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Government plans: carbon price floor or carbon price flaw?

In the recently published White Paper on Electricity Market Reform, UK Energy Secretary Chris Huhne unveiled a package of measures designed to encourage the investment needed to ensure secure, low carbon energy for the UK.

One of the five key policies outlined in the document was the introduction of a carbon price floor from 1st April 2013. 

The carbon price floor, first formally announced in the 2011 Budget, aims to put a lower limit on the price of EU emissions allowances (EUAs) traded in the EU Emissions Trading Scheme. The government sees the current price as too low to encourage sufficient investment in low carbon technology. The price floor is anticipated to raise prices to £16/tonne in 2013, rising to £30 in 2020 and £70 in 2030. 

The government’s key reason for the carbon price floor is to ‘reduce revenue uncertainty and improve the economics for investment in low-carbon generation’ .

It claims that the UK needs £200bn of investment by 2020 and a carbon price which is stable and transparent will be the most cost-effective way to incentivise polluters into investing in low carbon technologies. 

Problems with the price floor

A recent report by the IPPR has questioned the effectiveness of a carbon price floor. It argues that price stability is only assured when the longevity of the policy is not in doubt, however this policy will require an annual vote in parliament and therefore consistent support through successive parliamentary terms, something that is far from certain.

Moreover, a carbon floor price may reduce emissions in the UK, but the additional permits would remain on the market, as part of the EU-wide emissions trading scheme. The price of EUAs would fall until supply and demand return to equilibrium.

The IPPR report also criticised the UK-only floor price for generating significant economic inefficiencies, costing the UK £1.18bn between now and 2020. This occurs because relatively cheap carbon abatement in Europe is exchanged for relatively expensive abatement in the UK.

Another criticism has been made in a recent report by IDEAcarbon: that carbon price floors tend to increase, not decrease, market volatility. This is because once the price approaches the lower bound, risks become more asymmetric and speculators enter the market, either to bet that prices will move away from the floor or that the authorities will not have the necessary resolve to defend the price floor. Such a scenario would only scare away investors and prevent optimal price discovery.

Alternatives

A number of alternatives and modifications to the carbon price floor have been suggested.

The IPPR suggests an EU-wide carbon floor price, which would eliminate the problems highlighted above. However it admits that it may be difficult to gain consensus for such a step.

Barring this, the floor should be set at a low level, providing support, but minimising economic waste. This floor could take the form of a ‘Carbon Price Support Guarantee’ which pays investors if the price of carbon goes below a certain level. This would hopefully address the issue of credibility by binding successive governments into the scheme.

IDEAcarbon has a different solution; it says that a ‘Carbon Central Bank’ should be established to regulate the ETS, bringing greater co-ordination and credibility to the scheme. An independent central bank could be given a certain allocation of EUAs at the start of a compliance period, then hold auctions every month or quarter, releasing a greater or lesser quantity of those allowances, depending on whether the current carbon price was deemed to be too high or too low. Crucially, all actions would be communicated to the market in a predictable and transparent manner.

Wider impacts

The unintended consequences of a carbon price floor shows how the UK government has again failed to take into account the wider impacts of new policies on pre-existing frameworks.

Carbon Retirement previously reported how the Carbon Reduction Commitment overlapped with the EU ETS, and a similar oversight looks set to be repeated if a UK-only carbon price floor is implemented. MPs in the Commons Energy and Climate Change Committee (ECC) have already alerted ministers to this issue and urged them to go back to the drawing board.

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