Carbon trading and income distribution

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The ambition and scope of emissions trading schemes may also be constrained by their potential impact on income distribution. This is a particular problem for the UK, where the combined effect of income inequality and poor quality housing stock make 'fuel poverty' an enduring problem. This has long prevented the introduction of full-rate sales tax on household fuel and electricity purchases. In principle, emissions trading could be extended to cover household fuel use through a variety of means, including the introduction of a personal carbon allowance (PCA) scheme or an 'upstream' trading scheme (see Section 11.4). But without some form of compensation, such a move is likely to be regressive.

If allowances were to be auctioned, however, the revenues could be redistributed to households in a variety of ways to reduce the distributional impacts. Options include: increasing income tax thresholds or reducing rates of tax on low incomes; raising welfare payments such as unemployment, disability and child benefit; providing subsidies for energy efficiency improvements in low-income households and expanding subsidy schemes such as the UK system of 'winter fuel payments', whereby pensioners are provided with lump sum payments to help with higher fuel costs over the winter period (Clinch et al., 2006). It should be noted, however, that the EU ETS is already having a regressive impact on low-income households, since it increases electricity prices for all consumers. But, again, in the absence of allowance auctioning, there is no revenue available for compensation.

If allowances are auctioned, the simplest option is to return the revenues to all households on a lump sum basis. This should partially correct for the distributional impacts because low-income households will receive a higher amount, relative to their income, than high-income households. However, compared to lump sum payments, reductions in income taxes or changes in the benefits system are more likely to be effective in protecting the fuel poor. While earlier studies have suggested that careful targeting of tax and benefit changes could minimise distributional impacts (Metcalf, 1999), the Policy Studies Institute has suggested that this is unlikely to prevent a worsening of fuel poverty for up to a third of the poorest UK households (those in the lowest income decile), including those who are already badly affected by rising energy prices (Dresner and Ekins, 2006). The reason is that low-income households vary widely in energy consumption (owing largely to wide variations in the energy efficiency of housing) and some are very high energy users. Electrically heated homes and those with solid walls present the greatest difficulties, and these have been largely untouched to date by government energy efficiency programmes. The UK government has a target of eliminating fuel poverty by 2016, but this may only be achieved through substantial increases in funding for the relevant programmes, and could also be threatened by further increases in fuel prices.

Negative impacts on the fuel poor could therefore make it difficult to include household fuel consumption within a UK emissions trading scheme. Also, it makes little sense to internalise carbon prices in this sector while household energy use remains exempt from the full rate of sales tax. However, if the UK government continues to exempt all households from carbon pricing in order to protect the fuel poor, emissions in this sector could rise making it more difficult to meet carbon targets in the future. There is therefore a need for a dual approach: to accelerate the elimination of fuel poverty (or at least ensure sufficient investment to meet the 2016 target) while at the same time introducing alternative approaches that encourage emission reductions from non-fuel poor households.

In contrast to energy use in homes, including road transport in an emissions trading scheme should be broadly progressive (Dresner and Ekins, 2004). In the UK, nearly two-thirds of the poorest households (those in the lowest income quintile) do not own a car, compared to only one-third of households overall. Also, there is considerable scope for reducing distributional impacts through measures such as abolishing vehicle excise duty and subsidising public transport. More importantly, the resulting increases in petrol and diesel prices could be relatively small in the short to medium term. For example, a carbon price of £15/tC02 would increase petrol prices by less than one pence a litre, which compares with current UK duty levels of 47 pence per litre, and total taxation (including sales tax) of 60 pence per litre. The downside, of course is that the additional incentive for emissions reductions in this sector would be very small, which suggests that the trading scheme would need to be supplemented by other policies.

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