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Carbon Price Floor: What We Knew in Budget 2011 Will be Confirmed in Budget 2012

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The UK government has correctly spotted an important problem: investors in clean power need more certainty than current policy provides. The price of carbon, set in the market through the European Emissions Trading Scheme (EU ETS), is far too low and too uncertain for the long-term investment decisions that need to be made.

In response, the government has proposed to underpin the carbon price, by introducing a new tax on fossil fuels used for power generation in the UK. High carbon fuels such as coal would have a high tax, while lower-carbon fuels such as natural gas would have a proportionately lower tax. Its precise level would be adjusted in response to the market price of EU ETS allowances (EUAs), with the intention that the EUA price plus tax, or "tax-inclusive carbon price", would reach a specified minimum in each year.

In effect, the new policy would introduce a floor on the tax-inclusive carbon price facing power generators in the UK. If the EUA price is above the floor, the tax would be zero; if the EUA price is below the floor, the new tax would make up the difference.

Budget 2011 confirmed the introduction of this variable top up tax from 1 April 2013. The floor will start at £16 per tonne of carbon dioxide (tCO2) and follow a linear path to target £30/tCO2 in 2020 (both in 2009 prices), rising to £70/tCO2 in 2030. The last Budget announced that the carbon price support rates in 2013-14 would be equivalent to £4.94/tCO2. Indicative rates for 2014-15 and 2015-16 were set at £7.28/tCO2 and £9.86/tCO2 respectively.

According to Treasury, the new tax would raise £3.22bn in tax revenues by 2015-16, which is (unsurprisingly enough) roughly about the amount HM Treasury offered in give-aways at the last Budget.

In order to ensure that the floor price targets are reached and certainty to investors is provided, Wednesday's Budget 2012 will have to confirm carbon price support rates that ensure that the tax-inclusive carbon price starts at £16/tCO2 and rises as planned to its £30/tCO2 target by 2020. But volatility in the European carbon market will make sticking to this promise politically difficult - since March 2011 the EUA price has fallen by over 50 percent, from close to £15/tCO2 to below £7/tCO2. This means that if the Government is serious about the floor and its upward trajectory, the tax will need to increase proportionately to make up for this significant deterioration.

But even if the government sticks to its promise and significantly increases the proposed tax rates, the ongoing political debate (see reports in The Telegraph of the Environmental Audit Committee calling for it to be abolished), has confirmed what investors have known ever since the policy was introduced - that the "floor" is nothing more than another fuel duty escalator that can't possibly be banked on; that a well conceived policy in opposition has been ruined by Treasury in government; that it won't actually reduce net emissions in the EU; that the best way of introducing a carbon price floor is at a European level and this has been largely been ignored; and that it is a policy that will do nothing for investor confidence, except for providing a windfall to existing low carbon generation, particularly existing nuclear power stations.

Quite simply, a policy to reduce uncertainty must itself be certain and there are too many factors that have caused investors to doubt the carbon price floor policy as it currently stands. Budget 2012 and the debate leading up to it has re-confirmed this.

There is little that can be done now to remedy the situation - other than for government to finally acknowledge that the explicit purpose of the policy is to raise revenue in difficult fiscal times and to accept that some of it should actually be invested to speed up the energy revolution that the policy was originally meant to support. Government needs to create an ambitious package, paid for with new carbon tax revenues, that is designed to support the transformation of energy intensive industries, so they can become part of the solution to climate change and the other environmental challenges we face, and not remain part of the problem. Supporting the adoption of sustainable, low-carbon production methods and the retooling of industries would have the added benefit of enhancing our international competitiveness in an increasingly resource constrained world.

It's time to have an honest discussion about how best new carbon tax revenues can be shared between deficit reduction and the investment required to lay the foundation for sustainable, long term growth. Budget 2012 could be where it begins.