NARRATION TRANSCRIPT

MODULE 1:
CARBON TAXES – WHY AND WHEN TO USE THEM

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Welcome to the e-course on carbon taxation! In Module 1, we set out to define what carbon taxes are,
differentiate carbon taxes and other policy instruments for emission mitigation, and outline the role of
carbon taxes within broader policy mixes.

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Within the course of this module, we examine what carbon taxes are, what distinguishes carbon taxes
from other policy options and what role they can play as part of a broader policy mix.

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The climate is changing. Global warming – driven by greenhouse gas emissions – causes an increase
in the magnitude and frequency of natural hazards, such as rising sea levels, floods, droughts,
tropical storms and others. These hazards impose considerable costs on society related to
livelihoods, health, development, property and investments.

Under the Paris Agreement adopted in 2015, countries have agreed to work together to keep the
increase in global average temperature well below 2°C above pre-industrial levels. Each country has
defined its own Nationally Determined Contribution, which sets out how much it will contribute to the
global effort. Countries must then decide which policy instruments to use to achieve their targets.

Carbon taxes are one instrument available to governments to help reduce their emissions and meet
their targets. While carbon taxes can potentially support the achievement of a range of policy
objectives, governments most commonly cite the aim of reducing greenhouse gas emissions as the
chief driver behind their adoption.

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A carbon tax is defined as a tax that explicitly states a price on greenhouse gas emissions or that
uses a metric directly based on carbon (that is, price per ton CO2 equivalent).

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Carbon taxation can be applied in different ways; for example, on fossil fuels such as oil, gasoline,
natural gas and coal, according to how much carbon they emit. It can also be applied on measured
emissions of power plants, factories or even cars.

Although a carbon tax may be placed on fuels, it is distinct from other fuel taxes. The latter are usually
not based on the carbon emissions of each fuel and tend to focus primarily on revenue generation. A
carbon tax is also more likely to be specifically designed with the aim of reducing emissions.

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An important benefit of carbon taxes is that they address a fundamental problem in our economy.
When market actors exchange goods or services for monetary payments, they often engage in
economic transactions that drive greenhouse gas emissions. These emissions, in turn, drive climate
change. The fundamental problem lies in the fact that climate change incurs costs for everyone in the
society, including those who did not form part of the economic transactions that caused it.

The negative effect of market transactions on parties that are not involved in – or are external to – the
transaction is called an externality.

Climate change is considered a vast externality. A person who is born today, for example, will have to
bear the costs of climate-induced negative effects, such as more frequent tropical storms, even
though she is not responsible for the emissions resulting from economic activities before her lifetime.

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One way to reduce externalities is through government action. In particular, governments can
intervene in economic transactions by taxing the amount of greenhouse gas emissions that result
from them. Carbon taxes send a price signal to market actors by factoring in – or internalizing – the
social cost of emissions, with the effect of reducing demand for goods and services that produce such
emissions.

The collected revenue, in turn, can be used for the benefit of the entire society by virtue of public
spending. Public spending can target climate change in general through mitigation measures, such as
reforestation programmes, or benefit specific vulnerable groups through adaptation measures, such
as capacity building for small-scale farmers.

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Carbon taxes have been in place since the beginning of the 1990s. Early taxes were concentrated in
the Nordic countries, with Finland adopting the first such tax in 1990. These taxes were first
concentrated in the energy sector and “piggybacked” on existing administrative systems for excise
taxes on fuels.

Since the late 2000s, there has been a renewed and growing interest in carbon taxes. The
resurgence in interest in carbon taxes has come in the wake of enhanced global ambition to tackle
climate change. Today, there is increasing recognition that only concerted action by all countries can
effectively address the problem.

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At the same time, many jurisdictions have been gradually reducing their reliance on income and
corporate taxes, and using the tax system to achieve various policy goals beside raising revenue.

Use the Frame bar on the left to see the evolution of carbon taxes since 1990.

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Currently, there are 27 carbon taxes in place, with two more scheduled to come into force. Altogether
they cover about 5% of annual global GHG emissions.

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Carbon taxes can potentially be very effective in supporting mitigation targets. Yet they are just one of
several tools to achieve that goal. Before adopting a carbon tax it is important to understand how they
compare to the alternatives.

One important aspect in choosing the right policy is a consideration of the barriers to mitigation.
Different types of policy instruments are available to address different barriers. Can you match them?

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Several policy instruments are available that can potentially address externalities. In determining if
carbon taxes are the right instrument, it is useful to compare them with the alternatives, such as
command-and-control regulations, subsidies, emissions trading systems (ETS) and government
provision of services.

Importantly, two key factors distinguish the various instruments: the amount of discretion they afford
targeted entities; and the way they distribute the costs of controlling emissions as well as the costs
associated with unabated emissions.

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The discretion afforded to private entities with regard to how emissions are mitigated can vary widely.
Several broad approaches can be identified:

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The instruments used to address environmental externalities can also be differentiated by how they
allocate the costs – who pays and for what? In this context, two types of costs are relevant. The
obvious one is the cost of abatement, that is, the cost of reducing emissions. However, policy
programmes seldom drive emissions to zero, so there are also the costs associated with the
unabated emissions – the damages to society. The allocation of these two types of costs differs under
the various policy instruments.

Starting in the middle of the figure, command and control instruments and ETSs with freely allocated
emission allowances require the targeted parties to pay for emission abatement. However, they do

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not hold them responsible for the unabated emissions. By contrast, under subsidies and government
production, society (or its government) pays for the abatement and bears the social cost of the
unabated emissions. At the other end of the spectrum, under an arrangement such as a carbon tax,
parties pay not only for the reduction of their emissions but also for the emissions they fail to abate. In
these cases, the government may still shoulder the administration costs of the mechanism, which it
may cover from carbon tax revenues.

The allocation of costs is a continuum of not only a wide variety of instrument types, but also of many
different ways to design individual instruments, with designs leading to different effects in terms of
cost distribution.

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When compared to other instruments designed to address externalities, carbon taxes are
distinguished by two factors: high discretion and costs paid by private parties.

To determine whether a carbon tax is the right policy instrument to address a jurisdiction’s mitigation
goals, it is important for policy makers to consider how it compares to the other instruments available
at a general level.

Carbon taxes generally encourage emitters to invest in innovation and seek information about
available cleaner technologies. They do not necessarily resolve the fundamental problems that cause
underinvestment in research and imperfect information though.

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Carbon taxes allow market actors - consumers, producers and investors - to decide how best to
reduce emissions. Tax liabilities are based only on the actual level of emissions.

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In their purest form, carbon taxes require that emitters pay for the cost of reducing emissions and,
also, for the unabated emissions.

If a factory decides to reduce its carbon tax bill by cutting emissions in half, it has to pay for any new
technologies or practices it needs to adopt to achieve that cut and pay a tax on the remaining
emissions.

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Carbon taxes and emissions trading systems both seek to reduce emissions by pricing in the costs of
emissions into the emitting activity. Thus, they can also raise revenue for the government.

The primary difference between the two is the point of control. Where taxes specify a price on
emissions and subsequently allow the market to determine the quantity of emissions, an ETS sets the
quantity and allows the market to determine the price.

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Generally speaking, taxes provide certainty regarding the carbon price over a given period, often
crucial for facilitating private investment in emission mitigation. An ETS can provide more certainty
regarding the ability to meet a specific mitigation target but provides less certainty on the price.

Emissions trading can bring economic efficiency gains by allowing participants to exploit the lowest-
cost mitigation options across covered sectors. However, this presumes well-functioning markets with
sufficient numbers of participants.

In practice, carbon taxes and ETSs have differed significantly, particularly in terms of pricing. This is
due to a number of factors, including the location of the schemes and the difficulties ETSs have
experienced in managing the impact of market volatility on prices. This may change however as ETSs
introduce further measures to control price volatility.

From an administrative point of view, where a carbon tax can often be piggybacked onto an existing
tax administration, an ETS usually requires a new administrative structure to track and enforce
allowance ownership. This condition often makes carbon taxes more suitable for jurisdictions that lack
the substantial capacities to implement emissions trading.

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To achieve emission reductions, taxes are best applied in elastic markets. Governments that seek to
reduce emissions through price signals should examine whether producers and consumers are likely
to be responsive to price changes. A market is called elastic when agents respond readily to price
changes, and inelastic when they don’t.

It is important to consider elasticity of demand in a given sector before implementing a carbon tax. For
example, a tax (T) on energy supply will induce a larger decrease in energy use when the price
elasticity of demand for energy in the sector is relatively high. To achieve the same reduction when
elasticity is low (demand is inelastic), however, would require a higher tax.

If there are political obstacles to such a high tax, alternative mechanisms may be preferable.

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Demand elasticity in the transportation sector is considered to be relatively low, particularly in places
with limited alternatives to individual motorized vehicles.

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Looking back at our discussion in the previous sections, when do you think carbon pricing is the right
choice?

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No single policy can address all issues at once. Thus, carbon taxes are often part of a larger climate
and energy policy mix. This mix may include measures such as government-funded research and

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technology standards related to industrial energy efficiency, fuel efficiency or electricity generation.
Governments combine policy instruments for different reasons, some motivated by good policy, some
precipitated by circumstances.

It is important to understand how these instruments can complement, overlap with and even
counteract each other. Although in practice it is sometimes difficult to isolate these effects, the
distinction can nevertheless be useful.

Recalling the barriers to emission mitigation discussed previously, a sound policy mix will, at the least,
seek to address all major underlying issues in a complementary manner.

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Complementary policy instruments are those that work together to produce desired outcomes.
Generally, complementary instruments are most useful when either multiple types of market failures
or multiple social goals exist. Jurisdictions may sometimes need to engage in “gap-filling” because
existing systems are incomplete.

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Overlapping policy instruments are those that share objectives but may be redundant. For example, to
reduce emissions using both carbon taxes and an ETS for the same sector would be an overlapping
mix of instruments. In such a case, the price signal would be amplified. If the two instruments covered
different sectors, however, the mix would be complementary.

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Counteracting policy instruments are those that work in opposition to each other. For example, carbon
taxes on transportation fuels and consumption subsidies on the same fuels would be counteracting
policy instruments – one reduces emissions by raising the effective price of fossil fuels while the other
increases emissions by lowering their price. Jurisdictions should seek to avoid or at least minimize the
use of counteracting policy instruments.

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Let’s assess some examples of policy packages! Considering the spectrum of policy interaction, can
you tell in which category the policy combinations fall? Drag and drop the combinations at the bottom
of the Frame into the right category!

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When a carbon tax is adopted, it is built into an existing tax revenue system that includes many
different instruments, such as income taxes, corporate taxes, fuel taxes, etc. Within a single country,
these instruments might include taxes levied at different levels, ranging from national to local levels,
and reflecting economic and policy objectives. When considering the adoption of a carbon tax, it is

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therefore important to understand the ways the tax could interact with other elements of the fiscal
policy system.

Several factors are relevant in both determining whether to adopt a carbon tax and choosing the right
design options.

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In addition to these overall design considerations, a number of legal, political and institutional factors
are relevant for governments to consider when adopting a carbon tax.

Economically speaking, there is no distinction between a tax, a regulatory fee or a penalty on carbon.
Yet the language used can matter in the political acceptance of the policy, the ability of a particular
level of government to adopt the instrument and the legal rights of the stakeholders involved. For
example, a given level of government seeking to raise revenue might frame the instrument as a
“charge” or “penalty,” when it does not have the authority to levy a “tax”.

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Even when the financial instrument clearly is a tax, what type of tax it is can play a role in the
assignment of taxing powers. One of the most frequent tax typologies distinguishes between “direct”
and “indirect” taxes. The difference between the two is whether the tax is levied directly on persons or
indirectly, through firms. Indirectly, the tax is passed down to the supply chain. In this case, although
the tax is ultimately paid by customers through higher prices, the tax is collected and remitted by
firms.