activism energy politics

How to use VAT to encourage greener energy – a proposal

A couple of weeks ago I was thinking about VAT and the possibility of using VAT rates to encourage greener electricity.  It’s not the kind of thing I normally write, but it’s an idea that might be useful and so I wrote it up in a little detail over the weekend. See what you think. Chances are it’s full of holes, in which case please do point them out. If it survives, I might send it to a few people.

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At present, domestic energy use enjoys a discounted rate of VAT, at 5%. This is something of an anomaly. Usually we reserve discounts for things that we want to incentivise, but we actually need people to use less energy, both to meet our climate targets and to reduce our dependence on gas imports. The tax system recognises that oil use needs to be limited, and that it has a number of negative side-effects that need to be priced in. Accordingly, we pay 58p a litre in fuel duty as well as VAT at 20%. Why does household energy enjoy a privileged tax status?

The price of energy has risen steeply, and there is a lot of pressure to find ways to lower household bills and help the rising number of people living in fuel poverty. At the same time, our energy prices are among the lowest in Europe (see table below). Perhaps as a result, when European countries are ranked for energy efficiency, Britain comes in 18th. The average house scores a D on energy performance. This is rather perverse, and yet every effort to increase household efficiency has been met with a shrug.

The special VAT rate on household energy has several effects:

  • It holds back energy efficiency,
  • Subsidises waste,
  • Dis-incentivises alternative energy,
  • And excerbates Britain’s trade deficit

With all the attention on energy prices, removing the subsidy would be politically difficult. However, there are ways of adjusting the system to create the kind of incentives that we want. VAT on domestic electricity could be used to encourage people to seek out greener energy tariffs, and to encourage energy companies to invest in renewable energy. Here’s how:

Starting from 2015, VAT on household electricity bills would be variable, calculated based on the renewable energy content of the tariff. A 100% renewable energy electricity supply would be taxed at 5%. A tariff with 80% renewables in the energy mix would be at 6%, and so on.

Renewable energy %            VAT rate
100%                                                   5
80%                                                     6
60%                                                     7
40%                                                     8
20%                                                     9

 What this would do is switch the purpose of the subsidy from supporting general energy use to supporting green electricity. At the consumer end, households would now be shopping around for the greenest tariff they could find. At the supply end, energy companies would need to rapidly increase their investments in renewable energy or face losing customers to greener competitors.

The numbers above are theoretical. It would obviously need some investigation to ensure that the market would be able to respond in an appropriate time scale. Currently none of the big six energy companies have more than 10% renewables in their electricity mix. If every green tariff was immediately oversubscribed, we would have a backlog as renewable energy projects came online. This could be prevented by introducing the changes progressively.

For example, from 2015 VAT of 6% would be charged on any energy tariff with less than 20% renewable energy. From 2018, that would be ramped up so that less than 20% would now be charged at 7%, and anything less than 40% would now incur a higher rate of 6%.

Renewable energy %          2015    2018    2021    2024  
100%                                               5            5            5            5
80%                                                  5            5            5            6
60%                                                  5            5            6            7
40%                                                  5            6            7            8
20%                                                  6            7            8            9

The tax system would now be gradually increasing the pressure on energy companies to increase their energy mix, helping to achieve our carbon targets and lowering our dependency on gas imports. It would be done not through new taxes, but by progressively removing a perverse subsidy.

Even when explained well, there is every chance that opponents would pounce on the idea as a ‘green tax’ and say that it would raise energy bills for struggling consumers. One way around this would be to make sure that the change in tax was accompanied by an efficiency drive. Energy efficiency measures such as loft insulation, thermostatic radiator controls, etc, would all be zero rated for tax.

Furthermore, all households would receive a one-off energy efficiency grant of £100, funded through the future tax rises. This would be delivered as a cheque, accompanied by a flyer with ideas of how it could be used to reduce bills – and who to turn to if you are struggling to pay your bills. (This would be essentially advancing households a portion of their own future taxes.) If households used it as suggested, their energy use would fall and their bills would be the same or lower, and they would save money in the longer term. Provided people used the grant as suggested, nobody would need to see their energy bills rise as a result of the new tax measures.

What would we gain from pursuing change through VAT in this way?

  • Greater efficiency without necessarily raising prices
  • Incentivising investment in renewable energy
  • Liberalizing the market for energy by giving consumers more reasons to shop around.
  • Lower carbon emissions
  • Greater energy independence
  • Healthier balance of trade as gas imports for electricity generation fall.

5 comments

  1. Does it need to be that complicated? Why not just drop VAT on renewable energy, where each energy company reports what proportion of its supply is renewable? Now all you have to do is get get the oil companies on board. Penalising dirty energy is hardly creating a ‘level’ playing field for business.

  2. There’s no way to drop VAT on renewable energy as far as I can see, since businesses would already be reclaiming VAT on their purchases. It’s a tax aimed at consumers and businesses don’t pay it. Solar panels and energy efficiency measures are at the reduced rate of 5% already.

  3. Hi Jeremy, this looks like an excellent idea. In theory it would also increase the diversity of our renewable energy supply and storage capacity as it is very difficult to buy renewable energy all of the time (which may be only why to my knowledge only one company does it exclusively).

    To make it work there would need to be some control on pricing, it would be far too easy for the big six to cover a 4% difference by lowering the price of dirtier tariffs.

    If the ROC,system was likely to survive the energy review then this could have been used to provide a push by increasing the ROC requirement of supply companies at the same time as creating a market pull from the change in VAT. The proposed fit-cfd scheme could not do this as effectively as it is designed to control costs and not necessarily encourage deployment which is/was the purpose of the ROC scheme.

    To make the transition a very stable system would be required in order for companies to make the upfront investments that renewables generally requires. Maybe some of the vat revenue could be offered as low interest capital to help fund some of this, and also provide a stable long term income stream for the government.

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