manufacturers, around 80% of which are based in the northern England, Scotland and Wales;
  • The government will provide £60m for new low-carbon innovation to support carbon capture and storage technology;
  • The government will review the UK's North Sea tax regime to spur investment as the basin matures (in line with Wood Review recommendations);
  • The government will introduce a new tax allowance for ultra-high pressure, high-temperature oil and gas projects clusters in the North Sea; 
  • The government expects the cost to businesses of policies to deliver the UK's new low-carbon energy infrastructure to increase by around 300% by 2020; 
  • The first capacity market auction will take place in December 2014, subject to state aid clearance being received. Capacity will be in place by the winter of 2018;
  • The capacity market agreements will cover 15-year periods, which the government said will provide investment certainty for new gas-fired plants;
  • Existing power providers will be able to access rolling one-year agreements - although three-year agreements will also be on offer to plants needing significant refurbishment;
  • Penalties for unreliable capacity will be capped at 200% of a provider's monthly income and 100% of their annual income. The government said this will provide a strong incentive for capacity to be there when needed; and
  • The capacity auction will be capped at £75 per Kilowatt to protect consumers from excessive costs.
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