Budget 2014 - A budget for manufacturers & the environment

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There has been a wide range of responses to the energy related elements of yesterday's Budget and I'd like to take the opportunity to set out EEF's stall and respond to some of the commentators portraying yesterday's announcements as a capitulation to polluters and big business and a betrayal of our climate change ambitions. It was nothing of the sort and I believe it is disingenuous to portray it as such.

EEF fully understands and supports the need for concrete action to cut global emissions but this must be done whilst fully taking account of the realities and difficulties we are faced with. Somewhere along the line, many seem to have forgotten that the ultimate goal is cutting global emissions, not simply a UK with the highest carbon price, the most climate change legislation and the highest targets. This is not to call for a reduction in UK climate change ambition, far from it, merely recognition of the fact that we remain a long way from reaching a globally binding agreement for all countries to reduce emissions, and that until we reach this point climate change policy must be designed in a manner that reflects this. To do otherwise will do nothing to reduce global emissions but could do a great deal of damage UK industry, this is in no-one's interest.

It will of course come of little surprise that EEF, and the UK's manufacturing sector, view yesterday's energy related announcements as a positive step forward in terms establishing a climate change policy framework that will facilitate the transition to a low carbon economy whilst allowing UK manufacturing to benefit from and contribute effectively to this transition. The TUC Budget response captured the predicament that energy intensive industry is currently facing perfectly when it said industry is “...walking a tightrope from a high to a low carbon economy. Government policy should, we believe, enable the transition rather than add to its perils.”

But it is not purely energy intensive industry that is feeling the pinch from energy prices, in surveying our members we found numerous companies that don't qualify as energy intensive (in terms of access to compensation) but whose energy costs still constitute 10-20% of their total costs. With climate policy set to add 50% to the price of electricity by the end of the decade this could add a further 10% to a manufacturers' operational costs and it doesn't take too much imagination to understand that this may be somewhat of an issue. Even today, we've spoken to companies who've had to drop large portions of their low margin product because they simply can't compete in an international market where customers refuse to accept price rises or even demand year on year reductions. Where companies are able to absorb these rising costs it inevitably has a knock on effect on other areas of spend such as investment in new kit, skills and training, R&D or export.

A view often espoused by those pushing for ever more ambitious climate change targets is that there has been no strong evidence for carbon leakage to date and as such calls from industry should largely be viewed as purely self-interested short termism. It would be dishonest of anyone to claim that we are already faced with a mass exodus of industry from these shores setting up shop in China to make their own contribution to its troubling smog problem; this is clearly not yet where we find ourselves. But the situation is far more complicated than simply looking for past or present examples of relocation of production.

Firstly, where carbon leakage is likely to occur, it will be in the years to come. The UK is, for all intents and purposes, at the start of its transition from a high to a low carbon economy, climate change policy currently adds about 20% to electricity bills, climbing to 50% by 2020 and 70% by 2030. As such, it is in the years to come that we must look for the warning signs of relocation and guard against its eventuality. The green lobby correctly calls for government to take a long term view on climate change policy and this is an important element of it.

Secondly, we are not merely concerned here with relocation of production but also with, the more subtle, relocation of investment, this is much harder to see and there is already some evidence that this is occurring even before the costs of climate change policy is fully ramped up in the years to come. Many investment decisions will be taken at a global level, and it is increasingly clear that for EIIs in particular, the price of energy is having a major impact on where money is spent.

Thirdly, where a company has no overseas operations or the necessary ability to move production overseas, carbon leakage will be even more gradual and difficult to spot. For some time a company may be able to absorb costs, either by accepting reduced margins and/or by reducing spend in other business areas such as wages, plant investment or skills. In the long term, margins may be wiped out altogether or the lack of investment overtime will place the company at an increasing competitive disadvantage. In the event that the company ceases production, the production facilities will not move overseas but the slack created in the global market will of course be taken up elsewhere. I do not claim that this would automatically lead to increased global emissions, but even in the case where this is not the result we should not be blindly following policies that weaken manufacturing here in the UK unless there is a significant net benefit in the fight against climate change. With the UK manufacturing sector amongst the most efficient in the world, it is extremely difficult to see this circumstance arising.

Climate change policy must be designed in a manner that keeps manufacturing here in the UK and actually provides a boost and opportunities for the sector. To take one very simple example, the Committee on Climate Change's ‘ambitious renewables' scenario for decarbonising the grid up to 2030 demands some 38% of UK electricity to come from on and off shore wind turbines, 65GW up from 11GW in 2013. As this excellent post from the Energy Collective points out, you can't build a wind turbine without foundation industries and a surprising amount of fossil fuel. “On average 1 MW of wind capacity requires 103 tonnes of stainless steel, 402 tonnes of concrete, 6.8 tonnes of fiberglass, 3 tonnes of copper and 20 tonnes of cast iron. The elegant blades are made of fiberglass, the skyscraper sized tower of steel, and the base of concrete.” For the UK's 65GW of wind power by 2030 that's around 7 million tonnes of steel and 26 million tonnes of concrete. With the production facilities here in the UK to produce this, why on earth would we risk putting ourselves in a position where we needed to import this all?

Faced with the dual aims of enhancing UK manufacturing and meeting our emissions reduction commitments, EEF views that climate change policy must be designed in such a way that it meets three very basic criteria;

1. It achieves its aims in the most efficient and cost effective manner possible

2. It does not place UK manufacturing at a significant competitive disadvantage

3. All policy should meet its intended aim without being superfluous to requirements

And with these aims in mind, EEF's Budget submission called for two principle actions; a freezing of the Carbon Price Floor (CPF) and an extension of the current Energy Intensive Industries (EII) compensation package both in scope, to cover the costs of the Renewables Obligation (RO) and small scale Feed in Tariffs (FITs), and in longevity out to 2020.

Let us first consider the extension of the EII package before getting bogged down in the quagmire of the CPF. I think most will accept the need to minimise the risks of carbon leakage emanating from climate change policy where possible. Both the Committee on Climate Change and WWF have recognised this, as has government in granting the first compensation package for the costs of EU ETS and CPF and the exemption from the costs of the upcoming Contracts for Difference (CfDs). All yesterday's budget announcement has done is to complete this package, extending it to cover the other elements of the UK's support for renewables and providing this comprehensive cover out to 2019/20. This will have no detrimental impact on emissions levels; it simply places UK EIIs on a more even footing with others in the EU and elsewhere. As the oft referenced BIS report shows, without this compensation package EIIs in the UK would be facing climate change policy related costs at least 50% higher than the next closest competitor in the EU and vastly more than Germany that provides a far more generous forms of protection from the costs of climate policy to its own industrial base. Furthermore, EIIs will still have every incentive to reduce energy use, when energy is 40% of your overall costs you don't need much additional incentive, and the UK's EIIs are working in partnership with Government and academics to map out practical routes to decarbonising their operations out to 2050.

Now for the rather more complex issue of the CPF; its express aim when introduced last year was to encourage investment in low carbon generation by providing a sure and stable carbon price in the UK on which investors could rely. It was not, as some commentators have claimed intended to encourage industry to switch to greener fuels or to encourage energy efficiency. It is a tax on the fossil fuels burned to generate electricity which is then passed on to electricity suppliers raising wholesale and, ultimately, retail electricity prices. In doing so it raises the price of all forms of electricity, no matter what the generation source is, so how exactly a manufacturer is able to switch to a greener fuel and thereby reduce its costs is slightly beyond me.

Secondly, with the introduction of CfDs the CPF becomes essentially irrelevant and simply a government revenue stream. Low carbon generators entering into a CfD from this year will be guaranteed a price/mWh; it is surely of little concern to them what proportion of this comes from the wholesale price (inflated by the CPF) or the top up from the Levy Control Framework (LCF). They are guaranteed that price whatever. Yes, it is true that there will be a greater demand placed on the available funds in the LCF but this should ensure that only the most cost effective generation projects go ahead, and the consumer gets more bang for its buck or more mWh/£.

Thirdly, whilst there has been great support for carbon pricing, it is actually a highly inefficient way of funding low carbon generation. Because the CPF works by increasing the wholesale price of electricity, all generators will receive that increased wholesale price for electricity they sell regardless of whether they were subject to the tax. This has the effect of shrinking profit margins for fossil fuel plants (who have to pay the tax) and increasing margins for low carbon generation – precisely the aim. However, because of our generation current mix it does mean that only a small proportion, around 20%, of the additional money paid by consumers will actually go to new low carbon generation. About 60% will go to HMT and the remainder will go to existing nuclear or renewable generation as a windfall profit. One could actually increase funding for low carbon generation four fold and still save the consumer money, if we designed out inefficient measures like the CPF and relied exclusively on CfDs (albeit with greater safeguards to ensure competitions and price reductions).

Fourthly, EEF has for some time been concerned about the unilateral nature and impact on manufacturers of this policy and as the EU carbon price remains at historic lows the ability of the CPF to create a divergence in UK and EU electricity prices continues to grow. The Carbon Price Support (CPS) rate in 2015/16 is already almost twice that originally intended (at £18.08 as compared with the 2011 indicative rate of £9.86), and EEF estimates that this will constitute almost 10% of a large industrial user electricity bill and will leave the UK paying a carbon price about four times higher than the rest of Europe. This damages UK manufacturing and is not sustainable in the long term. Thankfully the Chancellor has chosen to freeze the CPS rates through to 2020, if he had not we'd have seen a UK carbon price of around £40 in 2020, some eight times higher than the rest of the EU.

Fifthly, many have commented that the freezing of the CPF has created uncertainty for low carbon generators; I believe these claims are entirely unfounded. The CPF was always going to be vulnerable to political circumstances and tinkering and the fact that it was deeply unpopular (not just with manufacturers) from the outset meant that it was never going to provide the rock solid investment signal it was meant to. CfDs provide that investment certainty in a far more effective manner and are here to stay even in the event of a change of Government. Furthermore, the stability of the carbon price has not in any meaningful way been altered; it is just lower than originally intended. With an EU price likely to remain stagnant for the rest of the decade at around £5/tCO2 and a CPS of £18/tCO2 investors can be fairly sure of a carbon price of £20-25 through to 2020. One could even argue that the announcement provides more certainty; we now have a CPS rate set for six years as opposed to just two previously.

Finally, even by 2020 the CPF was unlikely to have reached a high enough level to have seen coal replace natural gas as the marginal plant, and therefore started to have a real impact on taking coal off the grid. Most commentators point to a carbon of price of closer to £50 to close the price gap between coal and gas as a generation fuel. The demise of coal will come from direct legislative signals in the form of the Large Combustion Plant and Industrial Emissions Directives and the soon to be introduced Emissions Performance Standard as well as the natural retirement of aging coal power stations. Furthermore, given that nothing we do in terms of closure of UK coal power stations will have any impact of overall EU or global emissions, due to an EU wide cap on emissions, whilst it must be frustrating to some that they still operate in the UK you're not going to save the world by taxing them out of existence particularly when Germany's actually building more of them.

To draw things to a close, the energy measures in the Budget have done nothing to reduce the UK's ability to meet its climate change responsibilities. We still have the highest targets in the world, we still have the highest carbon price in the world, we still have binding targets for renewables out to 2020 and will soon have binding emissions reductions targets out to 2030. The 2030 target, will almost definitely be accompanied by an EU wide renewables target and, through the new governance structure, the UK will need to demonstrate how it will contribute towards this; this may mean increased investment in renewables in the 2020's or it may mean a greater reliance on other forms of low carbon technology, we should not seek to box ourselves into a highly specific path right now and the renewable lobby should stop demanding that we do so. The UK climate change policy framework still provides a remarkably secure investment platform for low carbon generation and will continue to do so through the 2020s.

Tackling global emissions remains the ultimate prisoner's dilemma; we must design our climate policy in a manner that accurately reflects the realities we face and how the world is not how we would like it to be. If this means accepting that limiting a global temperature rise to 2°C is no longer a realistic global target then so be it, this may sound pessimistic but I believe it is far better to be honest about what we can globally achieve and work towards this then to continue to kid ourselves, not least because this will help us take more appropriate adaptation options in the years to come. Far from an about turn on climate change I believe this year's Budget represents a realistic view of the challenge we are facing, strengthens the UK's ability to reduce emissions and our manufacturing sector's ability to contribute to this.

Author

This person has now left EEF. Please contact us on 0808 168 1874 or email us at enquiries@eef.org.uk if you have any questions.

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