Comment by Dr. Danial Sturge, Carbon Policy Practice Manager at Energy Systems Catapult and Esin Serin, Policy Fellow at The Grantham Institute. 

The government has committed to increasing the role of the UK Emissions Trading Scheme (ETS) in achieving Net Zero. With domestic heating and road transport fuels being two of the highest sources of carbon emissions in the economy, they are ideal candidates for any plans to expand the scheme. But what would be the impact of doing so on the economy and on consumers, ask Esin Serin and Danial Sturge, drawing on their new research.

A carbon price, when high enough, can provide an important price signal to reduce emissions in an economically efficient way. It directly exposes polluters to the cost of the emissions they produce and encourages them to decarbonise. The UK ETS, which operates under the cap-and-trade principle, is the country’s cornerstone carbon pricing policy.

So far, it has been possible to concentrate the coverage of the UK ETS on particular emissions-intensive sectors (power generation and industry) while shielding others. But such differentiation is becoming harder to justify given the urgency of Net Zero and slow progress so far in sectors not currently covered by the scheme. The Government has already committed to exploring expanding the UK ETS “to more sectors of the economy, including high emitting sectors” in its response last year to the Independent Review of Net Zero.

Extending carbon pricing can be challenging

Historically, an explicit carbon price has been politically challenging to implement. Regressive distributional impacts – where greater financial burden falls on lower-income compared with higher-income households – can make carbon pricing unpopular, unless it is combined with other, compensatory, measures.

Political and public sensitivity to carbon pricing reforms will be particularly acute given the current cost-of-living crisis affecting UK households, especially if such reforms entrench existing inequalities. The UK’s current economic climate of high inflation and weak growth could also exacerbate concerns over the potential macroeconomic implications of carbon pricing, increasing reluctance among policymakers.

These factors necessitate a balance between carbon pricing and other types of policies and regulations on the way to Net Zero. Where the balance should be struck also varies sector by sector. Thus, no country has relied solely, or even predominantly, upon the standard economic recommendation of carbon pricing for decarbonisation – all have used a mix of policies.

Illustrating the macroeconomic and distributional impacts of extending the ETS

When evolving the UK ETS to include new sectors, the Government must carefully weigh up economic, environmental and social consequences in order to achieve both immediate political feasibility and the durability of the policy over time. To help inform the Government’s thinking, we have modelled extending the UK ETS to the fuels used for heating, road transport and to a combination of both sectors under illustrative carbon prices of £40 per tonne of carbon dioxide equivalent (tCO₂e) (a low price) and £80/tCO₂e (a high price).

In our modelling, a carbon price extended to both heating and road transport fuels yielded reductions in economy-wide emissions of around 26% under the high price scenario and around 16% under the low price scenario. This suggests that if introduced, carbon pricing can have a meaningful impact on emissions reductions but that it will need to be part of a broader package of coherent policies to deliver the deeper emissions cuts required for Net Zero.

Our model also considers an option in which revenues raised from the UK ETS extension are redistributed to households and firms in order to (at least partially) offset distributional effects. This option significantly increases the fiscal multiplier effect (i.e. the impact on GDP), yielding a ‘double dividend’ whereby carbon pricing and revenue redistribution lead to a boost in GDP. Importantly, redistribution to households has very limited rebound effects on emissions (i.e. it does not unintentionally boost them).

Impacts vary across the sectors

The impact of extending the UK ETS is not the same for all sectors, with our modelling showing that a carbon price on heating fuels would yield larger emissions reductions (and smaller inflationary pressures) than one on road transport fuels. This suggests carbon pricing has potentially higher salience when it comes to heating, which is explained predominantly by the fact that there is currently no carbon price on gas heating in the UK. Road transport, on the other hand, already sees an effective carbon price via fuel duty, meaning increasing the role of carbon pricing in the policy mix only yields diminishing benefits.

However, carbon pricing applied to home heating fuels results in lower-income households being disproportionately impacted by the policy. This is not surprising (with heating fuels constituting a comparatively higher share of the earnings of lower-income households), but it reinforces the case for using carbon pricing revenue to offset these impacts. Our modelling shows that it is possible for the Government to raise revenue – up to 0.62% of GDP when the high carbon price is applied to both sectors – that would be sufficient to ensure at least the lower half of all income deciles do not feel any adverse impacts, while also generating surplus for government to spend on other priorities.

Sector-specific insights for policymakers

The UK ETS has the potential to assist efforts to decarbonise domestic heating through a phased extension over time, beginning with natural gas and eventually extending to cover other heating fuels. Introducing the UK ETS in this way could be an effective part of an approach to rebalance electricity and gas prices in the sector.

In road transport, on the other hand, there is an argument to focus (at least in the near term) on strengthening existing policies that have already started to enable emissions cuts as the more effective approach over a potential UK ETS extension. Regardless of the decision taken on the UK ETS, revenue collection from road transport is in need of urgent reform, to address the expected erosion of revenues from fuel duty due to the continued electrification of vehicles.

Ultimately, carbon pricing can support decarbonisation efforts in both domestic heating and road transport (more so in the former), but it does not offer the predominant mitigation policy in either sector. Rather, it will only work effectively as part of a coherent mix of policies. That will need to include investment in supply chains, skills and key infrastructure (e.g. grid, EV chargers and public transport) to make low-carbon options more attractive for consumers.

Political choices are critical for building public support

While any use of carbon pricing brings uneven distributional impacts, mitigating them is a political choice that can be achieved through revenue distribution. Failure to do so could undermine public and political support for plans to extend the UK ETS, and prohibit the potential contribution it can make to achieving Net Zero. As the Government develops its long-term vision for the UK ETS, the potential extension of the scheme to domestic heating and road transport fuels will continue to be relevant to these considerations.