Road to COP27 – how is tax being used to tackle climate change?

Although tax is not a headline item on the agenda at COP27, it is recognised by governments across the world as an important part of the toolkit to tackle climate change and perhaps weaves a quiet path through the collaboration and mitigation pillars of COP27. Both the OECD and the UN are vying to lead the charge on international collaboration on environmental tax policies, and it is clearly high on the list of priorities at an EU level. National governments are increasingly using tax measures to encourage mitigation of emissions, although geopolitical factors (as outlined in our earlier COP27 blog here) have slowed progress in this area.

How has the tax landscape in this area evolved since COP26? Since our previous tax blog (here), global carbon pricing revenues have increased, with a 2022 World Bank report showing an almost 60% increase in revenues in 2021 compared to 2020 levels, and carbon prices hitting “record highs” in many jurisdictions. However, according to the report, “less than 4% of global emissions are currently covered by a direct carbon price in the range needed by 2030 to meet the temperature goal of the Paris Agreement”.

The OECD in June 2022 launched its Inclusive Forum on Carbon Mitigation Approaches (the IFCMA). According to the OECD report on the IFCMA prepared for G20 Finance Ministers in October 2022, the Forum will “foster exchange among countries, facilitate easier access to systematic data and analysis to support better understanding of the combined effect of diverse policy approaches and enable countries to share their climate change mitigation policy experiences” and is intended to ensure the involvement of developing and emerging countries in decision-making. It is also multi-disciplinary, bringing together experts on climate, tax and economic policy.  Concurrently, the UN has established a Subcommittee on Environmental Taxation which met for the first time in January 2022 to develop a workplan for 2022-25, which will include:  (i) looking at the role of carbon taxes and other measures to support energy transition; (ii) the interaction of carbon taxation with other national measures; and Carbon Border Adjustment Mechanisms (CBAM) and (iii) how developing countries can avoid undesired spillover effects from other countries applying those measures.

The EU has also been pressing on with its “Fit for 55 package”. In June 2022, the European Parliament adopted proposals that include revising the EU Emissions Trading System and the introduction of a new EU CBAM. These now have to be approved by the EU Council. Whilst discussions continue on potential changes to the Energy Taxation Directive, some progress has been made in relation to VAT. Amendments to VAT rates under the VAT Directive were agreed in April 2022, such that supplies deemed detrimental to the EU’s climate change objectives will (from 2030) no longer be able to benefit from preferential VAT treatment and, on the flipside, Member States are allowed to apply zero rates or reduced rates to environmentally friendly goods and services.

Carbon Taxes Expanding

In terms of national measures, the OECD’s Tax Policy Reforms report, published in September 2022 noted that “promoting environmental sustainability has become increasingly central to the policy goals of taxing energy and vehicle use”, with several countries adopting new carbon taxes or removing tax exemptions. Austria, Denmark and Indonesia are amongst those that have recently enacted new carbon taxes. Singapore and South Africa increased their carbon tax rates in 2022 and explicit carbon prices are set to rise in Canada due to new benchmarking. Both Ireland and Iceland’s 2023 Budgets include proposals to increase their carbon tax rates and the Netherlands 2023 Budget includes proposals to expand its recently-introduced carbon tax regime.

Other Tax Tools

Carbon taxes are not the only tax tool being used by governments to tackle climate change, with some adopting the carrot rather than the stick approach. The Inflation Reduction Act, recently passed in the US, introduces and expands a number of clean energy-oriented tax credits. These measures are designed to encourage investment and innovation in the renewable energy production sector and incentivise consumers to purchase electric vehicles.  Canada and Korea are both also looking at tax incentives for clean technology. Carbon capture, utilisation and storage is another area of focus, with Norway consulting on a tax exemption for such technology and Canada proposing refundable tax credits for those investing in this area.

Vehicle taxes continue to form another large component of environmental tax revenues, with many countries (such as Germany, France, Norway and Sweden) recently altering their vehicle taxes so that more-polluting vehicles are taxed more heavily. Others are introducing tax incentives to encourage investment in, and purchase of, greener vehicles. In addition to the US measures mentioned above, Belgium has announced increased deductions for investments in this area, and countries such as the Netherlands, Germany and Ethiopia have tax exemptions for electric vehicles.

There are of course other measures such as fuel excise duties, with preferential tax rates for specific sectors or polluting fuels being phased out. In addition, the OECD report notes that taxation of plastics is becoming more common, with the UK introducing a plastic packaging tax from April 2022, and Greece, Spain, Italy and Colombia looking at taxes on single use plastics.

Potential Headwinds

However, it isn’t all plain sailing. The energy price crisis has led to emergency tax measures, some of which do not support the transition to net zero. These emergency measures (as outlined in our blog here) include the EU сap on market revenues for the generation of electricity, which hits renewables (it is also anticipated that the UK may set out plans for a similar temporary cap on renewable energy producers). This could potentially be criticised for sending the wrong signals to those investing in the renewable energy sector.

On the other hand, the EU’s proposed temporary solidarity contribution for fossil fuel businesses is potentially more aligned with decarbonising targets. In addition to targeting excess profits of fossil fuel businesses, Member States are permitted to use the proceeds from the contribution, as well as any alternative qualifying “equivalent national measures” (existing or enacted by the end of 2022), to invest in renewables and decarbonisation technologies, or to help reduce energy consumption. However, some may choose to prioritise, for example, supporting vulnerable households or energy-intensive industries.

Indeed, some governments have responded to the crisis by suspending various environmental tax measures in an attempt to alleviate the financial burden on households. For instance, Portugal suspended its proposed increase in carbon tax until the end of the year, Austria delayed the introduction of its carbon tax until October 2022, and Italy’s single-use plastic tax has been postponed to 2023.

There is also a sense that green taxes are slipping down the priority list more generally and there appears to be (for some at least) little sense of urgency in discussions in this area. The EU, a year on, is still negotiating to find a compromise on CBAM. The report of the French Presidency of the EU Council noted that changes to the Energy Taxation Directive are “complex” and require further technical discussion and it is not presently clear whether the January 2023 target date of entry into force can be achieved. The first meeting of the OECD’s IFCMA is not until February 2023.

There is also a trend of kicking the can down the road with some of the national measures, with governments announcing environmentally-friendly policies now which don’t bite until much later. For instance, the new Danish carbon tax does not come into force until 2025 and the EU’s phasing out of VAT preferential rates for environmentally “unfriendly” supplies does not apply until 2030. And, despite growing coverage on carbon pricing, overall effective carbon prices still remain low. So, although progress is being made, it is not being made quickly enough.

The Road Forward?

Jo Tyndall, Director of Environment Directorate at the OECD, speaking at the 14th meeting of the OECD/G20 Inclusive Framework on BEPS on 6 October put it very clearly, noting that “climate change is not a longer term challenge – this is a clear and present danger, with every continent of the world seeing dramatic weather events this year”. She emphasised the importance of making sure that government responses to energy price spikes do not derail that urgent need. Interventions that blunt price signals, such as reductions in fuel taxes, risk increasing dependence on fossil fuels. She spoke of using the current crisis to act as an accelerator and catalyst for investing in new technology and new infrastructure, a chance to encourage energy users to adapt and make the shift to alternative fuels and, at the same time, achieving stable lasting energy security. She highlighted the importance of taking a multi-disciplinary approach to tackling climate change. We can only hope that those heading to COP27 take note.