Should we shift energy taxes to make heat pumps cheaper to run?

Tariffs vary but averaged across the country, under the current OFGEM price caps, electricity costs four times gas per kWh. This means that by my estimate [1] unless you go off gas completely (hence avoiding the fixed daily charge) you need a heat pump efficiency (SCOP) of 360% to get similar costs. This is not unknown but considerably better than average. If you do go off gas completely, you need 320% which is still better than average. If you only got 300% you would be paying 6% more with the heat pump than gas. This is discouraging for people wanting to switch to low carbon heating.

However, a significant part of the electricity bill is due to environmental and social policies or 'taxes'. If these were removed or shifted, the ratio of electricity to gas price would be smaller, making heat pumps relatively cheaper. Hitherto, policy has been to keep gas cheap because so many of us rely on it for heating which is essential for health. However, doing so penalises households that make the transition to low carbon heating. What are these taxes and how much difference would this make? Here is a graph showing policy costs on gas and electricity as of September. There are more policy costs on the electricity bill than the gas bill and the home with a heat pump uses more electricity, so pays even more policy costs.

 

Policy costs for a typical bill of 12000 kWh gas, 3100 kWh electricity or, with a heat pump, 6650 kWh annually. The policy costs are from OFGEM [3] and the heat pump kWh used is from [1] Costs are taken from the period July/Sep 2023, the latest available. These costs vary little by region. The acronyms are explained below. 

Complications – varying by region

Averages hide a lot of detail. The electricity/gas price ratios vary by region, from 3.9 on the South West to 4.15 in London and the East of England. Also, your tariff may be very different – do try your actual prices in my heat pump cost/benefit tool. The variation is mostly due to varying network costs. 

Complications – solar panels

If you have solar PV panels you can use some of your own energy for the heat pumps so the increase in policy costs you pay is less.. However, not everyone has solar panels, or can have them. As of about now, only 5% of homes have solar panels [2].

What are the policy costs?

There are a range of policy costs added to your bills, described below. The first two apply to both gas and electricity and help make heating affordable for vulnerable households. The remainder are all aimed at shifting to renewable energy.

ECO – Energy companies obligation

Large energy suppliers are required to reduce carbon emissions by installing energy saving measures such as insulation mainly on hard to heat homes with residents who are on benefits. 

WHD – Warm Homes Discount

This is a discount on electricity bills (or sometimes gas bill) for households receiving certain benefits or on a low income. 

GGL – Green Gas Levy (gas only) 

This pays for the Green Gas Support Scheme which is a subsidy for green gas that is injected into the gas grid instead of being used to generate electricity. Green gas primarily comes from anaerobic digestion plants. It needs a lot more cleaning up as the purity standards for gas in the grid are very high. This scheme works a bit like the Feed in Tariffs used to for small scale renewables including domestic solar PV. The tariffs are index linked but the rates for new applications will decrease over time. The cost on the average bill is currently tiny (45p) but the scheme only started in 2021 and this will grow. However the budget is capped.

RO - Renewables Obligation (electricity only) 

This is the largest part of policy costs for electricity, even though it is closed to new applicants and has been replaced by CfDs. The RO scheme was designed to encourage an increasing proportion of renewable energy in the grid mix by forcing suppliers to buy renewable energy certificates or pay a buy-out price. The proportion of energy supplied that had to be renewable increased over time. The scheme closed in 2017 but payments will continue until 2037 and costs are still rising because the buyout price is linked to inflation. The average price of certificates is less than the buyout price but the required proportion of certificates is adjusted so that there is usually a deficit of actual renewables to avoid a price crash. (See Renewables Obligation (RO) Buy-out Price, Mutualisation Threshold and Mutualisation Ceilings for 2023-24 for an explanation.)

FiT - Feed in tariff (electricity only) 

This scheme is also closed to new applications (as of April 2019) but the tariffs are linked to inflation so costs continue to increase. This scheme applied to some commercial generators as well as households, and it still supports many wind farms and solar farms as well as rooftop PV. The last projects will end in 2039.

The scheme is partially replaced for households by the Smart Export Guarantee (SEG) which requires large energy companies to pay for renewable energy fed into the grid by households. The cost of SEG is not reported by OFGEM as they have little to do with it. The tariff paid is up to your supplier.

CfD – Contracts for Difference (electricity only)

This is the current scheme that replaces ROs and FiTs for installations of 5 MW and above. (Smaller schemes will have to rely on private agreements). Applicants have to take part in auctions where the lowest bids win. They then get a guaranteed price for all the power they deliver to the grid. When the wholesale price is lower than this, their income is topped up and when it is higher they have to pay it back. This means that CfDs help to stabilise prices for consumers. However there is a delay before the costs are reconciled which means it does not work as well as it could in this respect. None the less, OFGEM’s price calculations show that suppliers got paid back from CfDs during the three quarters Oct/2022 through Jun/2023. Over this period overall wholesale costs peaked at 52p/kWh (during Jan-Mar/23) so the CfD dividend did not make much of a dent but at least it was in the right direction.

OFGEM does not count CfDs as a ‘policy’ cost. It comes into the direct fuel category. However since it is similar in function to the RO which is in the policy category I have moved it into the policy bucket.

This chart shows the three main policy costs for electricity over the last few years. Note that the Y-axis goes down to minus two in order to show the CfDs. 

 

Calculated using data from OFGEM [3]

 

Carbon taxes – the Climate Change Levy

Electricity generators that use fossil fuels pay the climate change levy. This is currently 0.331p per kWh gas used [4]. However, this does not apply to our gas bills, only to large commercial users such as power stations. Gas supplies about 40% of our electricity and efficiency is about 50%, so this works out as about 0.26p/kWh on our electricity bills, much less than the CfD, RO or FiT. It does not appear in OFGEM’s calculation of policy costs as it is paid by the generators instead of the suppliers. However, the impact is small and assuming the proportion of renewable electricity continues to increase it will get smaller still.

Overall policy costs are only 3.4 % of the gas bill and 13.3% of the electricity bill

The chart below shows policy costs in context with other parts of the overall gas and electricity bills. This data is from July/Sep 2023. All policy costs (orange) are only 12.8% of the electricity bill. This proportion varies and when wholesale costs are low the proportion of policy costs increases.

 

Calculated using data from OFGEM [3] for July/Sep 2023. The CfD allowance has been shifted to the policy cost category.

 

Split policy costs equally between gas and electricity for a neutral redistribution

Currently the WHD is actually paid in the fixed per-day part of the bill, but not the ECO. This makes little sense to me. If you put all the policy costs into the per kWh charge, then you increase the per kWh prices a small fraction. This is shown in the chart below in the first two pairs of bars. In the third pair I have removed all the policy costs from both gas and electricity. This reduces the ratio to 3.64. The policy costs have to come from somewhere – very likely this would be from central government funding i.e. taxpayers. In the last pair of bars I have shared the policy costs evenly between gas and electricity so that if you are a typical customer using the typical amount of both gas and electricity the overall bill is the same. This has almost the same ratio of electricity to gas prices as the third bar but requires no extra funding from central government.

Impact of removing or shifting policy costs (including CFDs). Dots show the ratio electricity price/gas price. The actual price is the starting point from the OFGEM data [3]. In the baseline, the WHD cost has been shifted into the per kWh part of the price. 

With a price ratio of 3.7 you need a heat pump efficiency of 290% to break even – close to the average in the most recent large scale trial [5]

The balance will vary over time. When wholesale prices go up the policy costs are a smaller part of the bill and make less difference. When they go down the opposite applies. 

Is it reasonable to shift the policy costs?

There are two important considerations for policy on the ‘policy’ costs.

1.  Is it fair?
2.  Does it support the transition to net zero carbon?

There is a logic to charging subsidy on renewable electricity to electricity bills and similarly for gas. This means that electricity users pay the extra for clean electricity and vice versa. The policy costs for gas will increase if the green gas levy works out but they are unlikely to hit the same levels as the costs on electricity.

However, policy costs hit the fuel poor hard because a high proportion of their daily expenditure relates to energy. This applies to both electricity and gas. This unfairness could be corrected by giving appropriate cash benefits to those with high energy cost, assuming we had a sensible way of identifying these people. 

Considering the requirement for net zero emissions, high electricity/gas cost ratios hinder the transition to low carbon heating. Since this is such a critical part of our net zero plan and it is proving hard to achieve, we need to pull all the levers we can. 

Removing policy costs altogether would be most ‘fair’ and improve the price ratio to support net zero. However this would increase government spending which is unpopular with some. Shifting the policy costs so that they were spread evenly between gas and electricity for a typical customer would be cost neutral for that customer but have almost the same benefit in terms of price ratio.

 

[1] Getting a heat pump or other electric heating 

[2] From the MCS dashboard, 1.42 million homes have panels. From the ONS, there are 28.2 million households.

[3] Default tariff cap level: 1 July 2023 to 30 September 2023 (OFGEM) 

[4] Climate Change Levy Rates (www.gov.uk) November 2022 

[5] Heat pumps shown to be three times more efficient than gas boilers (Energy Systems Catapult) March 2023