Out-Law / Your Daily Need-To-Know

Carbon pricing and the drive to net zero

Out-Law Guide | 29 Mar 2021 | 12:57 pm | 8 min. read

'Carbon pricing' is designed to reduce greenhouse gas emissions by adding a cost to the creation of emissions.

The EU and the UK have adopted emissions trading schemes aimed at energy generators and heavy industry and the EU is considering a carbon border adjustment mechanism for imports. There are calls for carbon pricing to be applied more widely, and climate change could be taken into account in other areas of tax policy to incentivise climate friendly behaviour.

Net zero

In the landmark Paris Agreement agreed at the United Nations climate conference on 12 December 2015 (COP21), countries around the world agreed to work to substantially reduce global greenhouse gas emissions and to limit the global temperature increase in this century to two degrees celsius while trying to limit the increase even further to 1.5 degrees. 

The UK legislated in 2019 to reduce net emission of greenhouse gases in the UK by 100% back to 1990 levels by 2050. This is colloquially referred to as the 'net zero' emissions target. In December 2020, UK prime minister Boris Johnson set out an interim target for the UK of achieving a 68% reduction by 2030. COP26 takes place in November 2021 in Glasgow.

Carbon pricing

‘Carbon pricing’ is primarily a policy tool for combatting net emissions and is the name used for any method which aims to reduce emissions or increase the capture of greenhouse gases by adding a cost to those creating emissions, and in so doing encouraging the take up of alternatives and/or making the polluter pay for the damage.

There are two main methods of carbon pricing: a direct tax on emissions generated by a business or a system of allowances or permits to pollute, tradeable on a secondary market, referred to as an ‘emissions trading scheme’ (ETS) or ‘cap-and-trade’ system.

Under an ETS, a government sets a cap on the total amount of certain greenhouse gases that can be emitted annually by businesses covered by the scheme. Each business obtains a certain number of ‘allowances’. Allowances are auctioned off by governments, with some given for free and credits can be generated through carbon capture projects. After the end of each year a company must surrender enough allowances to cover all its emissions and, if the company has any ‘spare’, it can use these to cover its future needs or sell them on the secondary market to another business. By restricting the total number of credits in circulation, and allowing surplus credits to be traded on a secondary market, a market price is created which rises over time unless demand for carbon reduces.

A carbon tax directly sets a price on carbon by defining a tax rate payable by reference to greenhouse gases emitted by the polluters, or by reference to the carbon content of fossil fuels used by the polluters. A carbon tax is considered to be simpler to administer and may provide businesses with greater certainty, as it is not as variable as the prices for credits under an ETS. It is also better at raising money for governments, as the rates can be increased over time, whereas under an ETS, the amount raised in an auction of credits can be variable and dependent on the secondary market price at the time.

EU ETS

The EU ETS covers all EU countries plus Iceland, Liechtenstein, and Norway. The EU ETS applies to power and heat generation and energy-intensive industry sectors including oil refineries and steel works and the production of iron, aluminium, metals, cement, lime, glass, ceramics, pulp, paper, cardboard, acids, and bulk organic chemicals. It also covers commercial aviation in respect of flights between airports located in the European Economic Area (EEA).

UK

Before the end of the Brexit transition period, the UK was part of the EU’s ETS. In the summer of 2020, as the UK prepared to leave the EU’s ETS, the UK consulted on whether to set up its own ETS or to impose a ‘carbon emissions tax’ (CET). It would initially apply to the same industries as the EU ETS with businesses that exceeded their annual tax emission allowance becoming liable to pay CET rather than having to buy emission allowances.

In December 2020, the UK government announced that it would be proceeding with a UK ETS from 1 January 2021. The scheme applies to the industries covered by the EU scheme. The aviation routes covered by the UK ETS include UK domestic flights, flights between the UK and Gibraltar, and flights departing the UK to EEA states conducted by all included aircraft operators, regardless of nationality.

The scheme is being established with 5% fewer allowances in circulation than the UK had under the EU scheme and allowances will be subject to a transitional auction reserve price of £22. The idea behind these measures is to make allowances – and therefore emissions – more expensive than they were for UK emitters under the EU ETS, signalling the UK’s intent to lead from the front.

Issues with the ETS

At present only around 30-40% of emissions generated in the UK come from businesses that have to participate in the UK’s ETS. Indeed, the World Bank estimates that only 13% of emissions generated across the world are subject to any form of carbon pricing. 

There are calls for the base of the UK ETS to be extended to include more emissions activity. This is a matter that the UK government has already considered as part of its consultation on the possibility of the CET and in the chancellor's March 2021 budget. Outside the heavy industry already covered by the ETS, the next highest emitting sectors are shipping and meat and dairy products – plus aviation more generally.

The second issue with carbon pricing is that a country only applies the price to emissions generated domestically – there remains the issue about what to do about emissions generated in supply chains for goods and services consumed in that country. This is a problem which is particularly exacerbated because the ‘richer’ nations of the world have the most global supply chains and are responsible for a disproportionately high amount of the overall global emissions. Those emissions need to be priced, either in the country of source or through some other mechanism.

Allied to this is that one country or trading bloc striking it out alone creates distortions or what is called ‘carbon leakage’. A carbon price can lead to producers being undercut in the domestic market by competitors selling from countries that do not levy an equivalent price. It can also reduce the competitiveness of domestic exporters selling abroad and lead to domestic companies shifting operations to countries more tolerant of emissions.

Currently, the UK and the EU ETSs deal with the problem of carbon leakage by giving free credits to certain businesses which compete with businesses in countries not subject to carbon pricing. However, in terms of reducing emissions, this defeats the object of having a carbon price in the first place – as the emissions escape pricing altogether.

Carbon border adjustment mechanisms

The EU is therefore planning to introduce a carbon border adjustment mechanism (CBAM). A CBAM would apply a carbon price to materials and goods imported into the EU. The price would be based on the cost of allowances that the overseas producer would have had to have paid had the materials been produced in the EU. Credit would be given for any importer who can show that a carbon price or tax has already been levied elsewhere – which would spur foreign governments to introduce their own carbon pricing in order to claim a stake to revenues which are going to be raised anyway.

Concerns have been expressed over whether this would be seen as an import duty and fall foul of WTO rules. The EU has been careful to label the measure as carbon pricing, not a duty, and set out its position that it would not contravene WTO rules as it is not discriminatory – since domestic operators are subject to the same price.

The EU is intending to introduce the CBAM in 2023, with the European Commission intending to publish proposals in June this year. The CBAM would probably initially cover raw materials, potentially affecting in particular the cement, steel and chemical industries. Over time its scope is likely to be increased to cover finished products, with the long term intention that it would be in lockstep with the base on which domestic carbon pricing is levied.

There have also been calls for the UK to introduce a CBAM. If the EU presses ahead with its proposals, the UK may well follow suit.

Other measures

Carbon pricing is currently directed at heavy polluters and is levied close to the point at which the emissions are generated. Economic theory might suggest that it would be even more efficient to apply a carbon price when hydrocarbons are extracted or imported rather than burned. Carbon pricing has been shown to be very effective at transitioning power generators to renewable sources of energy. However, it is legitimate to question whether applying a carbon price that far up the supply chain is the only measure that should be imposed to address the issue. 

The UK already imposes the climate change levy (CCL) on the supply of fuels or electricity to certain non-domestic users. This entails different ‘main’ rates applying according to the inherent energy efficiency of the fuel or electricity – and a higher ‘carbon price support’ rate is charged by power-generators using carbon-based fuels to generate power. The CCL itself has been criticised for not hitting the right target – as its broad aim is to reduce energy consumption overall – especially since the exemption for electricity generated from renewable sources was removed in 2015.

To date most reductions in emissions have been driven by the power sector, primarily as a result of the shift from coal-fired power generation towards low-carbon generation. In the years ahead, many of the future emissions reductions required to reach net zero will actively involve individuals, whether by choosing to purchase low-carbon technologies, reducing air travel or by cutting their consumption of meat and dairy products.

Carbon pricing which only applies to heavy industry emissions means that the cost can become lost within the supply chain, lacking transparency for the end user in terms of how tax is being levied on their individual carbon footprint and how they can make greener choices moving forward. Carbon taxes which are levied closer to consumers, by reference to the emissions involved in producing a particular product or delivering a particular service, are more transparent for consumers, but more complex to administer.

Climate change could be taken into account in other areas of tax policy. For example, rates of VAT on domestic energy consumption could be lower for electricity than for gas and there could be lower rates of VAT for renovation and repair rather than construction or new products. Rates of corporation tax could depend on companies' climate credentials and/or there could be tax reliefs for taking up newer clean technologies, which can often be more expensive than those they replace.

Increased climate taxes will hit the worst off – greater carbon pricing will probably harm developing nations the most since the transition to renewables and circular economies needs investment. However, these issues can be addressed by social and other policies.

This guide is based on an article which appeared in Tax Journal on 19 March 2021 by Jason Collins and Catherine Robins, tax experts at Pinsent Masons, the law firm behind Out-Law.