The future of carbon pricing: c(o)alling out fossil fuels

Carbon pricing is considered one of the most important policies to reduce emissions by increasing the operating costs of high carbon fuels relative to lower-carbon alternatives. It is technology agnostic (caring only about the relevant CO2 emitted) and economically efficient.

After withdrawing from the EU at the end of 2020, the UK replaced the EU ETS (a flagship carbon pricing mechanism launched in 2005) with the UK ETS , a near-identical scheme that opened for trading in May 2021.

The UK ETS is a key policy for achieving the UK’s 2050 target of reaching net-zero emissions by 2050, however it should not be the only one. From the outset, the UK ETS was established with the promise of providing an opportunity for more ambitious carbon policy in the longer term. Although, the initial UK ETS arrangements largely mirror those of the EU ETS, the cap was reduced by 5% to what would have been the UK’s notional share of the EU ETS phase IV cap.

How successful has the EU ETS been so far?

Since the introduction of the EU ETS in 2005, emissions have decreased by 40%, in comparison to 14% between the prior 15-year period (1990 - 2005, Fig 1). Although it looks like if we continue the same trajectory to reach our carbon budgets we would be successful, it is important to note that the remaining sectors to decarbonise are much harder to abate than those targeted first. Therefore, reaching net zero will require the number of allowances in the scheme to be reduced significantly from current legislation to achieve the same level of decarbonisation as previous years. This would include reducing the cap for phase 1 (2021-2030, covering carbon budgets 4 and 5) from 1365 million allowances to between 887 million - 936 million allowances, which represents a 30-35% cut. However, to achieve the sixth carbon budget, total emissions would need to cut from around 450 MtCO2e today to 193 MtCO2e by 2035, the largest reduction yet (57%).

Figure 1. Historic annual carbon and other gas emissions over the last 30 years and the three next carbon budgets, CB4, CB5, CB6.

How have prices evolved over the last year?

Both the UK ETS and EU ETS have traded closely together despite being independent physically in supply and demand (Fig. 2). Over the last year, the UK ETS carbon price has increased by over 80%. In December, the Cost Containment Mechanism was triggered because the average price in each of September, October and November was above £52.88. Nevertheless, no intervention was carried out.

 Figure 2. UK ETS and EU ETS prices over the last year. Since inception of the scheme in may 2021 the UK ETS has increased from £47 / tonne to £78 /tonne.

The rise in carbon prices can be broadly explained by demand and policy announcements. Firstly, demand has increased. Coal assets are more frequently finding themselves in the merit order stack due to higher gas prices. With the UK dispatching more coal fired power stations more frequently, and with coal producing roughly 3 times the amount of CO2 per unit of electricity, demand for UK ETS certificates has increased. As a result, based on the C3PI (Coal to clean Carbon Price index), earlier this year, the UK carbon price required to switch from existing coal to existing gas became less attractive for the first time in over a decade (Fig. 3). Equally, interest from investors trading ETS certificates has pushed prices up. In policy, both the UK and EU have made announcements to tighten supply further in line with net zero targets (UK net zero alignment and EU fit for 55 - to increase 2030 emissions reduction target from 40% below 1990 levels to 55%) and as a result prices have spiked.

Overall, the UK carbon price required to switch from existing coal to new solar PV or onshore wind plus battery storage was -$171/tCO2. This represents an extraordinary decline of 137% since 2010 (Fig. 3) and can be attributed to the falling costs of renewable energy and battery storage. The price is negative due to rising carbon prices, decades of policy support for renewable energy, and Russia’s invasion of Ukraine, all of which has resulted in a marked increase in the price of coal and gas relative to low carbon alternatives.

Figure 3. The carbon price is calculated by transitionzero as the amount that needs to be added to (or, since January 2021, taken away from) the generation costs of an existing coal-fired power plant to make it marginally higher cost than a new onshore wind or solar photovoltaic farm plus battery storage.

Despite this, building generation assets[1] and switching takes time, and therefore gas assets are profiting from extreme market prices which on some occasions have been a multiple of the cost of production, giving generators a hefty inframarginal rent. For example, in September 2021, day ahead prices increased to over £2500 / MWh due to system tightness from reduced availability from nuclear, CCGTs, interconnector outages, and low wind levels resulting in de-rated margins falling to single digit percentages. Assets that benefit from this tend to be flexible / dispatchable generators which at the moment are predominantly gas assets (see blog on tight margins). National Grid’s Future Energy Scenarios project that by 2050 the energy system could require up to 160 GW of additional flexible capacity. Over 30% of this flexibility is expected to arise from end consumers who engage in smart charging, V2G and smart heating technologies. This would displace CCGTs in the merit order and would be beneficial in both terms of economic viability and carbon intensity.

It is expected that the UK ETS carbon price trajectory will continue to rise and even accelerate as the total number of allowances reduces to align the scheme with the UK’s Net Zero target, and fewer free allowances are available. This will likely increase the cost base for businesses either directly through purchasing allowances at a higher carbon price, or an indirect effect as the higher price is passed along the value chain.

So, what more can be done?

 Currently the UK ETS covers electricity generation, heavy industry and domestic aviation for compliance entities[2] (companies that have to fulfil regulatory obligations). The UK Government has committed to exploring the expansion of the UK ETS to domestic maritime and waste by the mid to late 2020s, including an additional 5 - 6% of UK carbon emissions. However, the two-thirds of emissions not yet covered by the policy, transport and building heating, largely rely on fossil fuels, such as heating oil, natural gas, petrol and diesel (Fig. 4). As part of the revision of the EU ETS the European Commission is proposing to extend emissions trading to the building and road transport sectors in a new, separate emissions trading system from 2026 . However, the UK’s carbon plans remain uncertain.

Figure 4. a) GB annual carbon emissions split by sector and sub-sector, b) absolute emissions illustrating those covered by the UK ETS verses potential sectors to be added to the scheme and the remaining deficit. Data for greenhouse gas emissions before the pandemic from BEIS: final UK GHG national statistics 1990-2019. 

Although road transport currently comprises approximately 20% of emissions, the debate remains whether the UK ETS is the right policy choice for it. Current schemes such as the Renewable Transport Fuel Obligation (RTFO), the ban on sales of new petrol and diesel vehicles by 2030, clean air zones and emission performance standards are already seeking to address the decarbonisation of road transport. Nevertheless, the inclusion of road transport in the UK ETS could be an additional incentive for technology / fuel switching and an effective way of simplifying the landscape and creating transparency, providing overlapping of policies is ruled out. Taxes raised could be used to support zero carbon charging infrastructure.

Domestic heat currently accounts for approximately 15% of emissions. Expansion of the UK ETS to the heat and buildings sector could help level the playing field between heat pumps and gas boilers. Currently the carbon account for heating is incredibly distortionary. There are two reasons for this (i) electricity generation is already covered by the UK ETS carbon scheme, while gas burnt directly for domestic heating is not, and (ii) policy costs for renewables support (e.g FITs) are loaded onto electricity prices but not onto gas prices. As a result, there is a significant cost differential between electricity and natural gas use meaning that higher carbon technologies, such as gas boilers, are often the cheapest consumer option.

Better alignment of policies to enable appropriate costing of CO2 emissions in the UK ETS would help drive investment decisions towards low carbon alternatives. However, the deciding factor for switching for most people is likely to be the cost parity in terms of both upfront and running costs between gas boilers and heat pumps. Exposing heat and buildings to carbon prices could impact fuel poverty and therefore a ceiling on prices to protect consumers may be required e.g akin to the EU’s Social Climate Fund or relief measures implemented in Germany (reducing the electricity price and increasing the commuting allowance) when a carbon price was put on heating and transport. Again, the levies collected could then be ring fenced to subsidise switching from gas boilers to heat pumps.

Summary – carbon pricing should not be a stand-alone solution

Carbon pricing is essential in promoting the switching between coal-to-gas-to-renewables and has already been responsible for a significant reduction in UK’s CO2 emissions from the electricity sector. However, without reform of the UK ETS, and a broader policy change, carbon pricing won’t fulfil is potential. The current scheme is half-hearted (covering only 25% of carbon emissions) and distortionary (driving up CO2 emissions in domestic heating). Expanding the scheme to more sectors seems logical. But, without careful design, it could risk undermining the efficacy of the mechanism. Policy and frameworks must align to ensure that barriers to low carbon technologies are removed. For example, cutting the permitting red tape so that more renewables can be built, reforming energy markets and incentivising technology neutrality. In sectors where carbon pricing may not be suitable there needs to be a clear set of complementary policy packages and strategies that will enable sectoral decarbonisation, including mitigating against carbon leakage.

[1] Note – the alternative to the cap and trade ETS is the verified / voluntary carbon market where there is a straight forward supply and demand for companies and individuals to offset their emissions.  

[2] It currently takes around seven years to create a wind project, including wind data collection, planning, construction and grid connection.