Comment by George Day, Senior Advisor – Net Zero Policies

Government policies influence the price of energy in various ways. This shapes the signals sent to households and clean energy innovators about the direction they should head to reach a cleaner future. Yet on the journey to cleaner home heating, it’s as though government were flashing up signs saying ‘reduce speed now’ or ‘road ahead closed’.

How does policy shape the economic drivers for decarbonising residential energy use?

The energy we use in our homes accounts for around 66 million tonnes of CO2e emissions per year or around 15% of the UK’s total annual emissions. If we break this 15% down by source we find that gas use accounts for around 65% of it, electricity about 23%, and oil and coal the remaining 12%.

To understand the signals that UK policies are giving for innovators to develop cleaner technologies and for businesses to adopt them, we’ve been analysing what are known as ‘effective carbon prices’. In our first blog we broke down these prices by sector, revealing which emissions are underpriced and overpriced. Then we showed how industrial emissions remain significantly underpriced compared with the £261/tCO2e that the government has estimated is needed to achieve our Net Zero obligations.

We’ve now found that the same is true in the domestic sector. The effective carbon price for all three major residential energy sources is well below £261/tCO2e. Yet it’s the under-pricing of carbon emissions from residential gas use that is by far the most important distortion, simply due to the high volume of emissions that burning gas causes.

Figure 1 shows how carbon pricing policies stack up for the three main residential energy sources.

In the case of electricity, differing policies counterbalance each other resulting in a net effective carbon price of £74/tCO2e.

Our analysis shows for gas use in the home that policies resulted in an effective carbon price of -£67/tCO2e. Yes, you read that right. This negative carbon price means that our policies are, in effect, subsidising us to produce carbon emissions by burning gas in our homes. This is where it gets interesting, and where our analysis is, I think, at its most revealing.

This negative price is the result of three main factors:

1. Government has chosen to apply a much lower rate of VAT on residential energy consumption. It’s set at 5% rather than the 20% rate applied to most other goods and services. This is akin to a subsidy for residential energy use and is equivalent to roughly £2bn in foregone tax revenue each year. Those of you with a fondness for taxation history will remember that residential energy was exempted from VAT when it was first introduced in 1973. In the 1990s, we saw John Major’s government attempt to apply the full rate but this proved politically impossible, ending in compromise at 5% which has persisted for the past three decades. (Although, there has been recent speculation that the government may remove VAT altogether from domestic energy bills).
2. Residential gas, unlike electricity, has no carbon pricing costs added by government policy. As you can see in Figure 1, electricity generators must pay costs related to the UK Emissions Trading Scheme and Carbon Price Support mechanism. Gas used directly in homes escapes this.
3. The retail price of gas includes hardly any costs associated with decarbonisation. Again, gas is treated differently from electricity because hardly any decarbonisation costs are added to bills. By contrast, electricity includes the cost of support for the rollout of renewables (see the pink block in Figure 1). The net effect is that the effective carbon price for burning gas is much too low to drive change in our behaviour or to provide an economic margin for businesses who might want to sell us goods or services that help us to make lower-carbon choices.

Meanwhile, electricity use in our homes produces fewer emissions and they’ve declined significantly since our first analysis in 2018 due to the ongoing increase in renewables like offshore wind.. But electricity use still has a residual carbon content and our analysis shows that the current policies result in an effective carbon price that is too low. This is a result of the low VAT rating discussed earlier though that’s partially offset by the costs from policies to support decarbonisation that are included in our electricity bills.

Taking a whole-system view, we need to worry less about the under-pricing of emissions from residential electricity use because of the strong signals coming from the government’s Clean Power 2030 Action Plan on the need to drive down the carbon content of electricity. But we do need to worry about how policy makes fossil gas cheaper than cleaner electricity.

What should policymakers do?

So, what does this mean for energy policy? And what are the policy changes government could implement to drive the changes needed to decarbonise the energy we use in our homes?

Firstly, we have a major structural barrier in the disparity between gas and electricity prices, which our policy measures exacerbate rather than reduce. There is a wide range of thinking about how we could begin to address that.

A recent Catapult perspective from my colleagues Katrina Young and Fay Holland suggests extending emissions trading to cover domestic heating, with some revenue recycled to address impacts on affordability for low-income households. There is also interesting work from Nesta on options for levy reform.

Whatever the precise details, we must, over time, make a  structural shift in the pricing of residential energy if we want to create markets that can deliver attractive alternatives to gas for heating and hot water in people’s homes.

In the absence of a significant change to the tax or pricing framework then this transition will have to be driven by technology-specific policies and subsidies or hard regulatory mandates, with all the risks that they entail.

The second key structural issue is the impact of the political concern about the cost of energy bills which underlies the current low VAT rating. Our analysis shows that this has a perverse impact on the UK’s economic framework for decarbonisation.

It also shows how indiscriminate the impact of that policy is. The highest users of the most carbon-intensive forms of residential energy are in essence capturing proportionately more of the benefits of this special treatment. We need to ask ourselves: is this what we really want to achieve when the room for fiscal generosity is so tight?

Clearly, the concerns that we make the energy transition affordable are understandable, but there is a strong case for using smarter approaches to help households. Our work on Warm Home Prescription suggests one such approach by directing support at people with health-related risks.

But there is a lot more room for positive disruption across the home heating market.

We must start to send innovators the right signals, ones that say ‘road ahead wide open’ and ‘speed up now’.