(The author is a Reuters market analyst. The views expressed are his own.)
By Gerard Wynn
LONDON, March 19 The variable carbon tax that Britain is introducing from April 1 to promote low-carbon investment will cause problems due to some incompatibility with the wider European emissions trading scheme.
The tax, called "carbon price support" by the British government, is levied on suppliers of fossil fuels to power plants and these will pass on the cost to electricity consumers.
It has uniquely united environmentalists and energy-intensive industries in opposition.
The tax will be applied when the price of European Union allowances (EUAs) is lower than a rising price floor per tonne of carbon dioxide (CO2) under the British scheme.
The idea is to send a clearer, long-term signal to investors in low carbon energy who may be deterred by the volatility of EUA prices.
The tax will be an important part of the British government's support package to attract investment in new nuclear power.
By raising wholesale power prices by more than 10 percent by 2015, however, it will also provide an unmerited windfall for existing low carbon generation including nuclear power and wind farms.
Applying the tax inversely to the price of EUAs seemed to be a clever way to avoid charging polluters twice, as a flat-rate British carbon tax would have done.
But with the benefit of hindsight, it is also the scheme's biggest weakness.
First, European carbon price have collapsed, making them far cheaper than the UK floor price and increasing the size of the tax.
Second, insofar as the scheme succeeds in cutting emissions by factories and power plants, it will decrease demand for EUAs, which can then be snapped up by other European polluters, simply displacing emissions in an effect called carbon leakage.
It may have been better for Britain to focus instead on sectors not embraced by the European Union emissions trading scheme (ETS), such as transport.
Finance minister George Osborne will give an update on the scheme in his budget on Wednesday.
The best economic outcome may be to guarantee that all the tax receipts - estimated at about 1 billion pounds ($1.5 billion) a year - are redistributed to compensate households for higher power prices; to pay for efficiency investments by energy-intensive industry; and to invest in low carbon research and development.
Britain has had little time for such hypothecation in the past, however, and so far has only offered various limited compensation which it may further elaborate on Wednesday.
Pressure will therefore grow to remove or weaken the carbon price floor at the earliest opportunity, probably in 2020, threatening the aim of a long-term investment signal.
The UK carbon price floor (CPF) will rise from 16 pounds per tonne of CO2 from April 2013, to 30 pounds per tonne in 2020, in constant 2009 prices, as confirmed in the 2011 Finance Act. (See Chart 1)
The resulting tax is calculated as the difference between the carbon price floor, adjusted for inflation, and the EUA price.
The applicable EUA price is the 12-month average settlement on the European Climate Exchange for the relevant EUA futures contract.
The tax for this financial year will be 4.94 pounds per tonne of CO2, and 9.55 pounds in 2014/2015.
The government on Wednesday will confirm the tax rate for 2015/2016, and publish indicative rates through 2018.
Using the Treasury methodology, it is relatively straightforward to calculate the rates which Osborne should confirm.
The consultancy IHS CERA calculated the 2015/2016 rate at 18.29 pounds per tonne of CO2, implying an annual doubling for two successive years, reflecting the sharp fall in EU carbon prices. (Chart 2)
Assuming that natural gas is the main marginal source of power in Britain, that would imply about an extra 7 pounds per megawatt hour (MWh) passed through to wholesale power prices in 2015, or about 13 percent of present year-ahead prices.
Chart 1: link.reuters.com/cam76t
Chart 2: link.reuters.com/mam76t
Tax receipts from the plan are estimated at about 3 billion pounds from 2013-2016, according to a parliamentary "Carbon Price Floor" briefing note updated last week.
The government has already announced various rebates.
For example, fossil fuels will be exempt where these are burned in combined heat and power plants, which are more efficient than conventional power plants that vent heat into the atmosphere.
It has proposed to provide up to 100 million pounds from 2013-2015 to mitigate the impact on electricity intensive industry.
"The Government recognises that supporting the carbon price will have a knock-on effect on the wholesale electricity price, which is likely to increase retail electricity prices in the short to medium term," it said in its consultation on compensation published last October.
But industries will be under no compulsion to spend the compensation on improving efficiency, making it a windfall.
"We consider that the inherent nature of energy intensive industries, combined with the Government's policy framework, will continue to drive greater energy efficiency and carbon reduction amongst those companies eligible for ETS and CPF compensation," the document said.
This leaves considerable receipts which the finance ministry, if it would only allow such hypothecation, could return to businesses and households (increasing their sympathy towards climate policies) and use to develop low carbon energy technology. ($1 = 0.6619 British pounds) (Reporting by Gerard Wynn; Editing by Anthony Barker)