Climate change tax policy: What you need to know

This article was originally published in Tax Journal on 3 December 2021 and is reproduced with permission from the publisher.

The United Nations Framework Convention on Climate Change (UNFCCC) meeting as the Conference of the Parties 26 (COP 26) ended on Saturday 13 November. Whilst the final ‘Glasgow Climate Accord’ contained a last-minute watering down of commitments for the ‘phasedown’ rather than ‘phaseout’ of unabated coal power, it turned some aspirations from the Paris Agreement of 2015 into specific actions and contained the first prominent recognition of the ‘loss and damage’ caused by climate change.

But what about tax policy?

Whilst regulation and the directing of public resources and stimulation of private sector investment will be major policy levers, is there now clear recognition of the role of tax policy in meeting net zero targets?

From a corporate perspective, there are two principal issues to contend with. The first, is the extent to which governments will pursue ‘explicit’ carbon pricing to help achieve climate goals, and where collection of this ‘tax’ will fall. The second is the extent to which other changes might be made to tax systems in order to remove obstacles or provide incentives to decarbonisation. Pretty much every major company is committed on a personal journey to net zero and heads of tax are now thinking much more about what this means for them in practice.

Over the summer, the European Commission published a slew of policy documents – and in the lead up to COP 26 the UK government published documents setting the direction of travel for UK policy. More significantly perhaps, in September 2012 the IMF and the OECD published a paper for the meeting of G20 finance ministers that took place before COP 26, and the indications are that the OECD is now gearing up to try to find international consensus on a harmonised global explicit carbon pricing regime.

Targets

Many leading nations have committed to ‘net zero’ GHG emissions by 2050 (two of the major emitters, China and India, have set longer targets of 2060 and 2070 respectively). Net zero means the total emission of greenhouse gases (GHGs), less GHGs captured or sequestered, in that territory, will be zero.

Achieving this goal requires extensive decarbonisation of the sectors responsible for emissions. As a very rough rule of thumb, in the UK emissions might be attributed to sectors as follows:

• Energy supply (commercial) – 38%
• Energy supply (residential) 21%
• Transportation – 16%
• Agriculture – 15%
• Industrial processes – 7%
• Waste management - 3%

Carbon pricing

One of the principal policy tools to reduce emissions is explicit ‘carbon pricing’ – which puts an economic cost on the negative externality, i.e. GHG emissions, in order to make emitting GHGs less attractive and alternatives more attractive. For business, this in effect makes the damage done to the climate by that business a cost input, like labour, materials and everything else.

Whilst carbon pricing can take the form of a simple tax, the more popular form is a ‘cap and trade’ scheme under which the total permitted emissions of a whole sector are capped, that cap reducing over time in line with targeted stage reductions in emissions. Permits to emit, which in sum total amount to the cap, are auctioned under the scheme – and can be traded in a secondary market.

EU: ‘fit for 55’ package

The EU is subscribed to a 2050 net zero target and runs the largest cap and trade scheme, the EU emissions trading scheme (ETS). The net zero target has been given extra urgency by the announcement over the summer of a ‘fit for 55’ package of measures, designed to reduce GHG emissions in the EU by 55% (previous target 40%) by 2030, including by revamping carbon pricing and tax policy.

EU carbon policy

First, the EU ETS only covers emissions from power generation, heavy industrial processes, and EU aviation. The European Commission is therefore proposing to extend it to EU shipping – and to create a second ETS to cover emissions from surface transport and heating/ powering/cooling buildings.

Second, the EU has published proposals to deal with ‘carbon leakage’. This is the concern that imposing a carbon price on an EU operator will incentivise the transfer of production to a non-EU country with no or a low carbon price, rather than reduce emissions. Currently, this issue is dealt with by giving free permits to emit to EU operators where this risk is considered to be highest although a free permit does not directly incentivise that operator to reduce omissions, an indirect incentive exists as any unused permits can be traded with an operator in another part of the scheme). The number of free permits issued has fallen over time but is still high in some parts of the scheme: there have been no free allowances issued in power generation since 2013 (although member states can derogate to facilitate the modernisation of their respective energy sectors); 30% are still given free for industrial processes (80% in 2013) and 82% are still given free for aviation (this has hardly budged).

An alternative approach to levelling the playing field is to charge for permits for domestic operators and impose a ‘border carbon adjustment’ (BCA) to imports which compete with the domestic operator. The EU’s proposed BCA is called the carbon borderer adjustment mechanism (CBAM) – which will apply a price on imports equivalent to the cost of the permits that would have been needed had the product been created in the EU.

EU CBAM

The CBAM will apply initially only to large scale products, where the ‘embedded’ emissions are easier to measure: cement; iron and steel; aluminium; fertilisers; electricity. There will also be a graduated implementation: from 2023, importers will have to report the ‘embedded’ emissions in covered products, but the liability to pay only kicks in from 2026. If successful, the CBAM would be rolled out to other products.

Crucially, an EU import of covered products will not be subject to the CBAM if the product has been subject to carbon pricing outside the EU. In effect the EU is saying it will price the emissions in making, say, Russian steel imported into the EU if Russia does not do it itself. The EU has been careful not to call the CBAM a tax – which would take it under the power of veto amongst member states, and there are issues about whether it is WTO-compliant.

Critics of the CBAM say that the EU’s unilateral approach will have the effect of making goods more expensive for EU consumers, putting them at a disadvantage to consumers elsewhere – and point to complexities in measuring embedded emissions and in whether to refund the carbon price paid in the EU on products exported from the EU. Others say that this unilateral action is exactly what is needed to precipitate change in the way that the unilateral digital services taxes appear to have been the catalyst for the international consensus seen with pillars one and two for reforming the international corporate income tax system.

ETD

Finally, the EU is also revamping the Energy Taxation Directive – under which member states are required to harmonise certain aspects of energy tax policy – including by ensuring that taxes are set by reference to carbon content and to remove incentives/exemptions for the use of fossil fuel, such as in aviation and maritime transport. There are further reforms proposed to encourage the take up of alternative sustainable fuels.

The UK

Shortly before COP26, the UK government published its long-awaited ‘heat and buildings strategy’, adding to previously published strategies on hydrogen and transport – along with its very upbeat net zero strategy, which brought all the strands together. At the same time the Treasury published its more sobering ‘net zero review’ (NZR).

Explicit carbon pricing policy

The NZR affirms the UK’s commitment to the UK ETS as the UK’s principal carbon pricing policy tool. It also reaffirmed its commitment to ‘look at’ extending the UK ETS to agriculture, transport and buildings.

However, the NZR pours a little cold water over the utility of a BCA. It questions the evidential base for carbon leakage risk and states its preference for international collaboration on carbon pricing rather than unilateral action. The Treasury does, however, plan to commit more resource to investigating the matter.

Changes to tax base

The NZR highlights the fact that over the next 30 years, revenues from taxes connected to fossil fuels will dwindle as the economy decarbonises. The principal source of such revenue is from fuel duty. The Treasury notes that expected revenues from the UK ETS, even if expanded, will not be enough to compensate this loss of revenue source. It also notes that there may be a need for tax rises (or reprioritising of spending plans) to fund the investment needed to decarbonise and that this might come from general taxation or explicit carbon pricing.

The Treasury also notes that the current system of levies added to electricity supply to pay for renewable energy investment doesn’t make sense. The levies should be applied to carbon-heavy sources of energy, not to electricity where increasingly the supply in the UK comes from renewable sources (up to 40%). The Treasury has committed to reviewing this area.

Social impact

The NZR also notes that as explicit carbon pricing rises, this will hit the lowest income households the hardest as a proportion of their overall spend. Whilst the highest income households are responsible for more emissions per capita (e.g. from larger houses and cars and more frequent air travel), carbon makes up a larger share of wallet for the lower income households (e.g. on car transportation, heating and power, and food). The Treasury is not keen on using the general system of taxation to address social inequalities (for example, it was set very much against reducing VAT on gas to help the poorest as wholesale prices rise) and prefers to find targeted solutions within specific regimes.

Aviation

Another politically thorny area is carbon pricing in aviation. The Autumn Budget 2021 attracted criticism for cutting air passenger duty on domestic flights, particularly the signal this sent in the lead up to COP 26. More fundamentally, the aviation sector enjoys in effect a state subsidy as against other forms of transportation. As with the EU ETS, many free allowances are given to the aviation sector under the UK ETS, rendering the inclusion of aviation in the scheme more one of form over substance. The UK is consulting on a new regime to promote take-up of sustainable aviation fuel (such as that based on ethanol). Those fuels are currently four or five times more expensive to produce than conventional jet fuel. The idea mooted is a levy based on debits for carbon-heavy fuel, and credits from carbon-light fuel, thus providing a forward price signal and incentive in order to encourage private sector investment in the development of the science. The consultation notes the need to ensure there is no double charging arising from any overlap of the UK ETS and this proposed new regime.

IMF and OECD

In September 2021, the IMF and OECD published a report for the meeting of G20 finance ministers and central bank governors, entitled Tax policy and climate change. They come out heavily in support of explicit pricing of carbon and other GHGs, provided that the system is inclusive and supports international development. They also say that the actual carbon price itself needs to be ramped up considerably.

More fundamentally, the report questions the efficacy of BCAs. It notes the complexity of applying a BCA to a range of products, whether to rebate domestic pricing for exports to jurisdictions with no carbon pricing (the mirror image of the BCA on imports), potential legal challenges under WTO rules and the political risk of a BCA being seen as protectionism under a green guise. It instead encourages multilateralism via an ‘international carbon price floor’, involving collaboration between the highest emitting countries (the G20 are responsible for 80% of global emissions). The focus on a smaller club of countries should, so the paper says, make for easier negotiation than is the case for a COP agreement, which involves over 195 parties – with what is agreed then being taken out to the broader world via a system like the Inclusive Framework.

Financial disclosure and reporting

Heads of tax will need to take note of these developments, but it is not just all about tax policy. The UK is seeking to lead the way in mandatory reporting (which I summarise in the jargon-buster; see the shaded panel). This will provide increasing amounts of data for the government to use to form policy. If the reporting of emissions in a business is of high quality, it is not inconceivable that it might be used as a basis for levying tax against a company, by reference to its carbon footprint, in order to encourage a greater pace of change. However, as things stand, the indications are that explicit carbon pricing is more likely to be levied on and collected from the suppliers of fossil fuels and power generated from fossil fuels, rather than the suppliers and consumers of goods and services which effectively contribute to emissions – except perhaps in case of non-carbon emissions, such as methane emissions in the agriculture sector. But if the UK and EU end up with a broadly-based BCA, importers will also need to add this to compliance with customs rules and plastic packaging taxes.

So where do we go from here?

Development of the science is considered one of the keys to unlocking our climate goals (and perhaps governments are relying too much on science coming to the rescue). The NZR states that UK government policy is centred on direct funding of R&D to help bring otherwise uncommercial technologies to the market. But is this enough? Can we do more to incentivise green R&D and by providing better capital allowances for the acquisition of the technologies emanating from that R&D?

There is also an increasing call for a wholesale review of the tax system to identify and remove disincentives to decarbonisation. Electric vehicle charging attracts a 5% VAT rate if done from home, but 20% if done at a public charging point. Land used for carbon sequestration doesn’t attract IHT relief whereas land used for emissions intensive farming does. There is ambiguity about the treatment of credits in voluntary carbon markets. The list goes on.

There is clear momentum building towards broader adoption of explicit carbon pricing – but without international harmony, what is a single worldwide climate goal (keeping the temperature rise comfortably under two degrees centigrade) becomes more difficult to achieve. The OECD appears to see achieving international consensus as its next project, hoping to replicate what it managed to achieve (largely) in relation to pillar one and two. In the meantime, the EU will continue to pursue a unilateral policy via the CBAM to encourage this direction of travel.

For most businesses, greater explicit carbon pricing will mean more expensive inputs, and some new administration obligations. Heads of tax will need to understand where this incidence lies and where their business may incur direct administrative liability. They will also need to monitor for and influence changes to general tax law with a climate goals hue, such as reduced VAT rates, incentives and allowances, or new taxes and levies brought in to replace dwindling tax revenues from carbon-related taxes as the economy decarbonises. For the next 30 years, we can expect these risks and opportunities to be front and centre of tax policy. The journey ahead is only now starting to take shape.

Jargon-buster

• Greenhouse gases: carbon dioxide, methane, nitrous oxide, fluorinated gases and water vapour. Most of the focus is on carbon dioxide emitted from burning fossil fuels. Methane causes greater warming but stays in the atmosphere for a much shorter period and reducing this is seen as a ‘quick win’.
• Territorial emissions: emissions of GHGs by human activity in a given country.
• Consumption emissions: the total emission of GHGs in the production of goods and services which are consumed in a country, irrespective of where the emissions take place. The UK has fared better in reducing territorial emissions than consumption emissions.
• UK net carbon account: emissions of GHGs from activities in the UK less GHGs captured or sequestered in the UK. The UK intends that its net carbon account will be zero by 2050.
• Carbon pricing: any system in which as proxy for the external cost of emissions (e.g. the damage caused to land, property and livelihoods by global warming) is charged to emitters. Used to discourage emissions and encourage the transition to alternative forms of energy. Most often in the form of a tax, levy or emissions trading scheme.
• Emissions trading scheme: often referred to as ‘cap and trade’, the scheme requires operators to have allowances or ‘permits’ to emit. A fixed number of permits are issued, reducing in line to meet emissions targets. Permits are auctioned by the government(s) operating the scheme, although a significant number of permits are allocated free of charge to reflect concerns about ‘carbon leakage’. The permits can be traded on a secondary market, allowing operators with too few permits to buy from others and operators with an excess to sell them into the market, creating a fluctuating market price.
• Carbon leakage: the concern that the imposition of a carbon price by one territory will cause emission producing activities to move to another territory where no such price is imposed.
• Carbon border adjustment mechanism: the EU’s proposed mechanism designed to deal with carbon leakage. Goods imported into the territory are subject to a charge equivalent to the cost of the ETS permits that would have been needed had the goods been produced in the EU. Favoured policy tool of the EU but is controversial.

Reporting obligations

• Emissions scope: the categorisation of emissions into graduated scopes to measure the performance of a business in tackling the emissions for which it is responsible for, broken down as follows:
  • scope 1 emissions are direct emissions from owned or controlled sources, for example from burning of fossil fuels to transport vehicles;
  • scope 2 emissions are indirect emissions from the generation of purchased energy;
  • and scope 3 emissions are all indirect emissions (not included in scope 2) that occur in the value chain of the reporting company, including both upstream and downstream emissions.
• The streamlined energy and carbon reporting regime (SECR): UK reporting regime under which quoted companies (LSE main market, any EEA market or NYSE/ NASDAQ) are required to report on global GHG emissions for which they are responsible through direct combustion or purchase of energy, plus other matters. ‘Large’ UK companies/LLPs (turnover £36m+, balance sheet £18m+ or 250+ employees) must report on their UK energy use, associated GHG emissions and other matters. SECR covers scope 1 and scope 2 and some scope 3 emissions.
• Taskforce on Climate-Related Financial Disclosure (TCFD): a framework of recommendations published by the Financial Stability Board to encourage and harmonise reporting by businesses of risk and opportunities which arise from climate change, both in terms of the impact of climate change on the business (e.g. extreme weather events) and the decarbonisation transition in the economy. LSE Premium listed companies are required to report under a regime which follows the TCFD recommendations – and for accounting periods starting on or after 6 April 2022 this will extend to all quoted companies, large private companies and large LLPs. Large means over 500 employees and, for non-quoted companies and all LLPs, turnover of £500m.
• Transition plan: a new requirement to be introduced by the UK for certain entities to publish net zero transition plans setting out how they will decarbonise in the period to 2050.