CLIMATE POLICY IN THE UNITED KINGDOM: AN ASSESSMENT Richard S.J.

Tol Department of Economics, Sussex University, Brighton, BN1 9RF, United Kingdom Institute for Environmental Studies, Vrije Universiteit, Amsterdam, The Netherlands Department of Spatial Economics, Vrije Universiteit, Amsterdam, The Netherlands 7 March 2012 Abstract Public policy, including climate policy, should follow a number of simple rules: One instrument per problem, uniform pricing at the margin, gradual intensification, credible signals, and technology neutrality. I evaluate HM Governments Carbon Plan and find that these principles are consistently violated. Climate policy is thus unnecessarily costly. Key words climate policy; United Kingdom; second-best analysis 1. Introduction Over the last decade, climate policy has changed from something that was planned for the future to something that has been implemented. Although it is too early for a rigorous, data-driven, ex post evaluation of the costs and effectiveness of greenhouse gas emission reduction policy, 1 qualitative assessments are possible already. This paper contributes to that literature, studying the United Kingdom. The UK is an interesting case study. The UK has been at the forefront of climate policy, both internationally and domestically. The UK also has a sophisticated civil service, capable of both analyzing and delivering complex policies. Finally, the UK has a proud academic tradition in public policy in general and environmental management in particular. You would therefore expect the UK to be not just a leader in the ambitiousness of its climate policy, but also be ahead of other countries in the cleverness of the implementation of that policy. The current paper puts this hypothesis to the test. This has been done before, notably by (Pearce 2006), (Helm 2008;Helm 2010) and (McIlveen and Helm 2010). These authors conclude that UK climate policy is far from its optimum. This paper adds to those assessments by look at the latest policies.

There have been case studies of selected policies; see (Leahy and Tol 2012) the references therein. Surprisingly, there appears to be no published analysis of the impact of Norways carbon tax, which dates back to 1991.

The paper continues as follows. Section 2 sets out the principles of climate policy. Sections 3 to 5 contrast this with actual and proposed policy, focusing on power generation, building heating, and transport, respectively. Section 6 concludes. 2. Principles of climate policy The principles of a sound climate policy are by and large the same as the principles of a sound environmental policy or any other public policy but because the problem has been identified, we can be more specific. Any proposed or actual climate policy should be tested against the following high level principles. The number of policy instruments should equal the number of policy goals. Going back to (Tinbergen 1952), this principle is both about costs and about effectiveness. If the aim is to reduce greenhouse gas emissions, then one policy intervention (say, a carbon tax) is sufficient. If the aim is to reduce greenhouse gas emission and improve security of supply, then two policy interventions (say, a carbon tax and capacity payments) are needed. If there are fewer policy instruments than goals, then at least one of the policy goals will be missed. If there are more policy instruments than goals, then it is difficult to predict whether the goal will be met, but costs are necessarily higher than needed. At the margin, all emitters should face the same price. (Baumol 1972) argued for equimarginal pricing for reasons of cost-effectiveness. It is a mathematical truism that a goal is reached at minimum cost if and only if every emitter pays the same at the margin, say for tradable permits. This principle also adheres to a basic notion of fairness: Every emitter pays the same penalty, and every emission reduction is rewarded in the same way. The price of carbon should rise gradually over time. As soon as a climate target is set through whatever process, there is a budget for greenhouse gas emissions. The budget is a resource, and the Hotelling Rule (Hotelling 1931) implies that, in order to minimize costs, the scarcity rent should rise with the rate of interest minus the rate of atmospheric degradation of greenhouse concentrations. There is another reason why climate policy should intensify over time. Climate policy should punish emissions so that people and companies change their behaviour. However, behaviour is often determined by long-lived capital (machinery, vehicles, buildings) so that climate policy punishes without changing behaviour. A climate policy that moves faster than the capital stock turns over thus causes economic pain without environmental gain (Wigley et al. 1996). Climate policy should be credible. Climate policy is about changing behaviour in the short-term, about changing investment so that behaviour can change further in the medium-term, and about changing research and development so that behaviour can change further still in the long-term. Investors and inventors do not care much about current policy. They respond to what they think future climate policy will be. Investors and inventors take their cues about future climate policy from current climate policy, the institutional stability of climate policy, and the rhetoric around climate policy. Policy makers routinely commit their successors, but only credible commitments have an impact. Climate policy should be technology neutral. Stabilizing the atmosphere requires deep emission cuts carbon dioxide emissions should go to zero in the long run. This cannot be done without a radical change in technology. There are a number of alternative

technologies, some more mature than others, that would meet the world energy demand without carbon dioxide emissions. No one knows with any sort of confidence which of these technologies will solve the climate problem. However, history has shown that the collective wisdom of practitioners disciplined by the market is a better guide than the ideas of civil servants, politicians and lobbyists. Therefore, climate policy should not engage in favouring any solution over any other but treat every emission reduction and every potential future emission reduction in the exact same way (Audretsch et al. 2002;Jaffe et al. 2003). Armed with these insights, let us consider HM Governments Carbon Plan (Cameron et al. 2011). The Carbon Plan correctly identifies and targets the three main sources of greenhouse gas emissions in the United Kingdom: Power generation; building heating; and transport. I discuss these in turn. 3. Power generation Power generation is responsible for some 35% of greenhouse gas emissions in the UK. Therefore, climate policy must involve power generation. Or must it? Emissions from power generation in the UK are regulated by the European Union Emission Trading System (Convery 2009;Convery and Redmond 2007;Ellerman and Buchner 2007). Following the principle of one goal, one instrument, UK regulation is largely unnecessary. The Carbon Plan contains two elements that are needed: planning reform and capacity payments. Electricity cannot be stored: Supply needs to meet demand every minute. Electricity demand varies. That implies that peak demand is met by a power generator that operates for a few hours per year only. Private companies thus have no reason to invest in peak supply (but they do keep old generators in reserve) and the UK is facing a shortage of peak supply by the end of the decade. This is regardless of climate policy. However, the demand for peak (and backup) supply grows as more and more wind and solar power are connected to the grid. Capacity payments a system of cross-subsidies from all power generators to peak plants provide the appropriate incentives to invest in peak supply (Joskow 2008). Planning reform is needed too. It is difficult to build anything in the UK. If electricity supply is to keep up with electricity demand, new capacity will have to be added. If the new electricity supply is to be climate-friendly, even more capacity will need to be added and the grid will need to be reinforced as well. It is hard to imagine that planning permission will be obtained in time under the current regulations. Planning reform is a prerequisite for climate policy. Other parts of the Carbon Plan are best forgotten. The EU ETS already regulates emissions from power generation. The planned emission performance standards are therefore redundant. The basic idea of tradable permits is that some companies will find it expensive to reduce their emissions, and so buy additional permits on the market instead. Emission performance standards would take away this option. This distorts the permit market, driven up emission reduction costs across the European Union but particularly in the UK. European emissions would be unaffected as the cap is EU-wide. Emission performance standards would reduce emissions in the UK, but emissions would rise elsewhere in the EU. Support for the carbon permit price has the same effects: Costs go up, emissions are unaffected. A UK-specific floor for the carbon price is equivalent to a unilateral carbon tax in a multilateral

permit market. It drives up the price of carbon in the UK, but every tonne that is additionally reduced in the UK is offset, one-by-one, by extra emissions elsewhere in Europe. This drives a wedge between the UK and the EU price of carbon, imposing costs on all but particularly on the Brits (Boehringer et al. 2008). The Carbon Plan for power generation thus violates the uniform price and one instrument per goal principles. It also violates technical neutrality. This is partly the fault of the European Union. The relevant Directives stipulate not only by how greenhouse gas emissions should be reduced, but also that a substantial share of this abatement must be achieved by a particular set of technologies, viz. renewable energy (European Parliament and Council of the European Union 2009a;European Parliament and Council of the European Union 2009b;European Parliament and Council of the European Union 2009c). As there are no intrinsic merits to renewable energy, this makes EU climate policy needlessly expensive (Bhringer et al. 2009). As all of the major Member States will find it difficult to meet their renewable obligations, chances are that these targets will not be enforced. Nonetheless, Member States will need to be seen trying, and the Carbon Plan foresees feed-in tariffs for renewable electricity. This may take the form of a price subsidy, or of a conditional price subsidy. In either case, renewable electricity will be favoured over other forms of greenhouse gas emission reduction. Costs will go up. Emissions will not fall. Besides the technological partiality imposed by Brussels, the Carbon Plan adds bias by expressing its support for two particular technologies, viz. carbon capture and storage (CCS), and nuclear power. Explicit subsidies for nuclear power have been ruled out, but the Carbon Plan does announce an enabling framework which will include setting the arrangements for assessment by the nuclear regulators of the safety, security and environmental impact. The real meaning of these words is hard to discern, but it seems that regulation will be relaxed to reduce the costs of nuclear power. The Carbon Plan is more explicit about CCS. HM Government is funding a demonstration plant. Public funding to demonstrate socially desirable but immature technologies is justified (Gomulka 1990). However, once a demonstration plant has been built, private companies should have learned enough to invest in commercial deployment. The Carbon Plan, however, foresees more subsidies for further demonstrations, despite declining opportunities to lean. Moreover, the Carbon Plan announces subsidies for gas-plus-CCS. Whereas coal-plus-CCS may well be commercially deployed in the foreseeable future and may thus be eligible for publically financed demonstration, it is hard to imagine that the price of carbon will rise sufficiently high in the medium term to make gas-plus-CCS a commercially attractive option (Clarke et al. 2009). Demonstrating gas-plus-CCS is therefore premature. 4. Heating Home heating is responsible for some 14% of UK greenhouse gas emissions. Companies add another 17%, but that is from a mix of office heating and industrial processes. The Carbon Plan has a four-pronged approach to residential emissions. (This violates the principle of one instrument per goal.) These schemes also extend to small and medium sized businesses, for which options are fairly similar as those available to households.

The energy efficiency paradox has been much commented on (Decanio 1998;Jaffe and Stavins 1994;van Soest and Bulte 2001;Weber 1997). There are many potential investments with a relatively small upfront costs and a relatively large pay off that are never realized. At first glance, households are irrational. They could save money and reduce emissions at the same time. A closer look reveals that households and small businesses are often poorly informed. Energy ratings, such as the Energy Performance Certificates for buildings, help to overcome this problem. Another explanation of the energy efficiency paradox is that households have limited access to the capital market. They would invest in energy efficiency if only they could borrow the money. The Green Deal targets this problem. It is a remarkable act of micro-management. The government selects a number of technologies (mostly insulation) that are eligible. (This violates the principle of technological neutrality.) The government also sets the guidelines that determine which particular investments are economically viable. It is often better to leave such decisions to the investors who tend to be better informed about the circumstances. Finally, the government obliges utilities to act as money lenders: The energy provider pays for the upfront costs, and then pockets the savings in the energy bill until the investment is repaid (with interest). There are several question marks. The Green Deal is focused on investment rather than on emissions. It is highly unlikely that households would face the same marginal abatement costs (violating the principle of uniform pricing). It is questionable that energy utilities are the right agents to extend loans to households. If this is done at a large scale, it might have a negative effect on the credit rating of energy companies while they will need to borrow substantial sums to finance the needed investment in energy infrastructure. Finally, limited access to capital is a generic problem, not one that is limited to energy. By extending cheap loans for one particular purpose, the government distorts household investment choices, probably at the expense of pensions and education. The Renewable Heat Initiative is aimed at non-domestic energy use. As the name suggests, it is about fuel switching rather than energy efficiency. It is unclear why energy efficiency improvement is the priority for households, and alternative energy for companies. Under the Initiative, companies are paid a particular tariff if they heat their buildings using a governmentapproved technology. The government picks the winners. The tariff is related to the type of technology and proportional to the heat provided and is thus unrelated to the carbon dioxide emissions reduced. The Renewable Heat Initiative thus violates both the uniform pricing principle and the technological neutrality principle. There are two additional elements of the Carbon Plan. Building standards will be tightened for energy efficiency. The additional costs are unrelated to the emissions avoided. Real time information on electricity and gas use will be provided to households. Experiments have shown that this does not affect behaviour (Nolan et al. 2008). 5. Transport Road transport is responsible for some 20% of all greenhouse gas emissions. (Other domestic transport adds another 2%.) Road transport is not covered by the EU ETS, but its emissions are regulated by the EU. Specifically, there is an emissions standard for new vehicles, and there is a biofuel obligation that could be met by mandated blending (European Parliament and Council of

the European Union 2009b;European Parliament and Council of the European Union 2009d). Furthermore, the UK has one of the highest fuel taxes in the world (European Commission DG Taxation and Customs Union 2012), partly justified by a concern for climate change. One could thus argue that transport emissions are overregulated already (Parry and Small 2005). However, the Carbon Plan adds more regulation. Particularly, the government plans to give grants for plug-in hybrid and electric vehicles for households; and for green buses and electrification of rail for public transport companies. Furthermore, the government plans to invest in a particular high-speed rail connection. The government clearly picks winners, violating the principle of technological neutrality. As the grants are related to the purchase of equipment rather than the reduction of greenhouse gas emissions, pricing is not uniform either. And as the grants come on top of a host of other regulations, the principle of one instrument per problem is violated too. Furthermore, the Carbon Plan announces research grants for low-emission vehicle technology. Government support of pre-competitive research is readily justified by the knowledge spillovers that drive a wedge between the public and private returns to innovation. However, the government should select research projects that are excellent rather than research projects that match the political flavor of the month. Excelling is hard to define, of course, and may reflect academic potential as well as applicability. As the automotive industry has largely left the UK, it is not obvious that there would be any economic benefit to these particular research grants. 6. Discussion and conclusion In this paper, I review UK climate policy, paying particular attention to HM Governments Carbon Plan. On the one hand, the Carbon Plan is a skillfully crafted document. Attention has clearly been paid to the detail. People have put considerable thought into the nitty-gritty of the proposed government interventions. On the other hand, at a higher level of abstraction, the Carbon Plan violates every rule in the book of public policy: There are (many) more policy instruments than goals. Marginal emission reduction costs are not uniform. Climate policy is not technology neutral. The Carbon Plan is largely silent on the long-term prospect of climate policy. The carbon price should rise gradually over time to guarantee dynamic efficiency, but the current policy so grossly violates static efficiency (a pre-condition for dynamic efficiency) that convergence of carbon prices should be the first priority. Credibility of climate policy is needed for investment and innovation. The Carbon Plan heavily replies on subsidies and grants, and history shows these have a short life time. Many winners were picked in the current plan, and chances are that different technologies will be favoured after the next election. The rapid expansion on nuclear and renewable energy may strike a seasoned practitioner as wishful thinking rather than as a credible plan. The Climate Change Commission that was established to remove the implementation of climate policy from the vagaries of day-to-day politics, seems to have failed its goal. UK climate policy is politicized in its overall goals as well as in its details. What should the government do next? At the first opportunity, a review should be commissioned, and climate policy should be subsequently overhauled. One instrument per goal means that a carbon tax suffices. All other policy initiatives should be abandoned. This

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