Carbon price: Floor it, can it, or coast?

Phillip Hammond’s first major test as Chancellor will come on November 23, when he delivers the Autumn Statement to Parliament.

In his first policy-rich statement since Brexit and his subsequent elevation to Cabinet second-in-command, Mr Hammond is expected to show how the direction of the Treasury will change under his governance. Headlines are likely to be dominated by his answers to questions such as:

• to what degree will austerity be eased and borrowing increase?
• will there be any signals on tax and housing?
• what will become of infrastructure development, namely HS2 and a new runway at Heathrow or Gatwick?

However, underneath all of this lies an important decision on a heavily-debated policy attracting the attention of the energy sector.

Floor it, can it, or coast?

The Carbon Floor Price (CFP) is up for review, with supporters and opponents already lining up to try and sway the decision.

The CFP is a levy paid by electricity generating companies upon the emission of CO₂. It was introduced in 2013 at a cost of £9 per tonne, and was set to rise steadily to £30 per tonne by 2020. In 2015, however, it was frozen at £18/tonne by George Osborne.

The aim was to top-up the cost of emissions, given that constant political special pleading between European nations led to the EU Emission Trading Scheme (EU ETS) consistently under-pricing carbon emissions and so not encouraging emission cuts as it was supposed to.

Most generating companies back the CFP, as it boosts power prices and therefore adds to their revenues, while heavy industry and free-market lobbyists claim it penalises UK companies and relocates carbon emissions overseas.

We've taken a look at the options available to Mr Hammond and the implications of his decision.

1. Coast: The CFP is left unchanged. The easiest fork in the road, continuing with current policy in which the £18/tonne levy is retained until 2020/21. The wholesale power price would remain largely unchanged, and current market forces would maintain pressure on coal generation. This would probably continue the progressive early retirement of ageing coal-fired stations as we saw recently with Longannet and Rugely.

Economic models forecasting the profitability of planned investments would remain unchanged. Without major changes in underlying economics, energy projects already in the pipeline would continue to move ahead under a “business as usual” situation. Some much-needed policy stability would prevent further hesitation on building new power plants, wind farms and interconnectors needed to replace the UK’s ever-ageing fleet.

2. Cut: The CFP is cut or removed. This seems unlikely considering recent lobbying from SSE and Drax – two of the largest coal-burners in the UK – and previous statements from Phillip Hammond backing effective carbon pricing.

Weakening the CPS would boost the profitability of coal-fired power stations, probably leading to them increasing output and remaining online until phased out by either the Industrial Emissions Directive or the Government’s plans to remove coal from the system by 2025 (for which we are still waiting on details). The re-ignition of coal-fired generation would displace gas from the generation mix, thereby increasing the carbon intensity of power generation.

Cutting the CFP would also reduce the wholesale power price. Lower revenue from the market would increase the scale of subsidies needed to build all new plants, whether fossil, nuclear or renewable-powered.

This makes the decision of free-market think-tanks to support ending the CFP unusual, to say the least. In particular, subsidies needed to encourage building of new gas-fired plants would have to rise if the government were serious about bringing new gas capacity online.

A lower wholesale price would also increase the cost of subsidies, as shown in recent economic projections of the cost of Hinkley over its lifetime. It would also hit the earnings of interconnector owners, throwing a spanner in the Government’s plans to expand interconnector capacity by 13 GW, thereby reducing the ability to export wind power generated in the UK to our overseas neighbours and earn revenue for Britain.

While the CFP does distort the market, its removal would increase reliance on old and increasingly unreliable power stations. Thus a measure that might appear to increase security of supply would, in fact, reduce it.

3. Floor it: The CFP is increased. With no calls for the levy to be raised, this outcome seems very unlikely - even though it would return to the original intention of putting an escalating price on carbon.

Boosting the CFP would see the profitability of running a coal-fired power plant fall faster, accelerating the removal of the final remaining coal stations from the grid. Increasing the CFP would also send a stronger market signal to encourage investment in low-carbon and gas-fired power stations and create downward pressure on subsidies needed - although it is likely that investors would still rely on the capacity market to part-fund new power plants.

Despite the original aim being to increase the CFP progressively, jacking it up by the extent needed to encourage subsidy-free investment in gas and renewable capacity would be another shock to the market, still reeling from Brexit, Hinkley and years of policy uncertainty. Even the most ardent supporters of the CFP are not calling for it to be increased.