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Climate Policies and the future of Manufacturing

Dr John Constable: GWPF Energy Editor

The failure of Tata Steel’s fragile UK operations is a salient, early symptom of more general and growing problems in the British economy.

Other indicators include falling electricity consumption across all sectors, now at levels not seen since the 1990s (See DECC’s latest update) and weak, near stagnant performance and falling rates of employment in larger scale manufacturing, as highlighted in this week’s Markit/CIPS Manufacturing Purchasing Manager’s Index (PMI).

The steadily accumulating effects of policy-induced energy cost increases are a significant part of this unfolding story, and, unlike many of the other causes involved, are actually under government control, so can be corrected. But just as the climate policies are slow but sure in the damage they cause, reforms will only bring benefits over the medium term, and so need to be made immediately to avoid serious problems in the next decade. Foresight and patience are both required.

Many commentators on the Tata crisis have noted the impact of energy and climate policies on the steel industry’s viability and competitiveness, and they are right to do so: steel is certainly an industry with an above average sensitivity to energy costs, particularly electricity costs, with in some cases, Tata being one, electricity expenditure equivalent to about 20% of its Gross Value Added (the threshold used by government to determine eligibility for partial relief under the package offered to Energy Intensive Industries). Perhaps about 10% of the steel sector’s total costs are directly related to energy, as compared to around 5% for many other industrial and commercial concerns.

But figures of this order, whilst constituting a significant fraction of profits, may not seem overwhelming, and economists have been more or less relaxed about such impacts, expecting efficiency and factor substitution to offset the costs. Similarly, while UK electricity prices certainly appear expensive in an international context (see DECC’s summary), being 7th highest out of the 29 member states in the International Energy Agency (IEA), and 25% above the IEA median, they may not seem sufficiently extreme to figure prominently in Tata Steel’s despair over its UK plant, if compared with, for example, Chinese competition.

However, this would be a mistake. Energy, and particularly electricity costs matter a great deal. To see why, we must recall, firstly, that climate policies affect not only the cost of energy bought by a business but also the energy rendered as the many goods and services, including labour, that must also be purchased. Secondly, the cost of energy policies is scheduled to rise sharply by 2020 with still further increases by 2030. In other words, both the present and the future contextual effects of climate policies are far-reaching.

The most recent Government estimates permitting understanding of these effects were published in November 2014, in the suspiciously discontinued Estimated Impacts of Energy and Climate Changes Policies on Energy Prices and Bills.

In the absence of any others, we must use these figures, which retain at least indicative value. In 2014 DECC estimated that prices to Energy Intensive users were 26% higher than they would be in the absence of policies. By 2020, in the Low Fossil Fuel price scenario, which now seems more likely than not, a large Energy Intensive Industry (EII) with a full cost relief package would face electricity prices (p/kWh) that are 22% higher than they would be in the absence of policies. Those unable to qualify for relief would see prices 76% higher than they would be without policies. No estimates are available for 2030, perhaps because DECC does not expect there to be any Energy Intensive Industries remaining in that year.

The electricity price impacts on other parties trading with EIIs are also large. Medium sized businesses would see prices 77% higher than they would be in the absence of policies in 2020, and 114% higher in 2030. Small sized businesses would see prices 61% higher in 2020 and 95% higher in 2030. Domestic households would see prices 42% higher than they would otherwise be in 2020 and 60% higher in 2030.

To these must be added electricity system costs, for grid expansion and management, and in the presence of large renewable fleets these could easily reach totals not much less than the subsidy costs themselves.

Officially, DECC believes efficiency measures will result in conservation and offset these increases, but hardly anyone else thinks this is realistic at the scale projected, though price rationing may in fact have some effect in holding back the increase in bills, and is arguably already doing so.

Thus, all businesses face significant short term increases in electricity prices, combined with further medium and longer term increases in other input costs as the electricity prices paid by its suppliers, including its workforce, gradually pass through their own share of the climate policy burden. The present is difficult, and the future is very bleak indeed.

It is not too late for government to take the hint from the Tata crisis, and review the policies, but correction will be difficult. Many of the instruments, such as the Renewables Obligation and the Feed-in Tariff, have created long-term legal subsidy entitlements, and retrospective cuts will surely be resisted in the courts. Furthermore, even if dramatic reforms are carried through, some degree of economic poisoning will persist for years, while the benefits would only gradually make themselves apparent. One remedy for this would be to drive out the higher cost inputs already entailed by flushing the economy with cheap energy. Fortunately, low cost oil and gas make this a real possibility. The question is whether government has the courage to seize the opportunity before it becomes a desperate necessity.