In recent times, conversations around environmental degradation have been as prolific as the disaster itself. Countries have come together at various fora to discuss potential strategies to deter the burning of fossil fuels, crucial to reducing the accumulation of heat-trapping greenhouse gases in the earth’s atmosphere as a means to counter the rapid deterioration of the environment. Towards this end, the imposition of the carbon tax, a proposal first mooted as part of the Paris Agreement, which is a legally binding international treaty on climate change, seems to offer some hope.
Having been adopted by 196 Parties at the UN Climate Change Conference (COP21) in Paris, France, on 12 December 2015,it came into force on 4 November 2016. The carbon tax could discourage the use of fossil fuels and encourage a shift to less-polluting fuels, thereby limiting the carbon dioxide (CO2) emissions that are by far the most prevalent greenhouse gas.
This stringent move has been mandated by studies, such as those carried out by the World Meteorological Organization, which establishes that without measures to reduce greenhouse gases, global temperatures are projected to rise by about 4°C above pre-industrial levels by the end of the century (temperatures have already increased by 1°C), with rising and irreversible risks of collapsing ice sheets, disruption of ocean circulatory systems, flooding of low-lying island states, and extreme weather events, a lot of which are already in evidence, such as the March 2019 Cyclone Idai, which took the lives of more than 1000 people across Zimbabwe, Malawi and Mozambique in Southern Africa, or the Australian wildfires of 2020 that have burned through more than 10 million hectares, killed at least 28 people, razed entire communities to the ground, taken the homes of thousands of families, and left millions of people affected by a hazardous smoke haze.
So, how does Carbon Pricing work? Carbon pricing works to curb greenhouse gas emissions by placing a fee on emitting and/or offering an incentive for emitting less. The price signal created shifts consumption and investment patterns, making economic development compatible with climate protection.An increasing number of non-Annex I countries under the UNFCCC are pursuing carbon pricing: South Korea, China, Thailand, Singapore, Bangladesh, Kazakhstan, South Africa, Côte d’Ivoire, Colombia, Chile, Argentina, Brazil, Mexico, Panama, Trinidad and Tobago, others.The V20, a group of 20 developing countries vulnerable to climate change, has also announced its intention to adopt carbon pricing by 2025.Placing an adequate price on GHG emissions is of fundamental relevance to internalize the external cost of climate change in the broadest possible range of economic decision making and in setting economic incentives for clean development. It can help to mobilize the financial investments required to stimulate clean technology and market innovation, fueling new, low-carbon drivers of economic growth.
There is a growing agreement among both socio-political as well financial institutions on the fundamental role of carbon pricing in the transition to a decarbonized economy. For governments, carbon pricing is one of the instruments of the climate policy package needed to reduce emissions. In most cases, it is also a source of revenue, which is particularly important in an economic environment of budgetary constraints. Businesses use internal carbon pricing to evaluate the impact of mandatory carbon prices on their operations and as a tool to identify potential climate risks and revenue opportunities. Finally, long-term investors use carbon pricing to analyze the potential impact of climate change policies on their investment portfolios, allowing them to reassess investment strategies and reallocate capital toward low-carbon or climate-resilient activities.
The Carbon Tax at Work
Carbon taxes, levied on coal, oil products, and natural gas in proportion to their carbon content, can be collected from fuel suppliers. They, in turn, will pass on the tax in the form of higher prices for electricity, gasoline, heating oil, and so on, as well as for the products and services that depend on them. This provides incentives for producers and consumers alike to reduce energy use and shift to lower-carbon fuels or renewable energy sources through investment or behavior.
While addressing climate change by reducing greenhouse gases, carbon taxes can also generate more immediate environmental and health benefits, particularly by reducing deaths that result from local air pollution. They can also raise significant revenue for governments, revenue they can use to counteract economic harm caused by higher fuel prices. For example, governments could use carbon tax revenue to ease the burden of taxation on workers by lowering personal income and payroll taxes. Carbon tax revenue could also fund productive investments to help achieve the United Nations Sustainable Development Goals, including reducing hunger, poverty, inequality, and environmental degradation.Other policies are likely to be less effective than carbon taxes. For example, incentives for renewable power generation do not promote switching from coal to gas or from these fuels to nuclear, do not reduce electricity demand, and, not least, do not promote emission reductions beyond the power-generation sector.Carbon pricing, on the other hand, works by capturing the external costs of emitting carbon – i.e. the costs that the public pays, such as loss of property due to rising sea levels, the damage to crops caused by changing rainfall patterns, or the health care costs associated with heat waves and droughts – and placing that cost back at its source.
Thus, carbon pricing effectively shifts the responsibility of paying for the damages of climate change from the public to the GHG emission producers. This gives producers the option of either reducing their emissions to avoid paying a high price, thereby addressing the root cause of the problem, or continue emitting but having to pay for their emissions. This strategy also creates a price signal that reduces, or regulates GHG emissions and at the same time provides a strong financial case for shifting investments away from high-emission fossil-fuels based technology towards cleaner technology.
Carbon taxes are generally straightforward to administer because they can be added to existing fuel taxes, which most countries already collect with ease. It is also possible to integrate carbon taxes into the royalties paid by coal mining and oil and gas drilling industries. With the establishment of emission-monitoring capacity, variants of carbon taxes can be applied to other sources of greenhouse gases, such as emissions from forestry, international transportation, cement manufacturing, and mining and drilling activities.Carbon taxes can play a key role in achieving countries’ pledges under the Paris Agreement of 2015, which lays the foundation for international action to combat global warming, to be updated every five years.
The chart provides a broad sense of the effectiveness of different levels of carbon taxes. Reductions in emissions produced by a $35 a ton carbon tax (green bars) would be more than sufficient to meet the total commitments of the Group of Twenty countries. Those commitments, shown by the black squares in the chart,
represent percentage reductions in projected fossil fuel CO2 emissions in 2030 below baseline levels (that is, levels in the absence of new mitigation measures) implied by Paris pledges.These findings may make the case for some degree of international price coordination. It is also worthwhile to consider equity rather than equality in imposing carbon taxes and affixing responsibility for environment preservation. It would be hypocritical to allow developed countries that have already reaped the benefits of exploiting the natural resources and degrading the environment to be taxed at the same level as developing countries that are far behind on the development continuum. Imposing equal taxes would also render products of developing countries non-competitive by being largely unaffordable to domestic markets. Thus, variable taxing, with the developed countries paying higher taxes than the developing countries, guarantees a certain level of mitigation effort among participants while also providing some assurance against losses in competitiveness. Advanced economies could accept more responsibility for mitigation through a higher minimum price requirement. And the regime could be designed flexibly to accommodate carbon taxes, emission trading systems, or other approaches.
Making the Carbon Tax More Effective
The most immediate challenge, however, is moving mitigation policy forward at the national level: carbon taxation can be politically very difficult. Carbon taxes should be introduced gradually, with targeted assistance for low-income households, trade-dependent industries, and vulnerable workers. The rationale for reform and the use of revenues must be clearly communicated to the public. Other instruments may be needed to reinforce carbon pricing, or substitute for it. One potentially promising approach avoids a politically difficult increase in fuel prices by implementing revenue-neutral tax subsidies to promote incentives for cleaner power generation, shifting to cleaner vehicles, and improvements in energy efficiency.Ministries of Finance will need carefully crafted policy packages to provide broader and stronger mitigation incentives, accounting for national efficiency, distributional, and political economy considerations.Under a carbon tax, the government sets a price that emitters must pay for each ton of greenhouse gas emissions they emit. Businesses and consumers will take steps, such as switching fuels or adopting new technologies, to reduce their emissions to avoid paying the tax.
Carbon Pricing Implementation Globally
A number of countries, regions, and local governments around the world have a carbon tax or something similar like an energy tax related to carbon content. As of 2021, 35 carbon tax and similar programs have been implemented across the world. For example, South Africa became to the first African country to implement a carbon tax in 2019. In the United States, interest in an economy-wide carbon tax has been gradually growing, proving that the economic implications of taxing pollution are well understood, but political viability is the primary challenge. Current debate often centers on how to use the revenue generated by a tax. One idea is to use the revenue to reduce taxes on productive activities, like payroll or corporate taxes. Other ideas include giving it back to all consumers, in the form of carbon dividends, or using it to pay for infrastructure improvements, with countries such as Singapore putting considerable thought into effective implementation of carbon tax proposals.
International carbon pricing took off with the introduction of the flexibility mechanisms under the Kyoto Protocol. Adopted at the third Conference of the Parties (COP) to the UNFCCC held in Kyoto, Japan, in December 1997, the Kyoto Protocol committed industrialized country signatories (so-called “Annex I” countries) to collectively reduce their GHG emissions by at least 5.2 percent below 1990 levels on average over 2008–2012. Annex I countries could fulfil their commitments through domestic actions or the use of three flexibility mechanisms International Emissions Trading, JI and CDM. The amendment adopted in Doha, Qatar, in December 2012 provided a basis for the three Kyoto mechanisms to continue for 2013–2020. The IET, JI and CDM were of significant relevance in the creation of cross-boundary carbon markets.
Looking ahead, carbon pricing can play a pivotal role to realizing the ambitions of the Paris Agreement and implement the Nationally Determined Contributions (NDCs). Article 6 of the Paris Agreement provides a basis for facilitating international recognition of cooperative carbon pricing approaches and identifies new concepts that may pave the way for this cooperation to be pursued. Paragraph 136 of the first COP 21 Decision (Adoption of the Paris Agreement) recognizes the important role of providing incentives for emission reduction activities, including tools such as domestic policies and carbon pricing. Many of the plans submitted to the UNFCCC recognize the important role of carbon pricing, with about 100 countries planning or considering carbon pricing mechanisms in their intended NDCs.
Factors to Consider for Effective Implementation
In order to alleviate progressive implementation challenges, the following are important considers why designing a carbon tax proposal:
Scope – The scope of the carbon tax depends on substances covered. For instance, a carbon tax could be levied on the carbon dioxide content of fossil fuels.
Point of Taxation – A carbon tax can be levied at any point in the energy supply chain. The simplest approach, administratively, is to levy the tax “upstream,” where the fewest entities would be subject to it (for instance, suppliers of coal, natural gas processing facilities, and oil refineries). Alternatively, the tax could be levied “midstream” (electric utilities) or downstream (energy-using industries, households, or vehicles).
Tax and Escalation Rates – Economic theory suggests a carbon tax should be set equal to the social cost of carbon, which is the present value of estimated environmental damages over time caused by an additional ton of carbon dioxide emitted today. The tax rate should also rise over time to reflect the growing damage expected from climate change. An increasing price over time also provides a signal to emitters that they will need to do more and that their investments in more aggressive technologies will be economically justified. One of the challenges of a carbon tax is forecasting the resulting level of emissions reduction from a specific tax rate. Building in review and opportunity for adjustment can help, but also reduces the one of the values of a carbon price – price certainty.
Distributional Impacts – Lower-income households spend a larger share of their income on energy than higher-income households. As a result, a price on carbon that increases energy costs can have a greater impact on lower-income individuals. Directing a certain percentage of revenue from a carbon tax toward low-income households to compensate for increased energy costs can help ensure that the tax does not disproportionately affect the poor.
Competitiveness – Without provisions protecting local production, a carbon price could put domestic energy-intensive, trade-exposed industries (EITEs), such as chemicals, cement/concrete, and steel, at a competitive disadvantage against international competitors that do not face an equivalent price. A shift in demand to those countries could result in “emissions leakage” from one country to another—reducing the climate benefit of a carbon price. All existing carbon pricing programs include mechanisms to address competitiveness concerns. These include allocations based on historical emissions, output-based allocations, exemptions for select sectors, and rebates. There is growing interest in a carbon border adjustment as a preferred approach to address emissions leakage and incentivize emission reductions.
Revenues – A carbon tax can raise significant revenue. How that revenue is used will ultimately be a political choice. Some or all of it could be returned to consumers in the form of a dividend. Alternatively, it could be reinvested in climate purposes, such as advancing low-carbon technologies or building resilience. Economic research suggests that using the revenues to reduce existing taxes on labor and capital—also known as a tax swap—can minimize the economic costs and may result in net economic benefits.
For governments, the choice of carbon pricing type is based on national circumstances and political realities. In the context of mandatory carbon pricing initiatives, ETSs and carbon taxes are the most common types. The most suitable initiative type depends on the specific circumstances and context of a given jurisdiction, and the instrument’s policy objectives should be aligned with the broader national economic priorities and institutional capacities. ETSs and carbon taxes are increasingly being used in complementary ways, with features of both types often combined to form hybrid approaches to carbon pricing. Some initiatives also allow the use of credits from offset mechanisms as flexibility for compliance.
Carbon pricing initiatives continue to be fine-tuned, adapting to new circumstances and incorporating lessons learned. Existing carbon pricing initiatives are evolving based on past experiences and upcoming initiatives try to learn from these experiences in their design.Various organizations have published studies to help governments and businesses develop efficient and cost-effective instruments to put a price on the social costs of emissions, including:
The World Bank Group, together with the OECD and IMF, set up the FASTER principles strategy, which are: F for fairness, A for alignment of policies and objectives, S for stability and predictability, T for transparency, E for efficiency and cost-effectiveness, and R for reliability and environmental integrity. The research draws on over a decade of experiences with carbon pricing initiatives around the world. It points to what has been learned to date: a well-designed carbon pricing initiative is a powerful and flexible tool that can cut GHG emissions, and if adequately designed and implemented, it can play a key role in enhancing innovation and smoothing the transition to a prosperous, low-carbon global economy.
In conclusion, all research indicates that Carbon Pricing is both environmentally and economically viable since it can:
Help facilitate emission pathways compatible with keeping global temperature rise to well below 2°C above pre-industrial levels and pursuing efforts to hold the increase to 1.5°C, as per the Paris Agreement.
Spur investment and innovation in clean technology by increasing the relative cost of using carbon-intensive technology. Businesses and individuals seeking cost-effective ways to lower their emissions will encourage the development of clean technology and channel financing towards green investments.
Promote the achievement of the Sustainable Development Goals by channeling financing to sustainable development projects.
Generate revenue which can be recycled into the green economy through government spending for research and development into green technology, helping vulnerable communities adapt to the effects of climate change, or managing the economic impacts of the transition to a low-carbon economy.
Create environmental, health, economic, and social co-benefits, ranging from public health benefits coming from reduced air pollution to green job creation.
References:
https://www.carbonpricingleadership.org
https://www.oecd.org › tax › tax-and-environment
https://www.indiabudget.gov.in/budget2015-2016/es2014-15/echapvol1-09.pdf
https://unfccc.int/about-us/regional-collaboration-centres/the-ciaca/about-carbon-pricing
https://www.imf.org/en/Publications/fandd/issues/2019/06/what-is-carbon-taxation-basics
https://www.c2es.org/content/carbon-tax-basics/
https://carbonpricingdashboard.worldbank.org/what-carbon-pricing
https://www.sciencedirect.com/science/article/abs/pii/S0959652623008521
https://www.iea.org/reports/the-potential-role-of-carbon-pricing-in-thailands-power-sector
https://www.ncbi.nlm.nih.gov/pmc/articles/PMC6473478/
Studies published by the World Bank –
State and Trends of Carbon Pricing 2021 (World Bank, 2021)
Emissions Trading in Practice: Handbook on Design and Implementation
Carbon Tax Guide: A Handbook for Policy Makers
Guide to Developing Domestic Carbon Crediting Mechanisms
A Guide to Greenhouse Gas Benchmarking for Climate Policy Instruments
EU ETS handbook – published by the European Union
