What role does carbon pricing have to play in an ‘economically-efficient’ Net Zero transition?

In its 2021 Net Zero Review HM Treasury highlighted the role carbon pricing has to play in the UK’s transition to Net Zero. Fast forward to 2022, and a new Net Zero review led by Chris Skidmore MP is asking what’s the most pro-business, pro-growth and economically efficient path to Net Zero? It will be interesting to see how far and in what ways the responses to this consultation highlight the role for carbon pricing in determining this path. New published peer-reviewed research from the Centre for Energy Policy at the University of Strathclyde sets out the broad-ranging impacts on producer costs and competitiveness and the wider economy and households of extending carbon pricing/taxation across the UK economy. It shows that careful consideration around design and implementation is required if negative economic consequences are to be avoided and pro-business, pro-growth and economically efficient outcomes achieved.

How carbon pricing could impact on the UK economy

Our research models the impacts of implementing a broad and fairly conservative carbon tax (£50 per CO2 tonne) across all sectors in the UK economy. Currently the UK Emissions Trading Scheme (UKETS) only applies to a set of energy intensive industries, the power generation sector and aviation. We find that wider economy outcomes are driven by three main factors:

  1. Industry and businesses’ ability to reduce their use of energy on which a carbon tax is imposed to produce goods and services.
  2. The impact on competitiveness if the UK moves first to implement a carbon tax with the result that the price of UK goods and services rise as producers attempt to pass on additional costs (directly and indirectly associated with carbon prices) to consumers.
  3. The impact of responses in the labour market, where workers may seek to protect real take-home wages even as unemployment increases where prices are rising due to the implementation of a carbon tax. Crucially, the costs of the carbon tax spreads across all sectors through what happens to the price of labour and other inputs to production. To-date the importance of labour market impacts is very much an under-explored factor and where our research provides critical new insights and analysis.

For example, in a central scenario (where we isolate and focus on the impacts of introducing the carbon tax) we find that extending carbon pricing in this way could ultimately deliver substantial reductions in fossil fuel use (by 13.4%) and total energy use (by 8.3%). However the economic picture is less positive, particularly if producer’s ability to reduce taxed energy use is low, prices of UK goods and services rise and workers push back against cuts to wages as labour demand falls. In this case, we estimate that demand for UK exports ultimately contracts by 3.4%, GDP per annum falls by 2.1%, employment decreases by 2% and there is a 1.5% sustained contraction in total real household spending. The lowest income households face a slightly higher increase in the CPI cost of their ‘consumption basket’ (2.07% compared to the 2.03% average) but real income and spending impacts are limited by our assumption that government increases benefits and pensions rise in line with inflation. However, the nominal demands on government spending, combined with the loss in (non-carbon tax) revenues associated with the economic contraction means that there is a net increase of the public deficit in the order of £2.5billion.

This picture improves if worker pushback against reduced real wage rates labour demand falls (leading to an average real wage reduction in the order of 1.3%). In this case, export demand contracts by less (1.1%, GDP drops by 0.8%, employment by 0.6% and household spending falls by 1.2%. Crucially, in scenarios where there is real wage adjustment rather than resistance, the increase in the CPI associated with extending carbon pricing reduces to 0.8% (from 2%) and the sustained public budget outcome becomes one of an annual net surplus of £4bn.

Where the burden of carbon pricing falls

These scenarios highlight that action to incentivise producer’s ability to reduce dependence on taxed energy is critical (in which carbon pricing has a role alongside other policy interventions to play), as is international cooperation around the implementation of carbon pricing across countries globally.

Our findings also highlight that, without careful consideration and integration within wider economic decision-making, the burden of carbon pricing in the UK could fall on households. In the case of working households, wage bargaining may result in resistance/pushback against any cuts to their real take-home pay, which will worsen overall employment and real income outcomes. Rising energy prices caused by the implementation of a carbon tax will hit the 40% of households on the lowest incomes hardest, primarily as they spend a higher proportion of their income on energy and food (which uses a lot of energy to produce). Moreover, outcomes will worsen if government is unable to sustain the real value of benefits and pensions. All of this, against the backdrop of the current context in which real wage rates and incomes are already falling and prices are soaring due to the energy price shock (which we have not included in our scenario simulations) suggests that implementation of any broad extension of carbon pricing/taxation could prove very challenging. This is due to the complex nature of consequent ripple effects on all prices and incomes.

The need for an integrated and coordinated approach to carbon pricing

There are a number of measures that could be considered alongside or in addition to a carbon tax that could address some of these issues. These could include reviewing and implementing a combination of other green taxes. For example, raising the Climate Change Levy charged to non-domestic energy users with linked reduction in labour costs through employers’ national insurance contributions. More generally, there could be value in shifting the burden of taxation via labour subsidies or income tax reductions, though our scenario simulations suggest that this will only protect the economy where there is limited resistance to real wage adjustment.

Ultimately, whatever choices are made about the implementation of a carbon tax and/or other carbon pricing schemes such as UKETS, it is essential they are integrated within wider economic decision-making. Indeed, as we highlighted in evidence provided to the Net Zero Review, the transition to Net Zero must be considered as an economic one as well as a route to achieving mid-century emissions targets. Only with this framing can the implementation of carbon pricing in the UK contribute to growth ambitions and an ‘economically-efficient’ Net Zero transition and avoid and/or mitigate negative consequences for the wider UK economy with a range of relevant and complementary economic policy interventions being put in place.