2

GREEN FISCAL REFORM

& POLICY INSTRUMENTS

FISCAL INSTRUMENTS FOR

GREENING THE ECONOMY
green fiscal reform & policy instruments
fiscal instruments
for greening the economy

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Course authors:
Giuliano Montanari, Maya Valcheva, Amrei Horstbrink (UNITAR); Philip Gass (IISD)

Contributors:
Jason Dion (IISD); Sirini Withana (UN Environment); Sarwat Chowdhury, Massimiliano Riva
(UNDP).

Creative Concept:
Arturo Rago

Graphic Design:
Pilar Lagos (UNITAR)

Photo credits
Unless stated otherwise, the photos used in the journal are under a CC license.
TABLE OF CONTENTS
Introduction 5

1 main categories of green fiscal instruments 6

REVENUE COLLECTION 6
REVENUE EXPENDITURE 6
ALTERNATIVE MARKET-BASED MECHANISMS 7

2 taxes, charges and Fees 8

OVERVIEW 8
VARIOUS TYPES OF ENVIRONMENTAL TAXATION 9
USING ENVIRONMENTAL TAXATION TO FOSTER INNOVATION AND GREEN INVESTMENT 13
ENVIRONMENTAL TAX SHIFT 14
ENVIRONMENTAL TAXATION: CHALLENGES AND OPPORTUNITIES 16

3 subsidies and related instruments 18

OVERVIEW 19
SUBSIDIES AND RELATED TOOLS THAT SUPPORT GREEN ECONOMY TRANSITION 19
REFORMING HARMFUL SUBSIDIES 24

4 Alternative economic instruments 28

OVERVIEW 28
TRADABLE PERMITS 28
OFFSETS 30

5 using fiscal instruments in a policy mix 32

6 key learning points 34

references 35
ABBREVIATIONS 39
 5
Introduction
A
s noted in Module 1, market failures
occur when environmental or social
functions are not well-reflected in
market prices, which results in externalities
affecting third parties. By using green fiscal
instruments, governments seek to correct
market failures and impose a price on negative
externalities and polluting activities to create a
change in behaviour toward more sustainable
consumption and production (UNESCAP
2012).
Green fiscal instruments can come in the
form of environmental taxation, harmful
subsidy reform, or alternative market
mechanisms such as pollution permits.
These instruments can be used to “facilitate
innovation, stimulate green markets or to
phase out environmentally or socially harmful
activities” (GGKP 2015). Domestic public
finance, mobilized through fiscal instruments,
can support green economic development.
Module 2 looks at how different fiscal tools
can be used to change economic incentives
and price signals, with a focus on practical
examples from key sectors.
Lesson 1 introduces the key categories of fiscal
instruments at the disposal of policymakers.
Lesson 2 outlines how taxes, charges and
fees can be used to tackle environmental
externalities, foster innovation for green
industries, or encourage green behaviour.
Lesson 3 addresses the role of subsidies and
subsidy reforms, especially in the context of
the energy sector. Lesson 4 covers fiscal and
wider market-based instruments that help set
incentives for the private sector.
After completing the module, participants will
be able to:
- List various fiscal instruments to address
market failures
- Discuss how environmental taxes and fees
can effectively support transition to a
green economy
- Outline how subsidy reform can advance
low-carbon development and improve
public finance
- Depict market instruments based on
collaboration between the state and
private sector
- Provide examples of how green fiscal
reform measures can be applied in
practice.
1

MAin categories of GREEN

FISCAL instruments
The green fiscal reform toolbox comprises several categories of instruments
that are used to collect revenue, manage expenditure, or mobilize action by
markets – all while advancing sustainability.

The following paragraphs provide a brief overview of three main categories of fiscal
instruments dealt with in this module.1

REVENUE COLLECTION
Instruments for revenue collection include pollution, payers are incentivized to limit
carbon taxes, usage charges, dumping and polluting activities, in order to reduce the
waste management fees, and many more. financial burden associated with this activity.

Environmental taxation targets polluting In contrary, by reducing taxation, e.g. by

industries, inefficient use of natural granting a tax rebate, on environmentally
resources, or environmentally harmful friendly practices and products, market
consumption patterns. The rationale is actors are encouraged to pursue sustainable
simple: By placing an economic cost on business and household behaviour.

REVENUE EXPENDITURE
Expenditure instruments include direct
and indirect subsidies, grants, low-interest
loans, sustainable public procurement,
public-private partnerships, etc. They
can be tied closely to revenue collection
if the funds collected through taxation
are directed to support green industries,
research and development, or efficiency
improvements. Importantly, expenditure
instruments provide fiscal support for the
green transition and help leverage private
investment. Thus, they help mobilize
domestic public and private resources for
investment in sustainable development in
line with 2030 Development agenda.

1 Further reading on reforms and specific tools: http://www.greengrowthknowledge.org/sites/default/

files/Withana_Overcoming_obstacles_to_green_fiscal_reform.pdf, http://www.e-elgar.com/shop/
environmental-taxation-and-green-fiscal-reform, http://www.greenfiscalpolicy.org/, http://www.
unep.org/greeneconomy/Portals/88/documents/news/Issue%20Briefs/fiscal%20policy%20brief_
EN_final.pdf, http://www.greengrowthknowledge.org/theme/fiscal-instruments
 7
ALTERNATIVE MARKET-BASED
MECHANISMS
There are different market approaches
that states can use to influence the private
sector.
For example, policy makers can set a scheme
that allows for permits that represent a
unit of pollution or emissions, to be traded
between market actors.
Each permit allows for polluting activity
to take place, however, the economic
costs associated with pollution creates
an economic incentive for companies to
become cleaner and sell excess permits for
economic gain.
These can also take the form of deposit and
refund schemes aimed at waste avoidance.
Payments for ecosystem services also
incentivize sustainable practices my market
actors.
Each of the following lessons deal in greater
details with these categories.
2
taxes, charges and fees
One of the most fundamental ways to discourage polluting activity is to
raise its cost. Revenue collecting instruments do just that and are thus an
application of the ‘polluter pays’ principle.
Overview
Environmental taxation creates enabling
conditions to increase efficiency in the
economy by encouraging green innovation
and investment, while placing increased cost
on polluting activities (Peters 2012).
The collected revenue can be allocated to the
general budget or directed to finance green
initiatives or lower taxation in other areas,
such as personal or business tax reductions.
The idea of environmental taxation is not
new – liberal economists and environmentalist
have been debating over its use for decades.
Sweden has made use of environmental
taxation and other economic instruments for
environmental policy since the 1970s (Nordic
Council of Ministers 2006).
Since the 1990s environmental tax reform has
spread to other Nordic countries, as well as
across much of Europe.
In more recent years, developing countries,
such as China, Vietnam, Cambodia, South
Africa, Thailand, and Tunisia, are taking
increasing lead in applying environmental
taxes (Heine, Norregaard and Parry 2012).
After the 2008 economic crisis, countries
looked at green taxes with renewed interest,
due to the need to raise additional public
resources.
Driving forces behind the political motivation
for environmental tax reform include:
- Desire for stronger environmental
outcomes;
- Possibility to generate new government
revenues;
- Increasing recognition that pricing
polluting sources is more effective than
regulatory approaches;
- Possibility for increasing the
competitiveness of the economy, by
redirecting taxes from labour and income
(Heine, Norregaard and Parry 2012).
There is also the motivation inherent in
meeting international obligations on the
environment, such as commitments through
the United Nations Framework Convention
on Climate Change (UNFCCC) or the
SDGs.
This lesson outlines lists various types of
tax-related instruments (2.2), describes how
they contribute to innovation and green
investment (2.3), and introduces the so-called
environmental tax shift (2.4). Furthermore,
criticisms and responses related to
environmental taxes are discussed portrayed
(2.5).
 9
FIG 1: Implementation of and plans for carbon taxation world-wide in 2015.3
Various types of environmental taxation
With ‘polluter pays’ as an underlying principle,
different types of environmental taxation
take a different approach to how polluters
pay for inflicted externalities. The following
paragraphs outline different taxation tools and
how they are implemented to collect revenue.
TAXES
Environmental taxes are a mechanism that
gives consumers and business a “least-cost
way to reduce environmental damage”
(OECD 2011).
That is to say, if a tax is imposed on a
particular good, e.g. petrol and diesel,
consumers have the ability to choose not
to consume that good and decide to use
alternate, less costly options, e.g. purchase
2 For more information read: http://www.oecd.org/env/tools-evaluation/48164926.pdf; https://www.cbd.int/
financial/fiscalenviron/g-fiscaltaxes.pdf
3 Retrieved from the Carbon Pricing Leadership.
ETS implemented or scheduled
for implementation
Carbon Tax implemented or
scheduled for implementation
ETS or Carbon Tax under
consideration
Carbon Tax implemented
or scheduled, ETS under
consideration
ETS and Carbon Tax
implemented or scheduled
more fuel efficient vehicles, use public or
active transportation.
Consequently, taxes can help drive innovation,
as consumers and producers would be drawn
toward least-costly options. Taxes also create
transparency as they are based on clear rules
as to what is taxed and when, who/what is
exempt, and what is the cost per unit of
pollution generated (OECD 2011). 2
As Figure 1 demonstrates a number of
countries have implemented carbon taxes
to account for the environmental damage
of carbon emissions. Other countries have
opted for emission trading systems (ETS) or a
combination between taxation and ETS (ETS
will be tackled in lesson 4 of this module).
 10

country and tax period evaluated impact

Finland 1990-2005 CO2 emissions 7 % lower than would have otherwise been.
Energy & carbon tax *A shift from carbon tax to output tax on electricity in 1997 may
have lessened impact.

Norway 1991-2007 21 % reduction in CO2 from power plants by 1995

Carbon & sulphur 14 % reduction in CO2 in 1990s, 2 % attributed to CO2 tax
dioxide taxes 12 % reduction in CO2 emissions per unit of GDP

Denmark 1992 6% CO2 emission reduction in affected sectors

Energy & carbon tax 20 % economic growth up between 1988 and 1997
5 % reduction in emission in one year as tax increased
23 % reduction in CO2 from business as usual in the 90s
26% increase in energy efficiency
*Subsidy for renewables may have accounted emissions reductions
as well

Sweden 1990-2007 0.5 million tonnes emission reduction per annum

Energy & carbon taxes 20% CO2 reduction from business as usual (baseline 1990)

The Netherlands 1999-2007 Emissions 3.5 % lower than would have otherwise been
Energy tax *Low tax rates may have limited impact
Germany 1999-2005 CO2 reduced by 15 % between 1990 and 1999 and 1 % between
Environmental tax reform, 1999 and 2005
taxes on transport, fuels & CO2 emissions 2-3 % lower than would have been
electricity *German re-unification an important factor in reductions

UK 2001-2010 2% CO2 emissions reduction in 2002 and 2.25% in 2003

Industrial energy tax Savings of 16.5 million tonnes of carbon by 2005
2.9 % reduction in UK energy demand estimated by 2010

TABLE 1: The impact of energy and carbon-based taxes in Europe up to 2009. Extracted from Green Fiscal Commission, 2009b:3

Depending on their design and However, their impact can be lessened if

implementation, environmental taxes can
have varied impact not only on the state of
the environment, but also on economic and
social development, e.g. influence over GDP,
jobs creation, etc.
they include exemptions or risk mitigation
measures. Table 1 gives a snapshot of some
of the results from energy and carbon-
based taxes implemented in some European
countries between 1990 and 2009.
 11

REFLECTION POINT
Has your country implemented any types of environmental taxes? Can you think of any
environmental challenges that can be addressed in this way?

If revenues are reinvested into green or the level of environmental damage (is
transition, positive environmental and social revenue needed for clean-up and restoration
outcomes can be amplified. of natural capital?).

A number of factors can influence the way
policy-makers decide to utilize revenue, such
as: concerns of stakeholder groups (e.g. are
the poor negatively affected by the taxation?),
the state of the economy (e.g. are there
nascent green industries that need support?),
Depending on the circumstances of specific
countries or regions, trade-offs between
policy objectives may arise.
Module 3 of this course will deal in
greater detail with challenges related to
implementation of green taxes (see module 3).

CHARGES AND FEES

Charges and fees are payments for the use
of goods or services. They can be applied on
quantity or content of pollutants released, use
of specific resource, the exercise of polluting
activity, or a mixture of these (EPA 2016).
Video 1 looks at the benefits and controversies
related to the London Congestion Charge 10
years after its implementation (see Box 1).

A major difference between taxes and

charges/fees lies in the use of the revenue. video
Contrary to the various possible uses of tax
revenues, charges and fees most often flow TEN YEARS ON: HAS LONDON’S CONGESTION
back to the programme or initiative, through CHARGE WORKED?
which they were imposed, to target the
environmental problem at hand or to cover
the cost of the good or service provided
(European Environment Agency 2000,
Sustainable Prosperity 2015).

WATCH THE VIDEO

 12

Enforcement is a necessary ingredient of any A consumer or firm would still purchase

form of taxation. For example, the London
Congestion Charge includes a sophisticated
enforcement mechanism including photo
tracking of vehicles and stringent penalties for
non-compliance (Transport for London n.d.).
the good or service at full price, thus the
producer receives market value for their
product or service. However, as the taxes
paid to the state are reduced or removed,
the net costs for production are reduced.

Charges and fees can be effective on As green products may be costlier to

changing individual behavior and consumer’s
preferences. For example, a fee on plastic
bags was introduced in China in 2008. A
year later, environmental awareness had
increased, and the country was using 50%
fewer plastic bags, generating 200 tonnes of
garbage reduction and saving of roughly 40
billion a year (Jierui 2009).
produce compared to conventional products,
the reduced tax costs levels the playing field
between green and conventional products
and services. The tax rebate can further drive
prices of green goods or services down, thus
making them more affordable for consumers,
and contributing to changing consumers’
preferences.

There can also be cases where existing tax

TAX CREDITS credits may need to be reformed if they
contribute to unsustainable activities, e.g. tax
Tax credits (also known as tax rebates) credits for fossil fuel producers.
incentivize green behaviour by reducing the
net tax paid for a specific good or service
that is environmentally friendly.

Foregoing government Turkey offers reduced licence fees for entities for licences to
revenue construct renewable energy facilities

Municipalities in India have established a rebate in the property tax

Tax incentives
for users of solar water heaters

Accelerated In Mexico, investors in green infrastructure have benefitted from

depreciation faster rate of depreciation of the values of eligible fixed assets,
which reduces investor’s taxable income

Fig. 2: Examples of taxable rebates/credits (Gaupp 2007) (Mexico 2007) (India 2010)

Using environmental taxation to foster
innovation and green investment
Using taxes to price externalities can help
tackle several policy challenges related to
fostering innovation and green investment, as
listed below:
- Insufficient demand for green
innovation: Higher prices would increase
environmental awareness of consumers
and producers and create a demand
for more cost-efficient and sustainable
options.
- Revert bias to incumbent technology:
The need to realize economic savings
would drive many companies to adopt
efficiency improvements in their
production methods and operations
– hence drive the switch from older
and inefficient technologies to new
and innovative solutions. Governments
can speed this process by reinvesting
revenues from green taxation into tax
breaks and credits to support companies
that produce green products, conduct
R&D, or adopt new and cleaner
technologies.
BOX 3:
CHINA’S RISE TO A GLOBAL INNOVATION HUB
Thanks in part to resolute public spending on
R&D, China has become one of the most dynamic
countries in terms of innovation in recent years.
In 2013, the country filed a total of 22184 patent
applications under the Patent Cooperation Treaty
(PCT), trailing only Japan (at ca. 42.000) and the
United States (at ca. 57.000). While the national
Pollution Levy System discourages use of a wide
range of substances, the Chinese government
has more than tripled public expenditure on R&D
13
- Lack of finance: Revenue generated
through taxation can directly (through loans,
grants, etc.) or indirectly (through reduction
in labour or corporate tax) increase available
resources for firms to invest in innovation.
Increased public funds can also leverage
private investment through public-private
partnerships or subsidies. Increasing the
cost of polluting activities makes non-
polluting activities more attractive for
investment as they become more cost-
competitive.
The extent of influence depends on factors such
as the taxation rate, implemented exemptions
and flanking policy measures, such as support for
R&D.
Examples of environmental taxation spurring
innovation and competitiveness are manifold
(Boxes 3 and 4) (OECD 2010).
between 2005-2013 to reach approximately 70
billion USD (OECD 2016). Economic incentives
for R&D are offered in the form of income tax
deductions and reductions in entreprise income
tax rates. For example, eligible R&D expenditures,
including resources and environmental technology,
enjoy a 150% super deduction on the tax bill.
SOURCE: Deloitte 2014
 14

Environmental tax shift

As previously mentioned, states can combine
environmental taxation with a comprehensive
tax shift of their fiscal systems.4
In essence, the shift entails that “taxes on the
things that are valued by society, like jobs,
incomes and profits, are reduced and the
lost revenue is replaced by taxes on things
society does not like, such as pollution and
environmental degradation” (Green Fiscal
Commission 2009a).5
This basic principle is shown in figure 3.
It is important to note that the tax shift may
remain revenue-neutral in order to avoid
popular concerns of increased taxation.
Ideally, the higher costs of resource use
will stimulate business investment into
green technologies and eco-efficiency, as
companies will look for ways to reduce their
tax burden. On the other hand, decreased
taxation on labour might incentivize
companies to create new jobs. A reform in
the tax shift would also lead to higher prices
for goods that are resource intensive, while
favoring those that are labour-intensive, thus
guiding consumers towards environmentally
and socially friendly products.
The carbon tax example from British
Columbia below shows how burden-shifting
can lead to triple bottom benefits for
sustainable development.

TAX BURDEN

INCOME

DETRACTS FROM SUPPORTS

GREEN ECONOMY GREEN ECONOMY

POLLUTION

REVENUE

Fig. 3: Environmental tax shift

4 Some sources use the term ‘green tax shift’ while the concept remains the same.
5
Further reading: http://www.greenfiscalcommission.org.uk/images/uploads/GFC_FinalReport.pdf;
http://www.greenfiscalcommission.org.uk/images/uploads/gfcBriefing7_PDF_isbn_v8.pdf;
http://www.greenfiscalcommission.org.uk/images/uploads/GFC_BRIEFING_2_FINAL.pdf;
http://unstats.un.org/unsd/envaccounting/londongroup/meeting14/LG14_18a.pdf;
https://www.imf.org/external/pubs/ft/wp/2013/wp13163.pdf
 15

REFLECTION POINT
Can you think of a scenario in your country where there is potential for tax shifting, i.e.
reducing cost of something positive by raising it on something negative?

BOX 4:
REVENUE-NEUTRAL TAX SHIFT IN BRITISH COLUMBIA

In 2008 the Canadian Province of British Columbia legislated its carbon tax on the purchase or use of fossil
fuels. The tax was considered revenue neutral, as increased taxes in fossil fuels are returned in lower personal and
corporate taxes. When it was first introduced, the tax was set at CA $10 per ton with a mandate to increase by
CA $5 annually. In 2012 the price was set at CA$30 and has been fixed at that price since. The Government
of British Columbia estimates up to three million tons of CO2e reduction by 2020 under the carbon tax. The
carbon tax in British Columbia resulted in triple bottom line benefits, including:

- Improved competitiveness of the economy and mobilized capital from energy efficiency gains;
- Reduced fuel use (down 16% between 2008-2013), hence reduced emissions (projected 3 million tonnes
reduced annually by 2020); and,
- Reduced income tax rates (almost CAD$ 1 billion in cuts since inception).

SOURCE: (BC Ministry of Finance, 2015a, 2015b) (Elgie and Lipsey 2015) (David Suzuki Foundation et. al. n.d.)
(Deloitte 2014).
 16
Environmental taxation: Challenges and opportunities
Historically environmental taxation has
faced (and continues to face) a number of
criticisms. Some of the main ones, along
with some responses, are listed below (Green
Fiscal Commission 2009a):
As we saw in Module 1, tensions and trade-
offs between fiscal and environmental taxation
instruments might arise depending on the
specific objective and the national context of
each state.
If revenue from the tax diminishes over
time (which should be the case if taxes are
Environmental taxation does not generate a stable
revenue stream (or the stream is small) and
should only be used as a way to raise funds for
environmental improvement.
Green taxes are regarded by taxpayers as
additional taxes, due to mistrust that
governments will reduce already existing taxes.
Industry is concerned about loss of
competitivness due to additional green taxes.
Environmental taxes reinforce poverty, e.g. rises in
energy prices, due to taxation, will be felt
significantly by low-income households.
6 For further reading:
http://www.oecd.org/env/tools-evaluation/48164926.pdf
http://www.ieep.eu/assets/1110/Background_paper_on_EFS_in_the_7th_EAP.pdf
http://www.oecd.org/environment/tools-evaluation/48178034.pdf
https://www.imf.org/external/pubs/ft/wp/2012/wp12180.pdf
effective), fiscal incentives for imposing
environmental taxation might indeed be
undermined.
This scenario, can be mitigated by
progressively increasing the level of the tax
over time (e.g. carbon tax in B.C., Canada),
expanding the tax base, or looking at savings
that may be achieved elsewhere, for example
in health care costs due to less pollution-
related illness incidence. Even if the demand
for the good or service declines, a healthy
budgetary balance can be maintained.6
Resource mobilization is a secondary objective of
environmental taxation. In fact, taxpayers pay the
x cost of not pricing negative externalities in other
ways, e.g. via increased health costs.
Environmental taxation can be revenue-neutral
x (see Box 4).
Insufficient, pollution practices should not be
subsidized in general but competitiveness
x concerns can be addresed, inter alia, via
compensatory measures, phased, implementation
or tax breaks to eligible firms to aid transition.
There are means to make the system more
equitable, for example through exemptions for
x low-income or subsidies for more energy efficient
products.
 17

In addition, it is important to note that, even The escalator was cancelled after severe
if the taxed activity remains stable, inflation protests in response to an accompanying
may significantly diminish the real value spike in oil prices in 2000.
of per unit taxes over time (inflation based
devaluation) (Schlegelmilch and Joas 2015). Depending on the design of the instrument,
taxation can become a win-win situation
In order to avoid frequent legislative changes, from environmental, fiscal, and social
two options are available to policymakers to standpoint.
anticipate revenue devaluation.
As noted previously, an environmental tax
By design, one may choose to automatically can generate a revenue-neutral outcome and
link the tax rate to annual changes in price does not have to become a burden for either
levels or build in pre-defined increase of the consumers or businesses.
tax from the outset.
Funds generated from taxes can be pooled
Automatic adjustments bear the risk, into the general budget and distributed back
however, to stir political unrest when into the system to benefit taxpayers, the
tax increases are perceived as untimely industry and the low-income households.
depending on economic circumstances.
Further ways to overcome and address the
The UK government introduced the “Fuel criticisms listed above will be examined in
Duty Escalator” in 1993 which foresaw greater detail in Modules 3 and 4.
annual increases in the range of 3-6 percent
(Figure 4).

40,000 0.8
tax rate for unleaded petrol [in EUR/liter]

35,000 0.7

30,000 0.6
tax revenue [in million EUR]

25,000 0.5

20,000 0.4

15,000 0.3

10,000 0.2

5,000 0.1

0 0.0
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Fig. 4: Tax revenue and tax rate for UK fuel duty (Schlegelmilch and Joas 2015)
 3

Subsidies and related

instruments
Making polluters pay is not the only approach in the toolbox of fiscal
policymakers. Green fiscal reform may also encourage positive change by
rewarding firms and individuals for sustainable consumption and production
practices.This is where subsidies come into play.

Overview
Subsidies, feed-in tariffs, payment for
ecosystem services, and sustainable public
procurement are some of the instruments
that governments can use to absorb a
portion of the cost of economic activity and
render a given sector, product or service
more competitive. Subsidies and related
instruments play a key role in stimulating
innovation and research, and enabling the
application of existing cleaner and resource-
efficient production methods.
This lesson focuses on the different
types of subsidies and related tools (3.2),
illustrates how inefficient subsidies can be
reformed (3.3) and highlights challenges
and opportunities in applying subsidy reform
(3.4).

Subsidies and related tools that support green transition

A subsidy is a financial contribution by a having the government absorb a share of the

government, or agent of a government, that
confers a benefit on its recipients.7
In order to know how and where to apply a
expenditure instruments, it is important to
differentiate types of subsidies and other
available tools.8
Subsidies are used as a way to increase
competitiveness of a product or service, by
supply cost.
These can come in the form of direct
payments (examined below), tax concessions
(which we reviewed in lesson 2), in-kind
support (e.g. government building roads and
other infrastructure), credit subsidies (public
loans or guarantees for loans), and public
procurement (agreement to purchase a
specific product from a producer). 9

7 Definition derived from the WTO Agreement on Subsidies and Countervailing Measures.
8
Application and viability of the tools described in this section also depend on regulations from international
agreements or bodies such as the World Trade Organization (WTO). For further information please see (IISD and
9
UNEP 2014).
These and other types of subsidies are defined in more detail by the IISD Global
Subsidies Initiative Subsidy Primer, which is useful further reading (Steenblik 2006).
 19

Definitions for the term ‘subsidy’ may vary.
One way to distinguish between subsidies
is to identify those that appear ‘on budget’
and those that are ‘off budget’ (European
Environment Agency 2006). 10
On-budget subsidies are transfers or public
loans given directly to companies, individuals
or institutions, such as research institutes,
and appear on national balance sheets as
government expenditure.
Off-budget subsidies typically do not
appear on national accounts as government
expenditure. They may include tax
exemptions, credits, deferrals, rebates and
other forms of preferential tax treatment.
They also may include market access
restrictions, regulatory support mechanisms
such as feed-in tariffs, border measures and
access to natural resources.
Quantifying off-budget subsidies is complex,
in some cases impossible. It often requires
that the benefit be calculated on the basis of
differential treatment between competing
subsidized items or sectors.
Subsidies can also be positive or negative,
depending on the nature of externalities –
desirable or harmful– that they entail.
An example of a positive subsidy is grants to
companies to implement energy efficiency
improvements, which create positive
externalities due to the reduction of energy
use and related natural resources.
Negative subsidies – for example tax
exemption to coal power plants, create
negative externalities (see also Box 1 from
Module 1).
Subsidies can effectively support green
development, however they can also be used
to promote inefficient and polluting activities.
In the context of green economy, subsidies
can be used to support green activities, clean
energy, sustainable products, etc.
Furthermore, reforming harmful subsidies,
e.g. for fossil fuels, can prevent market
distortions and discourage waste generation,
pollution, and inefficient use of resources
(IMF 2013).

REFLECTION POINT
Can you name any subsidy instruments in your country? Are they having positive or negative
effect on the environment?

10
In addition, there are ‘back door’ expenditures as well. This category is rarely used, however. ‘Back door’
expenditures are financed by taxes or levies that are in the budget, but that are authorized by
substantive laws outside the budget process. The main forms of these expenditures are entitlements (financial
obligations) and tax reliefs (Kraan 2004).
 20
DIRECT PAYMENTS
Subsidies through direct investments can take
many forms, including (IISD 2015a):
- Time-limited payment at the beginning
of a project or initiative, and usually
in relation to a specific investment or
activity related to green transition;
- Schemes for producers to receive a
payment per unit of production, or as a
way to compensate for any difference
between target price and the actual
market value;
- Vouchers for consumers for eligible goods
and services;
video 1
FARMING THE WILD - WILDLANDS
CONSERVATION TRUST (ENVIRONMENTZA)
WATCH THE VIDEO
FEED-IN-TARIFFS
Feed-in-tariffs (FiTs) are a package of
regulatory and economic incentive policies,
where suppliers or investors are paid through
a tariff by the government for investment in
and generation of renewable energy (see Box
5 for example).
The feed-in tariff is fixed, i.e. it is not open to
market competition, and is often delivered
under a long-term contract.
Thus, FiTs encourage investment by creating
a guaranteed competitive return for the
production of renewable energy.
- Compensation payments related to
losses to suppliers, perhaps in early
commercialization phase of a product.
Direct payments and tax credits are similar in
that both effectively represent an expenditure
on the state; the latter can be understood as a
lost or foregone income.
The video below gives an example of a project
that received direct funding by the Green
Fund of South Africa. 11
The Green Fund, established by South
Africa in 2011, finances public and
private green initiatives by providing
grants and loans in programs geared
toward renewable energy, waste
management, bus rapid transit, biofuels,
energy efficiency, and demand side
management
SOURCE: GGBP 2014.
The producers are interested in maximizing
output and efficiency of production as
this would further increase their return on
investment (UNEP 2012a).
Energy producers are typically granted access
to the energy grid and paid based on the energy
supplied.
Typically, to qualify for a FiT contract,
generators need to be able to build and connect
their power plant to the grid before they are
able to get payments.
 21
The secure and stable market for renewable
energy stimulates job creation, reduces
uncertainties related to access and
interconnection to energy grids, enhances
market access, and encourages technological
advancements (NREL 2010).
The design of FiTs can be a complex task,
as it needs to take into account a variety
of national market conditions, policy
considerations and constraints, such as:
investor security, grid stability, policy cost,
price fluctuations and many more (UNEP
2012a).
11
For its first phase 2011 and 2013, the Green Fund allocated to green projects a total of 245
million rands (approx. 15 million USD). The fund has grown to 1.1 billion rands (approx. 62 million
USD) due to its success and overwhelming demand.
BOX 5:
MAURITIUS’ EXPERIENCE WITH
FEED-IN-TARIFFS
As an island state, Mauritius predominantly imports
coal and oil for energy generation. The transformative
agenda Maurice Île Durable (MID, Sustainable Island
Mauritius), in place since 2008, aims at achieving
partial energy autonomy by increasing the share
of electricity from renewable energy, as well as the
efficiency of the grid. The national feed-in-tariff is
geared towards small and household-level producers
(50 kW maximum generation per contract). Notably,
households and businesses are required to use
generated energy for on-site consumption before
selling any excess to the grid. While this policy may
be less profitable for generators, it encourages lower
consumption at household level and helps raise
awareness. The cost of the FiT is covered by the MID
fund which is financed through carbon tax revenues.
The policy has seen strong support and the initial total
cap of 2 MW had to be raised several times to reach 5
MW.
SOURCE: Heinrich Böll Stiftung et al. 2013.

PAYMENT FOR ECOSYSTEM
SERVICES (PES)
PES is a mechanism that puts a price on
services provided by the ecosystem, such
as food production, air, water resources,
recreation. It covers beneficial activities
such as carbon sequestration, watershed
protection, biodiversity benefits, and
landscape beautification.
As a consequence, PES puts a cost
to the potential loss of these services.
These schemes aim to influence land and
natural resource use decisions by enabling
landholders to capture more of the value of
these environmental services than they would
have done in the absence of the scheme
(Barbier 2010).
PES works by providing a payment to the
suppliers of the ecosystem service.
The supplier (i.e. landowners) holds the
property right to the natural capital
BOX 6:
THE N’HAMBITA COMMUNITY CARBON PROJECT, MOZAMBIQUE
Initiated in 2003, the project pays 1,000
smallholder farmers in the buffer zone
of the Gorongosa National Park for
reducing emissions from deforestation and
degradation (REDD) of Miombo woodlands.
Farmers are contracted to sequester carbon
on their farmlands through adoption of
agroforestry practices from a ‘menu’ that
includes horticultural tree species, woodlots,
22
or environmental good and receives
compensation for the benefits created or
maintained. Set by the state, the payments
are usually funded through environmental
taxation and administered by a third party,
e.g. a non-government organization, that
performs independent verification of a
supplier’s, e.g. a landowner’s actions and
their impact on the natural resource. (UNEP
2008, DFID 2013) (Box 6).
PES promotes a change in economic
motivation of private agents through
compensation.
A landowner would not drain a wetland
area for agricultural purposes, if he/she is
compensated to preserve it in the same
amount, as the profit form the agricultural
practice.
intercropping food crops, planting native
hardwoods around the boundary, and
planting fruit trees within the homestead.
The N’hambita Community Carbon Project is
serving as a demonstration model, which can
be replicated in other areas both within and
outside of Mozambique
SOURCE: WRI 2011.
 23
Private sector can also organize and invest
in the set-up and implementation of PES,
and in this case this instrument can also be
considers an alternative market instrument,
due to the reduced state engagement and
public financial support (see lesson 4).
The potential to create an international PES
scheme related to forests and carbon has
become a key focus of international climate
negotiations.
SUSTAINABLE PUBLIC PROCUREMENT
Sustainable Public Procurement (SPP) can be
defined as the process whereby government
institutions meet their needs for goods,
services and utilities in a way that generates
benefits not only to the organisation, but also
to society and the economy, while minimising
damage to the environment. 12
Public procurement at central, provincial, and
local level represents around 15-30 percent
of national GDP (UNEP, 2012). In some
developing countries it can reach as high as
half of GDP (UNEP, 2015). Through SPP,
government spending can set an example for
private sector procurement, stimulate demand
and create a stable market for sustainable
products.
SPP can include products that have improved
recyclability or reduced packaging, goods that
have high energy efficiency, use of renewable
12
Based on the definition for
Sustainable Procurement accepted
by the Marrakech Task Force on
Sustainable Procurement.
REDD+ (Reducing Emissions from
Deforestation and Forest Degradation)
represents a multilayer PES scheme with
transfers of finance between developed and
developing countries in exchange for emission
reductions.
energy and reduction in water consumption,
and contracting of suppliers that use clean
technology in their services.
For example, the Transport Department
of Hong Kong has retrofitted its traffic
lights to LED lights, resulting in increased
energy efficiency (63 percent lower energy
consumption), cost savings (estimated
340.000 USD over the life-span of LED
modules), and lower maintenance costs both
in replacement supplies and man-power
(UNEP 2012b).
A number of countries have developed and
successfully implemented SPP policies. For
example, Japan and the Republic of Korea
enacted specific SPP legislation covering
a large number of certified products that
state institutions can choose from, and are
considered among the frontrunners of SPP
policies worldwide (UNEP 2015).
 24

REFLECTION POINT
Thinking about your place of work – is your procurement sustainable? What can be done to
improve the sustainability of procurement practices?

Reforming harmful subsidies

As we discussed, subsidies can promote
activities that have negative environmental or
social impact. For example, some of the most
wide-spread subsidies aim to increase the
competitiveness and market access of energy
products and services and can apply to both
clean energy or fossil fuels.
Globally, the amount of fossil fuel subsidies
surpasses many times the public funds used
to support renewable energies (IMF 2015a).
Other negative subsidies can be related to
water use, mining, agricultural production,
forestry, and many more.
Fossil fuel subsidies in particular can
contribute to negative impacts such as fiscal
deficits, excessive energy consumption,
and pollution, while diverting resources and
investment from clean energy and pro-poor
initiatives (UNEP n.d.).13
While environmentally harmful, in many
emerging and developing countries, subsidies
for kerosene, coal or electricity are motivated
on equity grounds because they give poor
households access to basic energy resources.
As studies have shown, the benefits of most
fuel subsidies in emerging and developing
countries actually accrue mainly to higher
income and already well-off households
(Coady 2010).
For example, in Indonesia fuel subsidies were
put in place to make energy more affordable,
particularly for poor people. In light of
rising budget constraints, since 2005 the
Indonesian government has taken steps to
implement fuel subsidies reform, accompanied
by a cash transfer programme to help
vulnerable families cope with higher energy
costs.
Governments can address the issue of
environmentally harmful spending by
implementing subsidy reform with the goal
of preserving natural capital, stimulating the
adoption of efficiency measures by companies
and households, and redirecting funds into
priority areas for public expenditure.
However, subsidy reforms need to be carefully
drafted, considering the needs of the poor,
and accounting for possible negative impact to
the competitiveness of key economic sectors.
A reform that builds on the three pillars of
right pricing, legitimacy and mitigation of
negative impacts is thus most likely to succeed
(Figure 5). These topics are elaborated further
in Module 3.

13
For an in-depth discussion of fossil fuel subsidy reform, especially from a policymaker perspective,
please refer also to the concise guidebook (IISD 2013). The guidebook focuses on Southeast Asia
yet contains several practical reform suggestions applicable to other regions as well.
 25

video 2
This video by the IISD provides a
PRICING AND TARGETING good introduction to the problems,
opportunities and recommended
approaches to fossil fuel subsidy reform.

WATCH THE VIDEO

KEY

GETTING THE PRICES BUILDING SUPPORT MANAGING THE

RIGHT FOR REFORM IMPACTS OF REFORM

Political mandate and internal organization

Communications: general
awareness raising.
Consultations: map
Explore options for pace and Project impacts and explore
stakeholders, gauge views
change of pricing system: mitigation options: direct
gradual vs. “big bang,” and indirect impacts, mix
strategic timing, consider the quantitative and qualitative
four dimensions of pricing approaches, consider three
types of mitigation measure

Fig. 5: Key pillars for success in fossil fuel subsidy reform (IISD 2013)
 26
India has recently successfully reformed
the price of diesel, thus correcting market
distortion and realizing fiscal benefits while
addressing social concerns (Box 7).14
Harmful subsidies also exist in other sectors,
such as water (IMF 2015b), fisheries (UNEP
2011) or agriculture (OECD 2014).
14
A number of case studies and lessons learnt on fossil subsidy reform are also available through the
Green Fiscal Policy Network.
For example, subsidizing water irrigation may
lead to wastefulness, inefficiency and inequality
in water use (Casey 2013, IISD 2016).
In addition to reforming subsidies, other green
fiscal instruments, such as feed-in-tariffs,
zero or low-interest loans, grants, or public-
private partnerships, can help address wasteful
spending and create a level playing field for
more efficient, low-carbon products and
services to develop and be commercialized.

BOX 7:
DIESEL PRICE REFORM IN INDIA
From 2005 until 2012 diesel fuel in India
has been heavily subsidized. Consequently,
consumption of diesel grew and it became
the single most consumed petroleum
product in India at nearly 44 percent
in 2012/13. Burning of diesel fuel also
contributes significantly to GHG emissions
and air quality problems from toxic gases
and air particulates. Following record subsidy
expenditure coupled with fiscal deficits, the
government announced a programme to
27
reform subsidies on diesel fuel with the goal
to completely remove the subsidies by 2014.
In January 2013, diesel price liberalisation
began. The result of this reform was a shift
from subsidizing domestic oil companies
to more market-based price formation in
October 2014. India also saw associated
decreased demand for diesel fuel. The policy
change yielded environmental and economic
benefits while also preventing macro-
economic destabilization (IISD 2015b).
 4
Alternative economic
instruments
Where governments are politically or economically constrained in introducing
new taxes or subsidies, they can use a variety of alternative instruments to
address externalities.
Overview
Alternative economic instruments, such
as tradable permits and offset systems, do
not fall into one of the two aforementioned
categories, i.e. revenue collection or
expenditure.
These market-based mechanisms are
characterized by direct interactions between
firms, rather than between the government
and private entities.
However, it is often governments that design,
implement and regulate alternative economic
instrument, such as cap and trade, emission
Tradable permits
Tradable permit schemes can be used, inter
alia, for carbon, water and biodiversity
protection. As opposed to taxes, which fix a
price for pollution and then allow the market
to determine the level of pollution, trading
schemes:
15 Deposit-and-refund schemes will be briefly reviewed in Module 4 of this course.
target schemes, or deposit-and-refund
schemes.
A government may choose these instruments
if there are political barriers to environmental
taxation or subsidies, e.g. public or stakeholder
concern.
Another reason for setting up tradable
permits and offsets schemes can be a desire to
mobilize market agents as a primary driver for
low-carbon development.
This lesson introduces the concepts of
tradable permits (4.2) ands offset systems
- Establish an overall level of pollution
allowed;
- Let the open market determine the price
of pollution;
- Allow firms to purchase (e.g. through
government auctions) and trade credits
to undertake polluting activities.
 29
Emissions trading usually targets high
emitting private entities within specified
sectors, such as transportation, oil and gas,
buildings, manufacturing.
The market actors are designated a specific
amount of emissions that they are allowed
to emit. If they emit below the allowance,
they can sell their emissions ‘gap’ at market
value in the emission trading system to
other companies that emitted above their
allowance.
In order to comply with the annual emissions
target and avoid penalties, high-emitting
companies may buy emission permits (see
Video 3) (EDF 2016, IETA 2015).
In principle, the cap is set in a way that it
progressively diminishes each year, thus
steadily encouraging companies to innovate
or perform efficiency improvements in their
operations and business models.
video 3
PRICING AND TARGETING
WATCH THE VIDEO
Cap and trade systems may target fossil
fuel producers, suppliers and distributers
(pollution at the point of extraction, or
upstream pollution). Alternatively, a cap
and trade system can also focus on the
point of combustion or use, and captures
16
Click here for more information on regulations and experiences related to the EU ETS auctioning.
In practice, some firms may just want to
avoid penalties by staying below their cap,
whereas others may actively seek to realize
additional profits (IETA 2015) by cutting
their emissions more decidedly.
The strength of such a scheme is that it
allows for both rationales as long as the cap is
respected.
Permits or allowances can be allocated to
businesses for free, via auctioning, or a mix
of both.
Depending on the initial costs, businesses
can be more or less motivate to implement
efficiency improvements in their operations.
Furthermore, the potential revenue of
auctioning can be considerable: In 2013, the
total revenue of the EU Emissions Trading
System (ETS) reached 3,6 billion EUR. 16
This video explains the purpose and
functioning of the EU ETS (Source:
European Commission)
more economic actors – factories, energy-
intense facilities, etc. (WRI 2008a). Box 7
looks at the Western Climate Initiative (WCI)
Cap and Trade, which governs emission trading
in Quebec and California.
 30

BOX 8
WESTERN CLIMATE INITIATIVE (WCI) CAP AND TRADE

The WCI trading system covers Quebec
and California and aims to reduce GHG
emissions from the highest emitting sectors
(>25,000 metric tons of CO2e annually).
The sub-national governments worked
together for two years to harmonize their
regulations, which were officially linked on
January 1, 2014. The linking meant that any
registered emitters from any jurisdiction can
purchase (through trade, offset or auction)
and surrender emissions allowances to their
respective governments to comply with their
respective regulatory emissions targets. At
its most recent auction WCI notes the sale
of over 75 million allowances at a price of
12,73 USD per allowance indicating revenue
of over 950 million USD
SOURCE: MDDELC 2015.

OFFSETS
Offsets are credits linked to activities that
lead to a quantifiable reduction in pollution,
e.g. emissions, biodiversity loss, water
impacts.
Accredited firms can generate offsets by
reducing units of pollution. Those offsets
can be bought by market or state actors
that have a mandatory or voluntary target to
reduce emissions (see Figure 2). 17
The type of projects, compliance standards,
and the price per offsets are determined by
the specific offset scheme.
The most common offset projects for carbon
emissions include methane capture, forestry
and agriculture projects (IETA n.d.).
In a way, offset mechanisms resemble
payment for ecosystem services (PES)
schemes, that we reviewed under lesson 3
Purchase of offsets can be used in a cap
and trade system as a way for regulated
companies to comply with their mandated
reduction in emission.

17 Individuals can now also purchase certified emissions reductions (CERs) in the context of voluntary offsetting
through “Go Climate Neutral Now!”, an online platform administered by the UNFCCC.
 31

REFLECTION POINT
Are there examples in your country of generated offsets either for international (e.g. Clean
Development Mechanism, CDM) or domestic/regional markets? Do you see sectors that may
benefit from this approach?

Fig. 2: How carbon offsetting works (Carbon Clear 2015)

For example, an entity in the energy sector
may purchase offsets from an afforestation
project to make up for the amount of
emissions generated over its emissions cap.
Credits can be traded within one
country, such as China, Australia, or
cross-boundary (e.g. Box 5: Western
Climate Initiative, RGGI, and the
European Union Emissions Trading
System). 18

18 The EU ETS legislation provides for the possibility to link the EU ETS with other compatible emissions trading
systems in the world at national or regional level. The EU is currently investigating possibilities to link its
system with other large systems, i.e. China and California. In general, the bigger the ETS the more pollution
can be governed –and eventually reduced– by it. Click here for more information. See also the International
Carbon Action Partnership (ICAP), which brings together countries and regions that are actively pursuing the
development of carbon markets through the implementation of mandatory cap-and-trade systems.
5

Using fiscal instruments in a

policy mix
Policy instruments for green reform can be viewed like a toolbox - each one
has a useful purpose, but often multiple tools are needed to complete the
job.

Whether it is instruments for revenue Another example is combining a cap-and-

collection, such as taxes, fees and charges;
instruments for expenditure, such as subsidies
and related mechanisms; or alternative
mechanisms such as emission trading and
offset schemes, there are a number of fiscal
mechanisms that countries can employ to
drive transition to a green economy.
trade system for the manufacturing sector
with an offset scheme in the agriculture
sector.
Countries might also provide grants for
recycling, which has been funded by a waste
dumping fee.

Notably, each instrument also comes with
a different set of financial, environmental
and social risks and context specific cost-
structure.
It is possible for countries to adopt multiple
fiscal tools in conjunction, in order to
implement green fiscal reform.
For example, a country that implements a
carbon tax on fossil fuel emissions can use the
tax revenue to subsidize a feed-in-tariff for
small scale solar power.
There is a virtually unlimited array of options
for combining tools based on the necessities
and conditions of a given country or region.
With the list of tools identified in this module,
the focus of Module 3 will turn to policy
design and implementation, i.e. how to
identify and apply appropriate fiscal policy
tools in concrete circumstances.
 34

key
learning points
1
There are a number of policy instruments for green fiscal reform. These broadly fall into the
categories of taxes (revenue collection), subsidies (expenditure) and alternative mechanisms
(such as market based instruments).

2
Taxes, charges or fees are designed to support green reform by placing an economic cost on
activities that are environmentally harmful. They address externalities and incentivize people to
choose greener products or services, while mobilizing resources which can be used to different
purposes, including green investment.

3
Subsidies, feed-in tariffs, grants and other economic support mechanisms, can provide fiscal
incentives for green investment and promote market development in areas such as clean energy,
waste management, sustainable buildings, etc.

4
Reforming inefficient and harmful subsidies can unlock significant resources for green and socially
inclusive development.

5
Alternative mechanisms such as offsets and cap-and-trade systems use market dynamics as a
driver for green transformation and provide a viable option for green fiscal reform to governments
that face political or financial constraints.

6
Fiscal policy instruments can be used in combination with each other to promote reform across
multiple sectors and in ways that recognize unique sectoral or political circumstances.
 35

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abbreviations
BBOP Business and Biodiversity Offsets Programme
BC British Columbia
CAD Canadian Dollar
CDM Clean Development Mechanism
CER Certified Emissions Reductions
CO2 Carbon Dioxide
CO2e Carbon Dioxide Equivalent
DFID Department for International Development
EDF Environmental Defense Fund
EPA Environmental Protection Agency
EU European Union
EU ETS European Union Emissions Trading System
EUR Euro
FiT Feed-in Tariff
GDP Gross Domestic Product
GGBP Green Growth Best Practices
GGKP Green Growth Knowledge Platfom
GHG Greenhouse Gas
ICAP International Carbon Action Partnership
IETA International Emissions Trading Association
IISD International Institute for Sustainable Development
IMF International Monetary Fund
IRENA International Renewable Energy Agency
KW Kilowatt
LED Light-emitting Diode
MDDELC Ministère du Développement Durable, de l’Environnement et de la Lutte contre les
Changements Climatiques
MID Maurice Île Durable
MW Megawatt
NREL National Renewable Energy Laboratory
OECD Organisation for Economic Co-operation and Development
PES Payment for Ecosystem Services
R&D Research and Development
REC Renewable Energy Certificate
REDD+ Reducing Emissions from Deforestation and Forest Degradation
RGGI Regional Greenhouse Gas Initiative
SDG Sustainable Development Goal
SPP Sustainable Public Procurement
UK United Kingdom
UNEP United Nations Environment Programme
UNESCAP United Nations Economic and Social Commission for Asia and the Pacific
UNFCCC United Nations Framework Convention on Climate Change
USD United States Dollar
WCI Western Climate Initiative
WRI World Resources Institute
WTO World Trade Organization