Setting carbon standards - key to achieving ‘Net Zero’ economy: new study by Energy Systems Catapult

Over the last 18 months, Energy Systems Catapult has been investigating how the UK can build a policy framework to reduce carbon emissions across the whole economy and deliver clean growth in a cost-effective way. 

The Rethinking Decarbonisation Incentives (RDI) project found that incentives to invest in low carbon solutions are too low in several UK sectors, most notably heating. 

The research found that currently a complex combination of taxes, subsidies, contracts and regulations, means the price paid by consumers and taxpayers varies by as much as £700 per tonne of carbon saved across different sectors of the UK economy.

However, experience around the world suggests that introducing an economy-wider carbon tax is “extremely challenging to implement”.

Instead, new sector-specific carbon standards could put the UK onto a net zero policy pathway, with a lower overall impact on energy prices. Carbon standards could be introduced alongside a system of tradeable credits, allowing energy companies more flexibility to innovate in meeting the standard.  

Heat example

Energy for heat currently has some of the weakest incentives for energy companies to invest in low carbon solutions, such as heat pumps, district heating or hydrogen.

Standards could be set for the carbon intensity of energy supplied (such as CO2 emissions per unit of energy) or for the average CO2 emissions per household across an energy supplier’s customer base. The carbon standard could be set to tighten over time, incentivising energy providers to innovate and offer the most efficient and consumer-friendly solutions, such as energy efficiency and low carbon heating technologies.   

In the medium term, there is an opportunity to create an economy-wide framework by extending carbon standards across other parts of our energy supplies (e.g. transport fuels).  

Similar approaches – such as setting standards for automotive emissions and condensing boilers - have driven innovation in electric vehicles, and boilers that are now over 90% efficient.

Head of Markets, Policy and Regulation at Energy Systems Catapult, George Day, said: “Reaching net zero will require strong and coherent economic incentives to reduce emissions and spur innovation across all sectors of the economy, particularly in how we heat our buildings.

“International experience suggests that an economy-wide carbon tax or emissions trading scheme is extremely challenging to implement. But approaches based on tightening standards have a strong record of delivering cost-effective carbon reductions in many sectors and jurisdictions.

“New carbon standards on harder-to-tackle parts of the economy, like heating, could be set to tighten over time, creating an enduring market pull for the innovation needed to achieve net zero.

“We believe an economy-wide carbon policy framework - comprising a mix of market, pricing, and regulatory interventions - can bring forward investment and innovation to deliver clean growth. 

“This will be vital for maintaining or enhancing UK economic competitiveness in a decarbonising world economy.”

Rethinking Decarbonisation Incentives recommendations

1. Take opportunities to improve the current framework of policies by adjusting existing mechanisms (i.e. subsidies, taxes, etc.) to align emissions reduction incentives across the economy.
2. Consolidate and streamline existing measurement, monitoring, and verification of all emissions and related incentives.
3. Take immediate steps to progress a carbon policy driver for residential heat, including detailed design of an enduring framework of carbon standards.
4. Develop a pathway towards economy-wide policy framework covering all emitting activities, with a linked market for greenhouse gas removals.
5. Integrate carbon reduction into the measurement of economic productivity, potentially through the Industrial Strategy Council. 

Notes to Editors:

How did we arrive at our recommendations?

First Step

We investigated the UK’s ‘effective carbon prices’ which are a measure of how much a firm or an individual is paid or rewarded per tonne of carbon (or COâ‚‚e) saved when they make a choice that lowers emissions. The UK’s current mix of policies creates ‘effective carbon prices’ across most of the economy that are too low to attract sufficient investment and innovation to reduce emissions.

Important sources of carbon emissions that currently have low effective carbon prices include:

• Residential gas use (circa 10-11% of emissions): Carbon emissions are not priced and VAT charged at only 5%.
• Agriculture (9% of emissions): No price signal is applied to emission-producing activities and the sector receives significant subsidies (of which only some target environmental outcomes).
• Air transport (7% of emissions): An air passenger duty is applied, but this is not related to the quantity of emissions and outweighed by the implicit subsidy from the zero VAT rating of air tickets. International flights make up the vast majority of UK aviation emissions. Flights within the EU are covered by the EU ETS, but the effective carbon price is low.

The effective carbon price varied by as much as £700 per COâ‚‚e across different parts of the economy.

The current pattern of effective carbon prices also reflects policy choices shaped by other fiscal and societal objectives, for example:

• Motoring is heavily taxed, but this only loosely aligns with incentivising choices that are less socially costly (i.e. less polluting and congestion causing). As more cars and vans are electrified, the significant fuel duty revenue will shrink and policy makers will need to reconsider alternative motoring taxation.
• Low carbon policy costs are recovered largely through electricity bills. This currently reduces incentives to cut emissions by electrifying heat and transport demand.
• The taxation of aviation emissions is constrained by international agreements, reducing incentives to make lower carbon travel choices.
• Public expenditure on agricultural policy support has been shaped by the Common Agricultural Policy (CAP) and is currently almost entirely disassociated from carbon impacts.

Second Step

After researching carbon policy globally (including California, USA, Canada, South Africa and New Zealand) we arrived at five options to reform UK carbon policy, representing a range of ambition and instruments to address anomalies and distortions; but there were no easy wins.

(a) Based on international experience, taxing carbon upstream would have immediate economy-wide cost implications and present trade policy challenges; (b) while implementing a VAT-style carbon consumption tax would require major measuring, monitoring, and verification challenges.

We believe an economy-wide carbon policy framework - comprising a mix of market, pricing, and regulatory interventions - can bring forward investment and innovation to deliver clean growth:

(c) Strengthening existing sectoral policies and addressing carbon policy gaps (such as on residential gas usage, making the carbon-related component of fuel duty explicit).

(d) Adopting sector-specific carbon standards (or mandatory carbon reduction obligations) that are technology-neutral in design and aligned with longer-term carbon budgets. Flexibility in compliance and tradable credits (eg. energy supplied with less carbon then the target standard generates credits that can be sold to suppliers who are unable to meet the carbon standard (i.e. in deficit). In the medium-term, the market for traded carbon credit instruments could be linked with broader carbon markets/emissions trading, such as:

(e) In line with Government’s favoured post-Brexit carbon-pricing approach, the introduction of a UK Emissions Trading System (ETS) to replace membership of the existing EU ETS, allowing us to widen the scope of sectors covered, and provide greater control over cap setting. 

Heat case study

In the UK context, our analysis of current effective carbon prices shows that there is a key gap in carbon policy relating to emissions from the dominant fuel for residential heat (gas). Our work on cost-reflective pricing also shows that the current policy approach to low carbon cost recovery introduces a significant distortion around choices between domestic gas and electricity usage.

Sufficiently stringent direct carbon pricing is likely to be challenging to introduce for the residential heat sector, therefore, suitably designed carbon standards may provide a step towards an enduring market framework. The case for applying a similar carbon standards approach to drive down emissions from road transport could also be considered.

Our work on the Smart Systems Heat Programme for the Department for Business, Energy & Industrial Strategy has also pointed to the potential for an ‘outcome-based decarbonisation obligation’ on energy or energy service providers. The importance of framing this in terms of ‘outcomes’ reflects the likelihood that technology solutions and systems integration challenges for low carbon heat solutions are likely to vary across different locations. This work concluded that such a policy instrument could help drive the creation of new business models and consumer-friendly low carbon heating offerings.

Our work on Local Area Energy Planning also points to the importance of local planning and investment co-ordination, particularly for heat decarbonisation. There is a strong case to integrate carbon policy with other local planning and development objectives.