Introduction
The UK government is legally committed to reaching net zero emissions by 2050. This means that by 2050 the UK must emit no more greenhouse gases than it traps (through trees, for example, or novel capture technologies). This is a significant ambition that likely requires changes across all sectors of the economy.
The cost of getting to net zero will depend on how, when and where we reduce emissions. There are cheaper ways to cut emissions and there are more expensive ways, and it is not necessarily possible for the government to know which are the cheapest ways.
For example, households can reduce their emissions by using less electricity – such as by avoiding using a tumble dryer – or by switching from a gas boiler to a heat pump.1 Using less electricity could be a more or less painful way to reduce emissions, depending on how much the household values the electricity it cuts. The cost to a household of switching from a gas boiler to a heat pump will also vary, depending on, for example, the cost of the heat pump, installation and associated hassle. Whether it is less costly to reduce emissions through cutting down on electricity or through installing a heat pump will thus vary across households in a way the government cannot feasibly know.
The role of the tax system in achieving net zero
The tax system has a vital role to play in the transition to net zero.
The tax system can be used to put a price on emissions. There is a clear rationale for doing this: emissions of carbon dioxide (and other greenhouse gases) create an externality – the carbon dioxide that one person emits harms other people by contributing to climate change – and, with no taxes, households and firms might not take this externality into account. A tax on the carbon dioxide emitted incentivises people to take this externality into account when choosing how to behave.
Ideally, the same rate of tax should be applied to each tonne of carbon dioxide, regardless of how it is produced. Doing this would provide the same incentive to cut emissions however it was done, allowing households and firms to choose the easiest ways to reduce emissions, without the government having to predict what the easiest ways are.
The current UK tax system is far from the ideal
The current UK tax system is far from this ideal of a uniform carbon tax across all sources of emissions. There is a patchwork of environmental taxes and tax-like policies in place which combine to create very different implicit taxes on carbon dioxide depending on where emissions come from. For example, the current system taxes carbon dioxide very differently based on whether it is emitted from a power plant producing electricity or from a gas boiler at home.
Figure 1 shows the radically different tax rates on carbon dioxide emissions for different end users (households, energy-intensive businesses and non-energy-intensive businesses) for both electricity and gas. The graph shows the total tax levied on an additional unit of fuel (either electricity or gas), which is then scaled by how much carbon dioxide that unit of fuel emits to get the rate of tax per tonne of carbon dioxide (CO2) – the implicit carbon tax.
There are three types of tax (or tax-like policies) included in Figure 1:
- policies directly targeting emissions reductions (the UK emissions trading scheme (ETS), the carbon price support and the climate change levy);
- taxes used to fund renewable subsidies (such as the contracts for difference levy) – these are levies that electricity suppliers pay per kilowatt-hour, which gas suppliers do not pay;
- VAT subsidies (we define a baseline tax rate to be 20% VAT and so consider the 5% rate of VAT applied to household energy to be a subsidy relative to other goods and services).
These policies apply unequally depending on the source of the emissions and the end user. For example, gas burned in a power plant is subject to the UK ETS, but gas burned in a household is not.
There are two key features of Figure 1. First, gas burned directly is taxed far less than electricity that is created from burning gas. The most extreme gap in tax rates is for non-energy-intensive businesses. For these businesses, a tonne of carbon dioxide attracts a tax of £52 if it comes from gas and £249 if it comes from electricity, a gap of £197. Second, the levels of tax for a given energy source vary substantially for different types of energy users. For example, there is effectively a £55 subsidy for every tonne of carbon dioxide emitted from households’ gas use (resulting from the reduced rate of VAT on household energy use), equivalent to around a penny off every kilowatt-hour of gas, while there is a £59 tax on each tonne of carbon dioxide from energy-intensive businesses’ use of gas, roughly a penny per kilowatt-hour.
These large variations in carbon tax rates are inefficient: heavily taxed emissions will be prioritised for reduction even if they are more painful to reduce. This ultimately makes net zero more costly than it has to be.
One example that is particularly relevant to this government is heat pumps. By taxing emissions from households’ electricity use more than emissions from their gas use, the current tax structure makes it more expensive to switch from a gas boiler to a heat pump. This means that some households that would find it easier to switch to a heat pump than to undertake costly reductions in electricity usage nevertheless make the costly cuts because of the tax – driving up the overall cost of net zero. It also works directly against another government target – recently restated – to install 600,000 heat pumps annually by 2028 (from a baseline of around 100,000 in 2024). In order to achieve this ambitious target, the government should reconsider the current structure of environmental taxes so they work for, not against, the government’s own targets.
Figure 1 focuses on the different incentives to cut back on gas burned by households and businesses versus gas burned in a power station. Across the economy, the effective tax rates on emissions from flights, waste and so on vary even more (Adam, Delestre, Levell and Miller, 2021). Even within the energy market, there are also large subsidies for renewable electricity (which differ depending on the technology used to generate the electricity). These provide further incentives to switch from producing electricity by burning gas to producing it from renewable sources – further reducing emissions. But these subsidies also incentivise more rather than less use of electricity – partly, though not wholly, offsetting the disincentive to use electricity described above (including the disincentive to switch to heat pumps, for example).
Much of the difference between how emissions from gas and electricity are taxed comes from taxes used to fund these subsidies for renewable electricity. These taxes apply to electricity but not gas. The contracts for difference scheme, for example, provides subsidies for renewable energy generators, paid for by a tax on all electricity produced. But gas piped into people’s homes or businesses is not subject to this tax. This is a choice. These subsidies could be funded through taxes that fall on all energy sources equally, gas and electricity alike, as recommended by the Skidmore review. Doing this would remove the lion’s share of the distortion between gas and electricity from gas, allowing net zero to be achieved at a lower overall cost and supporting the government’s heat pump targets.
As the UK transitions to a greener grid, with an increasing share of electricity coming from renewable sources, the tax differences shown in Figure 1 will get worse, not better. The government plans to achieve a green grid, in part, by expanding the amount of subsidies on offer for renewable electricity producers, with the cost of these subsidies forecast to more than double by 2029–30. Because of the government’s choice to fund these subsidies through taxes only on electricity, this will mean higher taxes on gas-based electricity with no change to taxes on gas. The government could achieve lower-cost emissions reductions, as well as lower electricity prices (though higher gas prices), by funding these subsidies through a uniform tax on all energy sources, gas and electricity alike.
Inconsistent tax rates on carbon dioxide emissions across different sectors can lead to bigger emissions reductions in sectors with high carbon tax rates and smaller emissions reductions in sectors with lower carbon tax rates. This could be part of the story in explaining the evolution of greenhouse gas emissions by sector over the last 20 years, as shown in Figure 2. Electricity has faced relatively high carbon taxes, with the introduction of the carbon price floor in 2013 as well as increasing prices from the EU ETS (now replaced by the UK ETS). Emissions from electricity generation have fallen dramatically, by 76% since 2000, moving the sector from being the largest source of emissions to one of the smallest. There are certainly other policies that have aided this dramatic fall. For example, there were generous subsidies for renewable electricity production throughout the last 15 years.
Meanwhile, emissions from buildings, most of which are from heating homes and businesses, face a much lower carbon tax rate, with gas use by households effectively being subsidised. Buildings have seen a slower rate of emissions reduction than electricity generation, falling by 34% since 2000. Again, this could be due to other factors, such as the historical cost of low-carbon alternatives. But the government’s choice to keep emissions-reduction incentives weak in this sector will not help it decarbonise.
Conclusion
The tax system has an important role to play in incentivising households and firms to reduce emissions in the lowest-cost way. The current tax system does not do this. There are huge differences in how emissions from gas are taxed compared with emissions from electricity, as well as significant differences by who is emitting, with households being relatively undertaxed and non-energy-intensive businesses taxed much more. This means that certain costly emissions reductions will likely take place while cheaper reductions will not, purely for tax reasons. This pushes up the overall cost of achieving net zero.
The government’s choice to fund the current set of subsidies for renewable electricity through a levy on electricity and not gas is responsible for a large amount of the difference between tax rates on emissions from electricity and gas. It would be better to fund these subsidies through a uniform tax on all energy sources, gas and electricity alike.