The current design of the UK Emissions Trading System (UKETS) includes an Auction Reserve Price (ARP) for allowances, set at £22/tCO2. This effectively establishes a minimum price, or price floor. The Government is now considering potential changes to the UKETS, including whether the ARP should be replaced with another mechanism, kept in its current form, or abolished.
Advantages of including a price floor within the design of an ETS have long been recognised. It has clear benefits when compared with a simple ETS, which allows prices to fall to any level. A floor can remedy the risk of carbon prices which are too low to adequately incentivise investment necessary to meet targets, including net zero, and too low to reflect the environmental damage caused by emissions. Although there is uncertainty about the appropriate level for a floor, the absence of a defined floor in effect sets the price floor at zero, which is certainly the wrong level.
Further advantages of a price floor are now becoming apparent as policy evolves. In particular, contracts for difference on the carbon price (CCFDs) are now widely discussed as a mechanism for supporting low carbon investment, with some steps towards implementation, for example in supporting CCS in the UK. Under a CCFD a carbon price floor can eliminate the risk to governments of larger payments under the CCFD due to very low carbon prices.
Benefits of price floors accrue to a range of stakeholders. The major types of benefits are summarised below. The advantages largely apply whether the price floor is in the form of an ARP or a top-up tax, as used in the Netherlands, but with some differences in detail, as noted.
In all cases the benefits from stability and reduced risks are much greater if the price floor is specified in advance for a number of years.
Benefits to investors in low carbon technologies
Reducing costs of abatement by providing greater certainty for investors. A minimum carbon price can support investments in low carbon technologies by reducing or eliminating the risks that carbon prices will be low, and that investments will consequently be unprofitable. This reduction in risks can facilitate the financing of projects and so reduce the cost of capital. This will in turn reduce the overall costs of investment. These effects are widely recognised by policy makers. For example, the European Commission has stated that a stable carbon price signal is one of the elements that can improve the investment climate for low-carbon investments. Long investment cycles imply stability is needed over longer periods than the current ARP.
Increasing expected average carbon prices. A floor on the carbon price removes the lower part of a price distribution. Other things being equal, this will increase expected average prices. A price floor thus makes the price both less volatile, and so less risky, and higher on expected average. This will in turn stimulate additional investment. In contrast a price ceiling makes the price less volatile but lower on average.
Greater political stability for the UKETS. Reduced price volatility and reduced risks for both investors and government may help sustain the political acceptability of the system, and reduce the need for ad hoc, unpredictable changes or interventions. This will further reduce risks for investors.
Benefits for government
Providing more stable government revenue from allowance auctions. Low prices can lead to low auction revenue for governments, and potential disruption to funding to government spending programmes. In contrast, with a price floor government auction revenue is unlikely to fall to very low levels (unless very many auctioned allowances go unsold). The risk under an ARP that allowances will be unsold does not occur with a top-up tax.
Reducing risks for governments of high payments under carbon contracts for difference (CCFDs). CCFDs are planned to provide used to support for low-carbon technologies, including CCS, in both the UK and EU. Low allowance prices could lead to large payments by the government under CCFDs. A price floor prevents this, and so protects the government against higher expenditure. This may in turn enable a greater volume of CCFDs to be issued, with consequent increases in the deployment of low carbon technologies.
Making sure that low cost abatement is incentivised. If prices can go to low levels there is a risk that emissions reductions will not be incentivised, even if they are clearly cost-effective (with environmental benefits greater than the cost of abatement), and clearly needed as part of a comprehensive programme of emissions reductions. A price floor avoids these risks, providing a clear signal to investors to undertake low cost investments. This reduces the overall costs to the economy of meeting carbon budgets.
Benefits for consumers
Reducing bills for consumers. Lower costs for technologies, and signalling investment in low cost abatement from a price floor will reduce the costs of the transition to low carbon energy system. This will in turn benefit consumers in the form of lower bills from lower prices, and reduced consumption through greater energy efficiency.
Benefits for the climate
Reducing cumulative emissions by cancelling unsold allowances. If allowances are unsold at the auction reserve price they may be cancelled, reducing supply and tightening the cap. This mechanism does not apply to a top-up tax, where the number of allowances is not directly affected.
Reducing emissions by enabling more ambitious targets to be set. Reducing the costs of low carbon investment can enable future caps to be more ambitious, and thus to secure further environmental benefits in future. Both an auction reserve price and a top-up tax can reduce future emissions in this way.
Protecting consumers from price rises
Carbon prices may in some cases be higher with a floor. This may in turn raise prices to energy consumers. The effect of a price floor on residential consumers’ bills is small – typically around a hundred times smaller than current wholesale energy price increases in the absence of government action[i]. However, any concerns about higher prices for residential or business consumers can be readily addressed simply by modifying or extending existing and prospective solutions. This includes the following.
- Allocating allowances free of charge or introducing Carbon Border Adjustment Mechanisms can continue to reduce the risks of carbon leakage for emissions intensive trade exposed industry.
- Direct financial compensation to electricity consumers is in place for some consumers and could be readily extended, for example by using auction revenue to further compensate customers or to fund energy efficiency measures.
- Moving away from marginal cost pricing in wholesale electricity markets would reduce the extent of the effect of carbon prices, as renewables and nuclear do not incur any allowance costs in any case.
The advantages of an enhanced and extended ARP are compelling. UKETS needs not only to retain the current floor, but also to strengthen and extend it.
Adam Whitmore – 27th September 2022
[i] For example, if the price floor leads to carbon prices £23/tCO2 higher than they would have been and full marginal cost pricing were retained in electricity wholesale markets (both of which currently seem unlikely), with typical electricity consumption of 2.9MWh p.a. then each consumer’s bill would increase by around £27p.a., about 1% of the currently expected increase in bills for 2022/3 in the absence of government intervention.