Carbon taxes

Carbon taxes and carbon trading

A carbon tax is a tax on carbon emissions. The term 'carbon' is now generally used as a shorter alternative to 'greenhouse gases', with C02 making up around 65% of global greenhouse gases [1].

Carbon is generated as a result of economic activity from both production and consumption. Most carbon emissions arise directly from the generation of energy from fossil fuels (coal, gas, and oil). In terms of sources of carbon, energy use if the single largest source, at 75% - comprising energy used in industry at 24.5%, energy used in buildings at 17.5%, and energy for transport at 16.2%. Agriculture and land use makes up a further 18.4% of emissions. [2].

Carbon taxes and carbon permits [3] are two methods which try to put a price on carbon emissions, and reduce the market failure [iii] arising from unregulated carbon emissions. Both carbon taxes and carbon permits use market mechanisms to help establish a price for carbon.

The Kyoto Protocol

A key turning point in the global effort both to acknowledge and to deal with increasing emissions was the signing of the Kyoto Protocol, which came into effect in 2005, and saw 192 countries commit to a staged reduction in their levels of carbon emissions. During the first phase, 37 industrialised countries, the EU and various transition economies committed to reduce emissions by an average of 5% against 1990 levels. The second phase committed signatories to an 18% reduction by 2020[4]. As part of their commitment, countries sought to develop methods to price carbon, including carbon taxes, and carbon permit schemes.

Classifying carbon taxes

There are several ways to classify carbon taxes depending at which stage in the supply-chain the tax is levied.

Upstream taxation puts a tax on the primary source of the carbon emission, including the industries that extract and process fossil fuels, such as oil, gas and coal producers. The tax is then passed downstream towards final users [1],  eventually resulting in increases in the downstream prices of goods (and services).

The effect of a carbon tax - costs are increased, pushing up prices.

In theory, a carbon tax could be imposed at any point in the supply chain of a particular good (or service). However, those responsible for designing carbon tax systems prefer the tax to be imposed as far upstream as possible as there are fewer 'entities' involved [5]. The initial tax is then passed down through the supply chain, finally arriving at the end-user - hence there are fewer administration costs for the tax authorities.

How do carbon taxes work?

Like all indirect taxes, a carbon tax is imposed on producers, rather than consumers, although the incidence of tax may fall more on consumers than producers - this depends on the price elasticity of demand for the goods or services on which the tax is levied.

The rate of tax should, in theory, equate to the external cost of carbon to society. Most countries that have a carbon tax set a rate per metric ton of CO2 produced.

A carbon tax is, in effect, an additional production cost. How much costs increase depends partly on whether the tax is a percentage tax - known as an 'ad valorem' tax - or a specific amount.

Globally, carbon taxes are typically set at a fixed amount per metric ton produced, with annual increases to take into account each country's target for reduced emissions. For example, Norway's current €60 per ton tax is set to rise to €200 by 2030. [6] Graphically, the effect of a tax is to shift the supply (cost) curve vertically upwards.

The effect of a carbon tax - the incidence of a carbon tax on consumers and producers.

The incidence of a carbon tax

The incidence of a carbon tax (or, indeed, any indirect tax) refers to 'who' pays the tax. In the above case, the incidence is split relatively evenly between the producer of the taxable output - in this case, the steel producer - and the consumer or user of the output - in this case, the downstream firms, such as motor vehicle producers. Motor manufacturers will, in turn, pass this on to the next stage - fleet car companies, or private car purchasers. Of course, governments can add additional taxes down the supply chain, such as introducing an additional carbon charge on new vehicles, or on petrol (gasoline) or diesel.

Impact of elasticity

The effectiveness of a carbon tax will depend upon the price elasticity of demand for the good or service on which the tax is placed. If demand is relatively inelastic, as shown below, the impact of the tax will be reduced. This suggests that other policies might be required to help shift the demand curve to the left.

This might include subsiding goods and services with a much lower carbon footprint. For example, governments could subsidise electric cars, which might shift the demand curve petrol and diesel cars to the left. The same effect could be achieved by subsiding green technology, which will eventually work its way into lower consumer prices.

The effect of a carbon tax - costs are increased, pushing up prices.

More countries introduce carbon pricing

As can be seen below, since 2005 carbon pricing has increased so that by 2021 nearly 25% of all carbon emissions were covered by some form of carbon pricing initiative. The single biggest impact on this growth was the introduction of China's national Emissions Trading System in 2021. Of course, critics would point to the 75% of global emissions that remain untouched by carbon pricing.

Chart to show which countries use carbon trading systems.

The global carbon tax map

The map below shows which countries currently use a carbon tax. This does not include countries who participate in an Emissions Trade System (ETS). It should also be noted that not all countries refer to these taxes as carbon taxes. For example, in the UK the relevant tax is called the Climate Change Levy.


A global map to show carbon tax take-up.

Advantages and disadvantages of using carbon taxes

Advantages

Carbon taxes provide a number of benefits, including:

  1. Helping achieve the socially desirable and sustainable quantity of carbon emissions.

  2. Taxes are widely 'understood' and accepted as a means of alterning behaviour.

  3. Carbon taxes are relatively cheap to collect, with a small administrative cost.

  4. Global take-up is increasing.

  5. Carbon taxes generate tax revenue.

  6. Rates can be increased each year to help governments meet their carbon reduction targets.

  7. Rates can be adjusted for different energy sources - different rates for gas, oil and coal.

  8. Jobs cab be created in the emerging 'carbon economy'.

  9. Taxes exploit the market mechanism to 'internalise the externality' - despite their failures, market forces are a powerful and effcient means of allocating resources and changing behaviour.

Disadvantages

Carbon taxes also have several disadvantages, including:

  1. While carbon taxes will affect the price of carbon they do not set a cap on emissions - unlike 'cap-and-trade' systems.

  2. Setting tax rates is subject to information failure.

  3. There may be unintended consequences, such as 'carbon leakage' where producers outsource production to territories which are not part of any carbon scheme.

  4. Reductions in carbon may not be guaranteed as consumers/users continue to undertake carbon emitting activities, and are willing to pay the tax [there is no cap on emissions].

  5. Indirect taxes tend to be regressive, with the heaviest burden on the poor (or poorest nations).

Discussion question:

Assess the merits of carbon taxation as a mechanism to reduce carbon emissions.

Sources and endnotes


[1] United States Environmental Protection Agency, 2019, viewed April 5, 2020, https://www.epa.gov/ghgemissions/sources-greenhouse-gas-emissions

[2] Options and Considerations for a Federal Carbon Tax, February 2013, Center for Climate and Energy Solutions, Viewed May 8th 2021, https://www.c2es.org/site/assets/uploads/2013/02/options-considerations-federal-carbon-tax.pdf

[3] Our World in Data, 2016, https://ourworldindata.org/emissions-by-sector, viewed May 1 2021

[4] UN Climate Change Report, viewed May 6th,2021, https://unfccc.int/kyoto_protocol

[5] Options and Considerations for a Federal Carbon Tax, February 2013, Center for Climate and Enegy Solutions, Viewed May 8th 2021, https://www.c2es.org/site/assets/uploads/2013/02/options-considerations-federal-carbon-tax.pdf (p5).

[6] The Bellona Foundation - https://bellona.org/news/ccs/2021-02-norway-proposes-e200-per-ton-co2-tax-by-2030#:~:text=Norway%20was%20one%20of%20the,cubic%20metre%20natural%20gas%20emissions.



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