If Government is serious about Net Zero, it must implement a UK Emissions Trading System in 2021

Published: 16 October 2020

By Dr. Danial Sturge, Energy Policy Advisor and George Day, Head of Markets, Policy and Regulation

Last week the Prime Minister spoke of “a green industrial revolution that in the next ten years will create hundreds of thousands if not millions of jobs”. Low carbon energy innovation can be the key engine for our post-Covid economic recovery.

The investment and innovation needed to meet Net Zero is colossal: potentially a doubling of the size of our power system; a new hydrogen economy; progress in nuclear, CCUS, and renewables; an average of 20,000 homes a week switching to low carbon heating system and 30,000 new EVs every week.

To mobilise the investment needed at the pace required, it is imperative we put the right economic signals in place. Right now, in too many sectors, we are subsidising pollution. In effect, we are trying to meet our targets with one hand tied behind our back.

Because getting these signals right is so important to the business case for low carbon innovation, we at Energy System Catapult looked closely at the UK’s current policy framework to incentivise emissions reductions over the past two years. We have also looked at the lessons from experience around the world.

We have found that current UK economic signals are both too weak in some parts of the economy and too incoherent across the whole economy to deliver the investment and innovation needed to reach Net Zero emissions by 2050. We need reforms that increase the implicit or ‘effective carbon price’ on emissions across all major emitting sectors. But crucially we also need to do this in a way that does not put our industries out of business, and which has acceptable impacts on consumers.

There has been plenty of technical debate over the years about the best way to put a price on carbon emissions. Some favour a carbon tax while others favour emissions trading systems. There are arguments on both sides.

Our work points strongly to the advantages of well-designed emissions trading systems to achieve this, compared to a carbon tax. The international experience with carbon taxes has shown how difficult they are to implement and sustain at anything like the stringency required, with policy reversals and controversy in a number of countries.

A generic, economy-wide carbon tax is hugely difficult to implement as a one-size fits all measure. Different emitting sectors face quite different challenges. Taxation choices are also by their very nature closely entwined with the business and fiscal cycle, making it tricky to deliver a stable, reliable long-term price signal through a tax instrument. The UK’s own experience – where a hastily implemented ‘freeze’ applied by George Osborne in 2014 to planned increases in the ‘carbon price support’ top up tax – does not provide a great track record, although it has successfully helped limit coal use in the power system.

The UK should take this historic opportunity of leaving the EU Emissions Trading System (ETS) to develop a coherent, sustainable, and bankable set of carbon policies across all major emitting sectors, including areas where the carbon incentives are very weak such as agriculture and residential heating. Introducing a UK ETS is preferable by far over a carbon tax as a first step along that pathway. A UK-ruled ETS is more easily adaptable to the particular challenges of key sectors, and we can align the cap setting process with our established carbon budget cycle – bolstering policy transparency and investability. This approach offers a more stable, investable, and innovative future for any UK green industrial revolution over the next decade.

But carbon pricing – either through a tax or a trading scheme – is not enough on its own to deliver that revolution. Getting the incentives rights is about a delicate balance between innovation support, regulation, and pricing. The success of offshore wind shows how successful that can be. That is why different approaches for different sectors is essential; it allows policymakers to refine the design and choice of instruments for the particular circumstances of each sector, and to combine it with packages of sector-specific complementary policies. So, for example, industrial decarbonisation policies or incentives can be combined with measures to address impacts on international competitiveness for trade-exposed industrial sectors. In residential energy, carbon policies use can be combined with measures to address fuel poverty.

A sector led approach pragmatically accepts that there is no easy way to Net Zero. As we progress deeper into the Net Zero transition getting the right balance of effort and depth of emissions reductions across different sectors will become increasingly important. Pragmatic, sector led approaches can be progressively linked through emissions trading markets and mechanisms. Such an approach will help capture the economic opportunity of this shift.