By Stefano Giuliano Partner, Tax, CMS Italy, Sabrina Polito Associate, Energy & Climate Cange, CMS London

Introduction

At all levels across society, climate change is widely regarded as the most defining and pressing issue of our time. But despite pledges made under the Paris Agreement, global carbon emissions have increased, with the last five years being the hottest on record. Scientists stress that even if countries meet their targets under the Paris Agreement, global warming will still rise more than 3°C.

The consensus is that it will be cheaper to prevent, rather than tackle, the effects of climate change. As such, the message is clear – it is not too late to act, but we need to take meaningful action now. The COVID-19 pandemic provides further stimulus to the discussion in two ways. Firstly, by reinforcing the message that certain matters should not and, perhaps, cannot be dealt with through unilateral measures and secondly, by giving us a chance to rethink our current systems and processes as we look to economic recovery.

It is not a new idea that fiscal policy can help in the fight against climate change. Recently the International Monetary Fund (IMF) claimed that a carbon tax is the ‘single most powerful way’ to combat global warming and reduce air pollution. However, as the environmental impacts of global rising temperatures become strikingly more severe, this raises the question of whether we have fully utilized the value taxation can deliver in fighting climate change.

In this article we’ll consider the success of carbon taxes in reducing greenhouse gas (GHG) emissions and what the future of taxation could look like in tackling climate change.

Have carbon taxes worked in reducing emissions?

In summary, yes, but generally the impact so far has been underwhelming.

What is a carbon tax?

For many years, advocates and politicians have talked about “putting a price on carbon” (also known as carbon pricing) to deal with the consequences of climate change. There are various ways in which this can be done such as carbon taxes or an emissions trading system. Carbon taxes work by directly setting a price on carbon by pricing each ton of GHG emitted or – more commonly – on the carbon content of fossil fuels.

Essentially, the result is the same – these measures will capture the external cost associated with carbon emissions (e.g. addressing environmental damage) and shift the burden of these costs on to those who are responsible for them. Polluters will have to decide whether to discontinue their polluting activity, take steps to reduce their emissions or continue polluting and pay for it. However, the aim is to encourage cleaner behavior, such as switching to low carbon power generation, energy conservation practices or cleaner consumer products etc.

The state of play

Today, some 40+ countries use carbon pricing mechanisms with many more in the pipeline.  Across these jurisdictions, carbon pricing varies massively, from less than US$ 1 to US$ 119 per ton of CO2. Moreover, studies show that the coverage rate in which the taxes apply to a country’s GHG emissions also varies significantly, from 15% to 80% of national GHG emissions.

Empirical studies examining the impact between carbon taxation regimes and GHG emissions are limited but generally, the findings of these are inauspicious. For example, a 2016 study by the American Council for an Energy-Efficient Economy (ACEEE) evaluated the carbon taxes in a number of jurisdictions (including the United Kingdom, Denmark, Costa Rica and the Netherlands) and assessed their impacts in relation to energy use and carbon emissions. The study found that the sample countries reduced their energy use and carbon emission intensities by an average of just 0.1–0.8% per year.

There are, however, some more successful examples. During the period in which Australia had a carbon tax (2012-2014), in 2014 the country recorded its largest emissions decrease in a decade, with renewable energy use increasing significantly too. In Sweden (which has one of the highest carbon tax rates in the world), emissions have decreased by 25% since 1995, while the economy has grown 75% during this time. Other studies have reported improved figures in emissions reduction as a result of carbon taxes, ranging from 2% in the United Kingdom to 9% in British Columbia. However, the ACEE report notes that the higher numbers represent short-term studies, with the median decline per year being 1.3%. If this median figure of emissions reduction is applied year on year, it would take over 110 years to reach the 80% emissions reduction target set out in the Paris Agreement.

It is not the purpose of this article to evaluate in depth why carbon taxes haven’t delivered the desired results so far. However, key factors are likely to include the variation in pricing and coverage of carbon taxes and ultimately, the fact that these taxes do not target the profits of high polluters. As such, it is exceptionally challenging to discourage polluting behavior where the cost of taxation can be recovered further down the value chain (e.g. on energy or end-product prices). Consumers, and particularly poorer households, will ultimately bear the burden, which partly explains why carbon taxes are unpopular. A shift is needed in public perception of carbon taxation, and commentators are calling on governments to both educate consumers about the steps they can take to support low carbon companies (e.g. purchasing energy from a 100% renewable energy supplier) and deliver the benefits gained from taxing high polluters straight to consumers (e.g. by way of a dividend or lowering national insurance tax).

Certainly, further work is needed to assess the impact of carbon taxes on long-term emission reduction strategies in order to fully understand whether the existing regimes can deliver the necessary outcomes in time. But as of now, when looked at globally, existing carbon tax regimes have had a noticeable, but far from dramatic effect on GHG emissions and quite simply, do not seem to be getting us to where we need to be fast enough.

What needs to change and what could the future look like?

Climate change is a global issue, in that it is the total worldwide emission of GHGs that counts to rising temperatures, regardless of where they have been emitted and it is undoubtable that no country will be able to overcome global warming with unilateral measures. As such, it makes sense that key climate action solutions, such as taxation, are considered at a global scale.

Effective carbon pricing is crucial 

An effective carbon price is one of the key tools that can help countries successfully decarbonize and currently, on average, prices are too low to deliver real difference. Commentators stress that markets are failing to reflect the costs and risks of GHG emission activities – emitting carbon is simply too cheap. Some research suggests that countries with higher carbon prices (such as the Scandinavian countries) see a greater reduction in emissions. The World Bank recently reported that almost half of the world’s emissions covered by a carbon price are priced at less than $10. Further to this, a study from the IMF states that at least $75 per ton carbon price is needed by 2030 to effectively meet climate change challenges.

Ultimately, the carbon price required for each jurisdiction to be aligned with targets set out in the Paris Agreement will depend on local context and the extent to which it has complementary policies in high carbon sectors such as transport and urban planning, as well as developments in technology and innovation. At a global level, the challenge with carbon pricing disparity could be addressed via an agreement on a carbon price floor for countries with high levels of emissions and a stricter price floor for advanced economies.

Whilst an effective carbon price is necessary, it will not be enough alone to drive decarbonization and other measures such as increased coverage, incentives and corporate income taxes should also be considered.

Carbon taxes need to cover more ground

As highlighted above, the coverage rate in which the carbon taxes apply to national GHG emissions varies greatly, mainly due to exemption schemes that exclude some high polluters.  This obviously has the effect of limiting the value carbon taxation can have in reducing emissions.

We are seeing some progress in this regard, with Iceland adding a tax rate on fluorinated gases as of 1 January 2020, New Zealand announcing plans to phase down free allowances for the industrial sector and Norway has abolished exemptions for natural gas and liquified petroleum gas for certain industrial processes and fuels. Commentators note that it is important to have some global consistency on the scope of the taxation regimes in order to prevent certain high polluting activities to move to countries with less stringent regimes/exemptions in place.

Encourage clean and sustainable behavior via incentives

In addition to robust carbon taxation policies, research and development (R&D) incentives can help encourage behaviors required for the transition to a low carbon economy. Currently, most R&D incentives are available to companies across multiple sectors, regardless of their carbon footprint or other polluting business activities. However, these incentives could be more effective in driving desired behaviors if a premium was offered to specific ‘low-impact’ products and technologies or to companies that had already dedicated a specific portion of revenues to cleaner business activities. These incentives can take the form of a credit percentage of investment made and then applied to tax liabilities (like a voucher scheme) or government grants.

A tax system linked directly to carbon footprints

The cost of addressing the physical impacts of climate change is growing exponentially around the world. The UN estimates that the global cost of adapting to these climate impacts could grow to US$ 140-300 billion per year by 2030 and US$ 280-500 billion per year by 2050. Therefore, it could be argued that these costs (more specifically the cause of these costs) should form part of the drivers in determining how much each taxpayer should contribute.

Consider a scenario where two taxpayers earn the same amount of income before taxes but one taxpayer has a low carbon footprint as a result of sustainable business activities and the other has a hugely adverse impact on the environment, spewing tons of emissions each year. The expense that the government will bear in respect of the impact on the environment of the latter taxpayer is much greater than the former. As such, is it fair that the two taxpayers end up paying the same amount of taxes?

Logically, the answer to this question should be no. Therefore, perhaps, the solution lies in a system that takes into account the “environmental cost” associated with a taxpayer’s business activities when calculating the amount of tax it should pay. Reshaping the foundations of corporate income taxes to transform them into “corporate income and environmental impact taxes” would enable corporate taxation to play an amplified role in climate action and accountability of high polluters.

Assuming this logical approach will drive future decisions, the question is how to do so. Only for the sake of prompting the discussion, an independent assessment of a company’s carbon footprint could be considered. The assessment could take into account not only the type of products manufactured, or services rendered but also decisions taken by the company with respect to the value chain. The assessment could be based, as an example, on a rating system. Taxpayers would be awarded a numerical score with respect to their impact on the environment, and their tax would be accordingly set through a system of different rates, so that companies which cause less harm to the environment (and have a lower environmental impact and, in turn, use less public money) would be rewarded by paying lower tax.

Concluding thoughts

As countries around the world plan for economic recovery following the COVID-19 pandemic, many commentators have expressed concerns that rescue packages will (either deliberately or inadvertently) prioritize a high-carbon economy as many industries and countries get back on their feet. We are already seeing a number of countries cut carbon tax rates or push back implementation of carbon pricing regimes in response to the crisis.

Undoubtedly, climate change is the biggest challenge we have ahead of us, at both a global and national level. Taxation is an important lever that policymakers have in their hands. This, combined with the current need to support the economic recovery, seems to push for a complete overhaul of the tax systems.

In doing so, the environmental footprint could be placed side by side with income in determining how much taxes should be paid. However, the only way this could be effective is through a global harmonized approach. The tax world has seen many examples of multi-jurisdictional efforts that have targeted specific tax issues and that, at times, has produced brilliant results. What we are considering here is not so much the solution of a technical problem or the allocation of taxing rights, but something much more important: the future of the planet. If the IMF is right in claiming that a carbon tax is the ‘single most powerful way’ to combat global warming and reduce air pollution, this should be a good enough reason to drive a new global effort.