Tag: environmental externalities

The UK energy regulator, Ofgem, has announced that the UK energy price cap will rise in October by an average of 2%. The energy price cap sets the maximum prices for electricity and gas that can be charged by suppliers to households. For those paying by direct debit, the maximum electricity price per kilowatt-hour (kWh) will rise from 25.73p to 26.35p, with the maximum daily standing charge rising from 51.37p to 53.68p. As far as gas is concerned, the maximum price per kWh will fall slightly from 6.33p to 6.29p, with the maximum daily standing charge rising from 29.82p to 34.03p. Ofgem estimates that this will mean that the capped cost to the average household will rise from £1720 to £1755.

The average capped cost is now much lower than the peak of £4279 from January to March 2023. This followed the huge increase in international gas prices in the aftermath of the invasion of Ukraine and the cutting off of gas supplies from Russia. Note that although the suppliers received these capped prices, average consumers’ bills were limited to £2500 from October 2022 to March 2024 under the government’s Energy Price Guarantee scheme, with suppliers receiving a subsidy from the government to make up the shortfall. But despite today’s cap being much lower than at the peak, it is still much higher than the cap of £1277 prior to Russia’s invasion of Ukraine: see Chart 1 (click here for a PowerPoint).

So is the capped price purely a reflection of the international price of gas, or is it more complicated? The picture is slightly different for gas and electricity.

Gas prices

As far as gas prices are concerned, the price does largely reflect the international price: see Chart 2 (click here for a PowerPoint).

The UK is no longer self-sufficient in gas and relies in part on imported gas, with the price determined in volatile international markets. It also has low gas storage capacity compared with most other European countries. This leaves it highly reliant on volatile global markets in periods of prolonged high demand, like a cold winter. Is such cases, the UK often has to purchase more expensive liquefied natural gas (LNG) from global suppliers.

Additionally, taxes, environmental levies and the costs of the nationwide gas distribution network contribute to the overall price for consumers. Changes in these costs affect gas prices. These are itemised below in the case of electricity.

With electricity pricing, the picture is more complex.

Electricity prices

Electricity generation costs vary considerably with the different methods. Renewable sources like wind and solar have the lowest marginal costs, while natural gas plants have the highest, although gas prices fluctuate considerably.

So how are consumer electricity prices determined? And how is the electricity price cap determined? The price cap for electricity per kWh and the daily standing charge for electricity are shown in Chart 3 (click here for a PowerPoint).

Marginal cost pricing.  The wholesale price of electricity in the UK market is set by the most expensive power source needed to meet demand on a day-by-day basis. This is typically gas. This means that even when cheaper renewables (wind, solar, hydro) or nuclear power generate most of the electricity, high gas prices can increase the cost for all electricity. The wholesale price accounts for around 41% of the retail price paid by households.

It also means that profits for low-marginal-cost producers could increase significantly when gas prices rise. To prevent such (low-carbon) suppliers making excess profits when the wholesale price is high and possibly making a loss when it is low, the actual prices that they receive is negotiated in advance and a contract is signed. These contracts are known as Contracts for Difference (CfDs). CfDs provide a fixed ‘strike price’ to low-carbon generators. The strike price is set so as to allow low-carbon generators to recoup capital costs and is thus set above the typical level of marginal cost. If the wholesale price is below the strike price, payments to generators to cover the difference are funded by amounts collected from electricity suppliers in advance using the CfD Supplier Obligation Levy. If the wholesale price is above the strike price, the difference is returned to consumers in terms of lower electricity bills.

Policy costs.  Electricity bills include an element to fund various social and environmental objectives. This element is also included in the cap. From October to December 2025, this element of the cap will be 11.3%. The money helps to subsidise low-carbon energy generation and fund energy efficiency schemes. It also funds the Warm Home Discount (WHD). In the October to December 2025 price cap, this amounted to a discount for eligible low-income and vulnerable households of £150 per annum on their electricity bills. The WHD element is included in the standing charge in the price cap. From October 2025, more generous terms will mean that the number of households receiving WHD will increase from 3.4 million to 6.1 million households. This is the main reason for the £35 increase in the cap.

Network costs.  These include the cost of building, maintaining and repairing the pipes and wires that deliver gas and electricity to homes. From October to December 2025, this element of the cap will be 22.6%.

Supplier business costs.  These include operating costs (billing, metering, office costs, etc.) and servicing debt. From October to December 2025, this element of the cap will be 15.4%.

Profit Allowance.  A small percentage is added to the price cap for energy suppliers’ profits. This is known as the Earnings Before Interest and Tax (EBIT) allowance and is around 2.4%. This has a fixed component that does not change when the overall price cap is updated and a variable component that rises or falls with changes in the cap.

Reliance on gas, low gas storage facilities, marginal cost pricing and the commitment to invest in low-carbon electricity and home heating all add to the costs of energy in the UK, making UK electricity prices among the highest in the world.

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Questions

  1. Why are the UK’s energy prices among the highest in the world?
  2. What are the arguments for and against subsidising wind power?
  3. What is the Contracts for Difference scheme in low-carbon energy. What CfDs have been awarded? Assess the desirability of the scheme.
  4. Is the capping of gas and electricity prices the best way of providing support for low-income and vulnerable consumers?
  5. How are externalities relevant in determining the optimal pricing of electricity?

In many countries, train fares at peak times are higher than at off-peak times. This is an example of third-degree price discrimination. Assuming that peak-time travellers generally have a lower price elasticity of demand, the policy allows train companies to increase revenue and profit.

If the sole purpose of ticket sales were to maximise profits, the policy would make sense. Assuming that higher peak-time fares were carefully set, although the number travelling would be somewhat reduced, this would be more than compensated for by the higher revenue per passenger.

But there are external benefits from train travel. Compared with travel by car, there are lower carbon emissions per person travelling. Also, train travel helps to reduce road congestion. To the extent that higher peak-time fares encourage people to travel by car instead, there will be resulting environmental and congestion externalities.

The Scottish experiment with abolishing higher peak-time fares

In October 2023, the Scottish government introduced a pilot scheme abolishing peak-time fares, so that tickets were the same price at any time of the day. The idea was to encourage people, especially commuters, to adopt more sustainable means of transport. Although the price elasticity of demand for commuting is very low, the hope was that the cross-price elasticity between cars and trains would be sufficiently high to encourage many people to switch from driving to taking the train.

One concern with scrapping peak-time fares is that trains would not have the capacity to cope with the extra passengers. Indeed, one of the arguments for higher peak-time fares is to smooth out the flow of passengers during the day, encouraging those with flexibility of when to travel to use the cheaper and less crowded off-peak trains.

This may well apply to certain parts of the UK, but in the case of Scotland it was felt that there would be the capacity to cope with the extra demand at peak time. Also, in a post-COVID world, with more people working flexibly, there was less need for many people to travel at peak times than previously.

Reinstatement of peak-time fares in Scotland

It was with some dismay, therefore, especially by commuters and environmentalists, when the Scottish government decided to end the pilot at the beginning of October 2024 and reinstate peak-time fares – in many cases at nearly double the off-peak rates. For example, the return fare between Glasgow and Edinburgh rose from £16.20 to £31.40 at peak times.

The Scottish government justified the decision by claiming that passenger numbers had risen by only 6.8%, when, to be self-financing, an increase of 10% would have been required. But this begs the question of whether it was necessary to be self-financing when the justification was partly environmental. Also, the 6.8% figure is based on a number of assumptions that could be challenged (see The Conversation article linked below). A longer pilot would have helped to clarify demand.

Other schemes

A number of countries have introduced schemes to encourage greater use of the railways or other forms of public transport. One of these is the flat fare for local journeys. Provided that this is lower than previously, it can encourage people to use public transport and leave their car at home. Also, its simplicity is also likely to be attractive to passengers. For example, in England bus fares are capped at £2. Currently, the scheme is set to run until 31 December 2024.

Another scheme is the subscription model, whereby people pay a flat fee per month (or week or year, or other time period) for train or bus travel or both. Germany, for example, has a flat-rate €49 per month ‘Deutschland-Ticket‘ (rising to €58 per month in January 2025). This ticket provides unlimited access to local and regional public transport in Germany, including trains, buses, trams, metros and ferries (but not long-distance trains). This zero marginal fare cost of a journey encourages passengers to use public transport. The only marginal costs they will face will be ancillary costs, such as getting to and from the train station or bus stop and having to travel at a specific time.

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Questions

  1. Identify the arguments for and against having higher rail fares at peak times than at off-peak times
  2. Why might it be a good idea to scrap higher peak-time fares in some parts of a country but not in others?
  3. Provide a critique of the Scottish government’s arguments for reintroducing higher peak-time fares.
  4. With reference to The Conversation article, why is it difficult to determine the effect on demand of the Scottish pilot of scrapping peak-time fares?
  5. What are the arguments for and against the German scheme of having a €49 per month public transport pass for local and regional transport with no further cost per journey? Should it be extended to long-distance trains and coaches?
  6. In England there is a flat £2 single fare for buses. Would it be a good idea to make bus travel completely free?

A happy New Year for 2024. Let’s hope that the coming year brings some good news amidst all the the gloom of war, squeezed living standards, the effects of climate change and the rise of authoritarian regimes.

One piece of good news is the growth in environmental debt swaps in developing countries. These are known as debt-for-nature swaps (or debt-for-environment swaps or green debt swaps). As Case Study 26.16 in Economics (11th edition) and Case Study 15.19 in Essentials of Economics (9th edition) explain:

A debt-for-nature swap is where debts are cancelled in return for investment in environmental projects, including protecting biodiversity, reducing carbon emissions and mitigating the effect of climate change. There are two types of scheme: bilateral and commercial.

In a bilateral swap, a creditor country agrees to cancel debt in return for the debtor country investing a proportion of the amount in environmental projects. In a commercial swap, the debt owed to banks is sold to an international environmental agency at a substantial discount (or sometimes even given away); the agency then agrees to cancel this debt in return for the country funding the agency to carry out various environmental projects.

The first debt-for-nature swap was made as far back as 1987, when environmental NGO, Conservation International, arranged for Bolivia to be forgiven $650 000 of its debt in exchange for the establishment of three conservation areas bordering the Beni Reserve (see either of the above case studies). In the 1990s and 2000s, debt-for nature swaps became popular with creditors and by 2010, the total debt cancelled through debt-for-nature swaps was just over $1 billion.

However, the popularity waned in the 2010s and with COVID, many developing countries were diverting resources from long-term sustainability and mitigating the effects of climate change to emergency healthcare and relief.

More recently, debt-for-for nature swaps have become popular again.

In May 2023, Ecuador benefited from the biggest debt swap to that point. The agreement saw $1.6bn of its commercial debt refinanced at a discount in exchange for large-scale conservation in and around the Galápagos Islands. At least $12m per year of the money saved will be channelled into conservation in the archipelago, with its unique flora and fauna.

Such projects are set to increase, with potentially significant beneficial effects for biodiversity, climate and the environment generally. At the COP28 summit in December 2023, a task force was set up by a group of multilateral development banks to promote an increase in the size and number of debt-for-nature swaps.

According to the Organisation for Economic Co-operation and Development (OECD), developing economies will need an annual $2.4 trillion of investment in climate action in the coming years. So far, the market for debt-for-nature swaps is set to rise to around $800bn. If they are to make a significant contribution to tackling climate change and loss of biodiversity, they need to be scaled up massively, especially as the cost of servicing debt has risen with higher global interest rates.

Nevertheless, as part of a portfolio of measures to tackle debt, climate change, loss of biodiversity and damage to the environment more generally, they are making an important contribution – a contribution that is set to rise.

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Questions

  1. Identify other types of debt swap and discuss their importance.
  2. Why are debt-for-nature debt swaps in the interests of debtor countries, creditors and the world generally?
  3. What is ‘green washing’? How may debt-for-nature swaps be assessed to prevent such green washing?
  4. Why are many developing countries’ debt burdens skyrocketing?
  5. Why may a developing country’s solution to its growing debt be detrimental to the environment?
  6. Assess the Belize debt-swap deal in tackling both its debt and conservation.

The global average temperature for July 2023 was the highest ever recorded and July 3rd was the world’s hottest day on record. We’ve seen scenes of wildfires raging across much of southern Europe, people suffering searing temperatures in south-west USA, southern India and western China, flash floods in South Korea, Japan and eastern USA. These are all directly related to global warming, which is causing weather systems to become more extreme. And as the planet continues to warm, so these problems will intensify.

The Secretary General of the United Nations, Antonio Guterres, in a press conference on 27 July warned that:

Climate change is here. It is terrifying. And it is just the beginning. The era of global warming has ended; the era of global boiling has arrived. The air is unbreathable. The heat is unbearable. And the level of fossil-fuel profits and climate inaction is unacceptable. Leaders must lead. No more hesitancy. No more excuses. No more waiting for others to move first. There is simply no more time for that.

The environmental, human, social and economic impact of global warming is huge, but concentrated on just part of the world’s population. For many, a more variable climate is at worst an inconvenience – at least in the short term. But it is the short term that politicians are most concerned about when seeking to win the next election.

Tackling climate change requires action to reduce carbon emissions now, even though the effects take many years. But one person’s emissions make only a minuscule contribution to global warming. So why not be selfish and carry on driving, flying off on holiday, using a gas boiler and eating large amounts of red meat? This is what many people want to do and governments know it. Many people do not like green policies as they involve sacrifice. Examples include higher fuel prices and restrictions on what you can do. So, despite the visions of fires, floods and destruction, governments are wary about raising fuel taxes, airport duties and charges to use old high-emission cars in cities; wary about raising taxes generally to provide subsidies for sustainable power generation; wary about banning new oil and gas fields that would reduce reliance on imported fuel.

Because the external costs of carbon emissions are so high and global, government action is required to change behaviour. Education can help and scenes of devastation from around the world may change the hearts and minds or some people. Also, the prospect of profits from cleaner and more fuel-efficient technology can help to spur innovation and investment. But to meet net zero targets still requires policies that are unpopular with many people who might be inconvenienced or have to pay higher petrol, energy and food prices, especially at a time when budgets are being squeezed by inflation.

Part of the problem is a distributional one. The people most affected by the cost-of-living crisis and higher interest rates are those on lower incomes and with higher debts. Politicians know that it will be hard to win the votes of such people if they are faced with higher green taxes. As elections approach, politicians are likely to backtrack on many environmental commitments to appeal to such people.

This is beginning to happen in the UK, with the government declaring that it is on the side of the motorist. Indeed, Rishi Sunak has just announced that the government will authorise more than 100 new licenses for new oil and gas wells in the North Sea. This is despite the United Nations, various other international bodies, climate scientists and charities calling for a halt to all licensing and funding of new oil and gas development from new and existing fields. The government argues that increased North Sea production would reduce the reliance on imported oil.

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Questions

  1. In what sense is the environment a ‘public good’? How is the concept of externalities relevant in analysing the private decisions made about the use of a public good?
  2. How may game theory be used to help understand the difficulties in reaching international agreement about climate change policies?
  3. What is meant by ‘net zero’? Is carbon capture and storage an acceptable alternative to cutting carbon emissions?
  4. In what ways could policies to tackle climate change be designed to reduce income inequality rather than increase it?
  5. What are the arguments for and against banning (a) petrol and diesel cars; (b) gas boilers; (c) fossil-fuel power stations? How much notice should be given if such bans are to be introduced?
  6. What is meant by ‘nudge theory’? In what ways could people be nudged into making greener decisions?
  7. What are the arguments for and against granting new licences for North Sea oil and gas drilling? Explain where you feel the balance of the arguments lies.