CARBON TAXES: KEY CONSIDERATIONS FOR POLICYMAKERS AND STAKEHOLDERS BY ROBERT KAINEG

REUTERS/TOBY MELVILLE

2 CARBON TAXES: KEY CONSIDERATIONS FOR POLICYMAKERS AND STAKEHOLDERS JANUARY 2013

Two primary methods have been used to introduce carbon prices, cap-and-trade markets and carbon taxes. While these approaches have some important differences, the challenges regulators face when designing carbon pricing schemes are remarkably similar. Here we discuss key design decisions facing governments instituting a carbon tax.

WHAT IS A CARBON TAX?A carbon tax is a direct levy on emissions for covered entities, it can take the form of special taxes on specific goods and fuels, or it may be economy wide. Under a direct carbon tax, compliant entities must report their emissions on an annual basis and pay a tax for each ton emitted. Another approach is a tax levied against specific fuels, such as coal or petrol/diesel, with the tax collect at the point of purchase based on the carbon content of the fuel. A related concept, currently implemented by South Africa, charges a tax on new passenger vehicles based on its emissions efficiency. A carbon tax delivers price certainty for market participants, but the quantity of emissions reductions achieved is uncertain because it can be difficult to predict exactly how covered entities will react.

Table 1: Pros and Cons of a Carbon Tax

PROS CONS

generate revenue for the public sector, and may be used to displace other taxes, such as corporate income tax or VAT.

business community, facilitating planning of investments.

do not require complex financial infrastructure to function.

reduction goals.

compliance” with target goals.

constituencies.

3 CARBON TAXES: KEY CONSIDERATIONS FOR POLICYMAKERS AND STAKEHOLDERS JANUARY 2013

GOALS OF A CARBON TAXIn general, GHG emissions are tied to energy use. The result of a carbon tax will thus be an increase in cost on users of energy. Therefore, when implementing a carbon tax, it is critical to consider the impact on domestic industries, sensitive constituencies, and international competitiveness. This can be a particularly difficult problem for jurisdictions where major domestic industries and fuel sources are emissions intensive.

For example, in regions where the power complex is almost entirely coal, a highly emissions intense fuel; the cost of a carbon tax are ultimately passed through to the residential, commercial, and industrial segments. Carbon taxation of residential heating and transportation fuels may have an especially burdensome impact on low income households, where energy costs make up a significant portion of overall revenue.

In general, policy makers need to balance carbon pricing regulation around a number of competing interests, including:

Achieving environmental targets and international commitments Regulators will want to ensure that their actions are sufficient to achieve their targets. As witnessed in the EU and other programs, it can be exceedingly difficult to properly predict the macro-economic trends that are major drivers of emissions growth. In many countries, such as Finland, taxes are periodically reviewed and may be increased as necessary. Other countries employ a steadily increasing tax. Any pricing flexibility built into the system should be well understood by the marketplace to avoid creating uncertainty.

Minimizing negative impacts on the broader economy and key constituencies In general, carbon taxes increase the cost of energy and fuel. This is the intended result of the tax, which is meant to provide an incentive for more efficient energy use and renewable energy, but may also create potential hardship for domestic industries and citizens.

Some industries, such as metals and mining, are both energy intense and trade exposed. Imposition of a unilateral carbon cost (relative to international competitors) can create an undue burden on these industries, resulting in economic losses as production shifts outside of the program. Under such a scenario, the environmental benefits are also lost, through a process called leakage. Therefore, a clear analysis of the carbon tax on the economic well-being of domestic stakeholders is critical to avoid economic losses, and also to ensure environmental benefits are not lost through leakage.

4 CARBON TAXES: KEY CONSIDERATIONS FOR POLICYMAKERS AND STAKEHOLDERS JANUARY 2013

There are a number of mechanisms that can be employed to mitigate unwanted negative effects. One approach, which has been used by the United Kingdom and British Columbia, is to make the

is used to offset personal income tax, business tax, or contributions to public insurance schemes. Making carbon taxes revenue neutral provides macroeconomic relief, but may not address industry competitiveness concerns. Many jurisdictions, including Finland, Sweden, and Boulder Colorado; reduce the effective tax rate for sensitive industrial segments.

field” between countries that implement emissions controls and those that do not. RFF conducted

Rebate, and Consumer Rebates across the electricity, oil, chemicals, non metallic minerals, iron and steel, and pulp paper and print industries. They found that border adjustment policies differed in effectiveness based on the industry type, but could be used to protect domestic industry and still be World Trade Organization compliant. DESIGN FEATURES OF A CARBON TAXBased on the desired outcomes of a carbon tax, regulators can choose specific features that will determine how the policy will affect the economy broadly, and individual stakeholder groups. Below, critical decision points are identified and briefly discussed.

WHAT AND WHO WILL BE TAXED? EMISSIONS, ELECTRICITY, FUEL, PRODUCTS?Determining the commodities on which the tax will be levied is a key first step of policy design. While it may seem obvious to tax the emissions themselves, this approach can be difficult to implement because it requires new infrastructure and procedures for measuring GHGs, and is only practical for the largest emitters or other entities already required to report annual emissions.

Many jurisdictions mandate a cost of carbon, or CO2, then calculate the embedded GHG emissions of various fuels on a per unit basis, and then apply a surtax at the point of purchase. For industries such as mining, emissions intensity (as measured per unit of output) will vary significantly based on the quality if extracted material and the amount of processing needed to isolate the valuable component. By taxing the fuels and power specifically, existing systems for tracking their respective distribution can be used to monitor and enforce the carbon tax.

Additionally, regulators will need to decide what segments of the economy should be subject to the tax. For example, in Boulder Colorado there is a carbon tax levied only on electricity which is paid by the utility, who in turn charges their customers. Transportation fuels are often a major source of emissions, however taxing them has an immediate impact on consumers, which may be undesirable. Many jurisdictions, such as British Columbia, cover all fuels and power sold within their borders.

5 CARBON TAXES: KEY CONSIDERATIONS FOR POLICYMAKERS AND STAKEHOLDERS JANUARY 2013

WHERE IS THE OPPORTUNITY TO REDUCE?In addition the practical necessity of data collection and enforcement, it will be the duty of regulators to consider which segments of the economy have real opportunities to reduce emissions. For example, electricity generators may find it difficult to achieve meaningful emissions reductions if low-carbon generation assets are not available. Thus any short-term emissions reductions will be generated through reducing demand or improving efficiency.

One key goal of introducing emissions pricing is to generate demand for low carbon technologies, driving innovation and creating new industries. An additional consideration, related to reduction opportunities, is whether or not the technologies to achieve reductions can be sourced locally. If there is no local capacity to produce, install, and operate low carbon solutions the costs of compliance will be higher and the tax will cause capital will flow out of the country when low carbon goods are imported.

Carbon taxes can be targeted to support specific fuels and technologies, which regulators favor for use in their region. This support is not limited to investments made with collected revenues; although many regions choose do re-invest collected taxes into green projects. Both Finland and the United Kingdom, for example, mandate lower tax costs for combined heat and power (CHP) facilities. Sweden’s carbon tax, on the other hand, has resulted in increased biomass use for heating and industry, because these fuels are considered renewable under their program.

WHAT SHOULD BE DONE WITH COLLECTED REVENUES?Many programs have explicit restrictions on how carbon tax revenue can be used. The most common stipulations include:

the expense of carbon intense industries.

Market based approaches are an important tool for incentivizing GHG mitigation. By reflecting the real cost of pollutants, regulators can incentivize green growth and generate significant non-GHG benefits to public health and natural resources. Fees collected through climate legislation can also be used to offset other taxes, such as corporate income or payroll taxes, or to ameliorate the impact of the regulation on sensitive constituencies. Carbon taxes can also be used to target specific sectors or activities identified has having an undue impact on the emissions profile of the country, i.e. taxing coal, providing a disincentive for targeted behaviors.

© 2013 Thomson Reuters FR-1002160 0213

ABOUT THE AUTHORRobert Kaineg is a consultant with Thomson Reuters Commodities and Energy Advisory practice. His work has focused on translating energy and environmental policy into business impacts for clients in the public and private sector through economic forecasting, project valuation, and strategy development. He holds an M.S. in Economics.

More information about Thomson Reuters Commodities and Energy Advisory practice can be found at http://www.pointcarbon.com/advisory

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