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The UK carbon floor price: How to enhance its credibility with investors

(London, 11 March 2011) The Government's carbon floor price policy, as currently proposed, is unlikely to command investor confidence. It needs to gain credibility if the Government wants to successfully attract new low carbon investment into the UK, says a report published today by Climate Change Capital (CCC), the investment manager and advisory group.

Investors will highly discount the value of the current policy because it will be implemented through the tax system. Investors would have to hope that every year Parliament will continue to vote for increasing carbon price support until at least 2030. This is highly unlikely say the authors. They also cite a recent study  commissioned by the Government that says a non-credible carbon price policy would actually lead to reduced investment in renewables and reduced security of power supply in the long term.

The CCC report suggests embedding the carbon price floor commitment in a contractual obligation, which would then provide investors with the long-term credibility they require to invest. This contract, or Carbon Price Support Guarantee (CPSG), would involve the Treasury underwriting the value of carbon price support so that the carbon price floor was guaranteed. It could sell these guarantees for a nominal fee to investors. Owners of the CPSG could exercise the contract if the Treasury breaks its own promise on carbon price floor levels.

Rupert Edwards, Head of Policy and Market Analysis at Climate Change Capital and one of the report's authors, said:

"The UK Government's carbon price floor proposals demonstrate that the UK has the ambition to take a leadership role on climate policy at a time when the EU as a whole seems to be losing its nerve."

"The trajectory for the proposed carbon price floor is meant to be set over the next two decades to give investors certainty so they can bring forward new low carbon investment into the UK. Investors will, however, have serious doubts about the long-term credibility of the carbon price floor policy as it is currently conceived. This is because it is a tax-based mechanism subject to annual votes in Parliament."

"A policy to reduce uncertainty must itself be certain. To ensure that certainty a contractual obligation could be created with no costs to Government if the Treasury keeps to its carbon price floor commitments. This Carbon Price Support Guarantee (CPSG) would increase certainty, reduce the incentive for investors to 'wait and see', and lower costs for investors and the economy. If part of an integrated approach, for example with Electricity Market Reform and the Green Investment Bank, it would be a powerful commitment to a low-carbon Britain."

To read the research report visit /thinktank/publications.aspx

ENDS

ENQUIRIES:

Climate Change Capital Ltd

Daniel Cremin +44 (0)20 7939 5319 dcremin@c-c-capital.com

NOTES TO EDITORS

About the authors

Rupert Edwards is Head of Policy and Market Analysis at Climate Change Capital. Prior to CCC Rupert spent  14 years in financial markets at JP Morgan in London, including as Head of European Government Securities Trading. Rupert Edwards has an MSc in Environmental Technology from Imperial College, London and an MA in History from Trinity College, Cambridge.

Dominic Maxwell is at the Harvard Kennedy School, specialising in energy policy. He has previously been speechwriter for Ed Miliband, Secretary of State for Energy and Climate Change; a Research Fellow at the Institute for Public Policy Research; and a Research Assistant for an MP. He holds a BA in Philosophy, Politics and Economics from Oxford University.

Carbon Price Support Guarantee (CPSG) in more detail

From an investor perspective the carbon price floor policy needs to be embedded in a contractual obligation to have long-term credibility.

Such a contractual obligation could be created, and with no costs to Government if the Treasury keeps to its commitment. A Carbon Price Support Guarentee (CPSG) would involve the Treasury underwriting the value of the carbon price support (the difference between the carbon price floor and the EU ETS price) for fixed 'expiry' dates in the future. The CPSG could be made available for a nominal fee (akin to a small put option or insurance premium) to investors who have a demonstrable risk exposure to carbon prices.

For example, the scheduled tax-inclusive carbon price for 2020 might be £30 per tonne of CO2. The consultation document includes a scheduled tax-inclusive floor price for each year, with £30 as the central policy scenario in 2020.

If the market price in the EU ETS was equivalent to £31, the floor would be satisfied, the carbon price support would be zero, and the guarantee would be met without any cost. If, however, the market price was £20 and carbon price support was only £5, the guarantee would oblige the Treasury to pay the remaining £5 per tonne to all owners who exercised the CPSG.

Depending on how carbon price support is determined, fixed expiry dates for the CPSG might, for example, be at every five years for 20 years into the future, with the 20 year commitment rolled forward every five years. Investors could, in effect, own a contractual 'put' option on the difference between carbon price floor and the EUA price (the latter can be hedged in the EUA forward market) for as long as 20 years. From an investor perspective the Government needs to take on a contractual obligation if investors are to account properly for real economy carbon liabilities in their balance sheets and investment committee spread sheets.

The CPSG could create a liability for the Treasury - but only if its own tax level fell below the amount promised. The Treasury would be able to adjust carbon price support to the scheduled tax-inclusive carbon price (the carbon price floor) level - as the policy is intended to do - and reduce its liability to zero. And as the consultation document points out: "carbon price uncertainty is predominantly driven by wider regulatory uncertainties and the Government might therefore be better placed to manage some carbon price risk." If Government is unwilling to take on liabilities that could be implied by the CPSG, then it cannot expect investors to do so. But if it does, the prize is great. By reducing uncertainty, an underwriting mechanism would reduce the time value of a 'wait and see' approach on the part of investors, accelerating investment and allowing for a lower overall carbon price floor trajectory. It would ensure that the cost of capital in investment spreadsheets was as low as possible. This would in turn allow the Government's modelling to assume lower overall costs to the economy and would preclude the need for a series of yet more policy interventions designed to reassure investors.