Discounting the UK carbon price floor30 Apr, 2012
The 2011 sell off in the EU ETS carbon price has left the UK government’s Carbon Price Floor (CPF) sitting at more than twice the level of the underlying market price. This has brought the weaknesses in both design and implementation of the policy into focus. The long run benefits of the CPF policy are unclear given the ability for carbon intensive industry to relocate elsewhere in the EU. The CPF is also overshadowed by a strongly political agenda to disguise support for nuclear generation, specifically for EDF as the most credible nuclear developer. But perhaps the biggest issue with the CPF is that its implementation mechanism erodes the ‘bankability’ of the carbon price signal it is supposed to provide.
Policy design issues…
The government’s headline reasoning for introducing the CPF is to reduce emissions by incentivising investment in low carbon generation. This in itself is a worthy ambition. But by taking a unilateral approach on carbon pricing, UK policy is now in direct conflict with broader European policy. This is unfortunate at a time when Europe is in desperate need of a united front on carbon policy. Even from a standalone UK policy perspective, the CPF sits uncomfortably alongside the FiT/CfD mechanism which is being implemented with the same objective of supporting low carbon generation.
The main flaw with the design of the policy is that ‘carbon leakage’ is likely to heavily dilute any emissions reduction given the UK is imposing a floor price on carbon within the wider EU ETS scheme . In other words if the cost of carbon emissions in the UK diverges with the rest of Europe, companies will relocate to avoid the cost burden. Carbon price divergence will also drive power price divergence placing a more general burden on UK industry. The extent of the divergence between the CPF and current EUA carbon forward curve is illustrated in Figure 1:
Somewhat embarrassingly the government seems to have recognised the carbon leakage problem in its own actions, with Chancellor Osborne committing £250bn in his recent budget to ease the burden of the CPF on UK industry. This approach seems like a highly inefficient policy of tax and redistribution.
Practical implementation flaws…
Policy design considerations aside, there are some very practical issues with the implementation mechanism. The government mechanism for administering the CPF by setting a carbon ‘top up’ tax in advance risks substantial over/under shooting given the volatility of underlying carbon prices. It also creates a hedging risk for market participants looking to lock in UK carbon prices beyond the horizon of the government’s top up tax announcements. The EUA component of price exposure can be hedged in the forward market but residual risk remains around the UK carbon price premium.
But more importantly for investors, because the CPR implementation mechanism is tax based, it carries substantial regulatory risk. As Climate Change Capital set out in a recent investor’s perspective critique of the CPF ‘Investors have to hope that every Parliament will continue to vote for increasing carbon price support until 2030’. Unlike the FiT/CfD mechanism where support for low carbon generation involves a contractual commitment, the government can effectively remove the CPF with the stroke of a pen.
Given the inherent risk to the UK government of guaranteeing a market floor price (there are still painful memories of the pound breaking out of the ERM mechanism), it is unlikely that a contractual approach to the CPF would ever be politically palatable. But the absence of a contractual obligation means that investors will heavily discount the impact of the CPF in their decision making.
Public scrutiny increases regulatory risk…
The government’s own Energy and Climate Change Committee issued a scathing criticism of the CPF in January, focusing on the ineffectiveness of the policy design due to carbon leakage. Osborne’s recent budget announcement of the top up tax levels have also attracted scrutiny given the 2014-15 top up is higher than the underlying EUA price. There is also a growing tide of private sector concern as to the impact of the CPF in driving carbon and power price divergence from the rest of Europe at a time when the UK is headed back into recession.
The price of carbon is a key driver of power prices and the return on low carbon investment. But the life expectancy of the CPF must come into question given the flaws in its design, price divergence from the ETS and the increasing public scrutiny of the policy. As long as it survives, investors are likely to heavily discount its impact for regulatory risk. As Climate Change Capital states:
‘If the Government is unwilling to take on the liability implied by uncertainty over its own future actions, then it cannot expect investors to do so.’