Climate change is one of the defining challenges of our modern society. The manmade global warming has already and will increasingly affect the weather and climate across the world. Climate change endangers fragile ecosystems and the habitats of wildlife and plants. It also affects societies and our way of living. Rising sea levels, desertification, and more extreme weather phenomena are just three examples illustrating how climate change affects where we can live, how we can do business, and that we are vulnerable to global warming. As a global challenge, it requires action at local, regional, national, and international level.

The key driver of climate change, CO2 emissions, needs to be reduced to achieve the internationally set goals to contain the adverse effects of climate change. At EU level, the European Green Deal and the latest Communication on Stepping up Europe’s 2030 climate ambition put forward by the European Commission sets the ambition to make Europe the first carbon-neutral continent by 2050 and to reduce GHG emissions by 55% by 2030.[1] These targets are aligned with the global efforts to limit global warming to well below 2 oC, and to limit it ideally to 1.5 oC to reduce the costs and risks linked to greater warming. The European Commission has set ambitious targets to make Europe the first carbon-neutral continent by 2050 and intends to reduce GHG emissions by 55% by 2030 compared to 1990 levels. Environmental tax measures help incentivise behavioural change and thus contribute to achieving these policy goals.[2]

To achieve these objectives, it is necessary to rethink our economies and societies and to mainstream the issue of climate change and GHG emission reduction across policies and instruments. Efforts have already been made. Data available until 2018 suggests that the EU is on track to achieve its goal to reduce GHG emissions by 20% by 2020 compared to the baseline year of 1990.

Mainstreaming efforts to limit climate change also includes first and foremost market-based instruments. The European Emission Trading System (ETS) is a key element of the efforts of the European Union to curb GHG emissions. The ETS creates a market for emission allowances companies need to buy and trade, incentivising them to lower emissions. According to the European Commission, the ETS has been effective in reducing emissions of installations covered by the system by about 35% between its set-up in 2005 and 2019.[3] Apart from the ETS, taxes are another market-based instrument to price emissions.

In general, taxes are among the common measures to disincentivise environmentally harmful behaviour and to internalise external costs not born by the polluter.

The Role of Environmental Taxation

The role of environmental taxation, and especially of carbon taxes, as key market-based instruments to tackle climate change is also widely acknowledged in the literature.[4]Nevertheless, at EU level environmental taxation is not harmonised and is in competence of Member States. This leads to large variations and discrepancies across the Member States. Carbon taxes are of special relevance to reduce greenhouse gas emissions of the sectors not covered by the European Emission Trading System (ETS) or to complement the EU ETS.[5] The most important of these sectors is transport, where GHG emissions have been rising continuously in the past and are now making up for more than 20% of overall EU GHG emissions.[6]

The European Green Deal committed to creating the context for broad-based tax reforms at national level, removing subsidies for fossil fuels, including the maritime and aviation sectors in the ETS, shifting the tax burden from labour to pollution, and taking into account social considerations. The ability of tax systems to support economic recovery by contributing to inclusive and sustainable growth, including through shifting taxation from labour to environment, has been recognised in the 2020 European Semester.[7]

In 2018, EU governments collected around EUR 325 billion of tax revenues from environmentally-related taxes. Depending on the Member State, environmental taxes account for more than 5% of overall tax income. The share is the highest in Latvia and Bulgaria with above or close to 10% of overall tax income and the lowest for Luxembourg and Germany just above 4%. In Iceland and Canada they are below 4%. Across countries, energy taxes account for the largest share of environmental tax revenue.[8]

More remains to be done. The adoption of carbon taxes varies among Member States and there is lot of heterogeneity in terms of scope and implementation of these policies.[9] Most commonly, these taxes target the transport sector and only some Member States have broadened the scope of fuel carbon taxes to other sectors than transport. Explicit or implicit carbon taxes are also relevant for other non-ETS sectors, in particular the housing sector.

In the realm of energy taxes, the recent evaluation of the Energy Taxation Directive (ETD)[10] concluded that the “overall EU added value of the ETD has eroded significantly over time in particular due to the lack of indexation of the minimum rates and the extensive and highly divergent use of optional tax exemptions […].” The evaluation found that the ETD was not coherent with policy efforts to reduce greenhouse and other pollutant emissions as well as energy diversification due to disregard of the energy content and CO2 emissions of energy products and electricity, (too) low minimum levels of taxation and (too) many exemptions.[11] However, it is important to keep in mind that the ETD arguably was an important element to price polluting behaviour in times when the price for emission allowances under the ETS was still too low to be effective. Following the evaluation, the ETD is currently under review.[12]

The evaluation also found that “the mandatory tax exemptions concerning international commercial aviation and maritime transport and optional exemptions and reductions for other modes of transport may distort the level playing field in the sector” and that “some of the preferential tax treatments may restrict the potential contribution of the transport sector to the EU’s climate policies”. As transport CO2 emissions have not decreased, but slightly increased between 2009 and 2018[13], the EU policy discussion focuses on how the transport sector may contribute to meet environmental and climate change goals and priorities. In this respect, one policy option is taxation: the aim of vehicle taxes is to switch purchase habits, increasing the tax burden on high-emissions vehicles while providing incentives for those with low or no emissions.[14]

Thus, if designed appropriately, tax measures can help leveraging efforts to reduce CO2 emissions. In addition, countries also set positive incentives that reward emission reducing behaviour with tax breaks or even tax exemptions. Commonly known examples are tax exemptions for the purchase and use of electric vehicles, or income tax deductions for companies and individuals that resort to energy efficient technologies and products. At the same time, many countries also still have environmentally harmful tax incentives that incentivise higher GHG emission levels.

Efforts to use taxes and tax incentives to tackle climate change differ across countries. Governments resort to different types of measures with a varying degree of success. A comprehensive mapping and comparison of the measures and the identification of good practice examples can therefore help to streamline efforts and enhance policy learning.

Tax Measures and Policy to curb Climate Change

Environmental taxes aiming at pricing individual environmentally harmful activities are emphasised as an effective and efficient instrument in environmental economics[15] to internalise negative impacts stemming from individual consumption behaviour and production activities. This goal is to be achieved by putting a price on negative externalities with the tax rate being set at the marginal social damage caused. The basic idea to use taxes to cope with negative externalities that are not included in market prices[16] dates back to 1920. Based on his seminal work so-called Pigouvian taxes have gained a place as key market-based instrument in the form of environmental taxes in general and of carbon taxes in the context of climate change in particular.

Environmental taxes are repeatedly integrated in the broader context of an environmental tax reform[17] i.e. the shift of the tax burden from labour to resource and environmental consumption. Such tax reforms have been a top research focus in environmental economics and have been on the agenda in the economic policy debate already for several decades[18]. These are based on an argument that such a tax shift, in addition to reducing environmental pollution, also brings about positive economic effects by using the revenues from environmental taxes to cut other more distortionary taxes[19].

Effectiveness of environmental tax disincentives

In principle, the introduction of environmental taxes or the implementation of an environmental tax reform should focus on the steering effect or environmental effectiveness of the instrument. The main motive is to set prices for negative external effects via fiscal interventions which increase the price of environmentally damaging inputs or activities. The tax base can be specified according to various criteria, depending on the type of externality to be regulated. This should change production and consumption activities towards more sustainable or environmentally friendly structures.

An environmental tax can be used to increase the price of a certain input or activity (e.g. a levy on fertilizers, pesticides or aircraft noise). If environmental pollution is caused by all economic sectors, a cross-sectoral, uniform environmental tax should be chosen, such as a tax on fossil fuels according to their specific climate impact in order to influence the current consumption by setting a price for external effects. Alternatively, instead of a tax on fossil fuels, i.e. an input tax, one could apply an emission tax, i.e. an output tax directly related to the pollution caused. In practice, inputs are often more easily accessible and are used as basis for calculating or estimating emissions. This is also the case in the context of climate change.

Taxing carbon emissions directly is not straightforward. Instead, in practice emission factors of the use of fossil fuels and their respective carbon content are used. However, such an indirect approach does not account for process emissions e.g. from steel or cement industries. Putting a tax on non-carbon greenhouse gas emissions might be associated with high administrative costs compared to taxing fossil fuel-based emissions.[20] When deciding on the tax base, policy makers will thus be confronted with a trade-off between the scope of the GHG emissions covered on the one hand, and administrative costs on the other hand.[21]

Taxes can also be used to influence investment and purchase of durable consumer goods, since these decisions subsequently determine emissions over the whole service life of the capital stock and of products.

Environmental taxes are characterised by a variety of design options with respect to tax base, tax rate and exemptions, and in the broader context of environmental tax reforms also regarding the redistribution of tax revenues. The price elasticity of demand or the tax incidence of environmental taxes influence the effectiveness of the tax. The extent to which the tax burden can be passed over e.g. to consumers when the production sector is taxed determines the distributional effects.

Summarising, the basic economic rationale underlying the effectiveness hypotheses is twofold:

  • there is a need for taxing certain side effects from economic activities, as the harm they are imposing on society (i.e. their negative external effects) is otherwise not considered in market transactions; and
  • the tax that attaches a price to these external effects alters individual choices and thus reduces environmental harmful effects. Pricing negative externalities has been one of the central pillars in environmental economics for long.

The main advantage of taxes and other market-based instruments compared with command-and-control instruments (standards, quotas, product bans) is their efficiency.[22] The efficiency of internalising environmental taxes vis-à-vis regulatory measures is explained with the flexibility polluters are provided with in how to respond when adjusting their operations. The cost efficiency of taxes and other price instruments may be reduced, however, when fiscal interactions, i.e. the effects of environmental taxation in factor markets (labour, in particular), are accounted for.[23] The environmental tax is reflected in higher consumer prices, which in turn means a reduction in real wages and leads to a decline in the supply of labour, unless revenues are recycled back into a lowering of other taxes.

Generally, taxes are favoured by economic theory as they are expected to encourage broad-based action to reduce environmental damage at least cost. Pricing instruments are seen as cost efficient in a static and a dynamic perspective: it is left to firms and individuals to find the least cost solutions and to search for new solutions that may reduce emissions further.[24] This of course implies that the regulator sets the optimal price and that economic actors know the social costs of carbon and have perfect information on abatement costs, which is not always the case in practice.

Taxes versus emission trading

Economists agree on the recommendation to use pricing mechanisms as the core element of an effective environmental policy. However, this consensus is embedded in a broader debate on instruments in environmental policy, which reflects the controversy over price (taxes)or quantity (Emissions trading) regulation. A tax sets the price of emissions, while uncertainty remains on the resulting aggregate emissions level. Cap and trade systems define an aggregate emissions level, leaving the resulting price uncertain. In theory, in a world with perfect information both instruments, taxes and quantities, achieve the same result. In the real world, where uncertainty and asymmetric information prevail, the two instruments may deliver outcomes that are different from the theoretical optimal solution.

Whether taxes or quantity restrictions are the preferable instrument, is addressed in the seminal paper by Weitzman (1974), [25]who shows that no clear conclusion can be drawn about which of the two approaches is to be preferred. He argues that only in the case of identical information on marginal costs and marginal damages would it be feasible to set the correct quantity or price signal. In a world with uncertainty and asymmetric information both instruments face efficiency losses. Weitzman’s theoretical model shows that the preferred policy instrument depends on the steepness of the marginal abatement and marginal benefit (damage) functions. In his model a price instrument is preferred by a regulator when the marginal benefit function from reducing emissions is flat relative to the marginal cost of abatement. The opposite holds if the marginal benefit function is steeper.

Goulder and Schein (2013), Haites (2018) and Stavins (2019) provide a review of the differences and similarities of carbon taxes and trade systems. Carbon taxes are associated with lower administrative costs. Absence of price volatility is another advantage of taxes compared to trade systems. Floor or ceiling prices are tax elements introduced into trading systems to prevent price volatility. Floor or ceiling prices thus are exogenous price elements for trading systems and transform a pure cap and trade system into a so-called hybrid system with the aim to dampen price volatility.

In summary, a broad agreement among environmental economists (EAERE 2019) exists that taxes are an indispensable instrument for an effective decarbonisation strategy (World Bank Group 2019). The specificities of climate change, however, require expanding the perspective on carbon taxes as the exclusive solution for climate change. Several aspects have been addressed already above, like market failure due to stock-flow relations, or uncertainty on the likelihood of irreversible climate change. Carbon taxes thus need to be integrated in a broader policy package.[26] One important element in such a policy package would be the elimination of environmentally harmful subsidies as they reduce the price of emission intensive activities and act as adverse incentive for investment in clean energy technologies and in energy efficiency.

Impact of carbon taxes on emissions

The EU’s Emissions Trading System (ETS)[27] is the world’s first international emissions trading scheme and the EU’s flagship policy to combat climate change. It sets a cap on the amount of greenhouse gas emissions that can be released from industrial installations in certain sectors. Allowances must be bought on the ETS trading market, though a certain number of free allowances is distributed to prevent carbon leakage. That system has been effective in addressing the risk of leakage but it also dampens the incentive to invest in greener production at home and abroad. Under the Commission’s new proposal for a revised ETS, however, the number of free allowances for all sectors will decline over time so that the ETS can have maximum impact in fulfilling our ambitious climate goals.[28]

To complement the ETS, the Carbon Adjustment Border Mechanism (CBAM) will be based on a system of certificates to cover the embedded emissions in products being subsequently imported into the EU. The CBAM departs from the ETS in some limited areas, however, in particular since it is not a ‘cap and trade’ system. Instead, the CBAM certificates mirrors the ETS price.

The environmental effectiveness of carbon taxes, as measured by their impact on carbon emissions, has been studied based on ex-ante model simulations as well as by ex-post econometric evaluations. While the former still dominate the existing body of empirical studies, the growing number of countries that have introduced some form of GHG taxation has brought along an increasing number of ex-post analyses on the environmental effectiveness of GHG taxation.

Altogether, there is an increasing number of ex-post studies demonstrating that carbon taxes can effectively reduce carbon emissions or at least dampen their growth. The existing empirical results for individual countries differ somewhat due to differing methodological designs and approaches as well as databases used; and also the time period covered matters.[29] These factors also determine cross-country differences in the empirical results regarding the effectiveness of carbon taxes. In addition, the tax design as well as differing economic conditions (including the structure of the energy system and the availability of low carbon alternatives) influence the effectiveness of carbon taxes. Moreover, regardless of the rather broad range of estimates concerning the size of the emission-reducing effects, the existing empirical research suggests that the order of magnitude of the effects is insufficient to reach current medium- and long-term emission goals as stipulated in international and national agreements and plans, which may have to do with the fact that in most countries tax rates are rather moderate. Finally, it is of interest whether carbon taxes or cap-and-trade systems are more effective to contain carbon emissions.

Energy Taxes

Directive 2003/96/EC (hereafter the Energy Taxation Directive or ETD)[30] establishes the minimum excise duty rates that Member States must apply to energy products for motor fuels, heating fuels and electricity. In principle, the Member States are free to apply excise duty rates above these minimum levels of taxation, according to their own national needs and environmental ambitions.

The ETD also lays down the conditions for applying tax exemptions and reduction for the above-mentioned energy products, which are however not systematically based on the potential of energy savings or emission reductions. Indeed, energy taxes do not directly focus on the reduction of GHG emissions, however they can have an indirect impact on the emissions firstly by improving energy efficiency (using less fuel per unit of output and less fuel at the margin) and secondly by increasing effectiveness if fuel with a lower carbon content is used (tax on fossil fuels increases attractiveness of alternative fuels).

Environmental taxes directly address the failure of markets to take environmental impacts into account by incorporating these impacts into prices (OECD, 2011).[31] However, effective implementation of environmental taxes requires careful consideration of a number of factors as inadequately designed taxes can lead to a reduced environmental effectiveness.

One of the key design features is the scope of tax measure. Energy industries, fuel combustion by energy users and transport sectors are responsible for the majority of GHG emissions in the EU. Energy industries and fuel combustion by energy users excluding transport are responsible for 54.5% of GHG emissions while road transport is responsible for 16.7% (almost 72% of all transport sector GHG emissions (23.8%) are attributed to road transport).[32] It can be considered that if a tax is applied to both sectors (energy and transport), it has a potential to be most effective, as the scope of taxed activities is the largest. To be environmentally effective, the tax base should target to the pollutant or polluting behaviour, with few (if any) exceptions.[33]

However, to the detriment to the effectiveness of environmental taxes, preferential tax treatment, lower tax rates or tax exemptions are sometimes applied to reduce sectoral distributional effects and lower the risk of carbon leakage. Certain countries grant tax exemptions that at the same time induce firms to change behaviour towards being more sustainable, in which case, environmental effectiveness is not compromised. Setting the appropriate level of tax rate is another key design feature of environmental taxation. The rate of carbon tax is one of the most important element of carbon tax design Coupled with the decision on the coverage of the tax, it will ultimately determine the amount of emissions abatement achieved. Carbon prices need to be significant to have an impact on decision making, and not lead simply to paying the tax and/or buying carbon offsets. In case of vehicle taxation, the tax rate applied should increase progressively in line with the vehicle’s CO2 intensity.

Research suggests that countries with high and highly differentiated (with regards to CO2 emissions) tax rates, have been the most successful in reducing average CO2 emissions. In order to measure the level of taxation, tax curves can be drawn to show how the CO2-based tax component changes with every g/km. The tax curves visualise the structure of the tax system with respect to CO2 emission values. Finally, it is considered that in order to impact consumption decisions excise duties levied on energy products (motor fuels, heating fuels and electricity) should be higher than the minimal rates currently required by the Energy Tax Directive.[34] In fact, many Member States apply rates which are considerably higher than the required minima. Defining the tax base is another important design feature. Research suggests that an environmental tax should generally be levied as directly as possible on the pollutant or action causing the environmental damage.[35]Therefore, taxes that have as its base carbon content or other greenhouse gas, can be considered most effective. The second-best approach is to levy a tax on a close proxy. Research suggests and stakeholders that took part in the workshop agreed that not all design features are equally relevant for environmental effectiveness. In particular, the scope of a measure appears to be the most important, followed, by the tax rate and the tax base.

The Carbon Border Adjustment Mechanism

The July 2021 package in support of the EU’s climate targets is an integral part of our strategy to achieve this, and will further seal the EU’s reputation as a global climate leader. As part of these efforts, the Carbon Border Adjustment Mechanism (CBAM) is a climate measure that should prevent the risk of carbon leakage and support the EU’s increased ambition on climate mitigation, while ensuring WTO compatibility.

Designed in compliance with World Trade Organization (WTO) rules and other international obligations of the EU, the CBAM system will work as follows: EU importers will buy carbon certificates corresponding to the carbon price that would have been paid, had the goods been produced under the EU’s carbon pricing rules. Conversely, once a non-EU producer can show that they have already paid a price for the carbon used in the production of the imported goods in a third country, the corresponding cost can be fully deducted for the EU importer. The CBAM will help reduce the risk of carbon leakage by encouraging producers in non-EU countries to green their production processes.

Carbon Border Adjustment Mechanisms are already in place in some regions around the world, such as California, where an adjustment is applied to certain imports of electricity. A number of countries such as Canada and Japan are planning similar initiatives. In addition, the IMF and the OECD have recently carried out work to study how such measures could support international efforts to reduce greenhouse gas emissions. In the communiqué following their meeting of 9-10 July 2021, G20 Finance Ministers also mentioned the need for closer international coordination on the use of carbon pricing mechanisms.

To provide businesses and other countries with legal certainty and stability, the Carbon Border Adjustment Mechanism will be phased in gradually and will initially apply only to a selected number of goods at high risk of carbon leakage: iron and steel, cement, fertiliser, aluminium and electricity generation. A reporting system will apply as from 2023 for those products with the objective of facilitating a smooth roll out and to facilitate dialogue with third countries, and importers will start paying a financial adjustment in 2026.

The CBAM will mirror the ETS in the sense that the system is based on the purchase of certificates by importers. The price of the certificates will be calculated depending on the weekly average auction price of EU ETS allowances expressed in € / tonne of CO2 emitted. Importers of the goods will have to, either individually or through a representative, register with national authorities where they can also buy CBAM certificates.

National authorities will authorise registration of declarants in the CBAM system, as well as reviewing and verifying declarations. They will also be responsible for selling CBAM certificates to importers. In order to import goods covered under the CBAM into the EU, they must declare by 31 May each year the quantity of goods and the embedded emissions in those goods imported into the EU in the preceding year. At the same time, they must surrender the CBAM certificates they have purchased in advance from the authorities.

By ensuring importers pay the same carbon price as domestic producers under the EU ETS, CBAM will ensure equal treatment for products made in the EU and imports from elsewhere and avoid carbon leakage.

Considerable research has been published on the limitations of the CBAM. Studies have suggested that there are many requirements for CBAM to be effective.[36] For example, it was pointed out that export subsidies on sectors with high carbon emissions must be abolished to realize the effects of the carbon border tax.[37] Also, other problems regarding the CBAM have been raised. When the data on carbon emissions becomes merged with international trade law, optimistic reduction effects could be realized.[38] Furthermore, regulations on export subsidies and Emission Trading System (ETS) free allowance allocations must be included to fully realize the effect of the carbon border tax. At the WTO Committee on Trade and Environment (CTE) meeting in March 2021, the lack of transparency in the CBAM and how it could potentially distort trade were pointed out.[39]

The CBAM as being akin to new trade barriers. In the process of promoting a carbon-free economy, Lowe[40] also pointed out that the CBAM may further increase the gap between developed countries and developing countries. It was also claimed that the risks to trade-related policies are growing for underdeveloped economies, since they have relatively less accessibility to low-carbon financing and technology, delaying the energy transition, which could decrease the stability and competitiveness of those economies. Moreover, the cost of applying the CBAM is not to be underestimated. Smaller economies and those with greater dependence on trade with the EU, such as African countries and those with borders adjacent to the EU, could face a greater shock. For these reasons, a collective climate measure may be preferred over the unilateral. There are concerns about how the implementation of the CBAM may intensify global protectionist sentiments due to the countermeasures of individual countries to the mechanism. Many researchers and practitioners, worry about retaliation against the EU. Moreover, there are concerns about negative effects from implementing the carbon border tax. This could lead to trade reduction and welfare loss in emerging markets and developing countries, where major industries with carbon emissions are clustered.

The EU has stated that it will invest the tax revenue earned from the carbon tax to enhance carbon technology. This means the development of low-carbon, high-efficiency energy sectors, and it is expected that this will reduce the demand for EU imports in energy sectors. To reflect this in the model, we set up a scenario where the weight the carbon tax has in the EU’s financial income affects the development of technology in the energy industry.[41]

With the announcement of the CBAM by the EU, awareness among companies of carbon reduction has been strengthened, and the global carbon credit market is revitalizing itself. The size of the global carbon credit market reached 229 billion euros in 2020, more than five times that of three years ago.

If countries with high carbon emissions, such as Russia, China, and India, engage in trade retaliation, the CBAM will become disadvantageous for the EU. As such, it is questionable whether CBAM can be implemented as the EU intends. Although the EU has undertaken various legal reviews to assert that the CBAM is compatible with GATT/WTO rules,[42] current CBAM initiatives cannot avoid normative violations.

No country will oppose a response to climate change, but for CBAM to be implemented successfully, technical, legal, and, above all, political issues must be overcome. The current CBAM, which poses a real risk of deteriorating the global trade environment, requires a new legal review, as well as an economic review, at the global level, but not from the EU’s point of view. The implementation period should be delayed, and an international information cooperation system should be discussed first, along with a technical analysis. Today, production is dispersed across multiple countries owing to the global value chain (GVC). When the carbon history of a specific product can be accurately estimated, and if related information can be shared internationally, a carbon border tax can be calculated rationally. Additionally, ways to use tax revenue to reduce the backlash against the CBAM require international agreement. Clearly, this is a new tax imposed on third countries, and if all the revenue, not part of it for international publicity, is used to support environmental technology in developing countries, international acceptance of the CBAM will improve, and criticism against it as a protectionist measure may diminish.

Recommendations

It is generally acknowledged that environmental taxes and beneficial tax incentives are an increasingly used tool among countries to support the green transition towards lower GHG emissions. A growing body of research is available to countries helping them to make informed policy choices to strike a successful balance between designing tax measures that are effective in reducing GHG emissions yet remain reflective of the wider political (including economic and distributional) implications.

Yet, there is still room to improve and learn from each other. Although there is a growing body of evidence that could help to design their taxes more effectively, in many instances countries still resort to second-best or less effective schemes for their taxes and tax incentives. Further, there are still important gaps in the research agenda, especially with regard to tax incentives. Countries further need to reflect if there is further room to enhance their efforts to curb GHG emissions via taxation. In some instances, the design of measures might rather serve other purposes, including revenue generation or meeting political demands, rather than focusing on a reduction of emissions. Striking the right balance between various and often conflicting interests will remain a key challenge for future policy making.

Do not reinvent the wheel – most likely other countries already have similar measures in place. Countries should compare their measures with similar measures in other countries and critically reflect if their or other countries’ measures are more effective in curbing GHG emissions, and why this is so.

Countries should map any gaps in their offer, assess why these gaps exist, and reform existing measures or implement new ones where deemed appropriate. The good practice examples provide for examples how certain taxes and tax incentives could be designed, what their strengths but also weaknesses or limitations are. To find successfully implemented tax measures, Member States should also look beyond countries in their direct neighbourhood.

Tax authorities, designing tax measures, are recommended to make sure to consider existing good practice. Particularly, where possible, aim at taxing GHG directly. Proxies appear to have an effect as well, yet the anticipated effect can be expected to be smaller. This applies to taxes, but also to tax incentives.

Moreover, in general terms, one needs to give priority to taxes over tax incentives. There is more clear-cut evidence for the effectiveness of taxes over tax incentives. In addition, given the larger scope of taxes, it is arguably possible to achieve greater GHG emission reductions via taxes than tax incentives. Among taxes, carbon taxes appear to have the greatest potential to reduce emissions effectively.

Reduce environmentally harmful subsidies and tax incentives, for instance towards specific transport modes, heating, or industrial purposes. Such a reduction would need to take into account the social and competitiveness impacts and consider complementary policies to tackle them.

Member States collectively and the EU level should increase the effective uptake of proven solutions, exchange, evaluation, and collaborative learning should be enhanced and foster exchange among countries to step up common efforts to reduce GHG emissions and to enhance policy learning. Coordination among Member States, at EU level and beyond can help to realise synergies and avoid adverse side-effects (such as, e.g., carbon leakage).

Finally, more research is needed to fully understand the effectiveness of tax measures in general, and tax incentives in particular. There are still significant gaps in the assessment of the effectiveness of existing measures. Critically reflect on existing policy measures and strengthen efforts to perform ex-post assessments more consistently, especially for tax incentives. These insights – including those on political viability – should then be used to strengthen the evidence base for future measures – to help ensure they are fit for purpose.

About the Author

This article has been authored by Dr Franklin Cachia, CSB Group Tax & Regulated Industries Director. For further information or any assistance required, you may contact one of our experts on info@csbgroup.com.

[1] https://ec.europa.eu/clima/policies/eu-climate-action_en accessed 23rd September 2022.

[2] Brussels, 11.12.2019 COM(2019) 640 final Communication from the Commission: The European Green Deal.

[3] https://ec.europa.eu/clima/policies/ets_en accessed 23rd September 2022.

[4] Kosonen, Katri and Nicodeme, Gaetan, The Role of Fiscal Instruments in Environmental Policy (July 2009). CESifo Working Paper Series No. 2719, accessed 24th September 2022 https://ssrn.com/abstract=1437501 or http://dx.doi.org/10.2139/ssrn.1437501. See also Janet E. Milne, Mikael Skou Andersen, Edward Elgar Publishing, 01 Jan 2012  Handbook of Research on Environmental Taxation. See also Impacts of a carbon tax across US household income groups: What are the equity-efficiency trade-offs? Lawrence H. Goulder a,b,c, Marc A.C. Hafstead b , GyuRim Kim d , Xianling Long a., Journal of Public Economics, accessed 24th September 2022.

[5] See the Communication from the Commission on Europe’s 2030 climate ambition: “The Commission is aware that carbon pricing does not address all barriers to the deployment of low and zero emissions solutions. Other complementary policy actions are needed to ensure that the incentives align and to trigger further investments in clean energy technologies and infrastructure or to overcome financing difficulties for low-income households.“ COM(2020) 562 final.

[6] Claudia Kettner-Marx & Daniela Kletzan-Slamanig, 2018. “Carbon Taxes from an Economic Perspective,” WIFO Working Papers 554, WIFO accessed 23rd September 2022.

[7] https://ec.europa.eu/info/sites/info/files/2020-european-semester-csr-comm-recommendation-communication_en.pdf   accessed 23rd September 2022.

[8] Data from 2018. Data for IL and CA from OECD (2014).

[9] European Commission (2018): IN-DEPTH ANALYSIS IN SUPPORT OF THE COMMISSION COMMUNICATION COM (2018) 773.

[10] https://ec.europa.eu/taxation_customs/sites/taxation/files/energy-tax-report-2019.pdf   accessed 23rd September 2022.

[11] ibid

[12] https://ec.europa.eu/info/law/better-regulation/have-your-say/initiatives/12227-EU-Green-Deal-Revision-of-the-Energy-Taxation-Directive accessed 23rd September 2022.

[13] See Eurostat [ENV_AIR_GGE].

[14] The European Commission published a proposal for a Council Directive to include CO2 as tax base in annual circulation taxes, see COM(2005) 261 final.

[15] The Theory of Environmental Policy, William Baumol (william.baumol@nyu.edu) and Wallace Oates, in Cambridge Books from Cambridge University Press, 1988. See also Tietenberg, T. and Lewis, L. (2009) Environmental Economics & Policy. 6th Edition, Pearson Education, Upper Saddle River.

[16] ARTHUR CECIL PIGOU, THE ECONOMICS OF WELFARE (1920)

[17] The common view of environmental tax reform (ETR) is the use of the revenue from environmental taxes to reduce distortionary taxes, e.g. taxes on labour. The European Environmental Agency (EEA, 2005) e.g. defines an ETR as “… the term used for changes in the national tax system where the burden of taxes shifts from economic functions, sometimes called ‘goods’, such as labour (personal income tax), capital (corporate income tax) and consumption (VAT and other indirect taxes), to activities that lead to environmental pressures and natural resource use, sometimes called ‘bads’.”

[18] The Role of Carbon Taxes in Adjusting to Global Warming, David Pearce Economic Journal, 1991, vol. 101, issue 407, 938-48. See also Environmental Taxation and the “Double Dividend:” A Reader’s Guide, Lawrence H. Goulder, WORKING PAPER 4896, DOI 10.3386/W4896, ISSUE DATE October 1994 & Environmental Tax Reform (ETR): A Policy for Green Growth, April 2011, Paul Ekins.

[19] See, e.g., Bovenberg and de Mooij (1994, 1997), Parry (1995), Goulder (1995, 2000, 2013) and Fullerton and Metcalf (1997) on such an interaction of environmental taxes with the overall tax system.

[20] There exist clear emission factors for each fossil fuel that can be readily translated into CO2 intensity (emissions per energy unit) which can be the basis for a respective carbon tax. Such a carbon tax translates into a specific price increase per fossil energy consumed. Non-CO2 emissions vary greatly among sectors (e.g. livestock, fertilizer production) and regions. Data requirements and estimates on emission intensities thus could be more challenging than for CO2-emissions.

[21] Smulders and Vollebergh (1999) Green Taxes and Administrative Costs: The Case of Carbon Taxation

Sjak Smulders (j.a.smulders@uvt.nl) and Herman R.J. Vollebergh, A chapter in Behavioral and Distributional Effects of Environmental Policy, 2001, pp 91-130 from National Bureau of Economic Research, Inc.

[22] Kosonen, Katri and Nicodeme, Gaetan, The Role of Fiscal Instruments in Environmental Policy (July 2009). CESifo Working Paper Series No. 2719, Available at SSRN: https://ssrn.com/abstract=1437501 or http://dx.doi.org/10.2139/ssrn.1437501

[23] Policy Analysis in the Presence of Distorting Taxes, Ian W. H. Parry and Wallace E. Oates, Journal of Policy Analysis and Management, Vol. 19, No. 4 (Autumn, 2000), pp. 603-613.

[24] The Promise and Problems of Pricing Carbon: Theory and Experience Joseph E. Aldy and Robert N. Stavins, Journal of Environment & Development 21(2) 152–180 © 2012 SAGE Publications.

[25] Prices vs. Quantities. Martin Weitzman · Review of Economic Studies, 1974, vol. 41, issue 4, 477-491. Date: 1974.

[26] https://www.carbonpricingleadership.org/report-of-the-highlevel-commission-on-carbon-prices accessed 24th September 2022.

[27] https://climate.ec.europa.eu/system/files/2017-03/ets_handbook_en.pdf accessed 26th September 2022.

[28] Consolidated version of Directive 2003/87/EC of the European Parliament and of the Council establishing a scheme for greenhouse gas emission allowance trading within the Community and amending Council Directive 96/61/EC.

[29] See Yan and Eskeland (2018) and Koch et al. (2019) and the literature cited therein.

[30] Note that the ETD is currently under revision after an evaluation found that its EU added value with regards to environmental protection and reduction of GHG emissions is very limited.

[31] https://www.oecd.org/env/tools-evaluation/48164926.pdf accessed 23rd September 2022.

[32]https://ec.europa.eu/eurostat/cache/infographs/energy/bloc-4a.html

https://www.eea.europa.eu/data-and-maps/indicators/transport-emissions-of-greenhouse-gases/transport-emissions-of-greenhouse-gases-12

[33] ibid 29.

[34] In the recent evaluation of the Council Directive 2003/96/EC of 27 October 2003 restructuring the Community framework for the taxation of energy products and electricity, the study had found that : “ETD provides no financial incentives for final consumers to participate in demand response, neither in the form of energy savings, nor in the form of demand flexibility. The current ETD sends wrong price signals, discouraging users from choosing greener and more efficient energy sources”. https://ec.europa.eu/info/sites/info/files/swd_2019_0329_en.pdf. Other research further suggests that energy taxes should be uniform (per unit of Gigajoule) and aligned with other policy efforts, as for example Andersen (2015) suggests.

[35] Ibid 29.

[36] Bacchus, J. Legal Issues with the European Carbon Border Adjustment Mechanism; CATO Briefing Paper, No.125; CATO Institute: Washington, WA, USA, 2021; pp. 3–6 and International Institute for Sustainable Development (IISD). An EU Carbon Border Adjustment Mechanism: Can It Make Global Trade Greener While Respecting WTO Rules? Commentary, 17 May 2021. Available online: https://sdg.iisd. org/commentary/guest-articles/an-eu-carbon-border-adjustment-mechanism-can-it-make-global-trade-greener-whilerespecting-wto-rules/ accessed 26th September 2022).

[37] Elliott, J.; Foster, I.; Kortum, S.; Munson, T.; Cervantes, F.P.; Weisbach, D. Trade and carbon taxes. Am. Econ. Rev. 2010, 100, 465–469. Elliott, J.; Foster, I.; Kortum, S.; Jush, G.K.; Munson, T.; Weisbach, D. Unilateral Carbon Taxes, Border Tax Adjustments and Carbon Leakage. Theor. Inq. Law 2013, 14, 207–244.

[38] Mehling, M.A.; van Asselt, H.; Das, K.; Droege, S.; Verkuijl, C. Designing border carbon adjustments for enhanced climate action. Am. J. Int. Law 2019, 113, 433–481.

[39] International Institute for Sustainable Development (IISD). An EU Carbon Border Adjustment Mechanism: Can It Make Global Trade Greener While Respecting WTO Rules? Commentary, 17 May 2021. Available online: https://sdg.iisd. org/commentary/guest-articles/an-eu-carbon-border-adjustment-mechanism-can-it-make-global-trade-greener-whilerespecting-wto-rules/

[40] Lowe, S. The EU’s Carbon Border Adjustment Mechanism: How to Make It Work for Developing Countries. Centre for European Reform. 2021. Available online: https://www.cer.eu/publications/archive/policy-brief/2021/eus-carbon-border-adjustmentmechanism-how-make-it-work

[41] Ibid.

[42] Pauwelyn, J.; Kleimann, D. Trade-Related Aspects of a Carbon Border Adjustment Mechanism; A Legal Assessment; European Parliament, Directorate-General for External Policies: Brussel, Belgium, 2020. Van Asselt, H. The Prospects of Trade and Climate Disputes before the WTO. In Climate Change Litigation: Global Perspectives; Brill Publishing: Leiden, The Netherlands, 2020.

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