Before setting out the detail of the sensitivity tests, it is worth explaining how the model predicts the impact of the carbon/energy tax on prices and tax revenues. The effects on total energy consumption and the use of fuels are derived entirely from the effects of the tax on prices. The carbon and energy components of the EU tax are treated separately. The carbon tax is converted from the $1.5 per barrel oil-equivalent in 1993 rising to $5 in the year 2000 (real 1993 prices) to a rate in pounds sterling (using the fixed exchange rate $1.75= £1) per tonne of carbon emitted for each year 1993-2005. The rate is indexed on UK consumer prices and rises from £8.8 per tonne in 1993 to £37.3 per tonne in 2000 and £45.0 per tonne in 2005. The carbon tax liability of all fuels is calculated on the basis of their carbon content, and is converted into pence per therm on the basis of their heat content. The energy component of the tax is expressed in pence per therm, and again indexed on the consumer price index, so the rate rises from 1.4p/therm in 1993 to 6.1p/therm in 2000 and 7.3p/therm in 2005. A matrix of total carbon/energy tax rates for each fuel and user can be constructed for each year and average rates can be calculated for each fuel and each user. Tax revenues can then be calculated from energy consumption for conversion, own use by energy industries and for secondary uses; the potential revenues will be reduced if consumption falls when the tax is imposed.
The EU proposals are modelled by assuming that imports and domestic supplies of fuels will bear the tax according to their carbon and energy content, with exports exempted from the tax coverage; the treatment is assumed to be very close to that adopted for excise duties on hydrocarbons. If it is also assumed that all the tax is passed on to the user of the fuels, and that the industrial user then passes on the extra costs in the form of higher prices (i.e. perfectly elastic supply conditions), then the new prices for all goods and services in the economy can be calculated. The increase in price will be a result of the direct and indirect carbon and energy content of each of the forty-three commodities and sixty-eight consumers' expenditure categories (to take two important sets of prices in the model). Most of the tax revenues are assumed to be used to reduce value-added tax (VAT) so that there is only a modest effect of the tax on consumer prices. However, some of the revenues are assumed to be used as direct transfer payments to help low-income households and some are allocated to energy-saving schemes, so that there is an overall increase in the consumer price index, implying some extra wage inflation and higher industrial costs and prices.
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