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RDI: Work Package 4 – Report 2 Prepared by

Rethinking Decarbonisation Incentives

___________________________________________________

ED 11408 | Issue Number 3 | Date 17/09/2018

Reform Options: Initial

Thinking Rethinking Decarbonisation Incentives

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Ricardo in Confidence Ref: Ricardo/ED11408/Issue Number 3

Ricardo Energy & Environment

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WP4 Report 2 - Reform options – Initial Thinking

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This report forms part of the Energy Systems Catapult project ‘Rethinking Decarbonisation Incentives’ co-funded by the Energy Technologies Institute. This report is the Copyright of Energy Systems Catapult and has been prepared by Ricardo Energy & Environment, a trading name of Ricardo-AEA Ltd under contract ESC1764 dated 19/02/2018. The contents of this report may not be reproduced, in whole or in part, nor passed to any organisation or person without the specific prior written permission of Energy Systems Catapult. Ricardo Energy & Environment accepts no liability whatsoever to any third party for any loss or damage arising from any interpretation or use of the information contained in this report, or reliance on any views expressed therein, other than the liability that is agreed in the said contract.

Author:

Florianne de Boer, Mark Johnson, Alan McCullough, Carolina de Oliveira

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Mark Johnson

Date:

17 September 2018

Ricardo Energy & Environment reference:

Ref: ED11408- Issue Number 3

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Table of contents Abbreviations ...................................................................................................................... 5

Nomenclature ...................................................................................................................... 6

1 Introduction ................................................................................................................ 7 1.1 Current UK policy landscape ............................................................................................. 8 1.2 Scope and rationale for options ......................................................................................... 8

2 Key policy design elements .................................................................................... 10 2.1 The role of complementary policy instruments ................................................................ 10 2.2 Relevance of international experience ............................................................................ 11

2.2.1 Coverage and point of regulation ........................................................................... 11 2.2.2 Price signal and policy certainty ............................................................................. 11 2.2.3 Governance ............................................................................................................ 12 2.2.4 Policy interactions and harmonisation .................................................................... 12

3 Reform option long listing and selection ............................................................... 13

4 Sectoral alignment of carbon policy (Option 1) ..................................................... 16 4.1 Key reform aspects ......................................................................................................... 16 4.2 Expected impacts ............................................................................................................ 18 4.3 Practicability .................................................................................................................... 18 4.4 Implementation issues ..................................................................................................... 18 4.5 Relevant international experience ................................................................................... 20 4.6 Key issues for further analysis ........................................................................................ 21

5 Broad-based upstream carbon taxation (Option 2) ............................................... 23 5.1 Key reform aspects ......................................................................................................... 23 5.2 Expected impacts ............................................................................................................ 25 5.3 Practicability and implementation timescales .................................................................. 25 5.4 Option element description .............................................................................................. 25 5.5 International experience and issues relevant to the UK .................................................. 26 5.6 Key issues for further analysis ........................................................................................ 27

6 Broad-based UK emissions trading (Option 3) ...................................................... 29 6.1 Key reform aspects ......................................................................................................... 29 6.2 Expected impacts ............................................................................................................ 31 6.3 Practicability and implementation timescales .................................................................. 31 6.4 Option element description .............................................................................................. 31 6.5 International experience and issues relevant to the UK .................................................. 32 6.6 Key issues for further analysis ........................................................................................ 33

7 Flexible portfolio standards (Option 4)................................................................... 35 7.1 Key reform aspects ......................................................................................................... 36 7.2 Expected impacts ............................................................................................................ 38 7.3 Practicability and implementation timescales .................................................................. 38 7.4 Option element description .............................................................................................. 38 7.5 International experience and issues relevant to the UK .................................................. 38 7.6 Key issues for further analysis ........................................................................................ 39

8 Consumption-based carbon taxation (Option 5) ................................................... 41 8.1 Key reform aspects ......................................................................................................... 41 8.2 Expected impacts ............................................................................................................ 43 8.3 Practicability and implementation timescales .................................................................. 43

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8.4 Option element description .............................................................................................. 43 8.5 International experience and issues relevant to the UK .................................................. 44 8.6 Key issues for further analysis ........................................................................................ 45

9 Common issues ....................................................................................................... 47 9.1 Governance ..................................................................................................................... 47

9.1.1 International experience of climate change policy governance ............................. 47 9.1.2 UK policy oversight ................................................................................................. 48 9.1.3 Fiscal governance .................................................................................................. 48

9.2 Managing Competitiveness ............................................................................................. 49 9.3 Investment in infrastructure and innovation .................................................................... 51

9.3.1 International experience ......................................................................................... 51 9.3.2 Current UK situation and challenges ...................................................................... 51 9.3.3 Options for supporting innovation and investment ................................................. 51

10 Next steps................................................................................................................. 54

11 References ............................................................................................................... 55

Appendices ....................................................................................................................... 57

Appendix 1: Non-shortlisted option summaries ............................................................. 58

Appendix 2: Overall option summary .............................................................................. 60

Appendix 3: Summary of option scoring ........................................................................ 61

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Abbreviations AFOLU Agriculture, Forestry and Other Land Use

BAU Business as usual

BCA Border Carbon Adjustments

BEIS Department for Business, Energy & Industrial Strategy

C&T Cap-and-Trade

CAT Carbon Added Tax

CCA Climate Change Agreement

CCC Committee on Climate Change

CCL Climate Change Levy

CHP Combined Heat and Power

CPI Carbon Pricing Instrument

CT Carbon Tax

DCLG Department for Communities and Local Government

DEFRA Department for Environment, Food and Rural Affairs

DfT Department for Transport

ETS Emission Trading Scheme/System

EU European Union

FiT Feed in tariff

GDP Gross Domestic Product

GHG Greenhouse Gases

HMT Her Majesty’s Treasury

ICT Information and communications technology

LCA Life Cycle Analysis

LCFS Low Carbon Fuel Standards

LSE London School of Economics

MPC Monetary Policy Committee

MRV Measuring, Reporting and Verification

NER300/400 New Entrants Reserve 300/400

ONS Office for National Statistics

RD&D Research, development and demonstration

RDI Rethinking Decarbonisation Incentives

TRL Technology Readiness Level

UK United Kingdom

WTO World Trade Organisation

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Nomenclature

EUR Euro

ktoe Kilotonne of oil equivalent

kWh Kilowatt hour

TWh Terawatt hour

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1 Introduction The Energy Systems Catapult’s ‘Rethinking Decarbonisation Incentives’ (RDI) project aims to develop

and articulate a range of policy options capable of improving the economic signals for future

decarbonisation across the whole UK energy system. Two earlier Work Packages described the current

framework of economic incentives and assessed the salience of incentives across each economic

sector. In Work Packages 3 and 4 a set of potential policy reform options are characterised, building

upon international experience, as indicated below.

Figure 1: Overview of reports developed in Work Packages 3 and 4 for the Energy Systems Catapult Project

“Rethinking Decarbonisation Incentives”

This report presents the output of Work Package 4. It introduces an illustrative set of potential reform

options and provides an initial description of how they could function. Section 2 introduces the key

design elements for the policy options. This is informed by experience emerging from a series of

international case studies carried out as part of the project. In Section 3 the process of long-listing

possible reform options is explained, together with the method for selecting five approaches. These

shortlisted options are then set out in subsequent sections, including initial thinking on how they could

be introduced and an indicative roadmap for considering them further.

Section 9 then explores three key considerations common to all reform options:

• The design of a long-term regime for governance of policy and implementation.

• Management of competitiveness concerns, especially through border carbon adjustments.

• The approach to integrating ‘core’ carbon policy with complementary measures to support and

enable decarbonisation.

Section 10 concludes by suggesting some next steps for the project.

WP3

Report 1

• 11 International Policy Case Studies

WP3

Report 2

• Synthesis of Lessons Learned from Case Studies and Identification of Key Themes

WP4

Report 1

• Reform Options Characterisation Methodology

WP4

Report 2

• Reform Options

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1.1 Current UK policy landscape The aim of the RDI project is to take a fresh look at the range of options to improve the framework of

economic drivers for decarbonisation across the UK economy. Current policies do not give rise to

coherent or clear enduring incentives for all emitting activities or sectors. This reflects the progressive

introduction of a multiplicity of policies each designed within a specific sectoral context, without explicit

attention focused on creation of a broader economy-wide framework to drive decarbonisation.

The options developed here take a different approach. They adopt a whole system perspective in which

a single policy concept is applied across many (or all) sectors, aiming to incentivise the most cost-

efficient investment over the long term.

Differences in the strength of decarbonisation incentives across the economy were examined in an

earlier report within this Energy Systems Catapult project1. That work showed that the effective carbon

price arising from current policies is below the level that the government considers necessary to meet

its climate change targets for many activities, but above target for others.

Table 1: Current levels of carbon pricing by sector

Activities with carbon price below target Activities with carbon price above target

Agriculture Road transport (including congestion and other

externalities)

Air transport Rail transport (to replace road transport)

Coal and gas-based electricity generation Historic renewables projects

Natural gas consumption for all main end users Nuclear power

Electricity use by households and large business

Oil and gas production

Fuel use by business and industry

Land use change

Lowest cost solar PV schemes

Under the current landscape many decarbonisation policies are sector specific, which contributes to

different effective carbon prices and limited incentives to trade off emissions reductions between

different sectors. This is because sectors differ in terms of the number and size of their emitters, and in

terms of their related policy challenges, which makes a single system wide policy approach difficult to

achieve. However, the present report considers options that could create a strong decarbonisation

signal in all sectors, including through a system-wide approach, and identifies ways in which that could

be achieved.

1.2 Scope and rationale for options The options have been selected on the basis that their implementation could credibly begin within five

years. However, they are very ambitious and are not all equally feasible. They represent alternative

approaches to the challenge of providing a strong decarbonisation signal across the economy and each

has its own weaknesses and trade-offs for aspects such as practicability, cost effectiveness and impacts

on related policy objectives.

The options are intended to illustrate the issues and range of potential approaches open to the UK. For

example, the broad taxation option is closely aligned with the ‘universal carbon tax’ outlined by

Professor Dieter Helm in the 2017 Cost of Energy Review. They are presented here as initial

characterisations, rather than as fully worked up designs or recommendations, and the main issues to

be examined further are explained.

1 Report titled 'Current Economic Signals for Decarbonisation in the UK' produced by Will Blyth, Oxford Energy Associates under Work Packages

1 & 2 of the ‘Rethinking Decarbonisation Incentives’ project

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Decarbonisation policies also have an effect on the achievement of other objectives, such as improved

energy security, increased deployment of renewables, reduced pollution to air and water and reduced

fuel poverty. They also relate to the wider fiscal regime including taxes on fuels, other goods and

services. This report focusses primarily on how to incentivise climate change mitigation and only notes

potential interactions with the achievement of these wider objectives.

The reform options are proposed at a time of policy flux. The government is developing approaches to

streamlined energy and carbon reporting2. The Clean Growth Strategy and Industrial Strategy both seek

ways of delivering decarbonisation in a way that is consistent with strong economic growth. The position

of the EU ETS after Brexit is unclear, although some degree of change to the carbon pricing regime for

the covered sectors is possible. These and other changes create an opportunity to consider the potential

for wider reform of decarbonisation policy. This report therefore considers policy reforms against the

landscape as it exists in early 2018, including different options for future UK participation in the EU ETS

or its own UK-specific ETS.

2 https://www.gov.uk/government/consultations/streamlined-energy-and-carbon-reporting

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2 Key policy design elements To be successful any reform option must provide a comprehensive incentive to steer the UK economy

down a low carbon path. The options introduced here have some form of carbon pricing at their core,

but consideration is also given to complementary policies that could achieve a robust system-wide

incentive. This is explained in Section 2.1. The options have been informed by a set of international

policy case studies, the main findings of which are summarised in Section 2.2.

2.1 The role of complementary policy instruments A recent paper from Grubb et al.3 suggests that the transition to a low-carbon economy requires a

combination of “three different domains of socio-economic processes and their associated modes of

decision-making”, which are called satisficing, optimising and transforming in Figure 2 below. Each

domain operates at different timescales and is driven by different types of policy instruments suitable

for the associated mode of decision making.

Figure 2: Illustration of three socio-economic domains and their time-frames for energy-climate transitions

based on Grubb et al. 2015

The first domain (satisficing) is broadly based on behavioural economics and focuses on delivering

short-term changes driven by standards and engagement measures. The second domain (optimising)

is underpinned by neoclassical economics and is mostly driven by markets and prices created by carbon

pricing policies. Corporate investment in products and projects lies in this domain. The third domain

(transforming) is based on evolutionary economics and is focused on delivering strategic investments

that drive infrastructure investments or R&D measures that deliver innovation4.

Grubb argues that a single focus on carbon pricing policy within the second, optimising domain, would

fail to deliver a full transition to a low-carbon economy. Therefore, a mix of approaches that uses a

combination of these domains and timescales will be necessary.

3 Grubb, M., Hourcade, J., Neuhoff, K. 2015. The three domains structure of energy-climate transitions. Technological Forecasting & Social Change

98(290-302). 4 Grubb, Hourcade, Neuhoff. 2014. Planetary Economics: Energy, Climate Change and the Three Domains of Sustainable Development. Routledge.

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Other literature sources point to the benefits of combining carbon pricing with measures that target

behaviour change and innovation5. For example, a recent analysis by the Grantham Research Institute

at LSE6 identifies three broad categories of policy instruments that can be used to stimulate innovation,

namely command-and-control regulation, technology-based standards and market-based policies.

Taking the above into account, the options identified in this report consider how ’core’ carbon pricing

measures in the second domain could be combined with complementary measures operating in the first

and third domains identified by Grubb et al. Since such measures could be applied for multiple options,

they are discussed in Section 9.

2.2 Relevance of international experience A set of 11 case studies have been produced to analyse how issues relevant to the UK experience have

been addressed internationally. The case studies include examples of a range of policy approaches to

the shaping of economic signals for decarbonisation, including standards, subsidies, tradeable

certificates and interacting suites of policies, as well as carbon tax and cap and trade approaches. A

summary of the key findings from these case studies relevant to the UK is provided here.

2.2.1 Coverage and point of regulation The extent of sectoral coverage of a decarbonisation policy is a key design consideration. More

comprehensive coverage offers greater potential to incentivise an economically efficient balance of

emissions reductions across different sectors. However, there may be challenges to design a policy

that has a wide coverage, because some sectors may be difficult to include from a practical perspective,

concerns may exist around competitiveness impacts or the sector may be perceived to have little or no

cost-effective abatement opportunities. Also, it is commonly argued that agriculture is particularly

challenging for carbon pricing instruments than other sectors, because of its specific characteristics,

especially the difficulty of measuring biological emissions. Experience suggests that partial sectoral

coverage is more easily achieved, but that this can lead to inconsistent incentives within those sectors.

In addition, phasing in of sectors and policies over time has been proven an effective way to test policy

impacts and allow time for participants to adapt.

Sector specific policies can lead to significant variations in the strength of decarbonisation

incentives and significantly affect the overall cost-efficiency of policy. One way in which sectors

can be covered differently by the same policy is through varying the point of regulation (i.e. the position

of the regulated entity in relation to the physical source of emissions). An entity responsible for

complying with the system can be either at the point of emissions (such as power stations) or upstream

or downstream from this point (such as respectively fuel suppliers or electricity consumers). The case

studies show that the point of regulation should be determined for each sector independently and where

cost-pass through is possible, an upstream approach can ensure comprehensive coverage and low

administration costs. The ETS in New Zealand provides a good example of this.

2.2.2 Price signal and policy certainty Target setting is critical to the strength and success of decarbonisation incentive policies.

Although there are different types of policies that could be employed, they would all need to be

underpinned by a target. The robustness of this target will strongly affect the credibility of the policy and

the emissions outcomes that are achieved. Therefore, targets should be based on verified data.

Mitigation of competitiveness impacts is a priority for carbon pricing design. The case studies

demonstrate that governments often implement measures to protect the competitiveness of industries.

5 Advani, A., Bassi, S., Bowen, A., Fankhauser, S. Johnson, P., Leicester, A., Stoye, G. 2013. Energy use policies and carbon pricing in the UK.

IFS Report R84. Centre for Climate Change Economics and Policy and Institute for Fiscal Studies.

Grimaud, A. and Lafforgue, G. 2008. Climate change mitigation policies: are R&D subsidies preferable to a carbon tax?, LERNA Working Paper

08.31.275, University of Toulouse. 6 http://www.lse.ac.uk/GranthamInstitute/wp-content/uploads/2016/01/Dechezlepretre-et-al-policy-brief-Jan-2016.pdf

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This can lead to a different decarbonisation incentive for protected industries (i.e. trade-exposed) versus

non-protected ones. From a price signal perspective, what is particularly important is whether the level

of financial protection received by a company depends upon its actual emissions. If that is the case,

then the protection measure is a subsidy to emit and the real price of carbon is lower than for non-

protected companies. By contrast, if the level of protection is fixed ex-ante, then the incentive to abate

is preserved.

Policies should be designed to ensure long term relevance. The case studies demonstrate that

policies are not designed at one moment in time with a single set of regulatory parameters that remain

unchanged. Instead, policymakers will want to ensure the policy remains suitable or even strengthens

its economic incentives for decarbonisation over time in line with emissions reductions targets. The way

in which policies are designed to adapt will affect the confidence that stakeholders have in them

(considered in the next sub-section in more detail). For instance, price ceiling or floor mechanisms may

be used to manage the volume or price of allowances in cap-and-trade systems in the event of

unforeseen economic changes. Alternatively, connections outside the system, for example offsetting

with international credits, may be used to provide access to international emissions savings should

abatement nationally become too expensive.

2.2.3 Governance Investor confidence in the robustness and longevity of policies and resulting incentives are vital

for influencing long term choices. An independent and legally enshrined policy framework which

clearly signals policy ambition level, empowers parties in the policy development process, and holds

them accountable to results, is paramount for ensuring investor confidence in the policy.

Investor confidence also requires a wider acceptance of the policy and a perception by

stakeholders that policymakers are addressing their concerns. Policy must be perceived as stable

and well-integrated with other related objectives and policy measures, for example on energy supply

and use. Substantial political will may be necessary to establish a carbon pricing approach, especially

if this covers multiple jurisdictions. Strong action by central government is required to define acceptable

carbon pricing systems, ideally enshrined in legislation to provide longer term policy stability.

It is important to balance policy flexibility with market stability. The case studies demonstrate the

balance to be struck between keeping policies relevant as economic conditions change and minimising

regulatory interventions. Transparent rules on how policy interventions would function and a lead time

before any changes are enacted can help manage market confidence.

2.2.4 Policy interactions and harmonisation Policies to complement carbon pricing are needed. Complementary policies are often required to

address additional objectives or barriers to emission reductions, which carbon pricing does not address.

These may overlap or interact with a carbon pricing instrument. Additional objectives could include local

economic development, creation of jobs or national energy security. Preferential support for renewables

or energy efficiency measures means that carbon price targets are less likely to be achieved at the

lowest cost. Policy makers have often accepted this, as it enables them to meet multiple objectives and

gain policy acceptance.

Effort sharing between traded and non-traded sectors is important. The balance of effort between

sectors covered by a carbon price and sectors covered by other decarbonisation policies can be guided

by analysis of the costs of investments in the relevant sectors and technologies. None of the cap-and-

trade mechanisms examined in this study are considered by their governments to be the full or only

approach to decarbonisation. In some cases, they are considered a back-stop policy in combination

with other, often pre-existing, policies to achieve GHG emission reductions.

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3 Reform option long listing and selection The reform options described in this report were selected from a longer list by the project team and

Energy Systems Catapult. They are not individual modifications to existing policies, but instead take a

whole systems approach to the construction of decarbonisation incentives.

The starting point was to identify a candidate set of policy approaches, drawing upon the international

case study reviews carried out within the project. These deliberately represented a range of policy

ambition from incremental modification of existing decarbonisation policies to more substantial reforms

such as uniform economy wide carbon taxation or new emissions performance standards.

A total of 12 potential reform options were identified and a simple high-level assessment carried out to

short-list the five options that are developed further in this report. Brief summaries of the reforms that

were not shortlisted are contained within Annex 1. The assessment used a subjective scoring system

to rank each option’s performance against criteria including:

• Strategic fit with current policy objectives

• Value for money

• Affordability

• Achievability

• Credibility.

The full set of options are presented in Figure 3, with those shortlisted shown in grey boxes. The

horizontal position of each option indicates the degree of change to the existing policy landscape. The

vertical position represents the point at which the regulation is applied in relation to the point of

emissions, i.e. upstream or downstream. It should be noted, however, that this diagram is only indicative

of the broad positioning of each option.

Figure 3: Overview of all 12 long-listed policy reform options

The shortlisted options were generally better scoring in the simple assessment but not universally so.

It was deliberately decided to develop a spectrum of approaches and to explore options even if they

are visionary and may be difficult to take forward in the short term. In particular they consider a mix of

price and volume-based measures. The five shortlisted options are:

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• Option 1: Sectoral alignment of carbon policy. Existing policies are modified to improve the

harmonisation of the decarbonisation incentive across the main sources of emissions.

• Option 2: Broad-based upstream carbon taxation. A uniform carbon tax is introduced and

applied across as many sectors and emissions sources as practicable, replacing many existing

decarbonisation policies. Complementary mechanisms are introduced to support behaviour

change, innovation and long-term infrastructure investment.

• Option 3: Broad-based UK emissions trading. A broad-based cap and trade is introduced.

This necessitates a mix of regulating larger emitters directly, (in line with the EU Emissions

Trading System approach), and upstream regulation of smaller energy/fuel consumers, such

as householders or vehicle owners. Many existing policies are replaced. Complementary

mechanisms are introduced to support behaviour change, innovation and long-term

infrastructure investment.

• Option 4: Flexible portfolio standards. Standards for the carbon intensity of energy use are

applied across as many sectors of the economy as possible. Tradable carbon certificates

provide flexibility for obligated entities. This replaces many existing policies.

• Option 5: Consumption based carbon taxation. A carbon tax is introduced, applied at the

point of purchase of products, either as a sales tax related to embodied carbon or a carbon

added tax at each stage in the supply chain.

We also consider three key design challenges which are relevant to all of these options:

• Policy design and governance to build long term credibility and confidence for private sector

investors.

• The management of industrial competitiveness concerns, especially through border carbon

adjustments.

• Integration of core carbon policy with complementary policies to promote behaviour change,

innovation and long-term investment.

These are addressed in Section 9.

Each of the five shortlisted reform options are described in the following sections. For each option, the

rationale for the reform approach is first outlined and the key reform aspects are then explained. The

relevance of the international case study experience is described, alongside the main UK policy issues.

Finally, a simple assessment of each reform option is presented and the main elements of a road map

for developing them further are described.

Each policy option is summarised in tabular form, showing which policies would apply to each main

sector and whether it is a change from the policies currently in place. These sectors and their current

policies are depicted in the table on the following page.

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Table 2: Overview of current policy landscape

Policy Instruments: EU Emissions Trading System (ETS), Climate Change Levy (CCL), Climate Change Agreements (CCAs), Climate Change Support (CPS), Fuel Duty

Sectors Current Policy Policy

Instrument

Power EU ETS applies to direct emissions at power stations. CPS applies to fossil fuels used for

power generation ETS CPS

Industry

Energy Intensive EU ETS applies for direct emissions (combustion and process) at energy intensive

industrial installations.

CCL applies for fossil fuels used within industry. Certain industries, especially those more

energy intensive, can receive CCL reductions by meeting CCA targets

ETS CCAs CCL

Other CCAs CCL

Buildings

Business/Public CCL applies to business and public sector use of energy in buildings. Some businesses

can receive CCL reductions by meeting CCA targets CCAs CCL

Residential

Waste

AFOLU

Transport

Road Fuel duty applies to road fuels Fuel Duty

Rail Fuel duty applies to rail fuels Fuel Duty

Aviation Flights within the EU are covered by the EU ETS ETS

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4 Sectoral alignment of carbon policy (Option 1) This option modifies existing policies to increase the coverage and coherence of the decarbonisation

signal. It does this by increasing the sectoral coverage of decarbonisation policies and harmonising the

level of their decarbonisation incentives. The approach maintains the sector specific design of the

existing landscape and is less revolutionary than other options, although nevertheless does comprise

substantial policy reform. The benefits of this approach are two-fold: to establish carbon pricing where

it is not currently employed, and; to broadly harmonise the strength of carbon price incentive across

these sectors.

4.1 Key reform aspects This option seeks to harmonise carbon pricing in the following sectors:

• Power

• Industry

• Buildings

• Waste

• AFOLU

• Transport (as option variant)

The main reform aspects are depicted in the table on the following page.

Reform to transport fuel duty is a variant that could be included in this option. Current fuel duty could

be modified to be denominated in carbon terms and aligned with that of a reformed CCL. However,

there are many other priorities for transport policy and a more holistic reform package that also

addresses local air pollution and congestion, for instance, could be considered.

Note: There is currently double carbon pricing of electricity through the coverage of its generation within

the EU ETS (the cost of which is passed through to consumers) and its supply under the CCL (for

businesses). This double counting could be avoided by the exclusion of electricity from either one of

these policies. The proposed approach is to exclude electricity from the CCL and keep it in the EU ETS

(or successor). The reason for this choice is that exclusion of electricity generation may not possible

under a post-Brexit ETS arrangement with the EU.

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Table 3: Overview of Option 1; Sectoral alignment of carbon policy

Policy Instruments: EU (or UK) Emissions Trading System (ETS), Climate Change Levy (CCL), Climate Change Agreements (CCAs), Climate Change Support (CPS),

Reformed Fuel Duty

Notes:

• An ETS continues in the UK under the same basis as the current EU ETS in terms of coverage.

• Carbon leakage risks are contained through free allowance allocations of CCAs which are available only to qualifying trade-exposed emission-intensive

activities.

Sectors Proposed Policy Policy

Instrument

Change from

Current?

Power Covered by the EU ETS (or UK replacement) plus a modified/extended CPS top up (aligned to

the required carbon price).

ETS CPS ✔

Industry

Energy

Intensive ETS CPS ✔

Other CCL is reformed to be based on the carbon content of fuels and aligned to the required

carbon price. CCAs remain for trade-sensitive industries. CCL CCAs ✔

Buildings

• Business/Public CCL is reformed to be based on the carbon content of fuels and aligned to the required

carbon price. Expanded to cover all the business/public sectors not currently covered. CCL ✔

Residential

CCL is extended as a carbon tax (aligned to the required carbon price) on the consumption

of fossil fuels. It does not apply to electricity consumption, which is already covered

upstream.

CCL ✔

Waste Qualifying actions (i.e. that demonstrably reduce emissions) are rewarded with tradeable

credits or direct land use/agriculture subsidies.

Carbon Credits ✔

AFOLU Carbon Credits ✔

Transport

Road Covered by a reformed Fuel Duty (denominated by carbon content and aligned with the

required carbon price).

Fuel Duty ✔

Rail Fuel Duty ✔

Aviation Covered by the EU ETS (or UK replacement). ETS ✘

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4.2 Expected impacts For all of the options the impact on emissions would depend on the strength of the incentive applied

(for instance the level of an emissions trading cap or carbon tax rate), and how this would be expected

to change over time. It’s beyond the scope of this work to calibrate the potential incentive strength of

policies, but it is possible to assess the broad likely pattern of impacts, in terms of the treatment of

sectors and fuels.

Under this option, the balance of incentives would shift to align effective carbon prices on the use of

primary fuels and electricity within the buildings sector, where currently the price is higher for the latter.

This change would also bring the effective carbon price in the residential sector up to the same level as

that in the business sector. Within the business sector, a carbon price incentive (credit) for emissions

reductions in the waste and agriculture sectors would be created at the same level as the price in other

business sectors. The effect of these changes compared with what would be expected under current

policies would be:

• Greater use of electricity compared with primary fuels.

• Lower energy use and emissions in the residential, agriculture and waste sectors relative to

business sector.

Note: as with other options in this report, a carbon price signal for fuels used in electricity generation

will be passed through to wholesale prices based on the cost of the marginal (price setting) generation

technology. If this technology is carbon intensive but the generation mix more generally is much lower

carbon, then consumers may be subject to a disincentive to use electricity that is greater than would be

warranted given the overall emissions from electricity generation.

4.3 Practicability Of the options described within this report, Option 1 would be the least practically challenging to

implement. The changes to CCL rates could be relatively quick since they are updated regularly anyway

and emissions factors for fuel use are well understood and published for other purposes, e.g. company

greenhouse gas emission reporting.

The proposed introduction of a carbon credit mechanism for agriculture and waste would be more

complex. It would require a new or existing body to take responsibility for administration, oversight and

the creation of rules for project eligibility and accounting. It would also require a mechanism to enable

the trade and transfer of credits. These aspects are likely to take several years to develop, and a pilot

phase may be necessary.

4.4 Implementation issues The main aspects involved in implementing the reform are described below, against a set of headings

that are used for all reform options in this report.

Fiscal aspects

The option principally involves changes to the rates applied within the CCL and the energy covered.

This will affect the revenues received by government and the incentive within each sector to decrease

energy consumption. The current rates for electricity and gas use are respectively 0.583p/kWh and

0.203p/kWh7, which correspond to carbon prices of about £17/tCO2 for electricity and £11/tCO2 for gas8.

7 HMRC. 2011. Climate change levy rates. Available from: https://www.gov.uk/government/publications/rates-and-allowances-climate-change-

levy/climate-change-levy-rates 8 Authors’ calculation

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A key change is the removal from the CCL of primary energy supplied to emitters who are already

covered by the EU ETS (to eliminate what is in effect double taxation). Natural gas supplied to industry

amounts to about 8,500ktoe9, or 99TWh. If this were the amount of energy to be excluded from the

CCL, then at current rates government revenues would reduce by about £200m per year. This simple

estimate would be refined upwards by taking account of the other fuels that would be excluded from

CCL under the option and refined down by recognising that not all industry gas is covered by the EU

ETS and that certain industries receive a rebate on the CCL payments under the CCAs.

A second aspect is the extension of the CCL to cover fossil fuel supplied to the residential sector.

Residential gas supplies amount to about 27,000ktoe and are by far the largest energy carrier to the

sector. Inclusion of this energy in the CCL (at current rates – which are significantly lower than target

carbon prices) would raise about £640m.

These changes should be considered in the context of existing CCL revenues and energy costs. CCL

revenues in 2016 were nearly £1.9bn, whereas the effect of the changes described above could be an

increase of around 20-30%, at current rates. In practice, however, the impact on residential energy bills

may create pressure to offset the additional costs to the residential sector, particularly for those groups

most affected.

Regulatory aspects

The reform option changes would involve amendment to the CCL statutory instrument to apply the levy

to additional sectors and to reform its rates. This could be done as an amendment to the Climate

Change Levy Regulation.

The Climate Change Agreement Regulation may need to be updated to reflect the revised scope of the

system.

The carbon floor price is currently implemented as special rates for CCL for power generation from gas,

solid fuels and LPG, and through fuel duty in the case of certain oils (especially fuel oil and gas oil). The

extension of the floor price to cover all fossil fuel supplied to emitters covered by the EU ETS could be

enacted through changes to these statutory instruments.

A new policy mechanism would be needed to establish a carbon credit system within the waste and

agricultural sectors. This could be based on existing carbon accounting and offsetting standards. It

would need to be established in law because it would be linked to the CCL or the ETS in the UK. This

could be done as changes to the legislation for those systems.

Institutional aspects

In general, this option involves changes to existing policies, rather than introduction of new ones, so

could be implemented with existing institutional arrangements. However, the introduction of carbon

credits for the waste and agricultural sectors would be new and would require an oversight body. In

particular, checks would be needed on the eligibility and performance of projects and a process would

be required to award credits to project operators. New reporting and trading systems would be needed

to transfer and track credits. These functions could be carried out by the Environment Agency (EA),

which has experience regulating the sectors concerned and implementing market-based policies.

Changes to the coverage of ETS and CCAs (via CCL changes) would impact the audit and oversight

regime for those polices. They are both regulated by the EA. For the EU ETS the EA currently validates

monitoring plans, assesses annual emissions reports and can carry out reviews of operator’s

compliance arrangements. For CCAs, the EA carries out an audit programme. The scope of these

activities would need to be changed.

9 Digest of UK Energy Statistics Table 1.1.5, data for 2016

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The CCL is currently charged on the supply of energy to certain customer groups and meters. A new

process would be needed if it were not to be charged when the energy is accounted for under the EU

ETS. This could be akin to the CCAs reduced rate certificates for CCL rebates. A checking regime for

these arrangements would be needed.

Border carbon issues

Common aspects related to the need for and application of border carbon adjustments are discussed

in Section 9. Option 1 concerns adjustments to existing measures and arrangements to compensate

trade exposed industries are expected to be maintained, avoiding the need for any new border carbon

adjustments.

4.5 Relevant international experience Several elements of this option have been discussed in other studies or relate to the international

experience reviewed as part of this project. These are described in the section below and concern:

• The continuation of the combination of the EU ETS with the CCL in the UK after Brexit.

• Crediting schemes for emission reductions in the waste and agriculture sectors.

Continuation of the EU ETS and CCL combination in the UK after Brexit

Maintaining the current combination of the EU ETS and CCL would be a relatively easy and cheap

climate policy option for the UK post Brexit, compared with developing new policies, as the government

has already spent time and resources on developing and implementing these systems1011. In addition,

participation in the EU ETS would give the UK continued access to low-cost options for emission

reductions in other countries.

The downside of linking or ongoing involvement in the EU ETS would be that the UK would be exposed

to changes to the EU carbon market but would have less influence over EU ETS policy decisions than

it does now12. As an example of the risks that linking can pose, the initial unlimited use of Kyoto credits

in the New Zealand ETS was perceived as a way to access cheaper abatement options and avoid

problems with lack of liquidity in the NZ ETS13. However, the experience in New Zealand showed that

it also made the system more vulnerable to negative occurrences in the other schemes, since the

collapse in the Kyoto market also contributed to a collapse in the NZ market.

Some studies outline how Brexit provides an opportunity for the UK to revise its climate policies. In

particular, one study points to the fact that current UK climate targets are more stringent than those set

under the EU10. There is therefore a need for additional policies in any case, even if the UK stays in the

EU ETS after Brexit. In addition, other sources highlight that any changes in policy should consider the

policy cycle of the EU ETS, i.e. Phase 3 ends at the end of 202014.

Crediting for waste and agriculture

New Zealand is one of the few countries that has seriously considered including agriculture in its

emissions trading scheme, but ultimately decided not to do so, due to concerns around carbon leakage,

lack of perceived abatement opportunities and lack of available emissions data. This experience

indicates it is a difficult sector to include in a carbon pricing system.

Carbon crediting is an alternative mechanism to create a decarbonisation incentive in the waste and

agriculture sectors, but avoid the problems cited above. In particular, participants who can monitor and

reduce emissions cost effectively can take part and benefit from credit revenues that improve their

10 Imperial College London. 2017. Carbon pricing in the UK post-Brexit: tax or trade? A Discussion Paper. April 2017. 11 Vivid Economics. 2017. Brexit and the UK’s future climate policy. Principles and options. May 2017. 12 UK Emissions Trading Group. 2017. Post Brexit UK Climate Policy options for UK installations and sectors covered by the EU ETS. March 2017. 13 WP 3 report 2 14 Committee on Climate Change. 2016. Meeting Carbon Budgets – Implications of Brexit for UK climate policy. Briefing note October 2016.

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competitive position. However, the literature highlights that crediting mechanisms require clear

methodologies and eligibility requirements and depend on other mechanisms that can create strong

demand for these credits15.

4.6 Key issues for further analysis A simplified assessment has been carried out in which each option is scored from +2 to -2 according to

how well it performs against a set of criteria, as depicted in Table 4. These are unweighted and were

used to support the shortlisting process described in Section 3. They were also used as a starting point

to identify the main issues with each option. Both the preliminary assessment and a set of key issues

are presented here to inform subsequent analysis to develop and critique the options further.

Table 4: Preliminary assessment of Option 1; Sectoral alignment of carbon policy

Scoring 2 1 0 -1 -2 Comments

Assessment criteria

Strategic fit ✓ Price alignment ensures consistency across economy

Value for Money ✓

This scenario seeks emission savings from sectors where it might be more expensive. It also has a higher administrative burden.

Potential affordability ✓ Raises substantial revenues, which could be offset by tax recycling

Potential achievability ✓ Likely resistance from residential sector (and transport if included)

Critical dependencies ✓

No reliance on new infrastructure or measure development, but would need to solve ETS oversupply

Competitiveness ✓ Industry would experience no change

Long term credibility ✓

Complex mix of inconsistent policies, additional regulations and measures that are vulnerable to change.

Price Signal ✓ Price alignment strengthens carbon pricing signal

Accelerates Transition ✓ Increases pressure for innovation and investment

Collateral effects and unintended consequences

Vulnerable groups Increases energy prices for those in fuel poverty

Consumer perception Increases taxes on food, travel and energy

Jobs Negative impact on business cost base

Innovation Increases regulation of SMEs

Resource efficiency No significant impact

Pollution / Waste Crediting increases waste recycling

Overall score -1

Further development of this option would be needed before it could be considered viable. Below are

the key design issues to be considered further.

Mechanism design and target setting

- CCL and CPF redesign would need to be in line with UK climate targets. This option,

deliberately, changes the level of decarbonisation incentive for certain energy types and sectors

by changing which policies apply to them. This means that different abatement would occur,

and the total level of abatement will be different than currently envisaged. The rates applied in

15 Rockefeller Foundation and PWC. 2011. Agricultural carbon markets. Available from: https://www.pwc.co.uk/assets/pdf/agricultural-carbon-

markets.pdf

https://www.pwc.co.uk/assets/pdf/agricultural-carbon-markets.pdf


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these policies would therefore need to be adjusted to achieve the UK’s intended long-term

decarbonisation targets.

Development of demand for waste and agriculture credits

- Purchases of credits generated by the waste and agriculture sectors would need to be

valid for liabilities under UK-specific policy mechanisms (i.e. CCL and CPF). The UK

would need to create a system enabling credits generated by the waste or agriculture sector to

be valid for compliance with UK policies (recognising that the UK could not unilaterally require

this for the EU ETS).

- Crediting mechanisms require clear methodologies and eligibility requirements. The

development of the methodology and eligibility requirements would need to consider lessons

learned from international mechanisms such as the Clean Development Mechanism (CDM)

and research into the most effective activities to reduce emissions from waste and agriculture

in the UK. In particular, it would be necessary to avoid rewarding cheap emissions savings that

might be made anyway.

Competitiveness concerns and revenue recycling

- Carbon leakage risk measures would need revision. The reform option would change the

costs incurred by companies from energy and carbon policies. The current measures to

address competitiveness concerns are free EU ETS allowances and CCL rebates for

companies meeting CCA targets. These would need to be reviewed to ensure they are fit for

purpose taking account of changes to policy coverage and effective decarbonisation signal

under this option. New measures may be required.

- Research revenue recycling options. The extension of the CCL is expected to raise

additional revenues that could be used to mitigate any negative impacts from the policies

presented in this option.

Stakeholder engagement

- Stakeholder engagement would be important to achieve support for changes to policy

coverage and incentive levels. The process by which carbon tax rates are reformed should

be inclusive, and the methodologies for calculating the rates should be transparent. This will

help gain stakeholder buy-in and reduce the possibility of legal challenge.

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5 Broad-based upstream carbon taxation (Option 2) This approach aims to replace the existing decarbonisation policy landscape in the UK with a single,

upstream carbon tax that covers the whole economy. The carbon tax would be complemented by policy

measures that aim to drive necessary behavioural, innovation and infrastructural changes that may not

be achieved by a carbon tax on its own. The benefits for this approach are:

• The establishment of a single carbon pricing regime across many sectors of the economy, to

create incentives for the lowest cost combination of emissions reductions.

• Additional support for measures to encourage shorter term behavioural change and longer term

low carbon innovation and infrastructure development.

5.1 Key reform aspects The policy reform approach achieves harmonised carbon pricing for fuel use in all sectors:

• Power

• Industry

• Buildings

• Waste

• AFOLU

• Transport

Carbon pricing for non-combustion (industry, waste and agriculture) emissions is applied as far as

practicable through a carbon tax, which is likely to be most suitable in industrial settings. The main

reform aspects are depicted in the table on the following page.

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Table 5: Overview of Option 2; Broad-based upstream carbon taxation

Policy Instruments: Carbon Tax, Reformed Fuel Duty

Notes:

• UK opts out of the EU ETS and removes existing carbon/climate change taxes.

• Complementary measures are introduced to encourage investment in behavioural measures, innovation or infrastructure to address barriers that carbon pricing

along cannot address.


Mechanism

Change from

Current?

Power An upstream carbon tax is introduced covering all fuels for energy-related purposes

(including electricity generation, heat, and transport). Carbon Tax ✔

Industry

Energy Intensive The carbon tax is applied to direct emissions, as practicable. Border tax adjustments are

introduced for trade-sensitive activities/products.

Carbon Tax ✔

Other Carbon Tax ✔

Buildings

Business/Public An upstream carbon tax is introduced covering all fuels for energy-related purposes

(including electricity generation, heat, and transport).

Carbon Tax ✔

Residential Carbon Tax ✔

Waste The carbon tax is applied to direct emissions from waste and AFOLU activities, as

practicable.

Carbon Tax ✔

AFOLU Carbon Tax ✔

Transport

Road

An upstream carbon tax is introduced covering all fuels for energy-related purposes

(including electricity generation, heat, and transport). Fuel Duty is reformed to focus on

revenue raising for other externalities.

Carbon

Tax

Fuel

Duty ✔

Rail Carbon

Tax

Fuel

Duty ✔

Aviation Carbon Tax ✔

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The principal variants of this option relate to the point of regulation. Alternative approaches to the tax

on production and import of fuels would be:

• A tax on the sale of fuels to end consumers (including power stations). This would be similar to

the current CCL or fuel duty. It would be more complex than the core option in terms of the

monitoring of emissions, but could increase consumer awareness of carbon costs, through

visibility in energy billing.

• End consumers could account for their carbon emissions and pay the tax directly to

government. For commercial entities this would be akin to the Carbon Reduction Commitment

Energy Efficiency Scheme and would incur higher administrative costs than the core option put

forward here. It also has the drawback of not being feasible for householders.

5.2 Expected impacts This option would drive emissions abatement at a uniform incentive level for all sectors and fuels. It

would mean that for residential and business sectors the incentive to reduce primary fuel use would be

increased to the same level as that for electricity consumption. The effective decarbonisation signal

would be the same across all sectors, whereas currently the transport sector is more heavily taxed. In

the waste and agriculture sectors a new carbon price would be introduced for direct emissions, as far

as is practicable.

Competitive industries would need to be protected from the effects of the carbon price, as long as their

competitors are not subject to the same price. The carbon tax approach would raise significant revenues

which could be used for this purpose, through use of rebates. The revenues could also support

substantial investment in low carbon innovation and infrastructure.

5.3 Practicability and implementation timescales This option might need to be phased in over a number of years because of its potentially significant

impact on all sectors of the economy. The timescales would be dictated by the need for policy impact

assessment and consultation. A further factor that could extend the timescales is the requirement to

supersede existing policies, which may have many years remaining. For instance, over the next few

years the EU ETS targets in the UK could be defined until 2030.

The technical requirements to determine the new carbon tax arrangements would likely be less limiting,

since the emissions characteristics of fuels are well understood, and fuel production and imports are

regulated activities already. A technical challenge would be with the development of a carbon

accounting system for non-combustion emissions. This exists for operators of plants covered by the EU

ETS but not for other operators. Extension of this across other operators and sectors would take time,

and could benefit from being phased in.

The proposed funding mechanism for innovation, infrastructure and behaviour change projects would

ideally be linked to the introduction of the tax but need not necessarily be. It would be possible to

consider the piloting and phasing in of such a mechanism.

5.4 Option element description Fiscal aspects

This option creates the decarbonisation incentive through the imposition of a tax. The revenue

implications would depend upon the tax rate applied, but follow from stopping fuel duty, CCL/, CCA and

ETS (foregoing auction revenues) offset by the revenues generated by taxing fuels used in business,

the public sector, households and transport. The inclusion of primary fuels used by householders would

raise significant extra revenue.

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The cost impacts would be a significant barrier to this option, especially for the residential sector.

Therefore, measures to mitigate this or even to implement the tax in a revenue neutral way would need

to be considered. The funding of measures to support behaviour change, innovation and long-term

investment could come from the tax revenues.

Regulatory aspects

The reform option changes would affect, through their removal, the statutory instruments for the CCL,

CCAs, EU ETS and fuel duty. New carbon tax legislation would be necessary, as would the mechanism

for providing support for behaviour change, innovation and infrastructure activities. The inclusion of a

border tax system would be especially complex politically.


The tax would be the responsibility of HMRC and this reform would relieve the EA of its regulatory duties

regarding the EU ETS and CCA. However, it does involve taxing non-combustion emissions, which are

not very easily monitored. Therefore, monitoring rules that build in proportional approaches to

uncertainty would be needed.

Overall, the disparity between a highly upstream approach to fuel related emissions and the monitoring

of non-combustion emissions at source would be a major weakness, since the latter would introduce a

regulatory obligation for large numbers of entities. A pragmatic approach could potentially limit coverage

for non-combustion emissions to key mineral industries (for instance the production of cement clinker).

A new system of funding for behaviour change, innovation and infrastructure development would be

required. This may require a body to have responsibility for developing the system’s framework and

rules, governing its operation, implementing a project selection process and carrying out monitoring and

review.


This option exposes internationally competitive industries to indirect carbon pricing. The cost effects

could be mitigated through compensation mechanisms funded from the tax revenues, such as rebates,

or through a border carbon adjustment (BCA). As described later in this report (see Section 9.2), the

complexities of applying BCAs generally restrict their applicability to imported basic goods and raw

materials so it could not provide a complete solution for all industrial subsectors.

5.5 International experience and issues relevant to the UK Two case studies carried out under this project provide examples for this option, namely the Swedish

and South African carbon tax systems. The tax in Sweden is long-standing and is applied upstream to

ensure wide coverage and low compliance and administrative costs. However, cost-pass through needs

to be possible to provide an economic signal for reduced consumption16.

In both Sweden and South Africa measures to address competitiveness concerns are considered

necessary. However, in both cases this involved reducing the effective carbon cost for relevant

industries, through allowances or lower rates, thereby reducing the incentive to lower emissions in these

industries. Approaches that compensate industries but maintain the carbon price would be more

effective at reducing emissions.

16 WP3 Report 2

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5.6 Key issues for further analysis The preliminary assessment for this option, on the same basis as that for the other options, is presented

below in Table 6, followed by a brief identification of key issues for further consideration.

Table 6: Preliminary assessment of Option 2; Broad-based upstream carbon taxation


Assessment criteria

Strategic fit ✓ Uniform carbon pricing, but emphasis on behaviour and innovation

Value for Money ✓ Upstream and using existing architecture

Potential affordability ✓ Raises revenues that could be recycled

Potential achievability ✓ Difficult to cover agriculture and transport, but could use revenue recycling to drive change in this sector.

Critical dependencies ✓ Dependent on ability to quantify non-energy emissions

Competitiveness ✓ Significant impact on transport sector

Long term credibility ✓ Credible and follows models in other countries

Price Signal ✓ Strong price signal

Accelerates Transition ✓ Increased rate of change compared to current situation


Vulnerable groups Impacts on those in fuel poverty

Consumer perception Impacts on transport and domestic fuel prices

Jobs Increased costs for SMEs

Innovation Increased costs for SMEs

Resource efficiency Increases pressure to improve resource efficiency

Pollution / Waste Increases pressure to reduce waste

Overall score 4




- Substantial research and policy dialogue would be required to design a new carbon tax

regime. Nonetheless, learning can be taken from existing regimes and it could draw on the

existing administrators and institutional infrastructure.

- The level of the carbon tax would need to be set based on verified data and lessons

learned from international experience. It might be necessary to phase in the level of the tax

over time to allow entities to adapt.

- The behaviour change, innovation and investment mechanisms would need to be

designed. There is extensive experience of funding mechanisms within the UK, EU and

elsewhere to draw on.

- Measuring, reporting and verification (MRV) systems for agriculture and waste would

need to be developed. This option proposes to cover non-combustion emissions in the waste

and agriculture sectors. However, international experience has shown that lack of data makes

it difficult to include these sectors in a carbon pricing system.

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Measures to mitigate competitiveness concerns

- The development of a comprehensive mechanism to address carbon leakage would be

required. As explained earlier, this could include border carbon adjustments (higher import

duties on goods based on their carbon content) or rebates for certain trade exposed industries.

However, these would need to focus on compensating for cost burdens rather than diluting the

incentive to abate. This can be achieved by compensating industries based on past carbon

emissions, rather than actual emissions within each year of the tax.

Revenue recycling

- Research into effective ways for revenue recycling are crucial for this option. As this tax

will cover almost all sectors in the UK, significant distributional impacts are expected. However,

the carbon tax will also be able to raise revenues that can be recycled to soften its impacts.

- Also, recycling mechanisms can be used to stimulate the behaviour change, innovation and

infrastructure investment measures that are proposed in this option.

Stakeholder engagement

- Extensive stakeholder engagement would be needed to inform the development of such

a transformative policy approach. Experience in Sweden has shown that public acceptance

of wider carbon taxation is possible. Early commitments to address international

competitiveness issues would be needed to help engage with industry.

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6 Broad-based UK emissions trading (Option 3) This approach involves creating a single emission trading system that covers the whole economy, which

would replace existing decarbonisation policies, including the EU ETS. Complementary measures to

encourage shorter term behavioural change and longer-term innovation and infrastructure investment

would also be introduced. The principal benefit of the approach is that it involves a single economy-

wide carbon cap that could be aligned with national climate change commitments. The abatement

necessary to reach that target would occur at lowest cost.

6.1 Key reform aspects This approach extends emission trading to cover most sectors and replaces the CCL and CCAs. The

following sectors are affected:

• Power

• Industry

• Buildings

• Transport

To achieve a large sectoral coverage (while maintaining relatively low administrative costs), it would be

necessary to look at upstream approaches. It is also assumed here that waste and agriculture would

not be covered. The ETS application is depicted in the table on the following page.

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Table 7: Overview of Option 3; Broad-based UK emissions trading

Policy Instruments: UK Emissions Trading System (ETS), Modified Fuel Duty

Notes:

• The UK opts out of the EU ETS and introduces its own ETS.

• The CCL, CCAs and CPS are all replaced by the UK ETS.

• Complementary measures are introduced to encourage investment in behavioural measures, innovation or infrastructure to address barriers that carbon pricing

along cannot address.


Mechanism

Change from

Current?

Power

UK ETS covers emissions from all fuels and industry (applied to suppliers of transport

and heating fuels, power generators and industrial emitters for direct emissions).

ETS ✔

Industry

Energy Intensive ETS ✔

Other ETS ✔

Buildings

Business/Public

Indirectly covered through fuel suppliers.

✔

Residential ✘

Waste Direct emissions from waste and AFOLU are not covered (although it may be possible

that waste installations are covered by an UK ETS).

✘

AFOLU ✘

Transport

Road

UK ETS covers emissions from all fuels and industry (applied to suppliers of transport

and heating fuels, power generators and industrial emitters for direct emissions). Fuel

Duty is modified to limit impacts on transport fuel prices.

Fuel Duty ✔

Rail Fuel Duty ✔

Aviation ETS ✔

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6.2 Expected impacts The expected impacts would be similar to those for the carbon tax in the previous option since it also

establishes a uniform carbon pricing signal across many sectors. As with the carbon tax, it would

levelise the price incentive across fuels and sectors, so that the effective carbon price for electricity

consumption in residential and business sectors would no longer be higher than for primary fuel

consumption. It also means the effective decarbonisation incentive for transport emissions would be

reduced to be comparable with those in other sectors. As far as possible a new incentive for reductions

in emissions in waste and agriculture would be established.

6.3 Practicability and implementation timescales This option is challenging and would take considerable time to introduce. The proposed approach of

only regulating directly those operators currently covered by the EU ETS and instead covering upstream

those emissions for other activities would minimise the lead time. This is because there are far fewer

numbers of fuel suppliers/producers than there are consumers, as well as systems in place to regulate

these entities and monitor the fuel they supply. As with the carbon tax option, the length of time to

develop the option would be affected by the need for a thorough impact assessment and consultation

process to cover all those stakeholder groups affected.

The approach has similarities with the carbon tax in terms of the funding proposed for behaviour

change, innovation and infrastructure development and also for the need to monitor non-combustion

emissions.


Revenue would be raised through the sale of emissions allowances. In current policies this tends to be

done for sectors that can pass their carbon costs through to consumers, which has been the basis for

justifying removal of free allocation to electricity producers within the EU ETS. Those sectors exposed

to international competition without carbon pricing, for which the carbon cost pass through potential is

more limited or not possible, tend to be allocated allowances for free. This helps mitigate their carbon

leakage risk.

The revenues would therefore be raised through the auction of allowances to electricity generators,

business sectors serving a UK customer base and the residential sector, which constitutes a substantial

part of the economy.

The revenues raised could enter the general budget or could be used for two other specific purposes.

Cost compensation could be provided to mitigate the impacts for the poorest households and some

businesses. Also, the proposal for additional support for behaviour change, innovation and long term

low carbon investment could be funded from auction revenues.

Regulatory aspects

The approach would involve the removal of the statutory instruments for the CCL, CCAs, EU ETS and

fuel duty. Instead, a new regulation would be required to establish the enhanced emissions trading

system. It is possible that there could be a requirement for modification to electricity and gas supply

licences; these are referenced in the CCL legislation and these utilities would be required to participate

in the emissions trading system.


Target (cap) setting would be done by central government. A regulator would be needed to oversee the

new carbon trading system. It would administer an allowance allocation system, create an MRV system

and enforce compliance with the policy. Systems for emission reporting and an allowance register would

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need to be created and maintained. The EA has historically acted as regulator for regulations affecting

direct emissions (such as EU ETS) and end users of energy (such as CCL and CRC). However, since

the system will involve the placing of an obligation on energy suppliers, in relation to the amount of

energy they supply, there could be a role for Ofgem. This would need to be examined further.


This option would raise the same concern over costs for trade exposed sectors as currently exist for

the EU ETS. To address this, the options would be to use free allocation of emissions allowances or to

use BCAs. The issues for BCAs are described in Section 9.2 and the options concerning other

compensation measures are described in the following section.

6.5 International experience and issues relevant to the UK Several elements of this option have been discussed in other studies or relate to the international

experience reviewed as part of this study. These are described in the section below and concern:

• Replacement of EU ETS by UK ETS.

• Upstream ETS approaches.

• Treatment of transport within a multisector carbon pricing regime.

• Measures to protect the competitiveness of industries.

Replacement of EU ETS by UK ETS

The option of developing a new UK ETS would have advantages over remaining within the EU ETS in

the long term post-Brexit. The UK would have complete control over the design and governance of a

new UK ETS and could set targets that aligned with its own climate change targets (i.e. carbon budgets).

The need for the UK to introduce the carbon price floor to encourage the desired decarbonisation of the

electricity generation sector shows that the EU ETS may not be adequate in terms of ambition for the

sectors it covers. The downside of the UK only approach is that it does not take advantage of the lowest

cost abatement elsewhere in the EU that is inherent in the EU ETS model.

A UK ETS approach also has advantages over non-cap and trade options presented in this report.

Electricity generation and industrial operators, as well as third party service providers, have built up

considerable experience participating in the EU ETS, especially concerning emissions MRV and carbon

market trading. This experience would help smooth the transition into an UK ETS if built upon the same

principles.

Upstream ETS approaches

The New Zealand case study shows that due to different sector characteristics, sectors can end up with

a mixed approach for the point of regulation. The driver for this is to minimise costs whilst achieving

high policy coverage. For the same reasons this option is suggested with a point of regulation suited to

each sector.

Treatment of transport within a multisector carbon pricing regime

Experience from the EU and California shows that inclusion of the transport sector within a carbon

pricing policy with other sectors may not be expected to create a strong enough signal to induce

technological change. This would be because of the high marginal abatement costs and low elasticity

of demand in the transport sector compared with other sectors. In the EU, transport was not included

in the EU ETS (other than aviation) and in California the ETS was considered a backstop measure to

other transport-specific policies. Therefore, the role of complementary transport policies would need to

be considered as part of an economy-wide ETS, as it would in an economy-wide carbon tax in Option 2.

Measures to protect competitiveness of industries

This option could incorporate measures to protect competitiveness of industries. Competitiveness

measures can involve covered entities not paying the full carbon price (e.g. South Africa Carbon Tax),

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paying it on only part of their emissions, or receiving compensatory payments (or free allowances, which

are essentially payments) (e.g. New Zealand and EU ETS).

From a decarbonisation incentive perspective, it is particularly important whether the level of

compensation (i.e. free allocation) is determined ex post, in relation to actual emissions, or is fixed ex

ante. In the former case, the compensation measure provides a financial benefit for emissions and the

incentive to abate is reduced (or removed completely). In the latter case the incentive to abate remains,

irrespective of the compensation measure.

For this option it would be necessary to develop an allocation approach suitable to the suggested

upstream regulation for some sectors. This would be relevant to any internationally competitive

industries covered in that way and also for any compensation for domestic consumers. Compensating

directly the regulated energy suppliers themselves risks them benefiting from a windfall profit therefore

a mechanism to compensate consumers directly would be needed.

6.6 Key issues for further analysis The preliminary assessment for this option, on the same basis as that for the other options, is presented below in Table 8, followed by a brief identification of key issues for further consideration. Table 8: Preliminary assessment of Option 3; Broad-based UK emissions trading


Assessment criteria

Strategic fit ✓ Uniform carbon pricing, but with emphasis on innovation and behaviour aspects

Value for Money ✓ Raises tax revenues that could fund unprofitable activities

Potential affordability ✓ Reduced revenues versus carbon taxation+ scenario

Potential achievability ✓ Complex system and requires negotiations

Critical dependencies ✓ Willingness of parties to invest time in negotiations

Competitiveness ✓ Supports wider range of abatement opportunities

Long term credibility ✓ Opaque and novel, but has longer term focus

Price Signal ✓ Enables price signal to be selectively increased

Accelerates Transition ✓ Includes more risks compared to other ETSs


Vulnerable groups No significant impact, if not linked to tax rises

Consumer perception No significant impact, if not linked to tax rises

Jobs Improved competitive position so more jobs

Innovation Innovation can be encouraged where lagging



Overall score 5




- Substantial research and policy dialogue would be required to design a new UK ETS

from scratch. Nonetheless, experience with the EU ETS and other UK climate policies would

be valuable, especially for target setting and regulatory approaches.

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- Complementary measures may be required for emissions sources that cannot be cost

effectively included in an ETS. This could include biological emissions from agriculture.

- As with the previous option, the behaviour change, innovation and investment

mechanisms would need to be designed. There is extensive experience of funding

mechanisms within the UK, EU and elsewhere to draw on. New mechanisms could be funded

from ETS allowance auctions.



required. This could involve free allocation of allowances, direct compensation for those

affected by the trading system (potentially funded by auction revenues) or a border carbon

adjustment system. A BCA in particular would need research into what is acceptable under

WTO rules and what is practicable (see Section 9.2). Any measure should be designed to avoid

windfall profits and preserve the strength of the carbon price signal.

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7 Flexible portfolio standards (Option 4) In this option performance standards are set for the carbon content of fuels supplied to each sector.

The obligation to meet the standard would be placed on the energy suppliers and each sector would

have its own target, for example a carbon intensity standard for transport fuels would be different from

the standard for fuels used for domestic heating. This is because the technically achievable

performance within each sector would differ17. Suppliers that perform better than the standard would

earn credits that could be used by those that perform below the standard. These credits could be traded

and used across sectors. The policy would require that the standards in each sector represent realistic

but appropriately ambitious decarbonisation pathways.

The intensity target model is an alternative market-based approach to cap and trade and it is helpful to

compare their main features:

• The main advantage of a standards and credits approach is that the target relates to

improvements in carbon intensity of the activity, and not the level of activity itself. This means

that the stringency of the target can remain largely unaffected by short-term business cycle

fluctuations in the level of economic activity potentially resulting in more stable carbon market

price movements (overcoming a weakness of cap and trade). The corresponding downside of

the intensity targets is that policymakers cannot specify absolute emissions outcomes to be

achieved.

• A cap and trade system can apply to non-combustion emissions, but they would not be covered

by a fuels standard.

• There may be greater natural liquidity in a cap and trade model since allowances equate to

each tonne of carbon emitted, whereas in the standards approach there is only crediting for the

difference between actual performance and the target.

• Both standards and credit and cap and trade models can suffer from undue stakeholder

influence in the setting of key policy parameters. For standards and credit this is the intensity

target itself, whereas for cap and trade it would be allocation rules. Both of these can be highly

technical sector specific issues for which the sectors themselves have a high level of expertise

and potential to influence the policymaking process.

The option described above is for a performance standard for fuels supplied, which is the option

considered in the subsequent subsections of this chapter. However, a carbon intensity approach could

be applied to the outputs of sectors, which is highlighted here as a possible alternative. In this case the

targets would apply to each company in terms of the carbon emissions per unit of its output.

Overachievement against the target would earn tradable carbon credits whereas underachievement

would require the company to buy and surrender credits. For major industrial sectors the targets can

be defined as the carbon intensity of the end products. This could be similar to the EU ETS benchmarks.

Other policies such as the UK CCAs or the new South Wales Greenhouse Gas Reduction Scheme

have used energy or carbon intensity targets, so the approach has some precedent.

The output-based concept becomes more complex for other sectors. It would be more challenging to

apply across diverse commercial sectors, for which activities are more differentiated, but could be based

on a measure of economic output, such as GVA. The CRC attempt to benchmark performance

according to turnover, whilst a different metric, provides a relevant example. For the residential sector,

however, such an approach does not seem possible.

Overall, there are several possible intensity-based approaches. The option described in the following

subsections is the fuels intensity standard, chosen because it could feasibly apply to more sectors than

the output-based approach.

17 A single standard to all sectors is possible. It would lead to suppliers to inherently higher carbon sectors having to buy allowances from those

that are lower carbon.

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7.1 Key reform aspects This approach creates harmonised carbon pricing by imposing performance standards with a tradable

compliance option. The following sectors are covered:

• Power

• Industry

• Buildings

• Transport

The elements of this option are depicted in the table on the following page.

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Table 9: Overview of Option 4; Flexible portfolio standards

Policy Instruments: Carbon Intensity Standards, Modified Fuel Duty

Notes:

• The UK opts out of the EU ETS and removes CCL, CCAs and CPS, as well as specific support for renewables (e.g. CfDs or RHI).

• A single carbon intensity standard is applied to suppliers of transport and heating fuels and electricity. This standard(s) is/are set to tighten progressively in line

with carbon budgets.

• A single standard could be set to over transport, heat and electricity (expressed in CO2 per unit of primary energy or a number of sector specific standards

could be set.

• In either case, credits would be tradeable across sectors. This would establish a near economy-wide carbon market.


Mechanism

Change from

Current?

Power A carbon intensity standard is applied to suppliers of electricity. Intensity

Standard ✔

Industry

Energy Intensive

Indirectly covered through fuel suppliers. Intensity

Standard

✔

Other ✔

Buildings

Business/Public ✔

Residential ✔

Waste ✘

AFOLU ✘

Transport

Road

Indirectly covered through fuel suppliers. Intensity

Standard

✔

Rail ✔

Aviation ✔

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7.2 Expected impacts The approach would establish a single carbon price for all fuel used across all sectors. It would therefore

drive the cheapest intensity improvements in the fuel mix. The cost of making those improvements

would be internalised in the price of fuel, which would reduce fuel demand.

7.3 Practicability and implementation timescales The option of fuel standards would be new to the UK although there are examples that demonstrate

how each of the main elements required would be possible. It would be necessary to regulate fuel

suppliers, as has been done for electricity suppliers under the Renewables Obligation (RO). A market

for credit generation and trading would need to be established, although the UK has a lot of experience

of this through for example the EU ETS and the RO. The definition of the fuel standards would require

future performance levels and the costs of making improvements beyond business as usual to be

understood, which should be possible. Overall, it would be a practicable option, although it would be

possible to consider phasing in of sectors.


This option in itself has relatively little direct fiscal interactions in terms of treasury receipts. The targets

are set by government and credits are earned for free in relation to overachievement of those targets.

It does not involve the auction of emissions allowances or raising of tax revenues. However, compared

with current policy the treasury impacts are substantial because it would involve replacing revenue

raising measures such as the CCL, fuel duty and EU ETS auctions. Alternative sources of revenue

would need to be considered.

Regulatory aspects

The replacement of existing measures would require the repealing of the CCL, CCAs, EU ETS and fuel

duty. The new policy approach would need additional legislation. This would likely be a single

framework, but provision would be needed for regular updates of targets.


Target setting would be done by central government. Regulation, oversight and enforcement of the

system would require a body that can carry out these functions for fuel suppliers. It might involve Ofgem,

since there are strong analogies with past performance-based systems such as the RO.


The approach would raise the price of energy because of the cost associated with supplying it at a lower

carbon intensity. This would be detrimental to the competitive position of trade exposed industries. This

could be addressed by direct compensation measures. As discussed in Section 9.2, border carbon

adjustments could be considered, although would be politically difficult and less practical for more

complex products.

7.5 International experience and issues relevant to the UK The main examples of performance standards from international experience come from the Low Carbon

Fuel Standards in California and SO2 trading schemes in the United States18.

Intensity targets as used in California can be argued to be particularly suitable for creating a robust

decarbonisation signal19. This is because intensity targets can accommodate changes in economic

18 WP3 Report 1 19 Pizer, W. 2005. The case for intensity targets. Discussion paper. Resources for the future. DP05-02.

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activity20, i.e. to meet the target it is necessary to make performance improvements irrespective of the

level of activity.

Performance standards can lead to predictable results, often have low direct costs and are therefore

argued to be cost-effective in achieving their objectives19 21. The experience of US SO2 emission trading

under the Acid Rain Programme (ARP) shows that it is possible to make significant emissions

reductions when performance targets are combined with cap-and-trade instruments. The tradable

approach encourages performance that is better than the standard, whereas a minimum standard on

its own would not provide as strong a driver for innovation.

However, literature also cites the disadvantages of performance standards22. First, intensity targets, by

their very nature, do not provide an incentive to achieve a particular environmental outcome (in absolute

terms), which is a trade-off that follows directly from the insensitivity of the approach to activity levels

described above. A second disadvantage of using performance standards, cited by Plevin et al. (2017),

is they cannot take account of opportunities for decarbonisation varying between regions.



Table 10: Preliminary assessment of Option 4; Flexible portfolio standards


Assessment criteria

Strategic fit ✓ Enhances growth, competitiveness, jobs and productivity so good strategy alignment.

Value for Money ✓ Depends on stringency of targets

Potential affordability ✓ Loss of CCL revenue

Potential achievability ✓

Dependent on data availability. Setting intensity-based reduction targets difficult if stakeholder resistance high.

Critical dependencies ✓ Availability of international benchmarks

Competitiveness ✓ Increased pressure to improve efficiency and competitiveness

Long term credibility ✓ Sets long term framework

Price Signal ✓ Sector specific price signal

Accelerates Transition ✓ Intensity targets provide certainty


Vulnerable groups No significant impact if not linked to tax rises

Consumer perception No significant impact if not linked to tax rises

Jobs Improved competitive position can lead to more jobs

Innovation Assuming mechanism drives innovation and growth



Overall score 8

20 Marschinski, R., Edenhofer, O. 2010. Revisiting the case for intensity targets: Better incentives and less uncertainty for developing countries.

Energy Policy. Volume 38(9):5048-5058. 21 Jotzo, F., Pezzey, J. 2007. Optimal intensity targets for greenhouse gas emissions trading under uncertainty. Environmental and Resource

Economics. Volume 38(2):259-284. 22 Plevin, R., Delucchi, M., O’Hare, M. 2017. Fuel carbon intensity standards may not mitigate climate change. Energy Policy. Volume 105. P93-97.

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- Substantial research and policy dialogue would be required to design a new carbon

intensity standard and credit mechanism. Nonetheless, learning can be taken from existing

experience with CCAs and the EU ETS, and it could draw on the existing administrators and

institutional infrastructure.

- The establishment of a robust mechanism to set standards would be necessary to ensure

intensity targets always incentivise improvements across all sectors. This would require a

governance system that can set long-term trajectories.


- The development of a mechanism to address carbon leakage would be required. This

could include compensation measures or border carbon adjustments.

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8 Consumption-based carbon taxation (Option 5) In this option transparent end user carbon pricing is established. A consumption-based carbon tax is

employed, in combination with carbon labelling. In principle this could apply to all products and services

and all sectors, although in practice there would be practical constraints, as discussed below.

The main advantage of this option is that it makes the carbon emissions associated with purchases

clear to consumers and applies a carbon cost associated with those emissions. In alternative upstream

carbon pricing (such as Options 2 and 3) the cost of carbon should be internalised in the cost of goods,

but this would be less clear to consumers.

There are two ways in which this option could be formulated. It could take the form of a carbon levy, in

which the emissions associated with the life cycle of a product would be calculated using an established

methodology and then levied on the price of the goods by the retailer. The retailer would then be

responsible for passing the revenues to the Treasury. There would be a carbon labelling system to

enable informed consumer decisions. This approach has similarities with other mechanisms such as

the sugar tax or plastic bag levy. It also has similarities with the CCL, which is applied by energy

suppliers in the bills for their commercial customers.

The second approach is more like a carbon VAT, or Carbon Added Tax (CAT). The tax is applied to the

sale of all goods and services. Commercial enterprises can claim back the tax for the purchases they

make. Each commercial enterprise in the supply chain must therefore supply to treasury the difference

between the tax they receive and the tax they have paid. A challenge with this approach is that whilst

VAT provides an analogy, that tax is calculated as a percentage of the sale value. For a CAT there

would need to be a system of evaluating the carbon content of the products and services sold as it

would not be based on sale value.

8.1 Key reform aspects This policy approach involves a new end user carbon tax and the scrapping of measures applied

upstream in the product life cycles, such as the CCL and EU ETS. The following sectors are covered:

• Power

• Industry

• Buildings

• Waste

• AFOLU

• Transport

The elements of this option are depicted in the table on the following page.

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Table 11: Overview of Option 5; consumption-based carbon taxation

Policy Instruments: End-User Carbon Tax

Notes:

• The UK opts out of the EU ETS and removes CCL, CCAs, CPS, Fuel Duty, and renewables’ subsidies.

• The consumption-based carbon tax can either be applied:

o As a levy by retailers at point of end use, based on a certified assessment of a service or product’s full life cycle emissions

o As a ‘Carbon Added Tax’ (similar to VAT) on the amount of carbon added at each stage of production and distribution of goods and services.

• Carbon labelling and life cycle carbon accounting is developed in all sectors.


Mechanism

Change from

Current?

Power

A consumption-based carbon tax is levied on goods and services (including emissions

from post-purchase combustion in the case of fuels, and potentially product disposal-

related emissions where appropriate).

Carbon Tax ✔

Industry

Energy Intensive Carbon Tax ✔

Other Carbon Tax ✔

Buildings

Business/Public Carbon Tax ✔

Residential Carbon Tax ✔

Waste Carbon Tax ✔

AFOLU Carbon Tax ✔

Transport

Road Carbon Tax ✔

Aviation Carbon Tax ✔

Rail Carbon Tax ✔

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8.2 Expected impacts This option would lead to reduced use of higher carbon intensive products and services. It would mean

that that the effective carbon price for all goods and services would be the same, whereas presently it

varies by sector and therefore product group. In practice, however, the impacts of the option would be

highly limited by the practicability of assigning carbon emissions to products and services (in the carbon

levy case), or to each company’s carbon contribution (in the CAT case).

The main challenge with either of these is the practicability and cost effectiveness of the emissions

accounting system. For the carbon levy it would be very difficult to assign carbon emissions to even the

main product groups within the economy. For a CAT it would be complex to require enterprises to

calculate the carbon contribution they make to each product or service they sell. In both cases there

would be a trade-off between the cost of the approach and its effectiveness. Simple carbon accounting

methods using generic emissions factors would reduce costs, but these would not then differentiate

products based on their actual emissions.

Nevertheless, these are visionary approaches that could have a long-term role, especially as the

permeation of Big Data in the future could enable the assignment of carbon emissions to individual

products.

8.3 Practicability and implementation timescales The timescales for this option would be very long, even when compared with other ambitious options

described in this report. The principal challenge is to develop and apply methodologies for assigning

carbon emissions to products and services. In practice, it would be necessary to consider applying the

approach to major product groups in a phased way. These would be higher carbon intensive products

for which life cycle emission determination would be more straightforward, but which also cause high

carbon emissions in absolute terms. Fuel use is an obvious candidate, but Option 2 would be a simpler

way to tax fuel use. White goods, other electronics, automobiles and food products might be further

candidates, but this would require more investigation.


This would be a revenue raising policy. It would replace current revenue raising activities, namely CCL,

EU ETS auctions and fuel duty. By covering life cycle across the economy, it would raise more revenue

than existing policies for a given carbon price. However, there would be concerns about the cost

impacts, for example as a result of raising the price of food, which might lead to exemptions or

compensatory measures. These would reduce the net income to the treasury.

Regulatory aspects

The replacement of existing measures would require the repealing the CCL, CCA, EU ETS and fuel

duty. The new policy approach would need additional legislation. An overarching tax framework would

be needed but also the provision for accounting methodology updates as new materials, products and

services enter the market.


As a tax the system would fall under the responsibility of HMRC. An expert body would be required to

define, oversee and update rules for attributing carbon to products and services. This could be a body

within HMRC but potentially involve external experts.


Border carbon issues are not significant for the case of a levy applied to end product purchase, since

the carbon cost is applied for the end consumer, irrespective of whether that product is manufactured

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within the UK or overseas. However, for it to function in this way it would be necessary that the

emissions from imported products are accounted for, and governments and companies in other

countries would not have process in place to do this. For the CAT option, a cost would be incurred for

UK producers that would not be incurred for producers overseas, for which some compensation or

Border Carbon Adjustment may be desired to protect competitiveness.

8.5 International experience and issues relevant to the UK This option includes two variants, a carbon levy and a CAT. Although the case studies carried out in

this project did not include these particular models, some examples of other downstream carbon

taxation were examined. Also, both variants have been discussed in literature. The main issues are

highlighted below.

Downstream carbon taxation

Several literature sources have examined carbon taxes applied to consumption rather than

production23. Carbon costs applied to production would not be passed through in the prices of goods if

those goods can be supplied from regions not subject to the carbon price. By taxing consumption, and

applying it to goods produced elsewhere, an incentive for reduced consumption is created. A further

key aspect is whether downstream taxes provide a more visible cost to consumers and therefore

whether it would have a greater effect on consumer choices 24. However, a paper by Courchene (2008)

states that with upstream taxes, firms are likely to separate out carbon costs in a way which would still

make it visible for consumers23.

Carbon Added Tax

Most of the literature on CATs focuses on how it could be introduced25. One common proposed method

is that it could be designed in parallel to today’s Value Added Tax (VAT) and over time it could replace

it. In addition, literature describes what possible impacts a CAT might have and what the requirements

are for implementing it.

A CAT would have to be put on both domestically produced and imported products. Companies would

pay CAT on their inputs as well as charge CAT on their outputs. The literature identifies that it would

work most efficiently if each individual company would monitor, verify and report the amount of CAT it

pays on its inputs, the amount of carbon that it emits, and the CAT charged on its products or services.

To put such a scheme in place, departments in companies dealing with tax and carbon accounting

would probably have to merge. For imported products, benchmarks would need to be applied.

CATs have been argued to support a more long-term transformation to a low-carbon economy by having

very clear incentives for companies to decarbonise. They would increase energy efficiency, incentivise

use of lower-carbon alternatives and also benefit products with greater value added, especially services.

In addition, because a CAT would raise significant revenues, it could be used to offset distortionary

taxes and their impacts26.

Literature identifies that a CAT would also have significant price impacts on certain products, including

food. However, due to the fact that the CAT would raise significant revenues, VAT rates could be

reduced proportionally as well. As carbon revenues would reduce over time as a result of

decarbonisation, the CAT would eventually have to be replaced with something else as well. Some

literature sources expect that a CAT would mean people would be more likely to eat out, that labour-

intensive products would become cheaper and that it would incentivise different building materials.

23 De Bruyn, S., Koopman, M., Vergeer, R. 2015. Carbon Added Tax as an alternative climate policy instrument. CE Delft. Delft, July 2015. 24 Metcalf, G., Weisbach, D. 2008. The design of a carbon tax. Tufts University and the University of Chicago Law School. 25 Courchene, T. 2008. Climate Change, competitiveness and environmental federalism: the case for a carbon tax. 26 Courchene, T., Allan, J. 2011. Missing the bigger picture: a response to McClure’s view of the carbon-added tax. Policy Review. IRPP.

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Most of the literature however points to the difficulties of implementing a CAT, mostly due to the high

associated compliance and administration costs27.

Carbon levy

The carbon levy approach presented here would tax the emissions associated with the life cycle of a

product. It would be calculated using an established methodology and then levied on the price of the

goods by the retailer. The retailer would then be responsible for passing the revenues to the Treasury.

Literature identifies that this approach has similar issues related to the CAT, including product cost

impacts. In addition, the required MRV and administration for this option would be even more complex,

as they would require a detailed life cycle analysis (LCA) for each product to establish the level of the

tax to be applied.



Table 12: Preliminary assessment of Option 5; consumption-based carbon taxation


Assessment criteria

Strategic fit ✓ Aligns with deregulation agenda. Increases end user accountability

Value for Money ✓ High administration cost and risks of double taxation

Potential affordability ✓ Raises funds through end-user carbon tax

Potential achievability ✓ Technically difficult to implement and significant consumer resistance expected

Critical dependencies ✓ Change in international trade regulations might be necessary

Competitiveness ✓ Might cause off-shoring of carbon intensive processes

Long term credibility ✓ Unproven and complex

Price Signal ✓ Provides a strong price signal

Accelerates Transition ✓ Likely to accelerate transition


Vulnerable groups Increased pressure on those in fuel poverty

Consumer perception Disruptive approach with many winners and losers

Jobs Potential offshoring of jobs

Innovation Likely to stimulate product innovation

Resource efficiency Likely to stimulate resource efficiency

Pollution / Waste Likely to encourage waste reduction

Overall score -1



27 McLure, C. 2010. The carbon-added tax: an idea whose time should never come. Carbon & Climate Law Review. Vol 4(3). Pp250-259.

https://www.jstor.org/stable/24323990?seq=1#page_scan_tab_contents


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- Substantial research and policy dialogue would be required to design a new

consumption-based carbon tax regime. In particular, the new emissions accounting

framework required would be challenging.

- Mechanisms to help companies prepare for the extensive accounting requirements

would be necessary. Companies would need to be able to calculate the carbon footprint of

their inputs, processes and outputs (depending on the policy approach chosen).

- Mechanisms to assure the calculated carbon emissions would be required to underpin the

integrity of the system.

- Information programmes including product labelling would be needed. This would help

consumers to make low carbon purchasing decisions where awareness of emissions is a more

important factor than product price.



required in the case of a Carbon Added Tax, for trade exposed sectors. As explained earlier,

these could include border carbon adjustments (higher import duties on goods based on their

carbon content) not paying the full carbon price (e.g. exemptions).

Revenue recycling

- Research into effective ways for revenue recycling would be important for this option.

In addition to the effect on industrial competitiveness mentioned above, the increase in the price

of goods that results could adversely affect consumers, for instance in raising prices of basic

foods. Consideration should be given to compensation measures or tax shifting, for instance in

reducing VAT.

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9 Common issues A diverse set of possible reform options are outlined in the previous chapters. However, they would

pose some common implementation challenges, three of which are explored in this section:

1. How could the governance of the policy regime be constructed to underpin wider stakeholder

confidence?

2. How can competitiveness concerns be addressed and in particular what are the issues

associated with border carbon adjustments?

3. How could new measures that provide incentives for investment and innovation be

constructed?

9.1 Governance The success of a carbon pricing policy in delivering long term emissions targets will be underpinned by

its governance, and consequently the confidence that investors will have in the policy’s longevity and

stability. This is common to all of the policy options identified in this report. In the following subsections

the experiences from the project’s case studies are summarised, followed by a brief analysis of the

main issues related to the governance of climate policy in the UK. Two issues in particular are examined

and the future options discussed:

• The consequences of reduced policy oversight when the UK leaves the EU (Section 0).

• The implications for government supported climate change investment given the recent

experience of the UK moving away from tax revenue earmarking (Section 9.1.3).

9.1.1 International experience of climate change policy governance International experience with carbon pricing instruments demonstrates the importance of a legal

framework underpinning decarbonisation policies for investor confidence (see Box 1). It thereby

identifies elements that should be considered when seeking to strengthen the governance of UK

decarbonisation policies.

Box 1: International experience with governance and regulation issues for decarbonisation incentives

International experience shows an independent and legally enshrined policy framework is

required for ensuring investor confidence in the decarbonisation policy

Decarbonisation policies seek to incentivise investments based on a regulatory framework or

government incentive. Therefore, investor confidence in the robustness and longevity of the policies

are important to successfully achieve the policy objectives. Investor confidence is dependent on the

empowerment, credibility, and accountability of policymakers and legal frameworks form an important

basis for this. In addition, they can include mechanisms to deal with change in a consistent and

predictable way.

International experience from California, Canada and the EU shows that strong action by a higher,

centralised level of government is required to establish carbon pricing systems. This then needs to

be enshrined in legislation. If there is policy uncertainty around the legal foundation and a culture of

law suits, then significant price volatility may occur.

Investor confidence also requires a wider acceptance of the policy and a perception by stakeholders

that policymakers are addressing their concerns. This includes that the policy must be perceived as

sitting well in combination with other related objectives and policy measures, for example policies

targeting energy supply and use.

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9.1.2 UK policy oversight The UK is committed, under the Climate Change Act 2008, to cutting carbon emissions by at least 34

per cent by 2020 and by at least 80 per cent by 2050 compared to a 1990 baseline. It requires the

Government to publish interim five-year carbon budgets which set carbon emissions limits and a plan

for meeting these. The carbon budgets set progressively lower emissions limits and act as a roadmap

towards achieving the 2020 and 2050 targets. The first five carbon budgets cover 2008 to 2032.

Under the Climate Change Act, the Government is required to publish a plan setting out its proposals

and policies for meeting the statutory emissions targets of current and future carbon budgets. The

current plan lists carbon reduction policies together with their expected emissions savings under the

first four carbon budgets, and milestones for delivery by departments and devolved administrations. A

plan for meeting the emissions reduction targets set by 5th carbon budget set in October 2016 is being

developed as part of the UK Government’s Clean Growth Strategy (October 2017). Progress against

the Carbon Plan is reported to the UK Parliament, an annual task undertaken by the Committee on

Climate Change (CCC) under an agreed framework

The current UK legislative framework for environmental and climate change regulation is composed of

a mixture of domestic and EU law. In many areas UK environmental regulation derives primarily from

the EU, but in some areas the UK has its own laws. EU environmental law will continue to apply for as

long as the UK is a part of the EU, and probably for some time following Brexit when it is incorporated

into UK national law. However, the existing requirements for the UK to report progress on emissions

reduction to the European Commission is likely to end, as will the European Commission’s role in

monitoring UK compliance with international agreements and EU Directives.

Many authors28 consider that this loss of EU oversight is likely to reduce the robustness of the current

governance and regulatory regime to changes in government policy direction, since alternative

mechanisms such as Judicial Review are frequently overturned by passing new legislation. The UK

Government has acknowledged this potential gap in governance and is consulting on a new

Environmental Principles and Governance Bill to fill this gap in England and for reserved matters

throughout the UK29.

9.1.3 Fiscal governance Each of the policy reform options involve either change to or replacement of current environmental

taxes, and to varying degrees involve use of revenues to support decarbonisation efforts. In this

subsection the issues related to these changes are discussed.

The UK Climate Change Levy and Climate Change Agreements were announced as part of the 2009

UK budget process and enacted by the Finance Act 2000 and supporting statutory instruments30. This

legislation is updated annually as part of the UK budget setting process and was significantly revised in

2013 to introduce the carbon price floor, and 2015 to reform incentives for renewable energy/CHP. It is

likely that any significant changes to the fiscal instruments would be introduced as part of the UK

budgetary process and enacted via new Finance Act, although minor amendments to rates of CCL

could be implemented by Statutory Instrument, where delegate powers have been granted.

The EU ETS Directive is transposed into UK law as part of the Greenhouse Gas Emissions Trading

Scheme Regulations31, while the carbon price floor/support rate is implemented by amending the

Climate Change Levy and exemptions for generators under the Hydrocarbon Oil Duties regulations32.

28 For example, Institute for European Environmental Policy. 2017. Ensuring compliance with environmental obligations through a future UK-EU

relationship. Available from: https://ieep.eu/publications/ensuring-compliance-with-environmental-obligations-through-a-future-uk-eu-relationship 29 https://www.gov.uk/government/news/new-environment-law-to-deliver-a-green-brexit 30 HMRC. 2018. Excise notice CCL1: a general guide to Climate Change Levy. Available from: https://www.gov.uk/government/publications/excise-

notice-ccl1-a-general-guide-to-climate-change-levy/excise-notice-ccl1-a-general-guide-to-climate-change-levy 31 The National Archives. 2018. Greenhouse gas emission trading in legislation. Available from:

http://www.legislation.gov.uk/all?title=Greenhouse%20gas%20emissions%20Trading 32 HMRC. 2014. Carbon price floor: reform. Available from: https://www.gov.uk/government/publications/carbon-price-floor-reform

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A noticeable feature of UK financial instruments is the requirement to annually update the rates of

climate change levy and carbon price support as part of the UK Government’s budget statement. While

changes in rates are generally outlined 2 to 3 years ahead, this mechanism does not provide a

consistent long-term price signal, as different governments have decided to increase rates annually in

line with inflation, delay increases due to economic circumstances, or reduce rates in real terms.

There has also been a noticeable shift in political thinking since the coalition government came to power

in 2010 over the role of “Environmental Taxes” since the Climate Change Levy Package of measures

was introduced in 2001. Instead of being viewed as a “revenue neutral” way of encouraging a shift in

consumer behaviour and raising funds that can be recycled into green investments such as renewable

energy, energy efficiency, and low emission vehicles - they are now used as important general tax

raising measures that can be used to reduce direct taxes on individuals and businesses33.

The policy options in this report can raise significant revenues, especially through taxes, yet the use of

those revenues would be critical in supporting low carbon investment, mitigating cost concerns such as

carbon leakage, or both of these. Therefore, any further consideration of these policy options would

need to examine how long-term confidence in the revenues being used in these ways can be

established, given the tendency in recent years for revenues not to be earmarked for such purposes.

9.1.3.1 Options for strengthening UK fiscal governance

Various analysts have commented on the need to strengthen the link between environmental taxes and

the positive behaviour that they are seeking to encourage, as a means of accelerating the transition to

a low carbon economy34. They have called on UK Government to commit to recycling funds raised from

climate change related taxes into energy efficiency measures and increased renewable generation.

Earmarking of tax revenues is also seen a means of providing a more secure stream of revenue for long

term infrastructure projects, and of making carbon taxes more acceptable to the wider public, particularly

if the government also provides more detailed information on how the funds are spent35. The EU is

moving towards this approach, since Member States agreed that half of funds raised by auctioning EU

ETS permits should be used to support specific climate and energy activities36.

Another possibility discussed by the Helm Review37, is that of an increasing UK carbon price based on

the marginal cost of abatement needed to drive the transition to a low carbon economy. This approach

is likely to provide a consistent carbon price signal over time, particularly if the price is calculated by an

independent body such as the CCC and based on emission reductions set in the carbon budgets. Other

authors have suggested that the CCC’s role and remit should be revised so it operates along the lines

of the Bank of England’s Monetary Policy Committee (MPC), so it both monitors progress and sets UK

carbon tax policy38, although this option has yet to receive cross party support.

9.2 Managing Competitiveness The policy options suggested in this report can increase the carbon costs for business that trade

internationally and thus place them at a competitive disadvantage. Policy options to address this

competitiveness impact should therefore be considered. These could include measures that are specific

33 Environmental taxation in the UK: the climate change levy and policy making, John McEldowney and David Salter, Denning Law Journal 2015

Vol 28 Special Issue pp 37-65. 34 For example: Vaze, P., Sunderland, L. 2014. The economic case for recycling carbon tax revenues into energy efficiency. Energy bill revolution.

Available from: https://www.e3g.org/docs/The_case_for_recyling_carbon_tax_Feb2014_Final.pdf 35 Carattini, S, Carvalho, M., Fankhauser, S. 2017. How to make carbon taxes more acceptable. LSE. Available from:

http://www.lse.ac.uk/GranthamInstitute/wp-content/uploads/2017/12/How-to-make-carbon-taxes-more-acceptable.pdf 36 European Commission. 2017. Analysis of the use of Auction Revenues by the Member States. DG Clima. Available from:

https://ec.europa.eu/clima/sites/clima/files/ets/auctioning/docs/auction_revenues_report_2017_en.pdf 37 Helm, D. 2017. Cost of energy review. Available from:

https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/654902/Cost_of_Energy_Review.pdf 38 A Review of the Role and Remit of the Committee on Climate Change, Peter G McGregor, J Kim Swales, and Matthew A Winning, Fraser of

Allander Institute, Department of Economics, University of Strathclyde, 2011.

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to the policy approach, such as allocating ETS emissions allowances for free or providing certain

companies with tax free allowances under a carbon tax regime. These are discussed within the

corresponding option sections above. However, an approach common to all national carbon mitigation

policies could be the use of Border Carbon Adjustments (BCAs). BCAs address carbon leakage by

imposing tariffs on the import of goods to a carbon constrained region from a region without the same

level of constraints. They can also apply benefits or carbon cost exemptions for the export of goods

from the carbon constrained region. However, the literature on BCAs highlights substantial

implementation challenges39 40, discussed below.

Calculating embedded carbon emissions

The development of a BCA involves calculating the embedded carbon content of the imported good,

through a life-cycle analysis method.

The complexity of the analysis increases with the complexity of the product. For example, calculating

the carbon content of basic goods or raw materials (fuel, electricity) is easier than intermediate

manufactured products (cement, aluminium) or final products (cars, electrical appliances), due to the

length and complexity of global supply chains produce these goods. The application of BCA to even a

restricted group of final products in an economy is therefore potentially prohibitively complex. A further

way of simplifying the analysis is to use generic emission factors, however this means that similar

products could be assigned the same emissions even if the carbon emitted within their supply chains

varies.

Where attempts have been made to include BCAs, this is usually on basic goods and materials.

California has applied BCAs to imported electricity, as described in Box 2, and considered the

implementation of BCAs on imported cement.

Box 2: Application of BCAs in California

California has put in place a BCA policy for the electricity sector

Electricity importers will need to pay for carbon allowances when the source of their electricity emits

more than 25,000 tCO2e per year. If the source is unspecified a default emission factor is used in

combination with a transmission loss correction factor. Moreover, California gives out free allowances

only to industrial entities within California, thereby reducing the carbon leakage risk in these sectors41.

Compliance with trading agreements

Perhaps the most substantial challenge to the application of BCAs is the threat of legal challenges

under existing trade agreements. Any policy that relates to import control would have to be approved

by the WTO according to the provision of non-discrimination. Under the General Agreement on Tariffs

and Trade’s (GATT’s) general exceptions rules of the WTO, in order to apply a BCA, it must be proved

that a comparable mechanism to reduce emissions does not exist in the exporting country42.

Additionally, a ‘good faith attempt’ to create a multilateral agreement needs to be carried out, before a

country can consider being eligible for the exception rules of the WTO, adding even more complexity43.

This could require the direct negotiation with the exporting jurisdiction of each competing good.

In the UK’s case, the existence of the EU ETS may mean that comparable mechanisms are in place in

the EU, and BCAs may not be required for goods traded between the UK and EU within the sectors

covered (electricity generation and certain industries).

39. Pauwelyn, Joost, Carbon Leakage Measures and Border Tax Adjustments Under WTO Law (March 21, 2012). Available at

SSRN: https://ssrn.com/abstract=2026879 or http://dx.doi.org/10.2139/ssrn.2026879 40 Flannery, B. 2016. Carbon Taxes, Trade and Border Tax Adjustments. Resources for the Future. Policy Brief. No. 16-02. 41 Partnership for Market Readiness. 2015. PMR Technical Workshop – Carbon Leakage: Theory, Evidence and Policy. Available from:

https://www.thepmr.org/system/files/documents/Exercise_Workshop_carbon%20leakage%20Californi

a_Final.pdf [accessed on 16-06-2017]. 42 World Trade Organization. 2011. Trade and Climate Change. Trade and Environment Division, WTO and UNFCCC. 43Cosbey, A. 2008. Border Carbon Adjustment. International Institute for Sustainable Development. Available from:

https://www.iisd.org/pdf/2008/cph_trade_climate_border_carbon.pdf [accessed on 16-06-2017].

https://ssrn.com/abstract=2026879

https://dx.doi.org/10.2139/ssrn.2026879

https://www.thepmr.org/system/files/documents/Exercise_Workshop_carbon%20leakage%20California_Final.pdf


https://www.iisd.org/pdf/2008/cph_trade_climate_border_carbon.pdf

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9.3 Investment in infrastructure and innovation Whilst a carbon pricing policy approach can encourage the most cost effective investment in products

and projects, especially within the private sector, as explained in Section 2.1 there is a strong case for

supplementing this with measures aimed at shorter term behavioural change and also longer term

infrastructure investment and innovation. Reflecting this, two shortlisted policy options (Option 2 on

carbon taxation and Option 3 on emission trading) both explicitly involve additional complementary

measures that would be funded from the revenues generated by those policies. In this section some of

the issues associated with incentivising infrastructure and innovation are explored.

9.3.1 International experience

Policy makers often expect that carbon price incentives, will not necessarily drive all the abatement

necessary to meet targets and therefore employ complementary measures, as in the New Zealand ETS

or Californian cap and trade scheme. This is because there may be barriers that the carbon price is not

able to overcome. For instance, complementary measures can be required for the following reasons:

• There may be a need to enhance consumer awareness of low carbon choices.

• Technologies with high upfront costs may pose financing barriers.

• Technologies with high research needs may not be encouraged if their commercialisation

timeframes are longer than the carbon pricing policy horizon.

• If the carbon price does not encourage emissions abatement throughout the product supply

chain

9.3.2 Current UK situation and challenges The UK Government’s Clean Growth Strategy44 outlines the scale of the investment needed to deliver

on the commitments made in the Paris Agreement, as the UK economy shifts to cleaner, low carbon

technologies in power, transport, heating and cooling, industrial processes and agriculture. It also

outlines the need to develop innovative new approaches, solutions and products that will enable UK

industry to gain a competitive advantage in the development of the global low carbon economy. In total,

central government invested £2 billion in 2016/17 in upgrading the UK’s digital, energy, transport,

housing, water and flood defence infrastructure, and this is set to rise to £5 billion a year by 2020/21.

The strategy document also outlines how an extra £2.5 billion will be invested in developing new

technologies over 5 years (2017 to 2021), and that this investment is expected to be able to deliver 93%

of the emission savings required by 2032 under the 5th Carbon Budget. However, it also outlines the

needs for substantial additional investment in new technology development to address the remaining

gap and to develop the new low carbon technologies that will be needed beyond 2032.

The Industrial Strategy sets out how the UK will approach R&D over the coming decades. It notes that

the level of UK expenditure on R&D at 1.7% of GDP is too low and needs to increase to the 2.4% by

2027 and 3% in the longer term. However, analysis suggests that globally, public funding for RD&D in

low-carbon technologies needs to increase by two to five times 2010 levels to achieve a 50% CO2

emissions reduction, so further increases in UK RD&D funding are likely to be needed to reach the

target 80% reduction by 2050.

9.3.3 Options for supporting innovation and investment

9.3.3.1 The role of policy in innovation

A recent analysis by the Grantham Research Institute at LSE concluded that there is robust evidence

on the effectiveness of public policy as a driver of low-carbon innovation45. This work also identifies that

three broad categories of policy instrument can be used to stimulate innovation:

44 BEIS. 2017. Clean growth strategy. Available from: https://www.gov.uk/government/publications/clean-growth-strategy 45 Dechezlepretre, A., Martin, R., Bassi, S. 2016. Climate change policy, innovation and growth. Policy brief. Available from:

http://www.lse.ac.uk/GranthamInstitute/wp-content/uploads/2016/01/Dechezlepretre-et-al-policy-brief-Jan-2016.pdf

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• Command-and-control regulations that set a specific level of environmental performance,

without dictating how the target is met, thereby maximising the scope for innovation.

• Technology-based standards that specify the general method that firms must use to comply

with a particular regulation, e.g. requiring a percentage of renewable electricity generation,

which can drive down the costs of technology by stimulating competition between alternative

solutions.

• Market-based policies that establish a price for emissions, thereby stimulating changes in

behaviour by incentivising continuous improvement and rewarding innovation.

This analysis is supported by an earlier analysis by Frontier Economics46 which identifies a need to

strengthen the price signal to stimulate levels of UK low carbon innovation and to tackle the barriers

that prevent the price signal from being sufficient for low-carbon innovation (see Table 13). They also

concluded that there was limited empirical evidence on the effectiveness of supply push mechanisms

used by the UK government i.e. grants, matched equity funding and prizes to support innovation,

although if carefully designed they could offer greater development of new technologies than demand

pull policies (e.g. feed-in-tariffs, suppliers obligations, standards and regulations, public procurement),

which were more likely to result in technology being imported.

Table 13: Barriers inhibiting innovation, from the firm's perspective (Frontier Economics)

Reasons the market signal is not there Reasons businesses cannot act on the market signal

• Carbon externality • Uncompetitive markets

• Customers have other priorities • Unintended policy consequences

• Lack of knowledge about technologies • Absent legal/regulatory frameworks

• Fossil fuel subsidies • Weak enforcement of policy

• Lack of access to capital • Limited skills

• Misaligned incentives • Catastrophic safety risks

It is interesting to contrast this conclusion with selected views from industry and academia which

advocate a strongly demand-pull approach to increasing innovation. For example:

• In Delivering Low Carbon Infrastructure47, the Green Building Council outlines the need to

stimulate innovation by adopting a performance standard based approach that engages the

entire supply chain rather than highly prescriptive target driven regulations.

• In The Role of ICT in Reducing Carbon Emissions in the UK48, BT outlines the case for investing

in Information and Communications Technology (ICT) and upgrading the network infrastructure

that underpins the digital economy to accelerate the transformation.

• In Low-carbon innovation for sustainable infrastructure: the role of public procurement49, IIS &

i2-4e outline the case to the EU to provide a dedicated funding stream that will enable public

procurement to be used to support low carbon innovation in line with the provisions of the 2017

EU package on Public Procurement50 which allow procurement based on a life cycle costing

approach that includes factors such as environmental impacts and carbon footprints.

46 Frontier Economics. 2009. Alternative policies for promoting low carbon innovation. Report for DECC. Available from: https://www.frontier-

economics.com/documents/2014/06/alternative-policies-for-promoting-low-carbon-innovation-frontier-report.pdf 47 UK Green Building Council. 2017. Delivering Low Carbon Infrastructure. Available from:

https://www.ukgbc.org/sites/default/files/Delivering%20Low%20Carbon%20Infrastructure.pdf 48 BT. 2016. The role of ICT in reducing carbon emissions in the UK. Available from:

https://www.btplc.com/Purposefulbusiness/Ourapproach/Ourpolicies/UK-Carbon-targets-May-2016.pdf 49 International Institute for Sustainable Development. 2018. Low carbon innovation for sustainable infrastructure: the role of public procurement.

Available from: http://i2-4c.eu/wp-content/uploads/2018/03/Low-Carbon-Innovation-for-Sustainable-Infrastructure-The-role-of-public-

procurement_v2.2_web.pdf 50Crown commercial service. 2015. The public contracts regulations 2015: guidance on social and environmental aspects. Available from:

https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/558032/20160912socialenvironmentalguidance

final.pdf

https://www.ukgbc.org/sites/default/files/Delivering%20Low%20Carbon%20Infrastructure.pdf

https://www.btplc.com/Purposefulbusiness/Ourapproach/Ourpolicies/UK-Carbon-targets-May-2016.pdf

http://i2-4c.eu/wp-content/uploads/2018/03/Low-Carbon-Innovation-for-Sustainable-Infrastructure-The-role-of-public-procurement_v2.2_web.pdf


https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/558032/20160912socialenvironmentalguidancefinal.pdf


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• In Effective carbon pricing and its role in the low carbon transition51, the managing Director of

Next Energy Capital, makes the case for a 30 year “flight plan” for carbon pricing or trajectory

based on a polluter pays principal where costs cannot be passed onto end-users, as the most

cost-effective way of stimulating innovation and investment in the power sector.

• In Policy for Heat: Transforming the System, Carbon Connect present a number of options for

replacing supplier obligations52, including revenue decoupling to incentivise suppliers to support

energy efficiency measures, funding energy efficiency via low cost loans (0.5%-0.7%) and

home energy efficiency improvement plans linked to mortgage and stamp duty relief.

• In Finance for innovation: Towards the ETS Innovation Fund, Climate & Strategy Partners53

recommend that the EU allocates some of the proceeds of the EU ETS auctions (2021-30) to

projects at Technology Readiness Level (TRL) 6 to 9. The aim is to break through technologies

to cross the “valley of death” and to support the scale up of new low carbon technologies.

Detailed proposals for this new NER400 innovation programme are currently being finalised.

• In Accelerating Green Finance54, the Green Finance Task Force recommends that the UK

government publishes a National Capital Raising Plan designed to align UK infrastructure

planning with the delivery of the Clean Growth Strategy and the 25 Year Environment Plan.

They also recommend that a Sovereign Green Bond be issued to raise funds needed to fund a

package of new initiatives aimed at boosting clean growth and green policies. It also made

recommendations on future policy and tax reforms that are needed to underpin investment.

There is a strong emphasis on the need for the public sector to lead the investment drive.

9.3.3.2 Financing investment in innovation

Analysis of 16 international carbon pricing schemes indicates that 9 schemes recycled a proportion of

funds raised into investment programs supporting the development and deployment of climate-friendly

technologies55. Four of these nine recycling schemes funded R&D into low carbon technologies,

including the creation of demonstration facilities and bringing existing technologies to market. The EU

Innovation Fund (NER 300/400) is further example of a carbon pricing scheme that recycles funds into

RD&D, which was introduced following the presentation of a strong economic case for increasing

innovation5657.

Currently the UK Government does not explicitly recycle taxes on non-renewable energy and carbon

emissions into RD&D, although £50 million raised by the introduction of the CCL was used to encourage

business to invest in the new environmental technologies and in renewable fuels58. If substantial funds

are raised by increasing the carbon price signal, then recycling revenues into clean technology RD&D

may increase public support for the reforms, although uniform lump-sum recycling of carbon revenues

to citizens is the option favoured by behavioural and political studies 5960.

51 Kazim, A. 2018. Effective carbon pricing and its role in the low carbon transition. Clean Energy News. Available from:

https://www.cleanenergynews.co.uk/blogs/solar/effective-carbon-pricing-and-its-role-in-the-low-carbon-transition 52 Carbon connect. 2015. Policy for heat: transforming the system. Available from:

http://www.igem.org.uk/media/367171/policy%20for%20heat%20-%20transforming%20the%20system.pdf 53 European Commission. 2017. Finance for innovation. Towards the ETS Innovation Fund. Available from:

https://ec.europa.eu/clima/sites/clima/files/events/docs/0115/20170612_report_en.pdf 54 BEIS. 2018. Accelerating green finance: green finance Taskforce report. Available from:

https://www.gov.uk/government/publications/accelerating-green-finance-green-finance-taskforce-report 55 International Council on Mining & Metals. 2018. Options in recycling revenues generated through carbon pricing. Available from:

https://www.icmm.com/en-gb/publications/climate-change/options-in-recycling-revenues-generated-through-carbon-pricing 56 European Commission. 2010. Innovation of energy technologies: the role of taxes. Available from:

https://ec.europa.eu/taxation_customs/sites/taxation/files/docs/body/taxation_energy_innov.pdf 57 European Commission. 2017. The economic rationale for public R&I funding and its impact. Available from:

https://publications.europa.eu/en/publication-detail/-/publication/0635b07f-07bb-11e7-8a35-01aa75ed71a1/language-en 58 House of commons library. 1999. The climate change levy. Research paper 99/93. Available from:

http://researchbriefings.files.parliament.uk/documents/RP99-93/RP99-93.pdf 59 Bowen, A. 2011. The case for carbon pricing. Policy Brief, Grantham Research Institute on Climate Change and the Environment. Available from:

http://www.lse.ac.uk/GranthamInstitute/wp-content/uploads/2015/11/Bowen-policy-brief-2015.pdf 60 Klenert, D., Mattauc, L., Combet, E., Edenhofer, O., Hepburn, C., Rafaty, R., Stern, N. 2017. Making carbon pricing work. Institute for New

Economic Thinking. Oxford martin school. Working paper 2017-11. Available from: https://www.inet.ox.ac.uk/files/Making_INET_Klenert_et_al.pdf

https://www.cleanenergynews.co.uk/blogs/solar/effective-carbon-pricing-and-its-role-in-the-low-carbon-transition

http://www.igem.org.uk/media/367171/policy%20for%20heat%20-%20transforming%20the%20system.pdf

https://ec.europa.eu/clima/sites/clima/files/events/docs/0115/20170612_report_en.pdf

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10 Next steps The UK has clear targets to reduce carbon emissions by 2050, but its decarbonisation policies are a complex combination of taxes, subsidies, contracts and regulations, which have been frequently changed by successive administrations. This means that the cost of decarbonisation differs between sectors and the policy uncertainty creates risks for investors, which comes at a cost. A new whole system approach could create an enduring framework of economic incentives to reward emissions reduction where they are most cost-efficient and support productivity improvements across the economy. To realise these benefits a set of five possible policy reform options have been described in this report. They represent different approaches to strengthening the decarbonisation incentive across the economy and deliver emissions targets in the least cost way. Whilst they all have their own strengths, they also raise significant challenges, in terms of their economic impacts, feasibility, and effectiveness in driving down emissions. The next step in this Energy Systems Catapult project is to evaluate and refine further the policy reform options presented here. This will take account of the following:

• Design choices that are fundamentally different between the options proposed. These particularly concern the sectors that would be covered, which entities would be regulated directly (upstream, at or downstream of the point of emissions) and how competitiveness concerns could be addressed. The practicability and cost effectiveness of the options will differ significantly.

• Design choices that are common to all options. These concern the governance of target setting and mechanisms to give confidence to the market that the policy will be enduring and stable. They also concern measures to stimulate behaviour change, innovation and long-term infrastructure development that can complement policies that provide carbon price incentives.

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Appendices

Appendix 1: Non-shortlisted option summaries ............................................................. 58

Appendix 2: Overall option summary .............................................................................. 60

Appendix 3: Summary of option scoring ........................................................................ 61

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Appendix 1: Non-shortlisted option summaries

Incremental policy option The approach here is that only existing policies are revised, with the objective of improving alignment

of the carbon price signal. The changes are more straightforward (relative to other options). It does not

seek to address sectors without current carbon pricing policies.

The Climate Change Levy (CCL) is revised so that the rates are based on the carbon content of fuels

and not the energy content. The carbon floor price that underpins the investment signal for electricity

generation is aligned, in carbon terms, with the carbon price in the reformed CCL. To avoid double

pricing, electricity consumption is excluded from the CCL. Reformed cost compensation measures for

energy intensive industry will be required as CCL liabilities and CCA coverage will change. CCL will

potentially be extended to commercial sector (SMEs) not currently covered and any public sector

activities not covered (non-business charities).

Max coverage policy option The priority here is to achieve carbon pricing in as many sectors as possible. Suitable sector specific

approaches are employed, and it is not the intention to seek broad coverage of any single instrument

or to harmonise the level of the price. The benefit of the approach is that it establishes carbon pricing

where it is not currently there.

An upstream carbon tax is applied for the residential sector, either as a new instrument or as an

extension of CCL. A carbon crediting system is established, to create a carbon price incentive for

emission savings projects in the waste and agricultural sectors. The demand for credits is established

by enabling them to be used for ETS, CCL or CCA compliance. A carbon tax on transport fuel is

established, through modification to current fuel duty. The CCL is expanded to cover the business sector

and any aspects of public sector administration not currently covered.

Supporting innovation policy option This approach aims to add more incentives for innovation for decarbonisation by adding a separate

carbon-based innovation mechanism to the existing policy landscape. It aims to address concerns that

carbon pricing does not incentivise long term innovation and abatement.

This option will keep all existing policies with economic incentives for decarbonisation in place but will

add a mechanism that provides a financial stimulus for carbon-based innovation. It will be linked to

existing compliance measures such as CCL offsetting or CCA targets so that obligated entities in these

systems could reduce their shorter-term carbon liabilities by investing in longer term innovation, on a

project basis. It could be supported from public money or emissions trading allowance auction revenue,

or both. It creates an incentive for commercial enterprises to invest their own capital.

Scaling carbon finance policy option This option seeks to address barriers to investment in decarbonisation by providing carbon-based

capital spend incentive. The incentive would be linked to carbon saved with a uniform carbon cost

assumption underpinning it. It was envisaged to replace other carbon pricing measures but since it

would be voluntary and based on capital investment this may not be appropriate. This option would not

apply to residential sector.

This is the creation of a new funding mechanism, akin to the functioning of green Investment bank or

Green Bonds, but is a more widespread government backed tax incentive system built upon a standard

carbon price. As above it may best be seen as complimenting existing measures. Alternatively, it could

compliment other measures, such as a uniform carbon pricing option.

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Command and control policy option This approach is based on the government deciding the final outcomes in a specific way rather than

establishing a market-based instrument for a carbon target. In other words, it involves the

predetermination, at a more granular level, of how the decarbonisation targets would be met, consistent

with other objectives.

In this option, the government sets parameters for key metrics like the fuel mix in a certain year in the

future or the percentage of electrification by a deadline. It thereby focuses on obligations and uses a

quota system that provides long-term signals. There is a possibility to create tradable energy quotas to

allow some flexibility in the system.

This reform option is based on case studies where policies were introduced that have additional

objectives beyond the carbon saved, e.g. renewable support schemes in the Netherlands and White

Certificates in Italy. These policies have targets for specific technological outcomes in the future to

reduce emissions and achieve other objectives such as job creation and national energy security.

Connected uniform price signal policy option The approach here is that all policies will be replaced by a universal trans-policy carbon compliance

commodity that is linked internationally to create more options for abatement.

This approach is similar to the single uniform price signal as described above. It however will link directly

with other international carbon markets, e.g. Kyoto units, the EU ETS or other carbon markets. It thereby

aims to be in line with the Paris agreement and create more opportunities for abatement.

Sectoral carbon budgets policy option This approach aims to split up the national climate target by sector and allowing each of them to meet

it with flexibility. Market based approaches can be adopted and sectors grouped for instance major

industrial sectors Ambition for each sector derived from carbon abatement cost expectations/analysis.

This option will replace all existing policies that provide economic incentives for decarbonisation and

replace it by setting sector-specific targets and obligations.

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Appendix 2: Overall option summary The options described here vary in their ambition and the type of reforms envisaged, but also have

some similarities in their overall objectives. Some options include elements of others and are extensions

in the ambition of others. The relationships between them are shown in the following two figures:

Figure 4: Option relationships by intervention logic grouping

Figure 5: Option relationship by timeframe and policy novelty

Internationally linked option not developed enough to have a place on second diagram. Sectoral carbon

budget and strengthened governance not shown either.

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Appendix 3: Summary of option scoring The criteria scoping across all options is shown below.

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