What next for carbon taxes?

Optimists will argue that if all governments fulfil their pledges, global warming can be kept to an increase of 1.8°C above the pre-industrialised levels, still above the target of 1.5°C, but that might be achieved with progress at future COPs. Others point out that it is unlikely that all pledges will be met and that the likely current trajectory is an increase in temperatures of 2.4°C. Pledges (even "legally-binding" commitments) to reach net zero are all very well, but the real challenge is devising policies that will ensure that these commitments are met.

This challenge should not be underestimated. From the perspective of the UK, the Government is correct to say that carbon emissions produced in the UK have fallen by 44% from 1990 to 2019, greater than any other G7 economy. There are a number of reasons why future reductions will not be straightforward.

First, the reductions so far have been heavily concentrated in the production of electricity where the UK has switched reliance from coal to gas. This could be considered as being the "low-hanging fruit" and is hard to replicate.

Second, in terms of reducing global emissions, the relevant measurement is not production but consumption. The UK’s consumption has fallen by 29% from 1990 to 2019, still substantial but much less than the fall in production. Essentially, we have exported some of our carbon emissions as we have imported more goods from China and elsewhere. Our consumption emissions are 37% higher than our production emissions¹.

Third, if we are to meet our net zero objective, the rate of reduction needs to be accelerated. According to the Institute for Fiscal Studies², emissions fell by an average of 1.4% of 1990 levels per year between 1990 and 2018. They will need to fall by an average of 3.1% of 2018 levels per year from 2018 to reach net zero in 2050. This will be difficult as many low-cost opportunities to reduce emissions have already been exploited.

The Government has set out its Net Zero Strategy in October 2021³. "Net Zero Strategy: Building Back Greener" brings together the Government’s strategies on achieving net zero across a range of sectors, including various sector specific areas such as power, heat and buildings, industry and transportation. One area that is not addressed comprehensively in the UK’s strategy nor was it a focus of COP26 is carbon pricing.

The case for carbon pricing

Climate change involves a market failure in that firms and households do not always face a cost to reflect the impact their actions have on the climate from emitting greenhouse gases (often referred to as negative externalities). The International Monetary Fund (IMF) has said that carbon pricing is “the most powerful and efficient [lever], because it allows firms and households to find the lowest-cost ways of reducing energy use and shifting toward cleaner alternatives”.

These incentives can have short term effects in discouraging consumer expenditure on carbon intensive products, but also long term in encouraging private sector investment in new technologies that will facilitate lower carbon products.

One advantage of carbon pricing over regulation or subsidies in tackling climate change is that it’s possible to take this approach across sectors so that consumers can determine their own priorities. As the Treasury has observed, regulations and public spending schemes “typically require government to design each intervention specifically for each sector and, due to potential government failure, carry a risk of imperfect information increases consumer costs or leads to other market inefficiencies”. Carbon pricing allows governments to be neutral on which technologies to adopt or which specific forms of carbon-emitting behaviour to discourage, allowing the market (the accumulation of decisions made by individuals and businesses) to decide how best to lower emissions.

Proponents of carbon pricing generally do not argue that regulatory interventions and subsidies will play no part in reducing emissions but that carbon pricing must necessarily play a large part if we are to undertake this task in as cost-effective and efficient manner as possible.

A further benefit of carbon pricing is that it raises revenue (at least in the short and medium term) – revenue that could be spent to mitigate and adapt to climate change (including support to developing countries who we wish to discourage increasing emissions) or to replace tax revenues lost as a consequence of changing behaviour (such as fuel duty as we move to electric vehicles).

How to price carbon

There are broadly two methods of pricing carbon – emission trading schemes (ETS) and carbon taxes.

The ETS approach (also known as "cap-and-trade") is largely the one that has been adopted in the EU and UK. An ETS involves determining the level of carbon emissions permitted in respect of a particular industry. Businesses wishing to undertake activity within this industry must bid for permits with a price being determined by demand given that supply is fixed. As a consequence, an additional cost is imposed in respect of the relevant sectors.

The UK was a member of the EU when the EU introduced its own ETS. The EU ETS attracted criticism for the potential for fraud, uncertainty as to the price of carbon, difficulty in determining the appropriate quota and favouring incumbents who were awarded free quotas.

Since leaving the EU, the UK has in place a scheme that essentially replicates the EU arrangements. It is currently considering whether to continue this arrangement, introduce its own ETS or move towards carbon taxes.

Carbon taxes involve, as the name suggests, taxing carbon - a direct tax levied at a given value against a quantity of emissions. One can argue that the UK already has many taxes that apply to carbon emitting activities and could be described as “implicit carbon taxes” (fuel duty, Air Passenger Duty, the climate change levy and many others) but there is little coherence to their operation. There is no one price for carbon that applies consistently per tonne of CO₂ equivalent emissions across different activities. For example, if we were to tax activity on the basis of per tonne of CO₂ equivalent emissions consistently, we would tax domestic fuel more (it is currently subsidised in the sense that a reduced rate of VAT applies) and tax cars less (the value of fuel duty is greater than a carbon tax would be). Similarly, airflights are undertaxed, electricity is overtaxed.

A comparison between an ETS and a carbon tax might suggest that an ETS provides certainty on emissions in that a cap on emissions is set but uncertainty for businesses and consumers on the price of carbon, whilst a carbon tax provides certainty on the price of carbon but uncertainty as to the level of emissions.

In reality, however, the difference is less clear. The number of permits produced by the EU ETS has been potentially subject to control in order to increase the carbon price and it is easy to see how carbon tax rates could be somewhat orchestrated in order to meet an emissions target.

Proponents of using carbon taxes to price carbon argue that trading schemes are unduly bureaucratic, vulnerable to fraud and can be unduly influenced by special interests, sometimes favouring incumbents and discriminating against new entrants to the market. They point to the early experience of the EU ETS where existing carbon emitters were granted free permits reflecting their existing emissions which resulted in incumbents facing a low carbon price that failed to change behaviour (even factoring in expected downward adjustments to the permits over time).

The case for an ETS is to some extent a political one. The additional cost of carbon is less obviously imposed by governments and less visible to consumers as compared to a carbon tax. It is, therefore, less likely to provoke criticism of governments from the electorate and is more likely to be politically deliverable.

The case against carbon pricing

There are three arguments that are frequently made against carbon pricing.

First, imposing costs on consumers is electorally disastrous. To take the example of VAT on domestic fuel, the original attempt to impose the standard rate of VAT on this in 1993 was defeated in the House of Commons and even a lower rate was deeply unpopular with the electorate. Attitudes to climate change have been transformed in the subsequent 28 years but there is little sign that an increase in VAT on domestic fuel would be anything other than a vote losing policy. Indeed, Vote Leave in 2016 called for a cut in VAT on domestic fuel and currently both the Labour Party and some Conservative MPs are calling for this to happen.

Those who support carbon pricing argue that if we are not prepared to price carbon, and admit that we are doing it, there is little prospect of meeting our net zero targets. In other words, if politicians are unable to persuade the public that carbon pricing measures are necessary, there is no other feasible route to meeting our objectives.

Nor is the level of carbon taxes necessarily going to be punitive. As Tim Harford has points out in the Financial Times⁴, in the UK carbon emissions are less than six tonnes of carbon emissions a year plus two or three tonnes to reflect the carbon footprint of imported goods. A £100/tonne tax (significantly more than the figure recommended by the IMF) that covered those emissions would raise the cost of living per person by just over £2 a day.

Of course, £2 per day for some people would be manageable but for others very painful. The second objection is that carbon pricing is regressive because, the poorest members of society spend disproportionately more on high carbon activity such as heating their homes. This is true and at least some of the revenue from carbon pricing will need to be used to compensate people if the overall policy is not to be regressive. Carbon use can vary significantly and the policy challenges in protecting some of the poorest households should not be underestimated.

Many would argue that rather than focusing on the additional costs of a carbon tax, one should consider the discount all sectors of the economy have enjoyed thus far, by not having had to factor in the true cost of their carbon consumption and negative externalities into supply chains and ultimately consumer prices.

Third, carbon pricing domestic activity will place UK businesses at a disadvantage compared to competitors in countries that do not price carbon or have a lower carbon price. This could mean job losses in iconic industries, such as steel (with all the related political pain) and do nothing to reduce our carbon consumption as production is simply exported to places where the price of carbon is cheap.

The answer to this criticism is to tax the price of carbon for imports at the border.

Carbon border adjustment mechanisms (CBAMs)

A CBAM is “a measure applied to traded products that seeks to make their prices in destination markets reflect the costs they would have incurred had they been regulated under the destination market’s greenhouse gas emission regime"⁵. In other words, it imposes a tariff on products that are imported from jurisdictions that have a lower price for carbon, disincentivising domestic consumers from favouring imports that are cheaper because of differential carbon pricing whilst incentivising other jurisdictions to raise the price of carbon so that they would benefit from the revenue.

The design of any CBAM will have to address a number of questions. How will carbon be priced for imports? Will it just involve tariffs on imports, or will credits for exports also be permitted?

One of the biggest challenges is ensuring that the imposition of CBAMs is consistent with the rules of the World Trade Organisation (WTO) which prohibits unfair discrimination. Legal commentary in this area is supportive of the view that a carbon pricing regime (whether a tax or an ETS) can apply to imports in principle but it must do so in such a way that meets a double non-discrimination test: non-discrimination between domestic and foreign suppliers, and non-discrimination between foreign suppliers.

Such matters can, of course, be contentious. In reality, the operation of a CBAM would result in Western countries imposing tariffs on goods imported from China, in particular. This is as much an issue about diplomacy as it is about the WTO rules and raises wider issues of geo-political stability. As The Economist has warned, a tariff-based approach to enforcing a minimum price for carbon is “fraught with the risk of capture and protectionism. Governments must tread with care—while also recognising that failing to price carbon adequately may be the greatest danger of all.”

Such problems could be addressed if there was multilateral agreement on how CBAMs could work, including developing consistent approaches to measuring carbon emissions and the extent to which measures other than carbon pricing (such as regulatory approaches) can be considered equivalent to carbon pricing when calculating the appropriate level of a CBAM.

In July 2021, the EU set out its plans to impose a CBAM. The EU CBAM will only apply initially to a limited number of carbon-intensive products: cement, iron and steel, aluminium, fertilisers and electricity. The CBAM will apply to imports at the price of carbon determined by the EU ETS system through auctions, which is expected to rise over time as free allowances in the five sectors listed above are phased out. The first CBAM charges will apply in 2026 and, subsequently, the EU CBAM may be extended to other import-competing sectors already subject to the EU ETS (including ceramics, glass, paper and other chemicals).

On the issue of compliance with WTO rules, the EU CBAM purports to treat EU and foreign suppliers equally since they would both be paying the same price for their embedded carbon emissions for products sold in the EU – by purchasing ETS allowances for the former and CBAM certificates for the latter. Foreign suppliers would be entitled to claim a reduction against the CBAM for any carbon price paid in the country of production (which is not rebated or in other way compensated for upon export). 

As for non-discrimination between foreign suppliers, the EU has stated that exemptions from the CBAM “could be granted to countries who have in place a carbon pricing system that imposes a carbon price at least equivalent to the price resulting from the EU ETS on products subject to the CBAM.” If the EU applies a clear and consistent criteria to its assessment of other countries’ arrangements and grants exemptions accordingly, it will be in a strong position to argue that it meets the second element of the WTO non-discrimination test.

Even if this requirement is met, however, there is likely to be controversy in that developing, and even least-developed countries will be subject to the same EU CBAM as more advanced countries, despite the principle of common but differentiated responsibilities enshrined in the 2015 Paris Agreement. This tension between WTO rules and the international approach to climate change could be addressed by revisiting WTO rules.

The introduction of the EU CBAM will raise issues for the UK, particularly in the context of exports of steel and aluminium. At the moment, the only countries that are listed as being exempt from the regime are those countries that have signed up to the EU ETS (European Economic Area countries plus Switzerland). The UK could participate in the EU ETS under the terms of the Trade and Co-operation Agreement but this looks unlikely given the UK Government’s general approach to favouring divergence.

Outside the EU ETS, UK products would not be faced with additional tariffs assuming that the UK maintained a carbon price that matched or exceeded that of the EU. In those circumstances, however, importers of UK products will be faced with additional bureaucracy in calculating the amount of CO₂ emissions embedded in the product and purchase CBAM certificates (unreasonable or disproportionate regulatory burdens would raise WTO issues, but any functioning regime is still likely to result in some burdens unless an EU/UK equivalence agreement was reached). 

A further complication is how the EU CBAM would work in the context of Northern Ireland. Treating Northern Ireland as falling within the EU CBAM would be seen as an extension of the EU’s domestic carbon price, whilst treating Northern Ireland as outside the CBAM risks creating a border between Northern Ireland and the Republic of Ireland, contrary to the intentions behind the Northern Ireland Protocol. This issue has the potential to create further tension between the UK and EU on the working of the Protocol⁶.

What next for policy in this area?

The UK Government has been reluctant to embrace fully the case for carbon pricing. With inflation high and cost of living pressures increasing, such a move might be considered to be politically high risk even if accompanied by measures to mitigate the costs given that there would still be financial disadvantages to some.

Nonetheless, public concern over climate change is growing and, at the time of the next General Election in 2023 or 2024, political parties will want to set out a credible case to the electorate that they have policies in place that are commensurate to those concerns. The case made by academics and other policy experts from across the political spectrum – including the Government’s own advisory body, the Climate Change Committee - that any credible policy agenda on climate change must more fully pursue a policy of carbon pricing may resonate with the public. In those circumstances, it is possible that the debate on carbon taxes and ETSs may change rapidly.

Even with current policies in place, including the UK ETS, relatively high energy costs may result in pressure to protect UK industries from foreign competition that does not face equivalent costs. The fact that the EU is looking to pursue a CBAM, as is Canada and with President Biden expressing interest in “carbon adjustment fees", may mean that a "coalition of the willing" of developed nations may work together to ensure that carbon prices are imposed on imports.

1 https://ifs.org.uk/publications/15653
2 https://ifs.org.uk/publications/15653
3 https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/1033990/net-zero-strategy-beis.pdf
4 https://www.ft.com/content/d666b9a8-f2a9-4a51-9c85-fb4223c556b0
5 A Guide for the Concerned: Guidance on the elaboration and implementation of border carbon adjustment, International Institute for Sustainable Development’, Cosbey, A. et al., 2012.
6 https://ukandeu.ac.uk/eu-cbam-uk/