Tuesday, March 21, 2017

ENERGY COMPANIES. VILLAINS OR VICTIMS IN THE PRICE CAP DEBATE?


Theresa May’s Conservatives have been rediscovering the virtues of a number of what were once familiar Labour themes, but perhaps their most surprising volte-face is the threat to impose price caps on at least some energy utility tariffs.  Populist interventions in what are supposed, in theory at least, to be competitive markets, are often bad news from a perspective of efficient markets and effective policy. And Ed Miliband and Labour were pilloried for this suggestion. On the other hand there is little evidence that the current UK retail market is working effectively, there is evidence that “captive” or “loyal” consumers get a bad deal, and consumers appear to be no happier with their utilities than in the “bad old days” of nationalised industry.

The real problem, at least in the electricity sector, is that there are a number of features of current market arrangements that are seriously dysfunctional. This is in large measure a reflection of “energy only” approaches to the construction of wholesale prices that are “baked in” to much of current thinking. Energy only wholesale prices, based around short run marginal costs, are incapable of rewarding investment. This has been a problem of the UK market since the NETA reforms in 2000, and has become an increasing problem for the rest of Europe. The UK government is now grappling with the resulting problems, including threats to supply security, through the mechanisms of capacity auctions, but these are aimed primarily at incentives for new capacity.

This is by no means a problem unique to the UK. It has been very evident for German companies in the power sector, and has had a number of adverse effects on their balance sheets, and may have damaged their ability to invest in new low carbon or indeed any form of generation, most notably in nuclear power (for RWE and EON).

The fundamental issue is that investors in infrastructure require the support of assurances over their long term revenue stream, support that had in the past normally been provided either by long term contractual or government commitment, or by the security of vertically integrated monopoly. To a significant degree the owners of conventional thermal generating plant lost that support, and found themselves in possession of stranded assets that find it increasingly hard to earn revenue in a world where marginal costs are often zero. Many of the companies anticipated the strategic problem many years ago and found at least a partial solution through vertical integration into the retail business, where market imperfections allowed them to recover some excess profit to compensate for the losses to which they were exposed in respect of their stranded assets.

The utilities, in this interpretation of events, can be viewed as both victims and villains. On the one hand older thermal plant constitutes an asset that has been stranded, at least partly through government policies for the power sector. As victims of this process, their attempt to recover lost ground through vertical integration was a necessary and logical response to that position. However this does imply that vertical integration confers an ability to exploit some form of market power, and is in some sense anti-competitive. The power that accrues to the supply companies comes through the inertia of their customers. That allows them to be portrayed as the villains.

As an illustration of this undue market power, we might contrast typical margins in retail supply with the view taken by previous regulatory bodies.  Prior to the introduction of retail competition, supply margins were generally assumed to be very low.  Thus a 1995 Monopolies and Mergers Commission Review held that 1.0% margin for Scottish hydro supply business was too high and set it at 0.5%.  Retail supply is not capital intensive and the “value added” is limited. In setting price controls in 1998, Offer and Ofgas considered a margin on sales of 1.5% would adequately take into account the increased risks from the introduction of competition.

In the “competitive” UK retail sector, margins have varied but have often been around 4%. Prima facie this looks like the extraction of extra revenue from the consumer for a function, supply, in which the retailer adds next to nothing in the way of extra value. If we add to this some of the extra costs of competing to do business (eg marketing costs) this does not look like good value for the consumer. Suppliers compete aggressively to maintain or gain market share, but a large number of consumers do not want the chore of perpetually searching for the best deal, and would prefer simply to get an uncomplicated service at a fair and reasonable price.

However it seems unlikely that imposition of a government price cap will resolve the deeper underlying issues of the power sector. What we really need is a more fundamental re-think of what we expect from retailers. My own view, expressed in more detail on another page, is that retail supply should be playing a much bigger role in shaping the future of the power sector, and that there are ways in which retail supply could become genuinely innovative and competitive.



Tuesday, March 14, 2017

DEEPMIND ALGORITHMS JUST THE START OF A CONSUMER FOCUSED REVOLUTION IN THE POWER SECTOR.



Deepmind algorithms to manage the Grid could be just the start of a consumer focused revolution in the power sector. The need to manage much more complex low carbon systems means there are strong incentives to manage consumer demand more pro-actively. This could be good news for consumers, offering them more choice, and also defusing some of the concerns that sit around supply security.

Yesterday’s FT reports[1]: Google’s DeepMind is in discussions with the UK’s National Grid to use artificial intelligence to help balance energy supply and demand in Britain.  “… It would be amazing if you could save 10 per cent of the country’s energy usage without any new infrastructure, just from optimisation. That’s pretty exciting,” Demis Hassabis, DeepMind’s chief executive told the Financial Times. National Grid’s role in balancing the system has become more difficult in recent years, however, as intermittent renewable sources of electricity — such as wind and solar power — have become a bigger part of Britain's energy mix. DeepMind’s algorithms could more accurately predict demand patterns and help balance the national energy system more efficiently.

This is currently a task that is at least partially delegated to the market. The principle behind most “spot” wholesale markets is that generators declare their marginal costs of generating (per kWh unit of energy produced) and are then selected to run in ascending order of cost (the so-called “merit order”), with the cheapest chosen first, and the most expensive plant that runs setting the price. That principle will be increasingly dysfunctional or inapplicable in the real world, partly because such a high proportion of current and future generating plant has zero or negative marginal costs of operation, and partly because the operational efficiency constraints on the power system are becoming more complex, involving considerations of plant inflexibility, intermittency, and energy storage, rather than just a simple stacking by ascending cost. Sophisticated algorithms are prima facie exactly what is needed to replace a defunct merit order.

This implies moving beyond prediction of demand patterns, for which fairly sophisticated approaches already exist, and addressing predictions of intermittent supply as well. It also means developing algorithms to make operational decisions that make sense in terms of efficiency and the secure operation of the system. The promise of a 10% saving in energy may be an exaggeration, not least because of the dominance of capital costs, and relative insignificance of fuel, in low carbon generation. But the bigger contribution of an algorithmic approach lies in the broader options it creates for the ways that the power system is managed and the ways in which consumption is managed. This could allow leaner systems and also transform the way that we think about electricity as a service.

Future Options

The conventional utility model has consumers able to treat electrical energy supply as “on tap”, with limited or no differentiation between applications (e.g. as between lighting, heating or mechanical power). Tariffs and prices for the most part approximate to an averaging of the costs of supplying electricity, with limited ability to differentiate on grounds of differing incremental costs, and a common security standard for all consumers and all applications. 

Consumer behaviour needs to be incorporated as a much more active component.  What is needed is to redefine the “consumer offering”, with electricity as a set of services, rather than a homogeneous commodity. This requires starting with a clean sheet in defining the nature of the services that consumers will want, and the basis on which they pay.  So, to take a particularly dramatic example, a consumer wanting to charge electric vehicle batteries might request 75 kWh to be delivered in a specified period, over several hours or even several days (eg a weekend), and the consumer’s terms of supply might specify that this requirement will be met in full but with timing that is “at the supplier’s discretion”.  Different arrangements and different tariffs could apply to the purchase of power for heat, and for some other uses, reflecting in each case the nature of the load, the extent to which it could be time-shifted without inconvenience, and the level of reliability for which the consumer was willing to pay.  Commitments to individual consumers would be made by energy service companies who would be able to aggregate consumer requests and feed them in to become part of the Grid’s system optimization routines. Such services might even be packaged with the provision of appropriate equipment (eg storage heaters).

The role of suppliers is then to act as aggregators, and their essential function would be to manage the complex interaction between consumer loads and system balancing requirements, including shaping and managing the pattern of consumption. This provides a major opportunity for a much more innovative approach to all aspects of metering and for the terms on which consumers purchase power. Suppliers could at the same time enter into individual contracts with generators, or a system operator or other agency, which would reflect the economic benefits of their ability to shape consumer loads. They would also take responsibility for managing loads within network constraints at lower voltages, ie within local distribution networks.

This has some powerful advantages.  First it allows consumers to purchase power for particular usages in ways more akin to their purchase of other goods and services, as opposed to perpetuating the “instantaneous commodity” characteristics that have hitherto been a unique and constraining feature of the power sector. This can reflect what consumers actually want and need from a utility.  At the same time it would help make the services more affordable.  Consumers could still choose to take some power “on tap” and would normally pay a higher price for this.[2] Many of the issues associated with administrative setting of security standards would become much less significant. Security standards would be chosen in a market, not dictated by a central authority.[3]

This change is enabled by one set of technologies – those that surround metering, remote control, and system optimisation (Deepmind).  But it also helps to resolve the problems posed by another set of technologies, those linked to intermittent or inflexible sources of non-fossil generation and distributed generation.

………..

These ideas have also been explored by the author in Double standards for reliability in power supplies. Not such a bad idea. This was a defence of a controversial proposal from Andrew Wright of OFGEM on a proposal for consumers to choose the level of reliability that they want. They have been presented in a broader context in a paper, Markets, policy and regulation in a low carbon future, produced by the author for the Energy Technologies Institute (ETI), which  published a number of perspectives on low carbon futures in 2016.







[1] DeepMind and National Grid in AI talks to balance energy supply. FT 12 March 2017
[2] “Electricity Markets and Pricing for the Distributed Generation Era”, John Rhys, Malcolm Keay and David Robinson. Published as Chapter 8 in Distributed Generation and its Implications for the Utility Industry, ed. F. Sioshansi, Elsevier, August 2014.

Wednesday, March 8, 2017

HOUSE OF LORDS DOWNPLAYS CLIMATE ISSUES AND THE BIGGEST MARKET FAILURE OF ALL. [3 of 3]


House of Lords Select Committee on Economic Affairs. The Price of Power. Reforming the Electricity Market. February 2017.                                                            

Perhaps the most controversial element of the Committee’s report lies in those of its recommendations which would have the effect of downgrading the sustainability objective aimed at reducing UK emissions. Whether the Committee might have felt emboldened by the election of climate sceptic Donald Trump, or the success of the Brexit campaign[1], will no doubt be a matter for political scientists to discuss. A degree of comfort to climate sceptics might even be considered ironic, given the current House of Lords stance in relation to the triggering of Article 50.  What is more disturbing is the absence of any serious evidence or analysis in the report to justify such a major change of stance in relation to the “energy trilemma” of sustainability, affordability and security. Ultimately these choices are indeed partly economic, especially in the affordability/ security trade-off, but the main issues in relation to sustainability have become essentially ethical and political, involving as they do, inter alia, considerations of intergenerational equity.

The Committee began with the intention of examining market failure in the power sector. Inadequate means to reflect into actual costs and prices the irreversible environmental damage of CO2 emissions, the “social cost of carbon” externality, is arguably the biggest market failure of all by a significant margin. A number of those giving evidence[2] drew attention to the issue, but the Committee nevertheless proposes a downgrading of the importance of the corresponding policy objective. It does this without solid argument, and perhaps more importantly without having taken much evidence relevant to a comparative assessment of the urgency attaching to climate objectives. In global terms this includes both growing scientific concern with climate change as an existential threat (eg over Arctic ice), and growing political acceptance of the need for urgent action as manifested, despite its shortcomings, in the Paris agreement.

The Committee has preferred instead to retreat to the letter of the 2008 Act and the 2050 target, arguing for a slower pace of emissions reduction towards that single year target. This in itself is somewhat disingenuous, given that attachment to arbitrary target dates is criticised elsewhere in the report. It is a rather obvious truth[3] that the real objective in reducing emissions has to relate primarily to cumulative carbon dioxide in the atmosphere, not to an annual emissions figure for an arbitrary year. Inter alia this tends to imply that current emissions reduction should be valued even more highly than future reductions.

The proposal that the pathway to 2050 can be back-end loaded is beguilingly simple but in reality is very misleading.  A globally back-end loaded reduction profile implies substantially higher cumulative emissions, and earlier and bigger climate impacts. Early reduction in emissions in contrast has substantial options value in postponing by several years both cumulative CO2 and climate milestones, as well as the need to spend large sums on adapting to adverse consequences of climate change[4]. In each case this means more time to address the most difficult parts of the emissions reduction problem (eg aviation) and the unknowns associated with adapting to impacts of climate change.

The Committee’s proposal has therefore the potential to be extremely damaging, at least to the UK’s contribution to climate change mitigation, and, if copied elsewhere, on a global scale. The only defence for this position that can be inferred from the report’s approach is that because the UK remains a small contributor to global emissions (c. 3%), it should therefore be willing to free ride on the efforts of others. This is hardly a principled position. The Committee has made itself a cheerleader for those parts of the energy industries that hope if they can postpone effective action for long enough then the problem will go away. It won’t.

Overall, and despite some useful content and evidence, this is a disappointing report, failing to recognise a number of changing paradigms both in the nature of the electricity sector and in the global environmental challenge. But on the key issue of sustainability it is a shortsighted and retrogressive attempt to downgrade the most fundamental challenges for energy policy, the growing existential threats of unmitigated carbon emissions and climate change.





[1] Ideological leanings and demographics may play a strong role in determining views on both climate issues and Europe.  CLIMATE CHANGE AND POLITICAL STEREOTYPES   
[2] For example in the submission by Professor Hepburn and his colleagues.
[3] The arguments, for anyone not familiar with them, are spelled out on another page of this blog, CUMULATIVE CARBON.
[4] Fuller discussion on this topic can also be found in the author’s earlier paper. Cumulative Carbon Emissions And Climate Change: Has The Economics Of Climate Policies Lost Contact With The Physics?, John Rhys, OIES Working Paper EV 57, July 2011.

Tuesday, March 7, 2017

TWO CHEERS FOR HOUSE OF LORDS ON MARKET FAILURE. [2 of 3]


SUPPLY SECURITY AND THE PROPOSED ENERGY COMMISSION. 

House of Lords Select Committee on Economic Affairs. The Price of Power. Reforming the Electricity Market. February 2017.

The Committee’s investigation began with the expressed wish to examine market failures in the power sector. In spite of some useful evidence and analysis their report ultimately fails to appreciate the fundamental nature of some of the current market failures. Its preference for “getting government out of the market” is at its root an ideological commitment to a market paradigm which will be increasingly untenable as power sectors move towards low carbon technologies. In consequence the report has some inconsistencies. In particular it fails to recognise the fundamental nature of the change brought about in moving away from an energy only market to include a capacity market overseen, implicitly at least, by a new agency, the Energy Commission. This inevitably brings a new “central” agency into all the most important aspects of investment choice.   This may well be a good starting point for a solution, but it does not correspond to the unrealistic dream of “getting government out of the market”.

Supply Security

The analysis starts with supply security. The Committee is quick to point the finger at renewables[1], although there is in principle no reason why security should be an issue in a well-designed low carbon system with adequate storage and load shifting options.

A bigger issue is the inconvenient truth that there has been under existing arrangements for the sector no party in the power sector with a properly constructed statutory or other responsibility for this aspect of supply security – adequate generation capacity. There is no obligation on generating companies; there is no obligation on suppliers; and it has not been the job of the National Grid. This does not have to be a weakness of market led systems. The arrangements put in place at privatisation in 1990 were built around a de facto obligation to supply. Suppliers (then confined to the regional companies) were obliged to meet all demand or pay a penalty related to the value of lost load (VOLL). This value was inserted by administrative means into the pool price, and in principle performed the same function as a capacity market, namely the ability to reward generation capacity. But this approach was abandoned in 2000 and since then generation security has been a matter that for all practical purposes has been left entirely to the market. Blaming government interventions is convenient but by no means the whole story.

This discussion brings together approaches to supply security and the so-called “missing money” problem. This major flaw in the market was pointed out by many commentators[2] and academics warning that failure to reward capacity would ultimately cause security issues. The position was neatly summarised by John Kay in the FT.[3]

But privatisation failed to provide a stable framework for planning new electricity generation. The initial regime reflected careful thought about appropriate incentives for capacity installation, but this regime was swept away in 2001 in favour of a simpler one modelled on other commodity markets and known as NETA (New Electricity Trading Arrangements), subsequently to be Betta (British Electricity Trading and Transmission Arrangements). As so often in commodity markets, this structure worked rather better in the short run than over the long term.”

The problems were concealed for a long time by an overhang of significant capacity surplus. But the essential point is that the root causes pre-date any significant impact of low carbon policies, good or bad, or the magnifying effect of zero marginal cost renewables. The Committee appears to be using these latter developments as a convenient scapegoat.

Market failure. Capacity markets as the solution.

One possible remedy is the introduction of a capacity market. The Committee focuses on this but does not deal comprehensively with the implications. It is deceptively simple to propose technology neutral capacity markets, appropriately designed, as a solution. It is quite another to deliver such a market, as the scope of the exercise will extend well beyond simple decisions on security standards.

A fundamental feature of capacity auctions is that they require someone to run them. Inter alia this means determining and setting a level of security, and hence the quantity of required capacity. That in itself represents a major market intervention[4], which can really only be decided by a public or quasi-public agency, and confirms the reality that security of supply is no longer being “decided by the market”. This is just the beginning. The complex tasks of defining capacity, and measuring and monitoring its delivery, will necessarily fall to the same agency.

This task becomes even more complex[5] in the context of a growing proportion of low carbon generation, which has entirely different technical and economic characteristics from those of relatively homogenous fossil plant. We shall in the future be dealing with a diverse collection of generation and storage technologies, each with its own complex mix of technical, operating and economic characteristics. This diversity of low carbon generation militates against simple application of technological neutrality in plant choice. Balancing the “capacity parameters” of different technologies may require complex auctions in order to differentiate between very different technologies.[6]

The Committee partially recognises this in its proposal for an Energy Commission to oversee energy policy and hence implicitly the process of capacity auctions. This can be viewed as a step in the right direction, towards a technically competent “arm’s length” agency with the responsibility for determining the investment mix, but the report seemingly fails to recognise just what a radical departure this will involve. It is prima facie at odds with the Committee’s apparent preference for minimising the role of government. The Energy Commission will be forced to consider numerous complex planning issues, and become a de facto central purchasing agency.  In my evidence I proposed establishment of a technically competent agency to take on that role. If that is what the Committee has in mind for the Energy Commission, then it can be applauded as a sensible recommendation. But a lot of people will not view it as removing government from the market, in fact an unrealistic ambition.







[1] even citing my submission that “a system heavily dependent on renewables … could face longer periods of sustained shortage”. The report fails to qualify with the context and hypothetical nature of this observation, or my comment that this was “possible but not likely in the near term”.
[2] These are too numerous to list but certainly include Dieter Helm who gave evidence to the Committee.
[3] John Kay.  FT.  July 2013.
[4] A recent blog expands on this theme in the context of UK and New Zealand experience

[5] I have for some time pursued the line that there are a larger number of market failures, and that they all need to be addressed in order to have a well-functioning power sector that can still make the best use of market disciplines to produce efficient outcomes. One summary of this more general debate, which includes other aspects of market failure the Committee could have addressed, can be read on a separate page of this blog, LOW CARBON POWER.
[6] A typical example of the need for some form of central coordination is the need to maximise the capacity provision from offshore wind by capturing the benefits of weather diversity. The economically efficient outcome requires a spread across multiple locations, not just those with the most wind or the shallowest water. Similar arguments will apply in the context of tidal lagoons.

Monday, March 6, 2017

HOUSE OF LORDS SPOTS AN ISSUE ON UK ENERGY PRICES BUT FAILS ON MARKET FAILURE. [1 of 3]




House of Lords Select Committee on Economic Affairs. The Price of Power. Reforming the Electricity Market. February 2017.

The HoL Select Committee report on the electricity market is a serious document that deserves discussion on several counts, and I intend to examine over a number of blogs whether the Committee has really grasped the extent to which market paradigms for the sector are changing. One of the many elements deserving discussion is its comparison of electricity prices and the international context. Two significant features are the comparison of electricity prices for large industrial consumers, and the alleged implication of flawed energy policies in the comparatively high prices observed for the UK.


An overstated problem. High prices for large energy users.


The Committee was clearly subjected to some intensive lobbying on this subject, but remained intelligently agnostic on the extent to which industry was badly affected, and on the familiar issue of carbon leakage. In an earlier blog I quoted


“It’s a lament that rarely holds up under examination of the facts. All too often, these complaints are part of a lobbying campaign that is essentially political. And when that’s not the case, we usually find there’s a lot of money at stake in industries that are reluctant to invest in adjusting to future challenges. And even when corporate leaders know that these investments are necessary, a majority of them still believe the cost should be paid by the taxpayer. That leads them to threaten using their deadliest weapon, the threat of job cuts and the relocation abroad of their factories and production operations.”


This might have been an opinion put in evidence to the Committee as a remark about UK lobbying. Or it might have been a response to a recent Donald Trump attack on the supposedly high costs of US industry. In fact the context is the competitiveness of European and especially German industry in relation to a low energy cost USA, and was written by a former German environment minister in 2014. The tendency of energy intensive industry to blame energy markets and lobby for lower prices is a universal one.


The complaint by European industry lobbyists, that energy costs are putting them at a “destructive” competitive disadvantage, simply doesn’t stand up to scrutiny. Industry lobbyists will say either that the costs of labour are too high, or that their big problem is the price of energy. America’s historically low gas prices are at present the cause of yet more European moaning.


The facts show how wrong they are. Energy costs account on average for less than 3% of gross production costs in Germany, whereas staffing costs account for about 20%. Even if you look at shares of gross value creation, the energy costs don’t exceed the 10% mark. Yet, industrial lobbies and trade associations continue to prophesy the end of the Western world.


The House of Lords agnosticism is fully justified in respect of their questions about loss of industrial capacity in the UK and energy costs as a possible cause.


But UK prices really are higher


The report does highlight a real divergence in UK prices. There is, unfortunately, a flaw in its choice of comparative statistics however which significantly impacts the comparisons. The latest statistics quoted in the report are for the first half of 2016 (H1). The 23rd June referendum resulted in a depreciation of the UK currency by up to 20% against other currencies, and this is not expected to reverse any time soon. This has a corresponding effect on any price comparisons relevant to the present and immediate future. It is prima facie larger than any of the supposed disadvantages imposed by low carbon policies. Moreover this depreciation makes the UK substantially more competitive across a range of costs, including labour and other locally incurred costs, which are a much higher proportion of total costs, even for energy intensive industries.


Even if the report exaggerates current divergences, it is useful to highlight just how much higher UK prices are (for large industry at least) by international standards.  The UK has been a world leader in liberalised market reform, and notwithstanding some of the implications of the report, has arguably continued to maintain an aggressively market and competition-based approach.  So if one has confidence in the superiority of the basic UK market model, then why should its prices, of which the wholesale cost component is the largest part, been so far out of line? Other EU countries have been slow and incomplete in following the example of UK liberalisation, but this does not seem to have damaged their “competitiveness”. This ought to caution against an uncritical acceptance of the assumptions of a liberalised market ideology in the power sector.


The Committee attempts to pin the blame on excessive UK devotion to a low carbon objective, but this does not really hold water, as much of the evidence shows. Robert Gross of Imperial College is rather scathing on this point.[1] Moreover while the UK may have made mistakes in promoting renewable energies, it is hardly alone in this. Germany is usually quoted as a fine example of how not to do it. The French achieved a much lower carbon footprint much earlier, at very low cost, without the benefit of a liberalised market and with a monolithic state-run power sector. Again this is an inconvenient truth for an ideological approach to energy policy.


A better understanding of UK comparative costs really would be a worthwhile exercise for the Committee. There are numerous other explanations that are a priori plausible. They are not considered, and play less well with the Committee’s predilection for blaming low carbon policies and small government.


Without prejudice to what some good research might uncover, and in addition to the many well-known difficulties of international data comparisons, I would suggest examining the following possibilities:


  • whether the UK has lesser natural endowments in power generation resources; it does not benefit from ownership of French nuclear or Norwegian hydro. Moreover compared to many EU countries it has less interconnection and hence less market access to low cost production elsewhere.
  • some other countries have substantial implicit or concealed subsidies that impact on industrial energy prices; Germany for example has a long tradition of cross-subsidising industry.
  • the effect of different market and regulatory conditions, and whether generation in other countries benefits from a lower cost of capital; what is particularly important in this respect is the degree of regulatory and policy security offered to investors (the report touches on this but only in a UK context)
  • the operation of market forces in a UK system that is approaching supply/demand balance or “tight” capacity. More purist advocates of “free” energy only markets argue that high “scarcity” market prices are a necessary part of inducing investment, and that a capacity market is per se an unwanted intrusion by government. Higher prices, on this reading of the market, are simply part of the market process that is necessary to induce new investment. But market fundamentalists rarely emphasise this point in public debate.













[1] Robert Gross of UKERC and Imperial College Why we can’t afford to move post truth in energy policy




Monday, February 20, 2017

ISSUES FOR A CARBON WEALTH FUND. ADAM WHITMORE RESPONDS


Adam has responded to some of the questions I raised in my recent blog reporting on his proposal for a carbon wealth fund.

John raises some interesting questions in relation to my proposal for a carbon wealth fund.  I will try to answer them briefly here.  I will assume that national funds are the only practical way forward in the short to medium term, and look at a UK sovereign wealth fund based on carbon revenue. 

Use of a global public good

First, John notes that there are some differences between conventional resources, such as oil and gas, held by nations, and the atmosphere, a global public good[1].  The distribution of a global public good will inevitably be contentious.  However existing carbon pricing regimes or simply emitting free of charge already use up a global public good.  Giving citizens and governments a greater stake in increased carbon prices is likely to decrease the quantity of emissions, and so the proportion of the global commons used[2].  This makes the approach I have proposed more compatible with good stewardship of the global commons than existing arrangements, at least for the next 50 years until revenues start to decline. 

Macro-economic effects

John also raises the issue of the macro-economic effects on exchange rates and economic activity.  However these effects would probably not be large.  The payment into a UK fund would be around £16 billion p.a. at present, a little under 1% of GDP per annum[3].  This would be unlikely to cause major economic dislocation, especially if phased in over a period of perhaps 5 years.  The fund would grow large over time, reaching around £860 billion by the end of the century[4].  However this is not vastly larger than the Norwegian fund today, which is for a very much smaller economy.  Furthermore any fund would have the effect of redirecting revenue from consumption to investment, which would probably have a positive macroeconomic effect in the context of historic UK underinvestment. 

Would it be regressive?

Then there is the question of whether increasing revenue from carbon pricing would be socially regressive.  The concern here is that poorer households spend a larger proportion of their income on energy than richer households, and so energy taxes tend to hit them disproportionately harder.  However poor households still spend less on energy, and therefore carbon, in absolute terms than richer households, so an equal dividend, as I’ve proposed, would have the potential to have net progressive effect.   Furthermore, households account for only a minority of energy use, but would get the full benefit of dividends (or at least a large proportion), increasing the extent to which it is progressive.

However there are some important intergenerational issues to consider.   The proposal for a fund takes the view that present generations should safeguard capital assets so they retain value to future generations.  This is in line with the standard definition of sustainable development[5].  However there are distributional issues here which need to be addressed.  Some present citizens will be worse off. 

Use of green taxes

The proposal is clearly consistent with using green taxes more widely as a policy instrument.  What’s different from the standard approach to green taxes is the suggestion of placing revenue in capital fund rather than using revenue to fund current expenditure.  The landfill tax to which I referred in my original post currently raises around a billion pounds per annum[6].  It would be natural to add this revenue to a UK wealth fund. 

Other uses of funds

Finally, there is no reason some of dividends from the fund should not be used to fund things like R&D.  As I have previously discussed there are many legitimate calls on revenue from carbon pricing.  However there are many compelling arguments for allocation direct to citizens, and this should in my view be a priority for the fund. 

There are also other issues to consider, such as governance structures.  Many of these have been reviewed in the wider literature on sovereign wealth funds[7].  Doubtless much work is needed to elaborate on these details, as would be the case for any new institution.  However the prize is worth the effort.

I very much welcome John raising these questions.  They are exactly the sort of issues that need to be discussed, and I hope the debate will not stop here.



Adam Whitmore - 20th February 2017





[1] There is an interesting question as to whether countries should have full property rights to natural resources within their territories, as is often assumed at present, but this is too large a subject to go into here.
[2] The assumption here is that increasing prices from current low levels will increase revenue.  Carbon prices would increase by a factor of say five or more in many cases, and it is unlikely that emissions would decrease by an equal factor – though if they did it would be very good news.
[3] This assumes 400 million tonnes of emissions are priced, compared with 2015 totals of 404 million for CO2 and 496 total greenhouse gases (source BEIS), implying a high proportion of emissions are priced.  Carbon price is assumed to be £40/tonne, roughly the Social Cost of Carbon at current exchange rates and well above current levels.  This would give total revenue of £16 billion in the first year, less than 1% of UK GDP of approximately £1870 billion in 2015. (source: https://www.statista.com/statistics/281744/gdp-of-the-united-kingdom-uk-since-2000/ )
[4] Assuming that the UK reduces its emissions in line with the Climate Change Act target of an 80% reduction from 1990 levels by 2050, and then to zero by the end of the century, and that 80% of emissions are priced at the Social Cost of Carbon as estimated by the US EPA, converted at current exchange rates of $1.25/£.

[5] Sustainable development is usually characterised as meeting the needs of present generations, without compromising the ability of future generations to meet their own needs.

[6] https://www.uktradeinfo.com/Statistics/Pages/TaxAndDutybulletins.aspx
[7] See here for a specific proposal for a UK wealth fund:  http://www.smf.co.uk/press-release-conservative-mp-calls-for-uk-sovereign-wealth-fund-to-address-long-term-and-structurally-ingrained-weaknesses-of-the-economy/  and Cummine (2016) cited in my original post for further details.