Can tax policy help us get to net zero? 10 things I have learned…

COP 26 has brought heightened focus on environmental matters and the steps we need to take to get to net zero. I wanted to understand the extent to which tax policy has a role to play in reaching this target. Here are 10 things I have learned:

1. Carbon pricing works but it needs to be better: Carbon pricing involves putting a price on the emission of greenhouse gases which is intended to incentivise a reduction in carbon-intensive activities and encourage investment in the development and use of emission-saving technologies. This can take the form of explicit carbon prices (such as carbon taxes and emissions trading systems) and implicit pricing (for instance through fuel duties or regulations that discourage carbon intensive activities or subsidies for cleaner technologies). There is a consensus that carbon pricing is effective at cutting emissions for those countries that have implemented it. However, part of the challenge is that to date, carbon pricing has only been applied to a fraction of emissions (for instance an IFS report shows that 71% of UK emissions are not covered by the UK ETS, and a recent IMF/OECD report indicates that 60% of emissions from energy use across OECD/G20 countries are not subject to carbon prices, although the OECD reports that things are moving in the right direction across the G20). For carbon pricing to be more effective it needs to cover a wider range of emissions and be applied more consistently. Furthermore, the price needs to be higher if countries are to meet the targets set in the 2015 Paris Agreement.

2. Without international cooperation, there is a risk of carbon leakage: One of the challenges with carbon pricing is that, even among those trying to meet their targets under the Paris Agreement, there are “widely divergent mitigation pledges” (according to the IMF/OECD Report) reflecting the fact that responsibilities differ with the level of a country’s development. This gives rise to the concern that higher carbon pricing in “high ambition” countries will lead to increased costs and thereby impact the competitiveness of businesses operating in such countries, potentially pushing consumers to choose cheaper suppliers from countries with lower carbon prices, or businesses to move production to jurisdictions with lower carbon prices. Either way, this could the effect of pushing up production in countries with less ambitious carbon targets, thereby increasing carbon leakage. International cooperation is therefore crucial. The IMF/OECD recommends greater international cooperation on a number of levels, including continued monitoring of explicit carbon prices, mapping and developing new tools and indicators for implicit carbon pricing policies, sharing metrics and indicators for measuring a country’s carbon footprint, updates on how a country is doing compared to its pledges and further analysis of impacts of rising disparities in carbon prices.

3. In the absence of global consensus, action by a few high emitting countries could be key: The IMF/OECD report discusses the potential of an international carbon price floor (ICPF) as an effective mechanism for scaling up global mitigation action. The key components of an ICPF are: a focus on a small number of high emitting countries that are responsible for the bulk of global emissions (such as the US, China and India) and a commitment to a minimum carbon price. The incentive for those countries to participate being the prevention of the destabilisation of the global climate system for the benefit of all. The theory is that with only a few players at the table and a focus on a single parameter (a minimum carbon price that must be implemented), there is more scope for this to be designed pragmatically and with flexibility to suit the specific needs of those participating.

4. Border carbon adjustments (BCAs) can be helpful, if done correctly: One way to address the issues around competitiveness and carbon leakage that come with carbon pricing is with BCAs. The IMF/OECD report describes a BCA as a “measure applied to traded products that seeks to make their prices in destination markets reflect the costs they would have incurred had their emissions been priced according to the regime in the destination market” (such as the EU’s proposed Carbon Border Adjustment Mechanism (CBAM) (as to which, see our recent briefing). But, these bring with them administrative and legal challenges, for instance, decisions around which sectors or industries are in scope. In a recent CIOT/IFS debate, the example was discussed of steel being in scope of CBAM but not e.g. car components or white goods. Could this push manufacture of those goods into lower ambition countries such that they are only imported into the EU once they are in component form and no longer subject to CBAM? There are further issues around assessing the embodied carbon in imported products, which benchmarks to use and the additional compliance and registration hurdles that BCAs bring. In addition, BCAs that impose tariffs on those who are not participating potentially raise trade concerns: clearly such measures will have to be aligned with WTO rules to avoid a trade challenge. More generally, the IMF/OECD recommend further alignment of trade and environmental policies (for instance a review of trade policies that increase emissions such as fossil fuel subsidies). One upside of an increasing prevalence in BCA measures is that this incentivises exporting countries to implement similar measures themselves, so that they benefit from the additional revenues rather than them going into the coffers of the destination state.

5. Environmental taxes are not operating in a vacuum: New measures have to be layered on top of existing tax rules which are not neutral from an emissions perspective. For instance, the IFS report illustrates that as a result of a patchwork of existing measures (e.g. VAT zero rating of flights, no fuel duties on jet fuel, air passenger duty set at rates that are not proportionate to emissions), buying a business-class ticket to New York is strongly incentivised by the UK tax system compared to other (lower carbon) alternatives. Although UK Budget 2021 seeks to address the point around long-haul air passenger duty rates, measures such as these which result in implicit carbon pricing are much less visible and illustrate why achieving a uniform carbon price across industries and sectors is more complicated than you might imagine (for instance, at present, international agreements largely prohibit taxes on fuel for international flights). Furthermore, there are other factors to consider in addition to emissions, for instance, tax incentives may well encourage greater use of electric cars, but could, say, run counter to policies designed to ease congestion.

6. Tax policies are not enough on their own: The OECD Report notes that “carbon pricing is not the only game in town” and a key challenge is balancing this with other policy levers such as stricter regulation (for instance changing emissions standards for cars), subsidies and incentives (for example to encourage further research into developing new greener technologies or to provide financial support to make these affordable and scalable) and public investment (for instance to update infrastructure to support cleaner technologies). However, such measures do not raise government revenues and funding such initiatives could involve putting up taxes and/or moving funding from other areas of spending. Public opinion will have to be in favour of such measures if this is to work.

7. The transition to net zero could be challenging for tax authorities: As well as increased spending on the subsidies, incentives and public investment needed to support decarbonisation, getting to net zero could also have a negative impact on tax revenues. The recent Net Zero Review published by the UK Treasury indicates that not only will there be “demands on public spending, but the biggest impact comes from the erosion of tax revenues from fossil fuel-related activity”. For instance, as motorists move away from using petrol and diesel vehicles, there will be a significant reduction in revenues from fuel duties and vehicle excise duties. Even for those tax authorities looking to make a shift towards a greater use of environmental taxes, the paper notes that “any temporary revenues from expanded carbon pricing are unlikely to be sufficient to offset the structural decline in tax revenues”. Furthermore, the more successful that environmental taxes are at cutting emissions, the less revenue these will generate.

8. Households and businesses are likely to bear the cost of moving to net zero: In this period of transition, ambitious carbon pricing means high energy prices, which will in turn increase the cost of providing goods and services for both suppliers and consumers. Similarly, the cost of government-funded programmes to promote decarbonisation will ultimately be borne by households or through lower spending in other areas. Care will need to be taken to ensure this does not disproportionately hit low income households and energy intensive businesses. The IFS report highlights that currently emissions associated with electricity are taxed more heavily than those from burning gas. Households and businesses are therefore not incentivised to move away from using gas (such as through greater use of electric heat pumps) or to develop low-cost carbon saving technologies in this area. However, changes in this area could disproportionately hit those who cannot afford it, so it will be important to strike the right balance between encouraging a shift towards greener energy and properly designed compensation measures.

9. The future could look very different from a tax perspective: Femke Groothuis, from Dutch thinktank Ex’tax Project envisages a shift in the tax burden away from labour taxes with a move to a more circular economy. She cites businesses that are leading the way in sustainability, for instance fashion houses selling pre-owned clothing to reduce the amount of primary materials used. This requires people power as opposed to more resource heavy disposable fashion. A move to this kind of business model requires knowledge, human skills and investment in innovation to redesign supply chains and overhaul consumption patterns: encouraging consumers to repair and reuse rather than buying new and cheap. In her view, a shift to a polluter pays model would remove financial barriers facing businesses, with taxes focused not only on carbon emissions, but also water usage, fossil fuels in creation of plastic, payroll tax credits for reskilling workers, credits for companies that employ more workers, resulting in more jobs and less pollution. It sounds idealistic, but this is just the sort of thing the EU is currently looking at in its reflection on “Changing the EU tax mix on the road to 2050” as part of its Business Taxation for the 21st Century Package (as to which, see our dedicated webpages).

10. This is not going to be easy: Even with the current momentum behind the push towards net zero, it is clear that getting there will not be simple. We are not starting from a blank piece of paper. There are existing rules to be navigated and multiple conflicting policy considerations to weigh up. Tax does not work in isolation and reducing carbon emissions is not the only issue facing administrations. How do you incentivise greener behaviours now, without giving up the right to tax such behaviours later. Governments going it alone risk making the problem worse through carbon leakage. Policymakers across sectors and across nations will need to work together. While the renewed interest from policymakers around COP 26 is promising, there is still a long and challenging road ahead.

See the Freshfields COP 26 climate hub for insights on how the areas of finance, litigation, regulation and transactions, can shape the legal response to climate change.