The Role of Fiscal and other Market-based

Instruments in an Eco-efficient Supply Chain

Management

A thesis submitted to the Bucerius/WHU Master of Law and Business Program in partial

fulfillment of the requirements for the award of the Master of Law and Business (“MLB”)

Degree

Joana Teresa Simão Costa

July 20, 2012

13.427 words (excluding footnotes and citations)

Supervisor 1: Dr. Stefan Spinler

Supervisor 2: Florian Lechner

Acknowledgements

I would like to thank everyone who helped me write my thesis. In particular, I owe sincere and

earnest thankfulness to my supervisors, Dr. Stefan Spinler and Florian Lechner, for the support and

guidance they showed me throughout my thesis writing. Their contribution was extremely valuable

and made this thesis possible.

Finally, I would also like to thank my parents and Philip, for the undivided support and interest,

for reviewing my paper and for inspiring me and encouraging me along the way.

Correspondence concerning this paper should be addressed to Joana Costa. Email:

joana.costa@law-school.de.

“The material shrinking of rewards and lightening of penalties, the

whittling away of stick and carrot”

The Economist. December 11, 1948.

IV

Table of contents

Table of contents ......................................................................................................................... IV

List of abbreviations .................................................................................................................... VI

Abstract ...................................................................................................................................... VII

1 Introduction ......................................................................................................................... 1

2 Direct Carbon Pricing .......................................................................................................... 3

2.1 Environmental Taxation .................................................................................................. 3

2.1.1 Tax Policy as a Carbon Efficiency Driver ............................................................... 3

2.1.2 Carbon Tax («sticks») ............................................................................................. 6

2.1.2.1 Description ............................................................................................................ 4

2.1.2.2 Strengths and weaknesses ..................................................................................... 4

2.1.2.3 Current examples (See Appendix A) .................................................................... 5

2.1.3 Indirect Taxation / VAT .......................................................................................... 6

2.2 Fiscal and non-fiscal incentives («carrots») .................................................................... 7

2.2.1. Description .............................................................................................................. 7

2.2.2 Strengths and weaknesses ........................................................................................ 7

2.2.3 Current examples (See Appendix B) ....................................................................... 8

2.3 Emissions Trading Scheme (ETS) ................................................................................... 9

2.3.1 Description .............................................................................................................. 9

2.3.2 Strengths and weaknesses ........................................................................................ 9

2.3.3 Current examples ................................................................................................... 11

2.3.3.1 The Kyoto Protocol ............................................................................................. 11

2.3.3.2 European Union Emissions Trading Scheme (EU ETS) ..................................... 14

2.3.3.3 National and regional trading schemes (See Appendix C) .................................. 16

2.4 Carbon Leakage – the common denominator ................................................................ 17

3 Indirect Carbon Pricing ..................................................................................................... 19

3.1 Command and Control Instruments and other non-market based instruments .............. 19

3.1.1 Regulation.............................................................................................................. 19

3.1.2 Voluntary agreements and social commitments .................................................... 20

3.1.3 Social commitments .............................................................................................. 20

3.1.4 Labeling schemes and marketing campaigns ........................................................ 21

V

4 Proposed approach: combining and linking ...................................................................... 22

4.1 Hybrid policy ................................................................................................................. 22

4.2 Complementary measures ............................................................................................. 24

4.3 The need for carrots ....................................................................................................... 25

4.4 Link by link toward a global market ............................................................................. 27

4.5 Timeline for Country X ................................................................................................. 29

5 Low-carbon Business Model ............................................................................................. 31

5.1 Making sustainable decisions ........................................................................................ 31

5.2 Reduction of costs, reduction of risk and revenue increase........................................... 32

5.3 Securing a competitive advantage ................................................................................. 34

5.4 Guidelines for Sustainable Supply Chain Management (SSCM) .................................. 35

6 Conclusion ......................................................................................................................... 39

Reference List ............................................................................................................................. 41

Appendix A ................................................................................................................................. 48

Appendix B ................................................................................................................................. 49

Appendix C ................................................................................................................................. 51

Appendix D ................................................................................................................................. 52

VI

List of abbreviations

CDM Clean Development Mechanism

CER Certified Emissions Reduction credit

CO2 Carbon Dioxide

ERU Emissions Reduction Unit

ETS Emissions Trading Scheme

EU European Union

GHG Greenhouse Gas

IPCC Intergovernmental Panel on Climate Change

JI Joint Implementation

NBS Network for Business Sustainability

OECD Organization for Economic Cooperation and Development

R&D Research and Development

RGGI Regional Greenhouse Gas Initiative

SCM Supply Chain Management

SME Small and Medium-sized Enterprise

SSCM Sustainable Supply Chain Management

UNFCCC United Nations Framework Convention on Climate Change

VAT Value Added Tax

WBCSD World Business Council for Sustainable Development

VII

Abstract

This paper aims at analyzing how fiscal and other market-based instruments can affect and in

particular foment business strategies and initiatives toward a sustainable supply chain management, as

well as how these instruments can deter corporate activities which harm the environment. The focal

point is the role of these instruments on the reduction of carbon dioxide (CO2) emissions – the main

greenhouse gas (GHG) responsible for global warming.

Climate change is a paramount issue that urges tackling in a consistent and far-reaching manner

and the reduction of CO2 emissions is a major step in that direction. This study focuses on three

market-based instruments as a way to achieve a low carbon economy: carbon taxes, emissions trading

schemes (ETSs) and incentives. However, it will also perfunctorily address other like-aimed

instruments, such as regulation, indirect taxation, social commitments, voluntary agreements and

information policies.

The analysis conducted in this study provides a theoretical approach of the different policy

instruments and uses national and regional examples to reach a final recommendation for a low-carbon

policy. Moreover, it attempts to show companies that investing in green initiatives can not only reduce

costs, but also provide attractive returns and position one-self in a competitive advantage situation.

There is still a long way to go and what is herein proposed can only be accomplished by global

action. Governments, institutions, companies, consumers and other environment stakeholders must act

together locally. In addition, a coherent and unidirectional strategy must be created on the international

level.

1

1 INTRODUCTION

Doing business today means paying attention to its impact on the environment. Bold headlines

report an inevitable 2ºC increase in global temperature due to the soaring of GHG emissions. The

Intergovernmental Panel on Climate Change (IPCC) has predicted a sea-level rise of up to 59cm,

which is already considered by the scientific community as “too modest” (“Special Report”, 2012).

Environmental impacts caused by resource intensive configurations are accumulating on a global scale

and are putting an increasing pressure on the planet.

The transformation the world is currently going through is unmatched in history; it is the

greatest environmental change ever created by humans. The major cause of global warming is clear: it

is the outcome of an escalation in atmospheric gases that lock in the heat and that consist essentially of

CO2 that is released when fossil fuels are burned (“Special Report”, 2012). This is the result of human

activity and it must be halted.

Furthermore, and notwithstanding the huge adverse impact these environmental changes will

have on mankind, they also present economic opportunities. Mainly in the Arctic, the unfreezing

means suitability of the land for agriculture and mining of minerals like zinc, gold, iron and nickel.

The area also has oil and gas and licenses for the exploration are already being issued (“Special

Report”, 2012).

As a result, any adopted environmental policy needs to be aggressive enough to make the

reduction of GHG emissions worth its costs. In the case of an environmental taxation policy, the costs

of being subject to fiscal and other market-based instruments must be kept lower than the costs of

pollution.

Modern environmental policy was born in the early 1970s and it has, since then, come a long

way. Long gone are the years of Milton Friedman (1970), when some believed that the only social

responsibility of a company was to generate profit for its shareholders. Nowadays, governments,

companies, stockholders, investors and consumers know that the protection of the environment is not

only a shared responsibility, but also an opportunity to create value. Nevertheless, the outcomes of

international conferences continue to make the scientific community and, to a certain extent, public

opinion disappointed and to fall short of expectations. A major reason appointed for this slow progress

is the global financial crisis, which is monopolizing the attention of managers and governments. A

representative number of companies is, however, taking action and is ready to go further, but

governments must set the framework policy and international coordination is key.

2

In June 2012, Rio de Janeiro hosted Rio+20 – the United Nations Sustainable Development

Conference. The Conference's main formal declaration did not include one of the most important

proposals – the one for the disapproval of fossil fuels subsidies. Moreover, the support for green taxes

was left behind. “This is a missed opportunity as integrating sustainability into business plans can

actually be part of pro-growth economic strategy, as GE, Siemens, Unilever, and many other

companies are showing” (Jenkinson, 2012).

In its Vision for 2050, the World Business Council for Sustainable Development (WBCSD)

highlights the need for a price of goods and services that comprises all their costs and benefits –

“economic, social and environmental” (WBCSD, n.d. a, p. 2). The carbon price would be one of these

costs – “the impact of CO2 emissions from the product or service on the environment” (WBCSD, n.d.

a, p. 2) – and it would be included in the full price. WBCSD further clarifies that, by determining a

carbon price, goods and services would be distinguished according to their carbon footprints1 and this

would influence consumers’ preferences and their decision to buy, because the price of products or

services whose manufacturers or providers incurred the cost of carbon would be above the market

price.

In this paper, I suggest how direct and indirect carbon pricing methods can help creating an eco-

efficient supply chain management; how, among others, measures like establishing a carbon tax or an

emissions trading scheme (ETS) or fiscal benefits can create the right incentives for companies to

reduce their CO2 emissions. Also, how these different methods can be combined in order to achieve an

optimal outcome, i.e. the highest level of emissions reduction possible at the lowest cost. This will,

ultimately, make way for the attainment of the emissions targets that countries struggle to establish

and execute. In the last section of this paper, I present the benefits that companies can reap from

climate change and how they can position themselves in a competitive advantage situation. Moreover,

I describe a framework on which companies can base their low-carbon strategy.

Throughout this paper I apply the terms GHG, carbon and CO2 as equivalents, when referring to

emissions. Carbon is an atom and CO2, or carbon dioxide, is the molecule that combines one carbon

atom and two oxygen atoms. Carbon dioxide is believed to be the GHG with the highest contribution

to global warming.

1 “The carbon footprint of a product is the net change in global carbon emissions as a result of the production and use

of that product” (WBCSD, n.d. a, p. 2).

3

2 DIRECT CARBON PRICING

2.1 Environmental Taxation

2.1.1 Tax Policy as a Carbon Efficiency Driver

The use of fiscal instruments to achieve environmental objectives is an increasing practice, as

companies’ corporate responsibility becomes wider and the need for a binding solution to tackle

climate change becomes steeper.

In principle, taxation can serve varied purposes, the most popular being the collection of

revenues for government undertakings and the encouragement or deterrence of a certain behavior or

practice. Taxes related to environmental matters can aim at achieving both of these goals.

The rationale of environmental taxation lies on the concept of externalities: “impacts on the

environment, and perhaps thence on people, which are side-effects of processes of production and

consumption and which do not enter into the calculations of those responsible for the processes”

(Ekins, 1999, p. 41). Fossil fuels release high amounts of GHG to the environment, creating multiple

externalities. For that reason, they are a major focus of environmental taxation. To tax GHG emissions

or to tax the activity or the product that generates the GHG is to internalize the external cost of the

processes that harm the environment.

These taxes are called Pigovian taxes2 and they correspond to the polluter pays principle, which

prescribes that the one responsible for the environmental harm should be the one liable for all the costs

involved.

When establishing an environmental tax, the following issues, inter alia, must be considered:

what activity is to be taxed; how to find the tax base and to calculate the tax rate; who the tax debtor

is; what fiscal period is to be considered; how the tax is to be administrated and how will the revenue

collected be applied (Bakker, 2009, p. 13). The answer to these questions varies from tax to tax and

from country to country and it depends on the national environmental policy.

In this chapter, I will analyze the following types of environmental taxation: carbon tax and

indirect taxation and environmentally-related fiscal incentives.

2 Pigovian taxes are applied to a distorted market outcome, in particular negative externalities. These taxes correct the

externalities by making the originator pay for them. The name comes from Arthur Pigou, a British economist who wrote The

Economics of Welfare (1920), where he introduced this concept.

4

2.1.2 Carbon Tax («sticks»3)

2.1.2.1 Description

A carbon tax is imposed directly by the government and is a tax on the level of CO2 emissions at

a certain point in time. Its payment, i.e. the tax rate, is based on the carbon concentration of the fuel

being released (coal, oil or natural gas).

What countries try to do is to measure the amount of fuel being burned and the amount of

carbon in the fuel. By knowing this, they can estimate the amount of CO2 being released and thus the

tax rate. This can be a very time-consuming and complex endeavor, so the IPCC published guidelines

for estimating emissions on all GHG and these became part of the United Nations Framework

Convention on Climate Change (UNFCCC)4.

Often these taxes are too low to have a material effect on the emissions. The tax rate must be

high enough to make pollution more expensive than its reduction.

2.1.2.2 Strengths and weaknesses

As Bakker (2009) describes, taxing CO2 encourages companies to invest on the reduction of

their emissions “until the point where eliminating one more unit of pollution equals the costs of

incurring tax on it” (Bakker, 2009, p. 14). This means that a carbon tax fixes the marginal cost for

carbon emissions and allows quantities emitted to adjust.

In general, a carbon tax is favored by its simplicity; it is easy to understand and implement. But

tax rules may convey many technical details and this can undermine the simplicity aspect. Therefore,

when establishing a carbon tax, policy-makers must a priori conduct a sufficient analysis of the

industries affected and of what would be a tax rate able to produce the desired outcome – the reduction

of carbon emissions.

A carbon tax has the potential to reach more emitters than an ETS: while prohibitive transaction

costs would prevent an ETS from applying to individual consumers, a tax on carbon emissions can

apply to everyone (e.g. tax on gasoline) (Baumert, 1998). However, too broad of a scope can also

make the interpretation and enforcement of taxation rules too complex.

Furthermore, it can also be argued that, on a long-term perspective, taxes are more efficient than

an ETS because the latter, by spurring the use of clean technologies and renewable energies, will lead

3 A common metaphor for these matters is the one of carrots and sticks, representing benefits and penalties as

behavior-drivers.

4 These guidelines can be found on the IPCC website. Cf. http://www.ipcc-nggip.iges.or.jp/public/2006gl/index.html.

5

to a reduction in the price of the allowances and thus also to a reduction in the incentive to cut

emissions (Baumert, 1998). This is, however, already provided for in most ETSs, by including a

gradual reduction of the total amount of allowances available.

In any event is the creation of a tax free of obstacles. Kosonen and Nicodème (2009, pp. 7-9)

describe the main objections that are usually raised: (a) the harm to firms’ competitiveness and (b) the

unequal income distribution among households.

(a) Environmental taxes increase the cost of production, which may reduce the competitiveness

of the firms located in the country where the taxes are levied, in relation to foreign competitors. A

logical consequence would be for firms to relocate to countries where carbon taxes are lower or even

inexistent. This phenomenon is known as carbon leakage5. Kosonen and Nicodème (2009, p. 9)

suggest that countries should use tax incentives to protect their most vulnerable industry sectors

against the increased cost. In any case, the competitiveness effect is often exaggerated. After all, heavy

polluters should bear the additional cost of carbon tax and they can also improve their competitiveness

by investing in eco-efficient projects and technologies (Ekins, 1999, p. 60).

(b) Households with a lower income spend, in relative terms, more of their income in basic

goods, like energy, water or transport. Since these goods are a focus of environmental taxation, this

would generate a disproportionate burden on those households. Also here Kosonen and Nicodème

(2009, p. 8) suggest that using tax incentives can eliminate this adverse effect, by compensating the

low-income households. Ekins (1999, p. 59) suggests “to have a tax-free threshold for essential use of

the taxed product” or to “introduce the tax progressively, with higher taxation on successive blocks of

consumption”.

Moreover, taxes levied on such a volatile matter as the environment can struggle to adapt to

sudden changes in the targeted sectors, namely to inflation and “changing supply and demand

conditions in an industry, which may cause marginal externalities to alter” (Tisdell, 1993, p. 97).

2.1.2.3 Current examples (See Appendix A)

In Appendix A, Table 1 lists some of the existing and proposed carbon taxes. In this section, I

refer to two of those taxation policies.

The Canadian province of British Columbia established in July 2008 a revenue-neutral6 carbon

tax, which is currently being reviewed. This tax is fairly broad, applying to every fossil fuel consumer

in British Columbia. In order to compensate the payers of the carbon tax, there are several measures in

5 Carbon leakage is analyzed in section 2.4 of this paper.

6 A tax is revenue-neutral if the amount collected by the Government is then used to reduce other taxes.

6

place: “income tax credits for low income individuals, cutting the first two personal income tax rates

by 5 per cent, providing northern and rural homeowners a benefit of up to $200 annually, and reducing

the business taxes” (“Carbon Tax”, n.d.).

South Africa announced in its budget for 2012 the creation of a carbon tax in 2013. The tax

will apply to CO2 equivalents. In the first phase (2013-2019), there will be tax free thresholds available

for all targeted industries and in the second phase (2020-2025) these will be reduced. Some sectors,

more exposed to trade, will enjoy an extra relief. So far, there is no planned application for the

revenues collected from the levying of the carbon tax (PwC, 2012).

2.1.3 Indirect Taxation / VAT

The main way Value Added Tax (VAT) can contribute for a climate change mitigation policy is

by contemplating differentiated rates, whereby environmentally-friendly goods and services would be

traded at reduced VAT rates.

As Kosonen and Nicodème (2009, pp. 14 ff.) show, the general tendency is, however, to

harmonize VAT rates, mainly because this way the tax is easier to administrate, it is more stable and it

reduces the risk of cross-border trade distortions. Furthermore, Kosonen and Nicodème (2009, p. 18)

also call attention for the fact that, since a large share of carbon intensive sectors is already covered by

ETSs, adding differentiated VAT rates would discourage the use of CO2 emitting products and thus

decrease the price of carbon allowances while leaving the level of carbon emissions untouched.

Such method would only be effective if it would target goods or services that per se contribute

to carbon emissions. “It would not be effective if applied to goods whose production processes

contribute to environmental pollution. Indeed, its effects could be quite counterproductive as it

provides a firm with no incentive to reduce its level of emissions” (Soutter, 1993, p. 109).

In conclusion, indirect taxation should not take part in an environmental tax policy, because any

beneficial effect would only be marginal.

7

2.2 Fiscal and non-fiscal incentives («carrots»7)

2.2.1 Description

Governments can incentivize companies to shift to clean technologies and production methods

in two major ways: by alleviating their tax burden – fiscal incentive – or by granting them subsidies.

A fiscal incentive is a preferential tax treatment, most frequently in the form of tax credits or tax

exemptions. This can be a very effective method to halt pollution and to foster environmentally-

friendly behaviors. Fiscal incentives encourage producers to choose less carbon-intensive inputs and to

invest in cleaner methods of production and they also incite consumers to opt for “greener” products.

They can assume several forms: reduced rates, tax credits, tax exemptions, tax holidays, expenditure

deductions and accelerated depreciation.

Regarding direct subsidies, one of the biggest debates pertains to the grants that support carbon

intensive activities. Public concern increasingly directs itself towards absolute removal of fossil fuels

grants, mainly because fossil fuel subsidies dissuade companies from shifting to sources with lower

emissions levels and hinder the development of renewable energies (Jenkinson, 2012).

Every incentive should be directed at promoting the development of low carbon and adaptation

technologies, “especially through the development and implementation of cost effective regulatory

frameworks for their deployment (e.g. carbon capture and storage8 … vehicle efficiency standards,

fuel quality standards) as well as through the development of appropriate financial support schemes”

(“Combating climate”, n.d.).

2.2.2 Strengths and weaknesses

In the case of fiscal incentives, the requirements for their applicability are often detailed and

very technical, but the final result of compliance is usually worth the effort. Tax benefits rules can, as

almost any other tax provision and also due to their political nature, be intricate and complex and tax

payers may find it hard to qualify for the requirements. This might happen for several reasons, such as:

the specificity of the benefit, whose scope does not comprise the applicant; the temporary nature of the

7 A common metaphor for these matters is the one of carrots and sticks, representing benefits and penalties as

behavior-drivers.

8 Carbon capture and storage (or sequestration) consists of capturing CO2 from power generators and other heavy

emitters and transporting it to geological formations, where it is stored. This technique has the potential to reduce carbon

dioxide emissions from fossil fuel power stations by as much as 90% by 2050.

8

benefit and the need for great amounts of documentation or a high level of bureaucracy (Nellen and

Miles, 2007, pp. 61, 62).

On the one hand, when drafting the provisions, policy makers must keep these challenges in

mind and try to reach a balance between accuracy, which might require more detail or technical terms,

and flexibility, so that businesses which invest in driving their GHG emissions down are able to

receive the preferential tax treatment. On the other hand, taxpayers must “perform a cost benefit

analysis before pursuing the incentive” (Nellen and Miles, 2007, p. 62).

Notwithstanding the caveat, it is reasonable to say that carrots work better than sticks. While

penalties relate to the nonobservance of minimum standards, incentives can give a prize to the

businesses with the best performances. In better words, sticks work optimally when combined with

carrots.

2.2.3 Current examples (See Appendix B)

In Appendix B, Table 2 lists different incentives implemented by several countries, in order to

encourage environmentally-friendly practices and to spur innovation and the development of clean

technologies and production methods.

It is up to the companies to structure their “green projects” in a way that makes them eligible for

the incentives available on a national or regional level. Wagner and Tarney (n.d., p. 2) provide some

examples of measures that can, depending on the national policies, qualify for tax benefits:

a) “Installing pollution control equipment;

b) Investing in energy-efficient buildings or components;

c) Manufacturing products from recycled materials;

d) Investing in systems to capture items from a company’s waste stream for recycling or

use by others;

e) Undertaking environmental remediation activities;

f) Adapting manufacturing or other processes to use alternative energy sources such as

solar, wind, and biomass; and

g) Producing alternative fuels for vehicles or using alternative fuels to power a company’s

own fleet.”

9

2.3 Emissions Trading Scheme (ETS)

2.3.1 Description

An ETS provides the framework for carbon to be traded in the form of credits or allowances.

The purpose of an ETS – also known as a cap-and-trade program – is, like in the case of a direct tax on

GHG emissions, to factor into the polluter’s costs what would be economic externalities and to reduce

emissions. The idea is that if one wants to emit, one must purchase an allowance (or sacrifice the

opportunity to sell one). This way, production costs go up and incentives to reduce emissions are

created.

The market for carbon emissions allowances experienced a steep growth before the financial

crisis in 2008. Now, as the world slowly recovers from the crisis, the trading venues are also expected

to pull through by increasing the trading volumes and the number and quality of participants, namely

institutional investors.

Carbon allowances are currently traded in several secondary markets. Haskins (2009, pp. 385,

386) describes the most important carbon-related exchanges: in Europe, there is the European Climate

Exchange (ECX) in London, the European Energy Exchange (EEX) in Leipzig and NordPool in Oslo.

“The ECX offers futures contracts in both EUAs and CERs. NordPool offers both spot and forward

contracts in EUAs and forward contracts in CERs” (Haskins, 2009, pp. 385, 386). The EEX offers

spot, futures and options in EUAs. In the US, there is the Chicago Climate Exchange, the Chicago

Climate Futures Exchange and The Green Exchange9.

2.3.2 Strengths and weaknesses

A well-functioning ETS has flexibility as its major advantage. Once the market for carbon

emissions allowances is solidly established, companies can choose to reduce their emissions where it

is cheaper for them (Baumert, 1998). Moreover, by reducing their emissions to a level below their

assigned amount, companies can profit from selling the allowances. Finally, if there are linking

possibilities attached to the scheme, i.e. if credits from other low-carbon mechanisms are accepted,

flexibility reaches its optimal point. Flexibility also means that an ETS can adjust to “inflation and

external price shocks” (Baumert, 1998).

An ETS is also more prone to survive a multiparty negotiation, when compared to taxes

(Baumert, 1998). Even though the current state of international negotiations on environment-related

9 Besides the exchange trades, carbon units can also be traded privately, via bilateral contracts, or in voluntary

markets (Haskins, 2009, p. 386).

10

matters is seeing a very slow progress, the imposition of an international carbon tax seems, mainly for

sovereignty reasons, incredibly more unlikely than the (phased) establishment of a global ETS, or at

least the establishment of a legal connection between the several ETSs.

Finally, an ETS has the potential to incentivize economic recovery and innovation, by

encouraging companies to invest in clean technologies.

The European Commission, in its 2009 report on the EU ETS, provides a very illustrative

example on the benefits of such a mechanism (see box 1).

Box 1 – ETS case study

Source: (European Commission, 2009, p.10)

As to the challenges the emissions market faces, one can start by pointing out its rather young

age (Hill, Jennings and Vanezi, 2008, p. 7): it is still relatively new and thus does not yet have a solid

record that would allow regulators to optimize it. This presents two main problems: the tax treatment

of carbon units and the insufficiency of information.

Regarding the first issue, in Europe, there is a weak harmonization regarding the treatment of

carbon credits within income tax. In the US, carbon allowances are either tax deductible, if they are

applied, or deemed capital gain or loss, if they are sold or exchanged (Haskins, 2009, pp. 386, 387).

Haskins (2009) argues that, as environmental policies shift toward a global scale, it would be desirable

Companies A and B both emit 100 000 tonnes of CO2 per year. Let us say their governments give each of them

emission allowances for 95 000 tonnes, leaving them to find ways to cover the shortfall of 5 000 allowances. This

gives them a choice between reducing their emissions by 5 000 tonnes, purchasing 5 000 allowances in the market

or taking a position somewhere in between. Before deciding which option to pursue they compare the costs of

each. Let us imagine that the market price of an allowance at that moment is € 20 per tonne of CO2. Company A

calculates that cutting its emissions will cost it € 10 per tonne, so it decides to do this because it is cheaper than

buying the necessary allowances. Company A even decides to take the opportunity to reduce its emissions not by

5 000 tonnes but by 10 000. Company B is in a different situation. Its reduction costs are 30€ per tonne, i.e.

higher than the market price, so it decides to buy allowances instead of reducing emissions. Company A spends €

100 000 on cutting its emissions by 10 000 tonnes at a cost of € 10 per tonne, but then receives € 100 000 from

selling the 5 000 allowances it no longer needs at the market price of € 20 each. This means it fully offsets its

emission reduction costs by selling allowances, whereas without the emissions trading scheme it would have had

a net cost of € 50 000 to bear (assuming that it cut emissions by only the 5 000 tonnes necessary). Company B

spends € 100 000 on buying 5 000 allowances at a price of € 20 each. In the absence of the flexibility provided by

the ETS, it would have had to cut its emissions by 5 000 tonnes at a cost of € 150 000. Emissions trading thus

brings a total cost-saving of € 100 000 for the companies in this example. Since Company A chooses to cut its

emissions (because this is the cheaper option in its case), the allowances that Company B buys represent a real

emissions reduction even if Company B did not reduce its own emissions.

11

for the OECD to come up with a set of rules to guide national taxation systems on how to treat carbon

credits.

As to the second issue, the short years of the emissions market mean that the participants, both

the companies’ practitioners and the investors, lack the desirable experience (Hill et al., 2008, p. 7).

Hence, there must be a consistent and extensive training policy and transparency in the market must be

improved, so that investors are provided with a reasonable amount of the relevant information.

Moreover, reporting from companies on emissions quantities and green strategies must be more

frequent and clearer, in order to build confidence within the market (Hill et al., 2008, pp. 7, 8).

When defining the rules for the functioning of an ETS, policy-makers must include a provision

that prevents the creation of an allowances monopoly; “this can happen if the environmental use

covered by the permit is essential to the operation in the industry and permits fall into the hands of one

or a few holders” (Tisdell, 1993, p. 99).

Finally, the need for detailed, far reaching and enforceable reporting and monitoring provisions

makes this mechanism more appropriate for large emitters. For smaller companies, the administrative

costs of measuring and reporting can be rather prohibitive.

2.3.3 Current examples

2.3.3.1 The Kyoto Protocol

The Kyoto Protocol (hereinafter the Protocol) was negotiated in Japan in 1997 and it came into

force on 16th February 2005, as an amendment to the UNFCCC (signed by 166 countries in 1992). The

purpose of this international treaty is to take the UNFCCC’s goal of bringing the GHG concentrations

to a point that will avoid “dangerous anthropogenic interference”10

with the environment a step

further, by creating binding commitments on the reduction of those emissions. This commitment

10 Article 2 of the UNFCCC, which reads (cf.

http://unfccc.int/essential_background/convention/background/items/1349.php): The ultimate objective of this Convention

and any related legal instruments that the Conference of the Parties may adopt is to achieve, in accordance with the relevant

provisions of the Convention, stabilization of greenhouse gas concentrations in the atmosphere at a level that would prevent

dangerous anthropogenic interference with the climate system. Such a level should be achieved within a time-frame sufficient

to allow ecosystems to adapt naturally to climate change, to ensure that food production is not threatened and to enable

economic development to proceed in a sustainable manner.

12

period started on 1st January 2008, it will end by the end of the current year

11 and it applies only to the

parties listed in Annex I of the Protocol.

The emissions limitation or reduction commitment regarding the GHG listed in Annex A12

is

quantified in Annex B of the Protocol for each of the Annex I signatories. As a result, countries know

their assigned amounts of GHG, i.e., the allowed level of emissions. These assigned amount units

(AAUs) are then distributed by the national governments to the companies in the respective countries.

Countries with extra emission units can, according to article 17 of the Protocol13

, sell them to countries

which have gone over their limit. If countries emit beyond their cap and cannot buy extra credits, they

are subject to penalties, which are to be defined by the signatory Parties.

In addition to these emissions trading units, companies can obtain other trading units via two

mechanisms that the Protocol contemplates: Clean Development Mechanism (CDM), governed by the

CDM Executive Board, and Joint Implementation (JI)14

, governed by the JI Supervisory Committee.

Both mechanisms are naturally also under the supervision of the UNFCCC. These instruments are

based on the fact that, regardless of where GHG are emitted, they contribute identically for global

warming and companies can reduce their emissions where it is cheaper.

The CDM is defined in Article 12 of the Protocol and it assists “Parties included in Annex I in

achieving compliance with their quantified emissions limitation and reduction commitments under

Article 3”15

, by allowing them to get Certified Emissions Reduction credits (CERs) as a result of the

implementation of emissions reduction projects in signatory countries not included in Annex I.

11 A clear second commitment period is not yet in place, due to the failure to reach a consensus during the past UN

Climate Conferences. The outcome of the Conference in Durban was merely a decision by the Parties to adopt a universal

binding agreement on climate change as early as possible and no later than 2015. The Parties agreed on the start of the

commitment period in 2013 and the end either in 2017 or 2020, but there are no clearly determined targets. Moreover,

Canada, Japan and Russia already announced their intentions of not participating.

12 The GHG contemplated in the Protocol are: carbon dioxide (CO2), methane (CH4), nitrous oxide (N20),

hydrofluorocarbons (HFCs), perfluorocarbons (PFCs) and sulphur hexafluoride (SF6).

13 Article 17 of the Kyoto Protocol reads (cf. http://unfccc.int/essential_background/kyoto_protocol/items/1678.php):

The Conference of the Parties shall define the relevant principles, modalities, rules and guidelines, in particular for

verification, reporting and accountability for emissions trading. The Parties included in Annex B may participate in emissions

trading for the purposes of fulfilling their commitments under Article 3. Any such trading shall be supplemental to domestic

actions for the purpose of meeting quantified emission limitation and reduction commitments under that Article.

14 These mechanisms do not provide for direct trading of emission units, but the units they generate can be transferred

to the Protocol’s ETS and they equal to one tonne of CO2.

15 Article 12 of the Kyoto Protocol reads (cf. http://unfccc.int/essential_background/kyoto_protocol/items/1678.php):

1. A clean development mechanism is hereby defined. 2. The purpose of the clean development mechanism shall be to assist

Parties not included in Annex I in achieving sustainable development and in contributing to the ultimate objective of the

13

The JI is defined in Article 6 of the Protocol and it applies to projects from an Annex I Party in

another such Party. These projects have to be “aimed at reducing anthropogenic emissions by sources

or enhancing anthropogenic removals by sinks of greenhouse gases”16

.

Convention, and to assist Parties included in Annex I in achieving compliance with their quantified emission limitation and

reduction commitments under Article 3. 3. Under the clean development mechanism: (a) Parties not included in Annex I will

benefit from project activities resulting in certified emission reductions; and (b) Parties included in Annex I may use the

certified emission reductions accruing from such project activities to contribute to compliance with part of their quantified

emission limitation and reduction commitments under Article 3, as determined by the Conference of the Parties serving as the

meeting of the Parties to this Protocol. 4. The clean development mechanism shall be subject to the authority and guidance of

the Conference of the Parties serving as the meeting of the Parties to this Protocol and be supervised by an executive board of

the clean development mechanism. 5. Emission reductions resulting from each project activity shall be certified by

operational entities to be designated by the Conference of the Parties serving as the meeting of the Parties to this Protocol, on

the basis of: (a) Voluntary participation approved by each Party involved; (b) Real, measurable, and long-term benefits

related to the mitigation of climate change; and (c) Reductions in emissions that are additional to any that would occur in the

absence of the certified project activity. 6. The clean development mechanism shall assist in arranging funding of certified

project activities as necessary. 7. The Conference of the Parties serving as the meeting of the Parties to this Protocol shall, at

its first session, elaborate modalities and procedures with the objective of ensuring transparency, efficiency and

accountability through independent auditing and verification of project activities. 8. The Conference of the Parties serving as

the meeting of the Parties to this Protocol shall ensure that a share of the proceeds from certified project activities is used to

cover administrative expenses as well as to assist developing country Parties that are particularly vulnerable to the adverse

effects of climate change to meet the costs of adaptation. 9. Participation under the clean development mechanism, including

in activities mentioned in paragraph 3(a) above and in the acquisition of certified emission reductions, may involve private

and/or public entities, and is to be subject to whatever guidance may be provided by the executive board of the clean

development mechanism. 10. Certified emission reductions obtained during the period from the year 2000 up to the

beginning of the first commitment period can be used to assist in achieving compliance in the first commitment period.

16 Article 6 of the Kyoto Protocol reads (cf. http://unfccc.int/essential_background/kyoto_protocol/items/1678.php):

1. For the purpose of meeting its commitments under Article 3, any Party included in Annex I may transfer to, or acquire

from, any other such Party emission reduction units resulting from projects aimed at reducing anthropogenic emissions by

sources or enhancing anthropogenic removals by sinks of greenhouse gases in any sector of the economy, provided that: (a)

Any such project has the approval of the Parties involved; (b) Any such project provides a reduction in emissions by sources,

or an enhancement of removals by sinks, that is additional to any that would otherwise occur; (c) It does not acquire any

emission reduction units if it is not in compliance with its obligations under Articles 5 and 7; and (d) The acquisition of

emission reduction units shall be supplemental to domestic actions for the purposes of meeting commitments under Article 3.

2. The Conference of the Parties serving as the meeting of the Parties to this Protocol may, at its first session or as soon as

practicable thereafter, further elaborate guidelines for the implementation of this Article, including for verification and

reporting. 3. A Party included in Annex I may authorize legal entities to participate, under its responsibility, in actions

leading to the generation, transfer or acquisition under this Article of emission reduction units. 4. If a question of

implementation by a Party included in Annex I of the requirements referred to in this Article is identified in accordance with

the relevant provisions of Article 8, transfers and acquisitions of emission reduction units may continue to be made after the

14

Both mechanisms allow for some flexibility regarding the fashion how Annex I Parties meet

their emissions reduction or limitation targets and they foment sustainable development and

technology transfers among the signatories.

The Marrakesh Accords (2001) set up three registries that keep record of the trading of these

units: a national registry established by each Annex I Party; a registry of CERs, kept by the United

Nations and the International Transactions Log, maintained by the UNFCCC.

2.3.3.2 European Union Emissions Trading Scheme (EU ETS)

The European Union signed the Kyoto Protocol as a single Party17

and committed itself to

reducing the aggregate anthropogenic emissions of GHG listed in Annex A of the Kyoto Protocol by

8% compared to 1990 levels in the first commitment period of the Protocol (2008-2012). The EU ETS

was created to achieve this goal and it was established by the Directive 2003/87/EC18

. It currently

covers around 11.000 power stations and industrial plants in 30 countries (the 27 EU Member States

plus Iceland, Liechtenstein and Norway). These businesses, because they perform activities covered by

the Directive, are obliged to participate in the trading scheme.

Within the EU, the burden for reducing emissions is divided unequally among the Member

States, by taking into consideration the country-specific conditions, including current GHG emissions,

the reducing prospects and the level of economic development. Each Member State has a number of

allocated carbon emission permits, each representing the right to emit one tonne of CO2 or equivalent

(“Emissions trading”, n.d.).

The companies that have emissions reduction targets under EU ETS can invest in the Kyoto

Protocol instruments – CDM and JI – to help meeting their targets. The establishment of this link was

made possible by an amendment to the Directive 2003/87/EC, by the Directive 2004/101/EC, and it

allows for the conduction of investments and the transferring of green technologies to developing or

transitioning countries.

The EU ETS was divided in two periods, starting in 2005, and the second one is now in place,

until the 31st December 2012. For this period, the Commission cut the number or permits allowed by

question has been identified, provided that any such units may not be used by a Party to meet its commitments under Article

3 until any issue of compliance is resolved.

17 Council Decision 2002/358/EC, of 25 April 2002.

18 This Directive was amended in 2008 by the Directive 2008/101/EC, which added the aviation sector to the trading

scheme and in 2009 by the Directive 2009/29/EC, which aimed at improving and extending the greenhouse gas emissions

allowance trading scheme of the Community.

15

6.5% in relation to the 2005 numbers, thus guaranteeing real emissions reductions (“Emissions

trading, n.d.).

By July 2012, carbon emissions permits traded at 7.5 EUR/t CO2 in the European Energy

Exchange19

. Many commentators believe that only once the price reaches EUR 25-30 will the trading

scheme produce the effect of “making it economically necessary for polluters to reduce emissions

significantly” (Hill et al., 2008). In order to drive the current price up, the European Union has to

tighten the cap, i.e. reduce the number of allowances available, and to generate the predictability

necessary to increase the number of investments (i.e., to increase demand).

This mechanism works as cap and trade: the total allowed amount of GHG emissions is limited

so that there can be scarcity and thus economic value20

. Within this limit, businesses receive emission

permits that they can trade among themselves. If a company has extra permits, it can keep them to

afford future emissions or it can sell them at the market price at that time. If the number of allowances

a company possesses falls short of its emissions and this company cannot reduce the emissions or buy

allowances (either within the ETS or in any other linked scheme), it faces heavy penalties21

.

The reduction of emissions is ultimately only possible with the reduction of available

allowances22

. According to the Directive 2009/29/EC, from January 2013 on the cap shall decrease

each year by 1.74% in relation to the average annual total quantity of allowances issued by the

Member States in the second trading period (Article 9 of the Directive). As a result, by 2020 the cap

should be 21% lower as in 2005.

In both trading periods, allowances were allocated under the condition that Member States

published national allocation plans, which were assessed by the European Commission. These plans

included the amount of allowances and the intended distribution per year. In the current trading period,

a minimum of 90% of the allowances had to be distributed by the Member States to the companies for

free. While only companies are given allowances, anyone within the EU can buy and sell in the

market.

19 Data retrieved from http://www.eex.com/en/Market%20Data/Trading%20Data/Emission%20Rights, on the 16th

July 2012.

20 The cap for the third trading period, to start in January 2013, was set in October 2010 at 2.04 billion allowances.

The cap for the second period (2008-2012) was 2.08 billion.

21 “The penalty, set initially at 40€ per tonne, is now 100€ per tonne. From 2013, it will rise in line with the annual

rate of inflation in the Eurozone” (European Commission, 2009, p. 19). In addition, some Member States also established

penalties on the national level.

22 In the first semester of 2007, the European Council made a commitment to reduce the GHG emissions in the

European Union by 20% by 2020 compared to the 1990 levels. This was a considerable improvement to the commitment

made at the time of the signing of the Kyoto Protocol.

16

As of January 2013, the third trading period starts and it will be in force for eight years. Some of

the major novelties are: the elimination of national caps to create an EU-wide cap and the progressive

use of auctioning as the method for allocation of permits (European Commission, 2009, pp. 11, 12).

These changes will foment the harmonization of the EU ETS rules and will function as

competitiveness drivers for the market. Moreover, and not less importantly, the announcement of these

changes contributes for the transparency of the market by providing the predictability investors need.

2.3.3.3 National and regional trading schemes (See Appendix C)

In Appendix C, Table 3 lists several existing ETSs. In this section, I will refer to four of those

trading schemes.

Australia has recently established its own low-carbon policy. This has been a long process

which started in 1998, when Australia signed the Kyoto Protocol23

. The Clean Energy Plan, which

includes a carbon pricing policy, was released and passed in 2011 and the carbon pricing mechanism

came into force in the first day of July 2012.

In the policy briefing about the Plan, Bayliss and Muir (2011, pp. 1, 2) explain that, until 2015,

carbon allowances will have a fixed price. Companies will buy permits from the Government at

AU$23 per tonne, rising by 2.5% every year. From July 2015, the carbon pricing mechanism will start

functioning on a cap and trade basis with a market price – only then will there be an ETS. Until 2018,

there will be a price ceiling of AU$20 and a price floor of AU$15. The scheme applies to businesses

emitting more than 25.000 tonnes of CO2, which represents around 60% of emissions in Australia.

The Australian policy includes a very important point which is worth mentioning: since the

costs of participating in the ETS will likely be channeled to consumers, the government will

implement tax reductions and create subsidies for households. In addition, a representative part of the

revenues collected will be used for funding of “regional infrastructure projects, tax breaks for small

businesses, and most notably, 1% cuts to the existing corporate income tax rate of 30% in both 2013

and 2014” (PwC, 2011).

The initiative is commendable and the door is now open for the establishment of a link with

other ETSs, in particular with the EU ETS.

In Japan, there is, among other initiatives, a voluntary ETS since 2005. It covers CO2 emissions

and the reduction targets are set by the companies. “Allowances are allocated by the Japanese Ministry

of the Environment (…) and subsidies are provided for emission reductions” (Reinaud and Philibert,

2007, p. 11). Subsides are also in place and they “can reach 1/3rd of the investment cost and have a

23 The ratification happened almost ten years later, in December 2007.

17

ceiling of YEN 200 million per site” (Reinaud and Philibert, 2007, p. 11). This ETS is linked to the

Kyoto Protocol, whereby “participating companies can meet their target by purchasing emission

reduction allowances from other participating companies or by purchasing CERs” (Reinaud and

Philibert, 2007, p. 11). Since the system is voluntary, there are no penalties; companies must however

reinstate the subsidies they eventually received.

In the United States, ten States got together to form the Regional Greenhouse Gas Initiative

(RGGI), in order to reduce CO2 emissions by 10% from 2009 to 2018. Most of the allowances are sold

by the States via auctions and the revenue is then channeled to clean technologies and renewable

energies. Each State, although following the RGGI Model Rule, has its own ETS provisions and CO2

budget. Nevertheless, the Initiative represents only one carbon market and thus companies can use

allowances issued by any of the participating States24

.

California established its own ETS in 2010, modeled on the EU ETS. This mechanism adds to

the already existent tax on energy intensive industries. While some parts are already being

implemented, the compliance period only starts in 2013. The program will cover 85% of the State’s

CO2 emissions. In the first year, 90% of the allowances will be free of charge, to help companies

prepare, and then the program will require companies to buy allowances from the State every year in

order to be able to emit a specified amount of GHG, which will gradually decrease. The market will be

operated by the California Air Resources Board (PwC, 2011, p. 13).

This mechanism is designed to be linked to other ETSs and, provided it proves successful, it

would be a great opportunity to extend the EU ETS over the Atlantic.

2.4 Carbon Leakage – the common denominator

When policy-makers introduce a carbon tax or establish an ETS, they are imposing an

additional cost on the participating businesses – the cost of pollution abatement. This leads, on the one

hand, to a cut in emissions in the country or region where the instruments are in force and, on the other

hand, to an eventual increase in emissions outside of that jurisdiction – this last effect is called carbon

leakage. It is “formally defined as the degree to which domestic reductions in emissions are off-set by

increased emissions outside the region pursuing climate policies” (Copenhagen Economics, 2011, p.

7).

For the players that are targeted by carbon pricing, doing business becomes more expensive

than for their competitors, who trade at market price, with no carbon cost. In a world where

24 More information can be found on the RGGI website (cf. http://www.rggi.org/)

18

transactions are concluded across borders every day, this does have an adverse impact on the

competitiveness of carbon cost incurring companies.

The level of carbon leakage depends on the following factors: percentage of energy costs in

total costs; transportation costs; ability to outsource part of the processes; trade obstacles; time span;

production efficiency (Copenhagen Economics, 2011, p. 7).

The higher the level of carbon leakage, the bigger the possibility of companies not subject to

carbon cost of increasing their market share, which might lead to distortions.

In order to solve this issue, when establishing an ETS, most countries give companies free

carbon allowances in the early stages so that companies do not incur the cost and have time to prepare.

Moreover, when regulating a carbon tax, countries can combine it with tax incentives for industries

that are subject to carbon leakage. Other options are to have more flexible regulations regarding

changes in prices by the producers or, naturally, to establish a global carbon price (WBCSD, n.d. a, p.

2).

In the EU, the third phase of the ETS (starting in January 2013) will already include measures to

protect the industries that are more exposed to carbon leakage25

. In addition, the Energy Tax Directive

exempts and reduces the tax burden for some energy intensive industries26

. The new ETS Directive

and the Energy Tax Directive are linked via article 17b of the latter – it allows Member States to apply

reduced tax rates to electricity consumption by the sectors covered by the ETS.

Once a global carbon price would be established, the risk of carbon leakage would disappear or,

in the case of linkage of ETSs or harmonization of environmental taxation policies, become marginal,

because there would no longer be the opportunity for companies to escape the cost of carbon.

However, the impenetrable cultural, political, financial and economic differences among countries

represent too big of an obstacle for the creation of a global carbon price; linkage strategies seem to be

the step to take27

.

25 Articles 10a and 10b of Directive 2009/29/EC.

26 Articles 2 and 17 of Directive 2003/96/EC.

27 More information on this topic can be found in section 4 of this paper.

19

3 INDIRECT CARBON PRICING

3.1 Command and Control Instruments and other non-market based

instruments

3.1.1 Regulation

The establishment of a carbon tax, of tax benefits or of an ETS are also decisions that have to be

materialized in a binding legal document (e.g. international treaty, regulation, directive or act). These

are not, however, the legal provisions that this section refers to; here I will address environmental

provisions that relate to sustainable practices or impose certain standards.

Regulation is a beloved method of policy-makers; it is well known to them and passing laws is

what they believe they were elected for. However, the complexity and width of the topic surpasses

what regulation can achieve. Although it is a good way to impose certain behaviors that are considered

right for the environment, there is the risk of overall reduced effectiveness; the topic is so

comprehensive that loopholes would be likely to occur. In addition, the enforcement costs for

governments are very high (Nellen and Miles, 2007, pp. 59, 60).

In conclusion, regulations tend to be rather specific and this may create high complexity and

low flexibility. One must also beware of policy bundles, because regulations may undermine the goal

of direct carbon pricing mechanisms, as ETSs; they may “force down the prevailing carbon price and

drive up the mitigation cost for the sector as a whole” (WBCSD, n.d. a, p. 6).

For the reasons indicated above and mainly due to their specificity, regulatory prescriptions are

of better use for the cases where the environmental impacts are characteristic of a specific location and

are different according to the source of pollution. When this is the case, environmental legislation can

even be a way to attract foreign investment. However, it can pose a great challenge for companies that

operate global supply chains.

Environmental provisions can consist of the following:

a) Emission quotas, which limit the emissions of a facility. Current examples include the

California Low Carbon Fuel Standard and EU Regulations (EC) No 443/2009 and (EU) No

510/2011;

b) Prohibition of using certain materials in manufacturing processes;

c) Non-monetary incentives for sustainable practices (e.g. free public parking for owners of

hybrid cars; free restock of energy-saving light bulbs); and

d) Mandatory use of a certain percentage of renewable energy in the total consumption of a

facility (e.g. EU Directive 2009/28/EC).

20

3.1.2 Voluntary agreements and social commitments

Voluntary agreements are a more flexible way to limit companies’ emissions. They are

concluded between companies and governments and are especially used for smaller companies,

because the compliance costs are lower when compared to direct carbon pricing mechanisms.

The most particular aspect of voluntary agreements is their bottom-up feature: “the

communication includes phases of initiating, advising, supporting, and evaluating innovations and

behavior of the industry” (Lindén and Carlsson-Kayama, 2002, p. 899). The parties should agree on

“the goals, the ways to handle efficiency strategies, reporting periods and report contents, ways to

handle, reformulate or reduce divergences from goals and strategies, and define evaluation variables in

terms of methodology, statistics or qualitative measures” (Lindén and Carlsson-Kayama, 2002, p.

899).

Lindén and Carlsson-Kayama (2002, p. 900) argue that, in order to be successful, voluntary

agreements should be precise and detailed, especially when it comes to the targets they define.

Croci (2005), points flexibility and cooperation as the main features of voluntary agreements

and describes the reasons why companies decide to enter into these agreements: to avoid austere

regulation; to gain flexibility within the existent regulation; to get protection from the government

regarding innovations; to reduce costs; to access credit more easily; to get tax incentives and to obtain

a good reputation (Croci, 2005, pp. 12-18).

Companies are naturally more willing to participate in such mechanism if they receive

incentives to do so. Koehler (2007, p. 697) argues that the most popular incentives are the good

reputation and the marketing benefits, both depending on the degree of public awareness.

3.1.3 Social commitments

Social commitments consist of voluntary statements by companies where they set their own

emissions reduction targets. Ante the inertia of governments, especially in the international playing

field, some businesses have been taking over the fight against global warming and committing

themselves to what they consider to be reasonable aspirations.

These targets are only morally binding and only as long as suppliers and customers regard them

as so and to the extent that the target-setting company values their perception. To fulfill their own

commitments, companies need a “high degree of voluntary reporting and transparency of this

reporting” (WBCSD, n.d. a, p. 4). However, if well publicized, companies will gain a good reputation

21

and be capable of attracting consumers’ preferences. Companies like Coca-Cola, Walmart or Unilever

have been taking full advantage of this28

.

3.1.4 Labeling schemes and marketing campaigns

Labeling schemes are a way to differentiate products according to their environmental features

and to show that directly to customers. An example is the EU Ecolabel29

, which consists of a voluntary

labeling scheme for which companies can apply.

In order for such a scheme to work, it needs to receive government support and it must be

effectively communicated (NBS, n.d., p. 17). Otherwise, it will not reach the necessary credibility.

Some concerns are also raised when it comes to the authorities responsible for the schemes, especially

in countries with lack of transparency or in need of a higher level of competitiveness.

Once implemented, these schemes can work more efficiently if combined with tax incentives,

also targeting the acquisition or consumption of such environmentally-friendly products.

Marketing campaigns can also help the popularity of products with a reduced impact on the

environment, but they can nonetheless have a wider scope and address several aspects of climate

change, by passing on relevant information and contributing to the change of mentalities. Marketing

campaigns can, in particular, raise awareness on issues like recycling and reusing or shopping online,

conducting business meetings online and purchasing local products to reduce the emissions in

transfers and transportation. These campaigns are the way companies and governments have to

propagate sustainable practices. As with labeling schemes, also here tax incentives can be a good

complement.

28 Further information can be found in the companies’ websites (Cf. http://www.thecoca-

colacompany.com/sustainabilityreport/index.html, http://www.walmartstores.com/Sustainability/8141.aspx and

http://www.unilever.com/sustainable-living/greenhousegases/why/index.aspx).

29 More information can be found on: http://ec.europa.eu/environment/ecolabel/information-and-contacts.html.

22

4 PROPOSED APPROACH: COMBINING AND LINKING

The ideal solution is to have a global carbon market. Only then the issues of carbon leakage and

competitiveness will be solved and only then the reduction of carbon emissions will achieve the

desirable level.

The world as it is today, in particular the impasse that exists in international negotiations, makes

it clear that it is impossible to have a global market just yet, be it a global or harmonized carbon

taxation or a global ETS. Therefore, the best possible answer is to have a gradual policy being

implemented, until countries are ready to negotiate a new international treaty to reach a low-carbon

economy.

Regardless of the policy adopted, its design and implementation should be made on a bottom-up

basis, i.e. governments must consult with other environment stakeholders (e.g. companies, NGOs) to

meet the sustainability targets and reduce carbon emissions. Moreover, governments must be the ones

to send clear signals and predictability to businesses and this can only be accomplished by clearly

communicating the adopted policies and their impacts for businesses and households.

In this section, I start by describing the policy bundle I propose. Subsequently, I explore some

options of complementary measures and I analyze the way to link ETSs until a global market is

reached. Finally, I introduce a tentative timeline for the steps to be taken toward a new international

agreement.

4.1 Hybrid policy

When compared with indirect carbon pricing instruments, taxes and ETSs are more efficient:

they allow polluters to assess their marginal costs, they provide more flexibility and they signal to the

market the environmentally friendly goods and services.

As discussed above, an ETS has several advantages that make it the ideal mechanism: it offers

full flexibility to companies, it incentivizes innovation, it minimizes intervention, it provides certainty

in the reduction of emissions (with the gradual reduction of the cap), it contemplates the desirable

predictability and, as long as price keeps at a certain level, an ETS is simply effective.

However, the amount of reporting and monitoring that is necessary in the first stages, for

companies to receive the carbon allowances and subsequently, for the authorities to examine the

companies’ performance and to review the structure of the scheme, can represent a prohibitive burden

for small and medium-sized enterprises (SMEs).

Therefore, SMEs would be exempted from participating in the ETS and would instead be

subject to a carbon tax or voluntary agreements, depending on certain conditions. It is important to

23

note that this would be an option given to SMEs. They could still choose to participate in the ETS and

the inherent reporting obligations; if they choose not to, a carbon tax would be levied on their CO2

emissions. This way the reporting obligations could be reduced but there would still be harsh penalties

on emissions to ensure maximum compliance.

There have been several concerns being voiced regarding the extreme burden of reporting for

SMEs and how their financial statements suffer with this additional cost. Although these worries are

understandable, SMEs cannot simply be free from any legal and enforceable limitation on their carbon

emissions. Regulation would not be able to comprehend such an immense topic and would likely lead

to several loopholes and merely medium-term effects. In addition, regulation “is typically designed to

punish underperformers, while over-performers – those being ahead of a standard – are not rewarded”

(Copenhagen Economics, 2010, p. 49). Contrarily, a carbon tax is simpler and all-embracing and it

provides a stronger and long-term incentive for the reduction of emissions and for the shift to cleaner

technologies (especially when combined with tax incentives). Moreover, with the possibility of

reduced reporting obligations, this additional cost would not weigh as much in the financials of SMEs.

In order to determine the size threshold that would divide the application of the two instruments,

countries could use the usual criteria: assets, market value, profits and sales. The companies with

figures above a previously defined value would qualify as big companies and would be obliged to

participate in the ETS. An alternative would be to use the European Union’s criteria: number of

employees and either turnover or balance sheet total (Table 4).

Table 4 – EU’s criteria for defining SME

Company Category Employees Turnover Balance Sheet Total

Medium-sized < 250 ≤ € 50 m ≤ € 43 m

Small < 50 ≤ € 10 m ≤ € 10 m

Micro < 10 ≤ € 2 m ≤ € 2 m

Source: http://ec.europa.eu/enterprise/policies/sme/facts-figures-analysis/sme-definition/index_en.htm.

Every company, regardless of whether participating in the ETS or being subject to carbon tax,

would need to report its emissions values and be subject to continuous monitoring. Both of these

aspects would be regulated and communicated clearly to the target companies. For the companies

covered by the carbon tax – the SMEs –, this might still represent a great administrative burden.

Moreover, the monitoring costs for the authorities would also be significantly high.

One possible way to approach this problem and reduce the monitoring costs would be to apply

the technique used by the United Kingdom in the Climate Change Agreements: emissions targets were

24

defined for each sector and the monitoring was reduced by, on a first instance, solely assessing the

sector and only if the sector was missing its targets would the companies be assessed individually

(NBS, n.d., p. 68).

In what concerns the reporting burden, companies should pursue streamlining and automating

techniques for their reporting processes, in order to reduce the time spent and other involved costs. In

addition, there are already simplified reporting alternatives in place, as the one provided by the Carbon

Disclosure Project (see Appendix D).

The policy I suggest can also be found in Switzerland, but in different terms. There also is a

combination of carbon tax and ETS, but they are in theory applicable to every company. The

companies that voluntarily decide to reduce their emissions participate in the ETS. By doing so, they

can negotiate their reduction targets and they are exempt from the CO2 tax, except for one situation: if

they are not able to meet their targets, “the CO2 tax is to be paid retroactively for each tonne of CO2

emitted since exemption was granted” (FOEN, 2012). The companies that do not participate in the

ETS are subject to the CO2 tax. For SMEs, when participating in the ETS, there is a simplified

approach for determining their reduction targets. In everything else they are, however, subject to the

same rules as bigger companies.

The basis for the Swiss approach is the voluntary character of the ETS: every company is

subject to the carbon tax, unless they decide to enter the ETS. Contrarily, my suggestion is that the

ETS be the standard policy for bigger companies and voluntary only for SMEs. An ETS is a better

method to reduce carbon emissions and only the need to protect SMEs, for their essential role in a

country’s economy, can turn the ETS into a voluntary mechanism.

4.2 Complementary measures

Taxes on carbon emissions are not sufficient per se. The main reason for this is, as Kosonen and

Nicodème (2009, p. 10) explain, market imperfections. Although taxes are able to factor into the

polluter’s accountability the negative environmental externalities, there are other imperfections that

escape their scope of protection: consumers’ lack of information; their tendency to disregard the long-

term benefits and focus on the up-front costs; search costs overpassing the savings per unit (Kosonen

and Nicodème, 2009 pp. 10-13).

These insufficiencies can be mitigated if taxes are combined with tax benefits for consumers of

environmentally friendly goods. In addition, taxes can be complemented with indirect carbon pricing

mechanisms, as standards imposed by regulations or information mechanisms like labeling schemes or

marketing campaigns.

25

Furthermore, there are three major issues that geographically limited carbon taxes and ETSs

create and that complementary policies can help reduce or eliminate.

The first issue is competitiveness: if a certain country, especially if it has an open economy,

applies a carbon price, this will represent an additional cost for the businesses under its jurisdiction,

which will either reflect on higher prices or lower profits or both (Ekins, 1999, p. 56). In order to

reduce this effect, countries can give tax incentives, impose border tax adjustments or harmonize their

carbon pricing rules. The first solution contradicts the purpose of carbon pricing, because tax

incentives would be given to the industries that pollute the most, since they are the ones with the

highest tax burden. The second solution, Ekins (1999, p. 57, 58) explains, aims at aligning the burden

of national and foreign industries. However, the tariff is very hard to calculate and such a rule would

be a breach of international trading rules. Finally, the third solution would be ideal – carbon price

would be a cost for every company.

The second issue is carbon leakage: if emissions leak from one country to another, the carbon

price produces no environmental gain (Ekins, 1999, p. 57). There are two ways to approach this

problem: tax benefits or global harmonization of carbon pricing rules. Several countries have

implemented tax benefits to protect the industries that are more exposed to carbon leakage. However,

besides the fact that these benefits may not be enough to eliminate carbon leakage, they undermine the

purpose of the carbon pricing, because the industries that are more exposed to carbon leakage are the

energy and carbon-intensive ones, i.e. the larger polluters. Therefore, the second solution would be the

optimal one. If countries or regions would have similar carbon prices, companies could no longer shop

for emissions-favorable jurisdictions.

The third issue concerns only carbon tax and is double taxation: if companies operate in several

countries and these countries have their own carbon tax, there is the risk that both countries will claim

the right to tax the emissions. In this case, the OECD should be the one to lead the way by reviewing

its Model Tax Convention in order to include a provision on carbon taxes. This would naturally only

be binding on the OECD members, but countries can also take the initiative to amend their bilateral

tax conventions or to create new ones that contemplate carbon taxes.

4.3 The need for carrots

As discussed before, a carbon tax alone would pose several inefficiencies. For that reason, a

carbon tax should be complemented by incentives (the so called “carrots”) and information policies

(labeling schemes and marketing campaigns). The same is true for an ETS, when established only on a

national or regional level.

26

Incentives are often suggested as a complementary policy. However, when designing them,

policy makers must assess whether there already is a signal sent by the carbon tax or the allowance

price. If this is the case, the incentives can be counter-productive because the reduction in emissions

they aim at would happen anyway.

In addition, it must be considered that the funds for the incentives come out of the government’s

budget, either from collection of tax revenue or from reduction of expenditure. Therefore, and because

it would be distortionary to raise other taxes or reduce other essential expenditures, the money should

come solely from the collection of the carbon tax – or from the auctioning of carbon allowances by the

government, in the case of an ETS – and from eventual penalties paid by companies when breaching

the standards imposed by regulation (when existent).

The following is a list of how to employ the revenue raised by the means described:

a) As explained before, the revenue should be applied in the concession of grants for sustainable

projects and R&D, namely for the development of clean technologies or environmentally

friendly products. The grants for fossil fuels should be eliminated;

b) To offset tax credits or exemptions, used as incentives for the applications referred to in the

previous point;

c) To reduce labor taxes. This is known as green tax reform and it consists precisely of the shift

of the tax burden from labor to pollution;

As part of the incentives policy, an R&D policy plays a very important role. A carbon pricing

policy should always be complemented by public grants for research and development of new

technologies. This way, as the report from Copenhagen Economics (2010, p. 44) explains, while

carbon pricing mechanisms internalize the negative externality, the subsidies for R&D internalize the

positive externality – once the new technology resulting from R&D is in place, everyone, and not only

the investing company, will benefit from it. In other words, the R&D grants will pay the company for

that positive externality.

When designing such grants, policy makers must keep in mind that the incentives are not

enough; the pricing policy has to be able to reward these investments from companies in the future.

R&D is an investment that only provides return in the long-term and thus “it is extremely important

that long term tax policies are well-defined, credible, and demonstrate a high degree of continuity over

time” (Copenhagen Economics, 2010, p. 47). Moreover, environmental policies will have to include

ambitious reduction targets and high carbon prices, in order to provide enough of an incentive for

companies to invest in R&D.

An ECFIN study from 2010 also suggests that, in order to achieve the sustainability targets, the

best policy is one that includes higher carbon prices and significant R&D support. In addition, it

27

concludes that the best combination for R&D support is a cap and trade scheme with reducing caps.

This is also what is suggested in this study, with the exception of SMEs, for which a carbon tax would

be more adequate.

As mentioned before, voluntary agreements could be an alternative to carbon tax, in a context

where even meeting the reduced reporting obligations of carbon taxation would present considerable

difficulties. Indeed, voluntary agreements can be a more flexible way for SMEs to reduce GHG

emissions and to incentivize them to pursue low-carbon strategies. These companies would of course

still be subject to emissions targets, but they would be defined in the agreement with the government.

In order for voluntary agreements to be effective, there are some conditions that must be

present. The NBS (n.d., p. 17) announces the following:

a) “Concentrated and organized industrial sector;

b) Tradition of communication between sector and government;

c) Non-economic mitigation barriers dominate (e.g. limited info about abatement options);

d) Positive and negative incentives for participation (e.g. market rewards, social license or threat

of future government regulation);

e) Credible but low-cost monitoring: detailed, quantified schedules and planned targets”.

In the analysis conducted in this study, there were other methods being referred to, namely

regulation and social commitments. When it comes to regulation, provisions like emissions quotas or

mandatory use of a certain percentage of renewable energies are counter-productive. These objectives

should be pursued, as indicated above, by a combination of carbon tax, ETS and incentives.

Contrarily, provisions like non-monetary incentives for sustainable practices or prohibition of use of

environmental harming products or materials and penalties upon breaches are acceptable and can

contribute to a shift in behavior toward an eco-efficient society. Regarding social commitments, it is

needless to say that they are always welcome and are a great boost on the public perception of a

company’s brand.

4.4 Link by link toward a global market

Although the Kyoto Protocol intended to implement emissions trading globally, this has so far

been impossible. As a result, particularly multinational corporations currently face a wide variety of

ETSs that differ in scope and enforcement, thus creating divergent levels of institutional constraints

across locations (Pinkse and Kolk, 2007, p. 441).

28

Small markets mean fewer trading opportunities and potentially higher costs. Hence, to establish

a global ETS would be ideal. There would be only one carbon cost and companies would have equal

access to the reduction opportunities with the lowest cost (WBCSD, n.d. b, p. 2). However, the current

international context does not yet provide the right framework for such a step. Therefore, first

countries or regions can establish their own ETSs and then start a mutual recognition process, so that

participating companies can choose to buy and sell allowances among the several ETSs in place in

order to meet their emissions reduction targets. This mutual recognition process is also known as

linkage process because it consists of the establishment of links between existent ETSs and the

creation of a free movement of allowances among them.

For the mutual recognition to be possible, there are some conditions that must be met. The

WBCSD (n.d. b, p. 4) suggests the following: clear definition of the sectors covered, accepted

reporting protocols, emissions history, uniform definition of the trading instruments, description of the

future steps, continuous assessment of rates that show the evolution of the sectors in emissions

reduction and identical system organization. This last requirement includes equivalence with regards

to “price measures, penalties, banking and borrowing provisions, monitoring and reporting, linkage

and offset policies, accounting and verification principles and approaches to allocation” (WBCSD, n.d.

b, p. 4).

All the requirements above enumerated assume an international framework, i.e. countries would

have to draft an international agreement that would provide the structure for the mutual recognition of

ETSs. This agreement would still be a step before the desirable final agreement, where all nations

agree to a global cap and a global price for carbon allowances, thence creating a global market.

In both cases, governance would be an issue. The UNFCCC is in principle the most legitimated

authority to supervise such arrangement. It would also be necessary to create a global registry,

eventually by simply expanding the existing International Transaction Log (WBCSD, n.d. b, p. 3).

Although this point is not key for the description of the ETS linkage, it would also be important

to create anti-abuse provisions, preventing actions from companies like the one of overstating their

emissions needs and then selling the extra allowances.

29

4.5 Timeline for Country X

Fig. 1

The timeline is set for a non-determined country, but in reality countries around the world are

moving at different speeds when it comes to environmental matters. Notwithstanding, the timeline

starts at a point in time where there would be no carbon emissions reduction policy implemented.

In reality, one possible solution is to start the mutual recognition among the OECD countries

(until 2015) and then expand to the emerging economies (from 2018).

The several steps that form the timeline are a summary of the policy bundle described before.

Aside from the carbon tax – subject to adjustments (even on a yearly basis) – and the different

implementation phases of the ETS, there are references to the international negotiations that must take

place, in order to achieve a global carbon market.

The negotiations in 2012 refer to the United Nations Climate Change Conferences in Bangkok

in August 2012 and in Doha in November 2012. Those are the ideal platforms for countries to launch

the cooperation for the drafting of the agreement. In 2015 the countries should be prepared to sign a

legal document creating the framework for the mutual recognition (or linkage, in the timeline) among

2012

2015

2018

2025

30

the several ETSs. In 2018 this agreement would start to expand to the rest of the countries and it would

include carbon taxes; the rules would provide for minimum carbon tax rates, so that there could be a

common floor for the tax burden, and then each country would determine its own tax rate. For

harmonization of carbon taxes to work, the idea has to be the following: internationally agreed floors

and nationally imposed rates. The determination of a minimum rate is very important, because

sometimes carbon taxes are too low to produce a material effect on reduction of emissions.

Finally, after every country – on a stand-alone or on a regional basis – has signed the document

and made it enforceable in its jurisdiction and once the measures have been implemented, the world

will be trading carbon allowances and taxing SMEs carbon emissions. An eco-efficient economy will

then become a reality.

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5 LOW-CARBON BUSINESS MODEL

5.1 Making sustainable decisions

Climate change has brought up new areas of risk for companies. Climate change-related supply

chain disruptions represent a great challenge for companies and require them to change their

procurement and logistic models. In order to become resilient to these disruptions, companies must not

only develop a carbon management strategy, but also integrate this strategy in their general business

strategy. Possible ways to do so are: to have the Chief Procurement Officer and the Heads of Climate

Change (or the equivalent within the firm’s structure) in the management meetings and to adopt a

reporting system30

that includes environmental information. Companies know this and several have a

strategy in place. However, the sustainability goals require constant decision making, which may be

hindered by individual or corporate biases. Arvai, Campbell-Arvai and Steel (2012, p. 9) synthesize

and describe some of these biases (Table 5).

Table 5 – Biases and Errors when making sustainability-related decisions

Decision Biases

& Errors

What happens? For example…

Loss avoidance We judge gains and losses relative

to our present state. We don’t like

to give up things we already have

Sustainability decisions may require us to

give up something (even if we get

something else in exchange)

Short-cuts We focus on information that’s

familiar, recent or easy to interpret

– even if it’s not very relevant

Sustainability decisions often use hard-

to-evaluate criteria, e.g. recreational

benefits or human health effects, which

are trumped by simple financial metrics

Intuition We over-rely on gut feeling and

intuition when distracted or faced

with new situations

Sustainability decisions are often novel,

so individuals may struggle to process all

relevant factors and rely instead on

intuition

30 E.g., the Carbon Disclosure Project reporting system (Cf. https://www.cdproject.net/en-

US/Pages/HomePage.aspx).

32

“Wants” vs.

“shoulds”

We tend to let “wants” trump

“shoulds” – particularly when

we’re tired or distracted

Sustainability decisions may yield longer-

term paybacks, falling into the category of

“shoulds” rather than “wants”

Source: (Arvai, Campbell-Arvai and Steel, 2012, p. 9)

By knowing and understanding these biases, managers can better direct their company’s

sustainability commitments, as well as train and motivate their employees and involve the other

stakeholders.

5.2 Reduction of costs, reduction of risk and revenue increase

Companies now realize that it is no longer enough to reduce their impact on the environment;

they must actively do good. Climate change is no longer a mere belief; it is happening and it can yield

the company increasing profits.

Doing good for the environment can be done via innovation31

. By investing in new products or

projects that are environmentally-friendly, companies can collect not only the tax benefits and other

incentives created by the governments, but also the revenue from the acquired market position as the

product or service pioneers.

This market share can, however, only be achieved with the support of top management, with a

higher amount of resources allocated to a sustainable procurement and logistics and if the consumer´s

mind is changed. Caring for the environment and preferring green products must be made trendy.

Companies need marketing specialists to create this picture and to conduct campaigns that create

public awareness.

When it comes to the operational activity of the company, there are three dimensions where

sustainable business practices can improve its situation: reduction of cost; mitigation of risk; increase

of revenues (Levefre et al., 2010, pp. 4 ff.).

Cost reductions come in many forms: “reduced energy costs, reduce over-specification, reduced

consumption and reduced social and environmental costs” (Levefre et al., 2010, p. 4). Regarding the

latter, one of the reduction opportunities consists of tax savings – as discussed before, by reducing

their carbon emissions, companies can pay less taxes. Moreover, by investing in environmentally-

friendly projects or assets, companies can not only collect the fiscal and non-fiscal incentives (a

31 A prime example is the one of Cradle to Cradle – a design concept that aims at an economy dominated by closed

loop materials.

33

revenue growth driver), but also develop more sustainable procurement and logistics models which in

turn will help them to further reduce costs.

In order to achieve this, some companies have put in place optimization schemes to reduce their

fuel consumption (e.g. Wal-Mart, UPS, PUMA) by, for example, reducing the number of vehicles on

transportation and the distances traveled, by including carbon emissions as an item in scorecards and

by rewarding suppliers that apply environmentally-friendly practices (Levefre et al., 2010, pp. 9, 10).

The rise of natural disasters and of public awareness has put increasing pressure on companies

to adopt sustainable practices that avoid or at least mitigate climate change-related supply chain

disruptions and to intensify the levels of monitoring and reporting of all players within the supply

chain. The financial, economic and social impacts for companies in case of a disruption have proven to

be devastating, so companies have a very strong incentive to comply with environmental policies and

to invest in projects or assets that eradicate bad practices throughout their supply chain and thus reduce

the risk of disruption.

The following are some examples of the costs that can arise for companies in case of a supply

chain disruption: the loss of the brand reputation, “recall of products, financial penalties, decrease in

market share, sales and market cap, product boycotts” (Levefre et al., 2010, p. 12).

Protecting the environment can also, besides reducing costs and risk, yield profits. Some

governments have supporting programs in place for companies that develop sustainability-driven

projects, which often involve the attribution of subsidies (e.g. R&D grants). Either with these grants or

by using the above mentioned cost savings, companies that execute such projects can be the levers for

innovation. With this they can gain market share and raise sales figures and thence improve their

revenue32

.

In order to achieve this, firms must work together with their R&D and marketing departments

and enhance the cooperation with suppliers and their own R&D and marketing representatives.

Furthermore, they should include procurement experts in the process and raise the awareness of their

target customers (Levefre et al., 2010, p. 5).

Besides innovating and creating new products or offering new services, firms can also increase

revenue by raising the prices (due to the added carbon cost), but, for this to be viable, consumers

would have to perceive an added value – the eco-efficient character of the product or service.

Otherwise, they will not be willing to pay the higher price (Levefre et al., 2010, p. 15).

32 An example of a strategy taken with basis on this belief was the Unilever-acquired Ben & Jerry’s, whose brand

was announced in 2010 to go fully fair trade by 2013 (Levefre et al., 2010).

34

5.3 Securing a competitive advantage

The current global financial and economic downturn is affecting business operations all around

the world. The crucial question is whether this will completely erase climate change from the

corporate agenda or whether reducing carbon emissions will continue to be seen as a business

opportunity.

The degree of involvement of companies in international negotiations and the continuing

development of low-carbon commitments and strategies suggest that the crisis will not cast out the

climate change initiatives already in place nor the establishment of new ones. Furthermore, the current

economic difficulties can even work as a filter: the firms that were or are truly committed to a low-

carbon economy will stay in the game and harvest the benefits of their investments; the firms that

announced their brand as green merely as a marketing trick, will now have to attend to the more

pressing crisis-related economic and financial issues and will have to step down from the climate

change scene, thus putting themselves at a disadvantage (AEA, 2009, p. 6).

The reason why sustainability will stick around is because it represents the most recent way for

companies to achieve competitive advantage. Once the economy stabilizes, the companies that

implemented low-carbon measures will be better positioned for growth, reaping the rewards of being

the “first movers” (AEA, 2009, p. 6). Of course governments play a driving role: they are the ones that

need to provide the monetary and legislative incentives to keep investments in the environment

attractive for companies.

It is only realistic to say that discretionary spend will disappear (AEA, 2009, p. 5). Anything not

connected to core business activities will be cut. Companies are also being forced to look for more

efficient ways to do business, especially by cutting in business travel and using long-distance cheaper

mechanisms, like video conferencing (AEA, 2009, p. 10). However, the real drivers will not

disappear. New markets can still be created and new ways of differentiating with suppliers and

customers are still available.

Shultz and Williamson (2005, p. 386) suggest three ways how businesses can secure a

competitive advantage in what they call a “carbon-constrained world”:

a) Minimize costs;

b) Product differentiation;

c) Profit from carbon credits (in an ETS scenario).

In order to reduce costs, companies can use different fuel sources (including alcohol and

biomass fuels), so that they can take advantage of the different price trends. In addition, they can

reduce their exposure to carbon price volatility by having executives responsible for carbon asset

management (Shultz and Williamson, 2005, p. 386).

35

In pursuance of differentiation, companies can try to create bundles to offer to the other players

in their supply chain – suppliers and customers. The first step is to understand the strengths and

weaknesses of each of them (including their own), so that they can react to them in an efficient way.

“For example, a fuel supplier might be able to secure low cost carbon credits and offer electric utilities

short on allowances a combination fuel and credit product that matches its customer’s allowance

needs” (Shultz and Williamson, 2005, p. 386).

Considering the ETS market current expansion, carbon credits can become a very attractive

source of profit. For some companies it will be cheaper to reduce emissions than to buy extra carbon

allowances and this way they can sell the extra permits (Shultz and Williamson, 2005, p. 386).

Moreover, under the Kyoto Protocol companies can earn extra credits via the implementation of CDM

or JI projects. One way or another, carbon allowances can achieve a high level of trading and become

one of the largest sources of profit for companies.

In conclusion, companies must, on the one hand, assess their strengths and opportunities for

growth within the constraints imposed by the applicable environmental policies and, on the other hand,

review their strategies, in comparison to the ones of their competitors, in order to determine where

there is leeway for differentiation. This way they can anticipate change and enjoy a competitive

advantage position.

5.4 Guidelines for Sustainable Supply Chain Management (SSCM)

SSCM, or eco-efficient supply chain management (SCM), refers to both the forward processes –

procurement, production, distribution – and to the reverse processes, which close the loop on the

supply chain.

The strategies for an eco-efficient supply chain management can naturally differ from industry

to industry and even from company to company. Nevertheless, and bearing in mind this caveat, the

following aspects can be seen as the standard or starting point and thus should be present when

designing such a strategy.

i. Understand carbon

If companies want to reduce their carbon emissions, they must understand how CO2 works and

they must become acquainted with the environmental policies in place within the territories where they

operate. For this, they must engage every player in the supply chain, from suppliers to employees.

Trainings, workshops and incentives creation are three great drivers to embed the idea of carbon

reduction within the organization. If the parties involved understand what carbon is, how it is

36

measured and how emissions can be reduced and if they fully comprehend their roles, a carbon

management strategy suddenly becomes viable.

ii. Key word: include

As awareness about the effects of carbon emissions grows and more information becomes

available, business strategies become more detailed and innovative. However, there must be a

unidirectional connective line between the general business strategy and the specific carbon strategy.

In order to achieve this, firms should include carbon management criteria in the supplier

scorecards, to measure their footprints, and in the procurement strategy; include procurement measures

in the climate change strategy; include the climate change strategy in overall corporate strategy

(Accenture, 2012). This way, all the strategies work as one and companies eliminate the risk of

redundancy and other inefficiencies.

iii. Clear communication of outcomes and methods

Especially in what concerns the two previous points, but overall throughout the strategy

implementation, goals must be communicated clearly to the other supply chain parties and strategies

must be agreed upon. This avoids misunderstandings later on and improves performance efficiency of

everyone involved in the design, implementation, enforcement, monitoring and reporting phases of the

strategy.

iv. Improve selection and evaluation of suppliers

When selecting suppliers, companies must include sustainability requirements. Only this way,

they can ensure responsible business practices throughout their supply chain. However, these

requirements cannot be constructed in a way that they are standardized and disregard the size and the

reality of the supplier.

An example is ISO1400133

– an accreditation system for suppliers. This system represents a one

size fits all approach: to get the accreditation might not mean that that supplier is the best suited for

that company. Moreover, companies are sometimes too different for such an approach to be viable and

productive and getting accreditation is costly and time consuming, which may become prohibitive for

smaller companies.

Instead, companies should develop their own criteria, based on material standards and adapted

to their specific goals. Suppliers have different ways to operate and different carbon footprints, so

33 More information can be found on the following website: http://www.iso.org/iso/iso_14000_essentials/iso14000.

37

those criteria must take into consideration the supplier’s business practices, the reporting data, its size

and its business strategy. A global accreditation system can be created, but it can only contemplate

figures – has the company effectively reduced carbon emissions? – and the final result – was the

business materially altered?.

Furthermore, it is necessary to induce higher transparency from suppliers regarding their

emissions reporting and mitigation strategies. L’Oréal, for example, developed a scorecard that

summarizes the information on carbon emissions reported by its suppliers to the Carbon Disclosure

Project and provides it to buyers so that they can better select and evaluate suppliers (Accenture, 2012,

p. 4).

v. Differentiate and motivate

Companies need to include suppliers in their SCM strategy and naturally they want to instigate

the highest standards among them. The screening can be done via differentiation. Firms should, on the

one hand, provide incentives or rewards for good performers and, on the other hand, penalize suppliers

that fall short on performance.

The creation of incentives by introducing a reward scheme is of major importance for a

successful carbon management strategy. The high performing suppliers (i.e. the suppliers with the best

carbon management strategies and with emissions measurement and reporting initiatives in place) can

be awarded preferential status when initiating a selection process and/or be mentioned in press releases

or featured in internal documents (Accenture, 2012, p. 4). “Vodafone, for example, has a supplier

scorecard that awards those suppliers who demonstrate management of the risks and opportunities

associated with climate change. Philips meanwhile uses suppliers' CDP disclosure scores in their

supplier sustainability ratings, which form part of their procurement assessments” (Way, 2012).

On the contrary, companies can discontinue business with suppliers that do not employ

environmental standards (Accenture, 2012, p. 4). This way, suppliers are encouraged to make climate

change a focal point of their strategies.

vi. Create shared value

When dealing with suppliers, companies must contemplate how they can contribute long term

value to their suppliers, beyond the individual transactions.

The CDP Supply Chain Report (Accenture, 2012, p. 9), states that suppliers’ “carbon

accounting is not yet at the level of their corporate customers”; suppliers are not yet “able to measure,

quantify and report their greenhouse-gas emissions” as satisfactorily. Nonetheless, their awareness and

38

involvement are rising and it is up to the big corporations to provide them the know-how that will

allow them to also take valuable action towards a low-carbon economy.

The best way companies can achieve this is by sharing their knowledge and their technology

and by accompanying suppliers in the implementation of sustainable strategies, i.e. to “work directly

with suppliers to help reduce their greenhouse gas emissions, supporting the development of product

carbon foot-printing, and reducing greenhouse gas emissions from transport and logistics” (Sullivan

and Gouldson, 2011). Companies can even go one step further and engage in R&D projects with

suppliers, to spur the best practices in sustainability and to develop new environmentally-friendly

products.

vii. Continuous updating

The information about GHG emissions is changing constantly and technological development

will allow for more thorough measurement and mitigation strategies. Therefore, companies that do not

keep up-to-date will suffer a drawback (Accenture, 2012, p. 13).

Moreover, companies can choose to stay ahead and start adapting their business practices to a

low-carbon economy and entering the clean technologies market immediately.

viii. Optimization

There is no one size fits all approach. Each company has to assess how to manage its supply

chain in a way that reduces environmental impact at the lowest possible cost and while yielding

profits.

A popular concept to address this matter is the closed loop notion. Supply chains are no longer

seen as one way streets. Once the product reaches its final consumer, there still is a reverse way to

close the cycle that presents several opportunities for companies.

There are several steps for the implementation of this reverse process: disassembly, repair,

remanufacturing, recycling and ultimately disposal. This way, products can be reused, the impact on

the environment can be reduced and companies can minimize the production costs and collect higher

profits.

In order for a closed loop scheme to work throughout the whole supply chain, companies need

to develop creative techniques that include every player in the supply chain and governments must

provide financial incentives to support the development of such techniques.

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6 CONCLUSION

Climate change provides great opportunities for companies and it is the supply chain where the

most important initiatives can be implemented. “The most forward-thinking companies are taking

specific actions today to produce real, measurable business value, in the form of increased revenue,

lower costs, mitigated risk, and a host of intangibles” (Accenture, 2012, p.13). Managers can collect

financial and strategic benefits (e.g. cost savings, competitive advantage, reputation and prestige and

improved customer relationship) from adopting measures that reduce the impact on the environment.

However, the role of the government, as policy designer and negotiator, is essential both on a national

and international level, in providing the necessary certainty and credibility in a matter as volatile as

carbon emissions.

Along this study, I analyzed several policy options for the reduction of CO2 emissions by

companies: carbon tax, fiscal and non-fiscal incentives, ETS, regulation, voluntary agreements, social

commitments, labeling schemes and marketing campaigns. Although my initial topic was fiscal and

other market-based mechanisms, I also addressed non-market based ones because I realized during my

research that the latter play a significant role in the reduction of CO2 emissions as well.

After having weighed the strengths and weaknesses of the different instruments, the solution I

suggest is a combination of carbon tax, ETS and information mechanisms. As far as my research goes,

this is a solution not yet implemented. Although its application requires a high degree of international

coordination and harmonization, I believe it to be the most adequate and comprehensive policy.

The central point of my recommendation is the implementation of a carbon tax and an ETS at

the same time. The major reasons why I propose such a combination are the following:

a) Provided there is a market with enough participants, a wide range of emissions types and a

steadily high price, an ETS is the most efficient way to reduce emissions. It offers full

flexibility to companies, it spurs innovation, it minimizes intervention and, with the gradual

reduction of the cap, it actually reduces emissions. In my proposal, SMEs also have the right

to join the ETS, as long as they feel prepared to bear the additional reporting cost;

b) A carbon tax for SMEs is the most adequate way to allow reduced reporting costs and still

have a solid carbon price. This creates an incentive strong enough to reduce emissions and

stimulate innovation, by punishing emitters and rewarding the companies that invest on

reduction (especially when in combination with tax incentives).

Further exploration of this topic can be done by investigating the simplest and most accurate

way to determine the tax rate for carbon tax, by developing a simplified reporting mechanism for

40

SMEs and by detailing, on a national basis, the steps for each country to take in order to create an ETS

and/or to enable the linkage with other trading schemes.

The policies and strategies described in this paper are directed at governments and companies

and they can start to be implemented today.

Global emissions now need to decrease by 4.8% a year for targets to be met. Had we begun in

2000, this figure would be halved (PwC, 2011). This study intends to be a call for action for

governments. Market-based instruments are the most attractive way of dealing with climate change

and they are effective when appropriately combined. World leaders must work together toward an

international carbon price. The solution for climate change is no other than global action and local

execution.

41

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48

Appendix A

Table 1

Carbon taxes around the world

Country/

Jurisdiction

Start Date Tax Rate (EUR and USD) Revenue Distribution

Finland 1990 €18.05 per tonne of CO2 (€66.2 per

tonne of carbon)34

Government budget;

accompanied by independent

cuts in income taxes

Netherlands 1990 $20/metric tonne CO2 in 1996 Reductions in other taxes;

Climate mitigation programs

Norway 1991 $15.93 to $61.76/metric tonne CO2

(NOK 89 to NOK 345)

Government budget

Sweden 1991 $150 per tonne of CO234

Government budget

Denmark 1992 $16.41/metric tonne CO2 (90 DKK) Environmental subsidies and

returned to industry

British

Columbia

2008 $9.55 per metric tonne of CO2 in

2008 (C$10), increasing $4.77 (C$5)

annually to $28.64 (C$30) in 2012

Reductions in other taxes

France Proposed $24.74 (€17) per metric tonne of CO2 Reductions in other taxes

South

Africa35

Proposed

for 2013

R120 ($16) per tonne, increasing

10% per year from 2013 to 2019

No earmark

California 2008 $0.44 per metric tonne of CO2 Climate mitigation programs

Switzerland36

2008 EUR 29.9 (CHF 36) per metric tonne

of CO2

Redistribution for

individuals and businesses

Data as of December 2009. Source: (Sumner, Bird and Smith, 2009, p. 8)

34 Source: http://www.carbontax.org/progress/where-carbon-is-taxed/. Page last updated in 25th July 2011.

35 Source: (Pwc, 2012).

36 Source: http://www.sbs.com.au/news/article/1492651/Factbox-Carbon-taxes-around-the-world.

49

Appendix B

Table 2

Fiscal incentives around the world

Fiscal incentives for investments in environmentally-friendly assets

Australia R&D concessions and grants; Clean Business Australia grants; rebates

supporting the installation of renewable energy water pump systems

Canada Immediate deduction or invest tax credit on expenditures related to Scientific

Research & Experimental Development Program

China Tax credit for investments in certain environmental protection, energy and

water conservation equipment

India Compensation from multilateral fund of Montreal Protocol; tax exemption for

collecting and processing or treating of biodegradable waste water; deduction

of profits derived from infrastructure related to water; deduction of profits

derived from biotechnology

Netherlands Allowance for investing in sustainable energy and certain type of energy-saving

assets

Spain Tax credit for environment protection investments, acquisition of vehicles and

for investments in renewable energies

Sweden Deduction of expenses related to forest planting and ditching

United Kingdom Capital allowance of 100% on specific categories of energy-efficient or

environmentally friendly assets

United States Tax credit for environmentally friendly vehicles; tax credit for energy-efficient

homes and appliances; alcohol fuels and biodiesel fuel credits; low-sulphur

diesel, renewable electricity and advanced nuclear power facility production

credits

Fiscal incentives for investments in environmentally-friendly projects

Australia R&D concessions and grants; Clean Business Australia grants; rebates

supporting the installation of renewable energy water pump systems

Canada Various incentive programs, Environmental Damages Fund, Federal Financial

Assistance Program for Environmental Technologies, Emerging Technologies

50

Program, etc.

China Tax exemption or reduction for income derived from qualified environmental

protection, energy and water projects

Spain Tax incentive for “woodland associations”; tax exemption for subsidies

regarding the exploitation of forest farms

United Kingdom Deduction against income of expenditure on the remediation of contaminated

land; deduction of expenditure on the renovation or conversion of business

properties that have been vacant

United States Tax credit for clean renewable-energy bonds

Data as of April 2009. Source: (Bakker, 2009, p 491-493).

51

Appendix C

Table 3

Emissions Trading Schemes around the world

Country/Jurisdiction Scheme name Status

Australia Australia ETS Operating

27 EU Member States37

EU ETS Operating

Norway, Iceland, Liechtenstein Linked to EU ETS Operating

Switzerland Swiss ETS and CO2 Tax,

planned link to EU ETS

Operating

New Zealand New Zealand ETS Operating

China Pilot ETSs in several cities

and provinces

Under development

Republic of Korea National ETS Under development

Japan Japanese ETS; Metropolitan

ETS in Tokyo; Provincial

ETS in Saitama Prefecture;

Voluntary ETS

Under development

California ETS Operating

Connecticut, Delaware, Maine, New

Hampshire, New York, Vermont,

Massachusetts, Rhode Island and

Maryland

Regional Greenhouse Gas

Initiative

Operating

California (USA), British Columbia

(Can), Manitoba (Can), Ontario (Can),

and Quebec (Can)

Western Climate Initiative Under development

Source:http://www.climatechange.gov.au/government/international/global-action-facts-and-fiction/ets-by-

country.aspx. Page updated in 20th April 2012.

37 Austria, Belgium, Bulgaria, Cyprus, Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece,

Hungary, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, Netherlands, Poland, Portugal, Romania, Slovakia, Slovenia,

Spain, Sweden and United Kingdom.

52

Appendix D

Excerpt of CDP Supply Chain 2012 Information Request for Small & Medium sized Enterprises

7. Emissions Methodology

7.2 Please give the name of the standard, protocol or methodology you have used to collect

activity data and calculate Scope 1 and Scope 2 emissions

If you have selected “other”:

7.2a Please provide further details

8. Emissions Data

Scope 1 and 2 Emissions Data

8.2 Please provide your gross global Scope 1 emissions figures in metric tonnes CO2e

8.3 Please provide your gross global Scope 2 emissions figures in metric tonnes CO2e

13. Emissions Performance

Emissions Intensity

13.2 Please describe your gross combined Scope 1 and 2 emissions for the reporting year in

metric tonnes CO2e per unit currency total revenue (CDP 2011 Q13.2, amended)

Intensity

figure

Metric

numerator

Metric

denominator

% change

from

previous year

Direction of

change from

previous year

Reason for

change

mtCO2e Unit total

revenue

15. Scope 3 Emissions

15.1 Please provide data on sources of Scope 3 emissions that are relevant to your organization

Sources of Scope 3

emissions

Metric tonnes CO2e Methodology If you cannot provide a

figure for emissions, please

describe them

Source: https://www.cdproject.net/CDP%20Questionaire%20Documents/CDP-SME-Supply-Chain-Information-

Request.pdf