Environmental Taxation
Arun Advani
arun.advani@ifs.org.uk
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Outline
• Objectives for Policy.
• Theory.
• Current policy in the UK.
• An improving reform to household policy.
• Distributional effects.
• Potential compensation package.
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Objectives for policy
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Key objective for environmental taxation
• Reduce CO2e emissions in line with our targets.
– Target to reduce emissions by 80% relative to 1990 levels by 2050.
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Getting to the 2050 target – UK carbon budgets
800
Total emissions (mtCO2e)
700
600
500
400
300
200
100
Source Advani et al. (2013a), Figure 2.1
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2050
2045
2040
2035
2030
2025
2020
2015
2010
2005
2000
1995
1990
0
Key objective for environmental taxation
• Reduce CO2e emissions in line with our targets.
– Target to reduce emissions by 80% relative to 1990 levels by 2050.
• Want to achieve this whilst:
– Maintaining energy security.
– Avoiding negative distributional consequences.
– Minimising “carbon leakage”.
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Distribution of energy budget shares
18%
Average budget share
16%
Other fuels
14%
Gas
12%
Electricity
10%
8%
6%
4%
2%
9
Richest
Equivalised non-housing expenditure decile
8
7
6
5
4
3
2
Poorest
0%
Source Advani et al. (2013b), Figure 3.6
• Energy makes up 16% of spending for poorest 10%; 3% of
spending for richest 10%.
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Theory
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Correcting Externalities (1)
• Externalities.
– Costs or benefits from an activity borne by third parties which are not
reflected in prices.
– Lead to misallocation of resources e.g. overconsumption of a ‘bad’.
• Pricing the externality can internalise these costs.
– Decentralised way to achieve the optimal allocation.
– Can lead to a welfare gain.
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Correcting Externalities (2)
Costs
Marginal
Social Cost of
Pollution
t
Marginal
Private
Cost of
Pollution
Marginal
Cost of
Abatement
Pollution
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Other imperfections
• Principle of Targeting.
– If we have other objectives or constraints, where possible it is better to
tackle them through well-targeted instruments.
– If you use one instrument to target two objectives, may not achieve either...
• Lots of policy options for dealing with other objectives and constraints.
– Taxes.
– Permits.
– Regulation.
– Subsidising abatement or alternatives.
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Current policy in the UK
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Current UK policy
• These can be broadly defined in four categories:
1. Policies to price carbon.
2. Policies to support renewables.
3. Policies to support energy efficiency improvements.
4. Policies to support domestic energy bills.
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What do these policies mean for carbon prices?
• We calculate implicit carbon prices in 2013 and 2020.
• Two fuels:
– Electricity.
– Gas.
• Four end-users:
– Households.
– Small businesses.
– Medium businesses.
– Large energy-intensive businesses.
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Emissions produced by each end-user in 2012
140
120
Emissions (mtCO2)
Gas
Electricity
100
80
60
40
20
0
Households
Small businesses
Medium businesses Large energy intensive
businesses
Source: Advani et al. (2013a), Figure 6.1
• For comparison, total UK emissions in 2012 were 572MtCO2e.
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Which policies affect carbon price for different
end-users?
Households
Small
business
Medium
business
Large
energyintensive
business
Electricity
EU ETS
CPSR
RO
FITs
WHD
ECO
VAT subsidy
EU ETS
CPSR
RO
FITs
CCL
EU ETS
CPSR
RO
FITs
CCL
CRC
EU ETS
CPSR
RO
FITs
CCA
Gas
WHD
ECO
VAT subsidy
CCL
CCL
CRC
EU ETS
CCA
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Calculating carbon prices
• We take estimates for the impact of each policy on energy prices
• These impacts are converted into an implicit price for a tonne of
carbon dioxide equivalent
• This varies across fuels due to differences in carbon content.
– Gas is currently less carbon intensive than electricity
• For gas, we use the carbon content of domestic gas
• For electricity, we use the long run marginal emissions factor
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Implicit carbon prices for electricity, 2013
70
Implicit carbon price (£/tCO2e)
50
30
CPSR
10
-10
-30
-50
-70
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Households
Small business
Medium business
Large energy
intensive business
ETS
Implicit carbon prices for electricity, 2013
70
Implicit carbon price (£/tCO2e)
50
30
FiT
10
-10
RO
Households
Small business
Medium business
Large energy
intensive business
CPSR
ETS
-30
-50
-70
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Implicit carbon prices for electricity, 2013
70
Implicit carbon price (£/tCO2e)
50
30
CRC
CCL
10
FiT
-10
Households
Small business
Medium business
Large energy
intensive business
RO
CPSR
ETS
-30
-50
-70
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Implicit carbon prices for electricity, 2013
70
Implicit carbon price (£/tCO2e)
50
ECO
30
WHD
CRC
10
CCL
-10
Households
Small business
Medium business
Large energy
intensive business
FiT
RO
CPSR
-30
-50
-70
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ETS
Implicit carbon prices for electricity, 2013
70
Implicit carbon price (£/tCO2e)
50
VAT
30
ECO
WHD
10
CRC
CCL
-10
-30
Households
Small business
Medium business
Large energy
intensive business
FiT
RO
CPSR
ETS
-50
-70
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Implicit carbon prices for electricity, 2013
70
Implicit carbon price (£/tCO2e)
50
30
10
-10
-30
-50
-70
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Households
Small business
Medium business
Large energy intensive
business
Implicit carbon prices for electricity and gas, 2013
70
Implicit carbon price (£/tCO2e)
50
30
10
-10
Households
Small business
Medium business
-30
Electricity
-50
-70
Source Advani et al. (2013a), Figure 6.4
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Gas
Large energy intensive
business
The size of the implicit VAT subsidy
• The carbon content of a fuel depends on the quantity burned
– Prices on quantity of fuel used can be a reasonable proxy for a
carbon price
• The size of the VAT discount doesn’t vary with the quantity of
fuel, but with the price of the fuel
• This makes it hard to predict the size of the subsidy in a given
year, as this depends on the retail price of the fuel that year
– If prices rise, the rise of the subsidy will also increase
• Hence the VAT subsidy adds significant complication and
uncertainty to the carbon price, as well as making it uneven
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Implicit carbon prices in 2013 and 2020
140
Gas 2020
Gas 2013
Electricity 2020
Electricity 2013
Implicit carbon price (£/tCO2e)
120
100
80
60
40
20
0
-20
-40
Households
Small business
Medium business
Source Advani et al. (2013a), Figure 6.5
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Large energy
intensive business
Implicit carbon prices in 2013 and 2020
(excluding the VAT subsidy)
Gas 2020
Gas 2013
Electricity 2020
Electricity 2013
140
Implicit carbon price (£/tCO2e)
120
100
80
60
40
20
0
-20
-40
Households
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Small business
Medium business
Large energy
intensive business
An improving reform to household
policy
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Potential reform to carbon prices
• DECC publish an estimated “non-traded carbon price” consistent
with meeting the government’s carbon emissions reduction
targets.
– For 2013 this “target price” is £59/tCO2e.
• Potential reforms to bring household price close to target:
– Introduce a gas tax of 0.8p/kWh (average retail price is 4.8p/kWh).
– Introduce full rate VAT on both electricity and gas.
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Implications - initial
• Price rises similar to those seen in recent years...
– Electricity prices rose by 15% between August 2011 and May 2013.
– Gas prices rose by 33% between November 2010 and May 2013.
• ...But, can use the revenue raised to provide compensation.
• If one assumes no change in energy demand, this raises £8.3
billion.
– For comparison, the OBR estimates energy-related taxes raised £3.0
billion in 2012-13.
– This is composed of CCL, EU ETS, CRC, RO, FITs, WHD.
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Implications – short term
• Price rise reduces household demand.
– Around 4% for electricity.
– Around 10% for gas.
• Also raises average bills by £300.
• Expect to raise £7.5 billion accounting for this.
• Emissions to fall by eight million tonnes of CO2e per year.
– 1.4% of total annual UK emissions.
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Implications – long term
• Over longer horizon people will replace boilers and other
appliances.
– Some replacement would happen anyway...
– ...but higher energy prices encourage both production and take-up
of more efficient models than without this.
• Expected saving of 22 million tonnes of CO2e per year.
– 4% of total annual UK emissions.
– Worth around £1 billion a year.
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Distributional effects
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Average effects without compensation
Average cost as % of total expenditure
Equivalised non-housing expenditure decile
0
0.5
1
1.5
2
2.5
3
3.5
4
20% VAT
Gas tax
• Policies add an additional 1.5% to average total expenditure.
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Distributional effects without compensation
Average cost as % of total expenditure
Equivalised non-housing expenditure decile
0
0.5
1
1.5
2
2.5
3
3.5
20% VAT
Gas tax
4
• Combined reform adds around 1.8% to middle of distribution.
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Distributional effects without compensation
Average cost as % of total expenditure
Equivalised non-housing expenditure decile
0
0.5
1
1.5
2
2.5
3
3.5
20% VAT
Gas tax
4
• Combined reform adds around 3.7% to bottom 10% of households.
• Energy is large share of budget for these households.
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Distributional effects without compensation
Average cost as % of total expenditure
Equivalised non-housing expenditure decile
0
0.5
1
1.5
2
2.5
3
20% VAT
3.5
4
Gas tax
Source Advani et al. (2013b), Figure 6.2
• |n absence of compensation, reform is ‘regressive’ in the sense
that poorer households pay more as a share of expenditure.
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Potential compensation package
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Compensation for inflation
• These price increases therefore feed through noticeably to
inflation (one-off effect).
– CPI inflation rises by 1.2 percentage points.
• There is a degree of “automatic compensation” that comes from
uprating of tax and benefit thresholds.
– Estimated cost of this is £2.6 billion.
• Since energy makes up much larger share of budget for poorer
households, even after this change they are most likely to be
worse off.
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Additional compensation for poorer households
• We increase the size of some means-tested benefits, to provide
compensation.
– This reform is illustrative and broadly revenue neutral (spend £7.2
bn).
– Many alternatives are available depending on distributional
priorities.
– We consider a strongly progressive option, to see how well one
could compensate poorer households if that were the aim of policy.
• Groups targeted:
– Poor pensioners.
– Unemployed.
– Low-income employed.
– Individuals receiving disability benefits.
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Average effect by decile
Relative spending/income impact (%)
10
8
Cost as % of spending
6
4
2
0
-2
-4
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Equivalised non-housing expenditure decile
All
Richest
9
8
7
6
5
4
3
2
Poorest
-6
Average effect by decile
Relative spending/income impact (%)
10
8
Cost as % of spending
6
Gain as % of spending
4
2
0
-2
-4
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Equivalised non-housing expenditure decile
All
Richest
9
8
7
6
5
4
3
2
Poorest
-6
Average effect by decile
Cost as % of spending
8
Gain as % of spending
6
Net effect
4
2
0
-2
-4
Equivalised non-housing expenditure decile
All
Richest
9
8
7
6
5
4
Poorest
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3
Source Advani et al. (2013a), Figure 8.1
-6
2
Relative spending/income impact (%)
10
Within-decile variation
100%
90%
Households affected
80%
70%
60%
50%
40%
30%
20%
10%
0%
1
2
3
4
5
6
7
8
Equivalised non-housing expenditure decile
Loser
Broadly unaffected
9
10
Winner
Source: Figure 8.2 of “Energy use policies and carbon pricing in the UK”
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Potential compensation - conclusions
• It is possible to harmonise household carbon prices whilst
compensating poorer households on average.
• Within poor households there is significant variation.
– Those who consume relatively large amounts of energy will still be
worse off.
• Reform shown is illustrative.
– Precise implementation depends on a government’s distributional
preferences.
– We target poorer households particularly.
– Also need to consider the interaction with work incentives.
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Conclusion
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Conclusion
• Energy use policy is currently incoherent, inefficient and unstable.
– This comes from having multiple conflicting objectives.
– However, not clear we are tackling these in the best way.
• Have shown it is possible to introduce reforms which rationalise
the price and compensate most of those with low incomes.
– Whilst reforms can be progressive on average, can’t ensure every low
income household is compensated.
• This would reduce emissions substantially at no additional
economic cost.
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Further Reading
• Advani, A., Bassi, S., Bowen, A., Fankhauser, S., Johnson, P.,
Leicester, A., and Stoye, G. (2013a) Energy use policies and carbon
pricing in the UK, IFS Report R84 http://www.ifs.org.uk/publications/6915
• Advani, A., Johnson, P., Leicester, A., and Stoye, G. (2013b)
Household energy in Britain: A distributional analysis, IFS Report R85
http://www.ifs.org.uk/publications/6916
• Stern, N., (2006), The Economics of Climate Change: The Stern
Review, Chapter 2
• Fullerton, D., Leicester, A., and Smith S., (2010), Mirlees Review:
Dimensions of Tax Design, Chapter 5 Environmental Taxes://
• McKay, D., Sustainable Energy - Without the Hot Air, 2009
http://www.withouthotair.com/
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