Tax Law and Climate Change

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    Executive summary

    Taxation can be a powerful tool for meeting policy goals, and the net zero transition is no exception. Governments can apply Pigouvian taxes, which aim to disincentivise behaviour, to goods and services that cause greenhouse gas emissions. They can also grant tax relief to entities engaging in activities that help mitigate or adapt to climate change. More broadly, tax revenue is vital to the significant public investment required to address climate change. Reducing emissions, however, will also reduce revenue from taxes paid by highly emissive industries.

    Tax law and policy can therefore play a key role in disincentivising behaviour that contributes to climate change, and accelerating activity which aims to combat the climate crisis. Of course, this is all set against the backdrop of economic issues and political attitudes, which are sometimes at odds with environmental objectives in taxation. Nonetheless, fiscal policy remains an important mechanism for addressing climate change in the UK and abroad. This section summarises some of the current and future intersections between taxation and climate change.

    • Tax revenue is important to funding climate policies, but the net zero transition will also involve phasing out some industries that pay a significant amount of tax so maintaining a stable tax base is vital. Environmental taxes should therefore be evaluated in light of the government’s broader fiscal policy.
    • Carbon pricing is a highly effective policy lever for addressing climate change, though it must be accompanied by other policy measures. The UK has a suite of environmental taxes affecting different parts of the economy, alongside a broad emissions trading system. Environmental taxes may be accompanied by targeted dividends or subsidies to ensure they do not burden vulnerable communities.
    • The UK provides tax relief for certain environmentally friendly products and services. Some products are also subject to lower VAT, though the efficacy of these measures is contested.
    • The government has indicated the possibility of expanding the UK’s emissions trading system to cover more sectors, and there have been some calls to impose an economy-wide carbon tax.
    • Global cooperation on carbon pricing is growing – there are now efforts to develop international carbon pricing mechanisms, impose carbon tariffs on goods that have not paid a carbon price, and link emissions trading systems.

    Tax revenue 

    One significant risk associated with climate change, which was drawn out strongly in the Treasury’s 2021 Net Zero Review, is shrinking tax revenue as petrol and diesel use declines. The Treasury assessed that expanding carbon pricing would likely not be enough to plug this gap. Since public investment will remain vital to tackling climate change alongside other government objectives, this may mean increased taxes in other segments of the economy. Industries that will grow during or emerge from the net zero transition may also face increased taxes. For example, the Treasury suggested ensuring that motorists using electric vehicles still pay taxes to fund public services. The government may also remove tax relief for green products as they become more common to fill this gap in revenue. The relationship between tax and climate change is therefore much broader than just specific environmental taxes, as maintaining a stable tax base is critical to ensuring sufficient public funds for green investment. 

    Environmental taxes 

    Many economists agree that pricing greenhouse gas emissions is a highly effective policy lever for addressing climate change. The fundamental justification for pricing carbon is that climate change is a negative externality, so the government should intervene so that market actors pay for the real costs of greenhouse gas emissions. One way of doing this is through taxation. This can either be done directly through taxing entities based on the volume of CO2e[1] emitted, or indirectly through taxing behaviour or products that cause emissions. Carbon prices tend to increase over time. Climate change has already prompted a suite of environmental taxes and other carbon pricing measures in the UK. 

    The UK taxes carbon emissions directly through two mechanisms – the Climate Change Levy (CCL) and the Carbon Price Support (CPS). The CCL is a downstream tax that must be paid by larger businesses that consume electricity, gas or other fuels. The CPS applies upstream to electricity generators that use gas, LPG or solid fuels. The government has received close to £2 billion per year in tax revenue from the CCL. Failure to pay the CCL can result in prosecution for tax evasion alongside civil and criminal penalties. CCL rates for natural gas will increase over time, whereas electricity will decrease slightly. 

    Taxes on fuel existed before widespread climate change awareness, but function as an indirect carbon tax given the emissions intensity of various fuels. The UK’s Fuel Duty, which applies to petrol and diesel, is therefore highly relevant to climate change. The fuel duty has been frozen at 57.95p per litre since 2010, with a temporary cut in effect from March 2022. Many have argued that the freezing the tax, rather than letting it rise with inflation, has increased emissions, and that it is not compatible with the UK’s net zero target.[2] 

    The Landfill Tax is another relevant mechanism that does not specifically target climate change. Although the Landfill Tax primarily aims to reduce waste, this can in turn reduce emissions – in consideration that around 4% of the UK’s emissions come from the waste management sector. Indeed, potential to emit greenhouse gases is part of the criteria that the government uses to evaluate whether materials should pay a lower Landfill Tax rate. Similarly, the Plastic Packaging Tax introduced in April 2022 may reduce the use of non-recycled plastics, the production of which is a significant source of greenhouse gas emissions. There was an increase to the rate of the tax in April 2023, in line with the Consumer Price Index.  

    There is growing evidence that public concern for environmental issues is influencing developments in climate risk policy, as evidenced in a 2023 amendment to the UK Infrastructure Bank Act, which has introduced new rules around public funding support for UK water firms. Under the policy, companies are unable to be funded by Bank support, including tax receipts, if they do not provide “a costed, time limited plan demonstrating they are committed to preventing discharge.”[3] This change makes clear the duty water companies have to ensure their services do not negatively impact water quality across the UK, and the financial consequences of not meeting planning requirements.  

    Some authors have argued that the UK’s patchwork of different environmental taxes and pricing mechanisms should become more coherent.[4] Additionally, existing measures do not cover emissions from certain sources, such as those from agriculture and embedded in imports.  

    Some proposals explored in this page, including expanding the UK’s emissions trading system and introducing a carbon border adjustment mechanism, would address these gaps. Finally, it is important to note that there is general agreement that, while tax is a highly effective policy mechanism for addressing climate change, it is not sufficient on its own and should be accompanied by other policy measures such as regulation and investment in new technologies. 

    Tax relief 

    Energy-intensive industries and operators can pay a reduced CCL rate by taking energy efficiency measures and entering into ‘Climate Change Agreements.’ Under CCAs, the government sets out sector-wide energy efficiency targets. The parties to these ‘umbrella’ CCAs are sector associations and the Environment Agency. The Environment Agency also enters into ‘underlying’ CCAs with individual operators that contain more specific targets. Sector associations manage these underlying CCAs. Climate Change Agreements therefore operate as a form of tax relief that encourages sector-wide action to reduce emissions. Government analysis showed a reduction in emissions from sectors with CCAs from 2019-21 and found that, in this period, operators tended to overperform against their targets.[5] 

    The UK also provides tax relief for climate-friendly goods through ‘enhanced capital allowances.’ Businesses can claim allowances for equipment such as electric vehicles for up to the full expenditure in the year that the business purchases the equipment. The government has also reduced what consumers pay on certain energy-intensive goods, incentivising green products.  

    Emissions Trading 

    The UK Emissions Trading Scheme (UK ETS), implemented following the country’s departure from the European Union and its Emissions Trading System (EU ETS), is the UK’s broadest mechanism for pricing emissions. Emissions trading involves putting a cap on the volume of carbon emissions per year and issuing tradeable ‘allowances,’ which companies must retire if they wish to emit a corresponding amount of greenhouse gases. In contrast to a carbon tax, which is set by the government, the carbon price under an emissions trading system is the market price of each allowance. Although carbon pricing can theoretically have the same effect regardless of whether it is implemented through a tax or a trading system, the mechanisms differ in their operation and in the implementation challenges that they face.[6] Prices of allowances in emissions trading systems tend to increase over time–as the government does not directly set prices as it does with taxes, this happens through reducing supply of credits. 

    Carbon taxation 

    As explored above, the UK uses a variety of different mechanisms, including multiple taxes, to price carbon. Carbon pricing currently covers different sectors and businesses through the UK ETS, the Climate Change Levy, and the Carbon Price Support. This means that different products and activities pay a different effective carbon price per tonne of CO2e. There has been particular attention to disparities in how gas and electricity are taxed. This will become especially important as the UK continues to shift to greener sources of electricity generation, and the Climate Change Committee (CCC) has suggested shifting the focus away from taxing electricity bills.[7] Potential changes include the introduction of road pricing, which is technology-neutral, to make up for the loss of Fuel Duty revenue as petrol and diesel vehicles becomes less common. A ‘Green VAT’ rate would give favourable VAT treatment to sustainably-sourced products, and may be particularly appealing to the public.[8] The government has already introduced a temporary zero-rate for VAT applying to energy-saving installations in residential buildings until 2027, and may consider applying a similar rate to other products. Some scholars, however, assert that VAT reductions are not an effective means of reducing emissions, as they reduce the tax base, can increase administrative burden, and subsidise wealthy households to the same extent that they help poorer households.[9] An alternative is keeping a flat VAT rate and providing direct subsidies for climate-related products and services. 

    Another potential change in this area is a broader, more uniform method of pricing carbon across the country through an economy-wide carbon tax. This idea has seen some support from industry and advocacy groups.[10] Impacts of an economy-wide carbon tax, including efficacy and administrative burden, could vary greatly by its design. Given that new taxes are often unpopular with the public, which can narrow the tax base,[11] taxes might also be designed with the aim of being politically palatable, and to ensure that their impacts are not regressive. The IMF has suggested that target cash transfers to lower income households may be particularly effective in developed economies like the UK.[12] One example is coupling a carbon tax with a dividend that goes towards households below a certain income threshold.[13] 

    Although the UK government initially expressed interest in a general carbon emissions tax following Brexit, emissions trading emerged as the primary instrument for pricing emissions across a broad range of sectors. Broader carbon taxation may still be implemented in the future. 

    Finally, it is important to consider the tax benefits that certain emissive industries receive. E3G suggests that exemptions to the Energy Profits Levy[14] introduced in 2022 constitute subsidies under the Subsidy Control Act and should be removed. Phasing out these tax benefits could ensure that activities that contribute to climate change are not incentivised, while also increasing tax revenue in the short-term. Planned to remain in place until March 2028, the Energy Profits Levy is expected to raise almost £26 billion.   

    Emissions Trading Reform 

    As the UK’s broadest carbon pricing mechanism, the UK ETS will likely undergo reforms to align it more closely with climate ambitions. These reforms may include broadening the scope of sectors covered by the ETS,[15] changing the ETS cap, and strengthening the UK ETS Registry’s enforcement powers. Another proposal is to ‘link’ the UK’s ETS with the EU ETS to create a larger, more robust carbon market. The EU and UK have committed, in the Trade and Cooperation Agreement, to ‘give serious consideration to’ linking their emissions trading systems and to cooperate on carbon pricing generally, as modelled in the UK’s Carbon Price Floor (CPF) policy when part of EU ETS.[16]  

    International carbon pricing reform 

    Numerous researchers, leaders, and nongovernmental organisations have called for an international mechanism for pricing carbon. Although the UNFCCC has created a global voluntary carbon market through the Clean Development Mechanism and its successor mechanism under the Paris Agreement,[17] mandatory carbon pricing does not exist at an international scale. An ambitious option is a global carbon tax, the revenue from which could be used to support international development.[18] Though reaching an agreement on carbon taxation at a global scale is expected to be difficult, international collaboration on tax, as seen in initiatives such as the OECD’s base erosion and profit shifting scheme, indicate prospects for this measure in the future. 

    Another option, which has seen some support in the IMF, is an international carbon price floor. Under these arrangements, countries may have the ability to choose their own pricing mechanism (whether that be a tax or a trading system) as long as the price paid per tonne of CO2e exceeds a certain threshold. This price floor could vary between countries based on their development. Implementing this could also help discourage shifting goods production to countries with less developed carbon taxation, in attempt to evade compliance with stricter emissions regulations—a phenomenon known as carbon leakage

    In the absence of a global carbon pricing mechanism, governments can seek to reduce emissions abroad by introducing carbon border adjustment mechanisms. The government is considering using this mechanism to ensure that imports pay the same carbon price as domestically produced goods. This mechanism, which is already being introduced in the EU, is discussed in the trade law section of this resource. 

    General changes to tax policy and institutions 

    In addition to specific changes to taxes and tax relief mechanisms, the government may reform tax institutions more generally to better align the system with climate goals. General suggestions include ensuring that government budgets are linked with net zero strategy. The Climate Change Committee has recommended that the Treasury undertake a review of how its fiscal policy will fit within the UK’s net zero goals.[19] Many groups, including the House of Commons’ Public Accounts Committee, have criticised the Treasury for failing to evaluate the impacts of its environmental taxes and tax relief schemes.[20] The Institute for Government has suggested a ‘net zero tax audit’ to address these concerns.[21] The Institute has also recommended requiring that budget measures are assessed by the CCC or OBR for their compatibility with net zero goals. More broadly, they suggest that all government departments consider the tax implications of their climate strategies. 

    [1] One tonne of ‘CO2e’ emissions refers to one tonne of carbon dioxide emissions, or the volume emissions from another greenhouse gas that would have the equivalent impact on the climate. 

    [2] Simon Evans. ‘Analysis: Fuel Duty Freeze has Increased UK CO2 Emissions by up to 5%.’ (Carbon Brief, 10 March 2020). < https://www.carbonbrief.org/analysis-fuel-duty-freeze-has-increased-uk-co2-emissions-by-up-to-5-per-cent/>. 

    [3] UK Parliament, ‘UK Infrastructure Bank Act 2023.’ (UK Government, March 2023). <https://www.legislation.gov.uk/ukpga/2023/10/enacted>.  

    [4] Stuart Adam et al, ‘Tax and Climate Change’ in Tax by Design’ (Institute of Fiscal Studies, 2011). 

    [5] Environment Agency. ‘Climate Change Agreements: Biennial Progress Report for 2019 and 2020’. (UK Government, 24 November 2021). < https://www.gov.uk/government/publications/climate-change-agreements-cca-biennial-report/climate-change-agreements-biennial-progress-report-for-2019-and-2020>. 

    [6] Noah Kaufman. ‘Carbon Tax vs. Cap-and-Trade: What’s a Better Policy to Cut Emissions?’ (World Resources Institute, 1 March 2016). < https://www.wri.org/insights/carbon-tax-vs-cap-and-trade-whats-better-policy-cut-emissions>. 

    [7] Climate Change Committee. ‘Progress in Reducing Emissions: 2022 Report to Parliament’ p15 (June 2022). <https://www.theccc.org.uk/wp-content/uploads/2022/06/Progress-in-reducing-emissions-2022-Report-to-Parliament.pdf

    [8] Zoe Avison and Libby Peake, ‘A Greener Tax System: The People’s Verdict’ (Green Alliance, 2021). <https://green-alliance.org.uk/publication/a-greener-tax-system-the-peoples-verdict/>. 

    [9] Stefanie Geringer, ‘The EU VAT Rate Reform 2022 from an Environmental Policy Perspective’ (2022). <The EU VAT Rate Reform 2022 from an Environmental Policy Perspective by Stefanie Geringer :: SSRN>. 

    [10] Josh Burke and Esin Serin. ‘UK Carbon Pricing Needs to be Part of Comprehensive Tax Reform’ (Grantham Institute, 22 February 2021). <https://www.lse.ac.uk/granthaminstitute/news/uk-carbon-pricing-needs-to-be-part-of-comprehensive-tax-reform/>. 

    [11] Rita de la Feria and Michael Walpole, ‘The Impact of Public Perceptions on General Consumption Taxes’ [2020] British Tax Review 67/5

    [12] David Amaglobeli, Emine Hanedar, Gee Hee Hong, and Celine Thevenot, ‘Fiscal Policy for Mitigating the Social Impact of High Energy and Food Prices’ (International Monetary Fund, 2022). 

    [13] Canada has implemented such a system in its federal carbon pricing mechanism. See Output-Based Pricing System.  

    [14] Energy (Oil and Gas) Profits Levy Act 2022 s 2. 

    [15] This may include expanding the ETS to cover emissions from road transport and buildings. 

    [16] Trade and Cooperation Agreement, Article 392(6) 

    [17] Paris Agreement to the United Nations Framework Convention on Climate Change (2015). Article 6.4. 

    [18] Alice Pirlot. ‘How and Why a Global Carbon Tax Could Revolutionize International Climate Change Law’ (Oxford University Centre for Business Taxation, 19 October 2021). <https://oxfordtax.sbs.ox.ac.uk/article/how-and-why-a-global-carbon-tax-could-revolutionize-international-climate-change-law>. 

    [19] Climate Change Committee (n 5). 

    [20] Committee of Public Accounts. ‘Environmental Tax Measures’ (UK Parliament Website, 28 April 2021). <https://publications.parliament.uk/pa/cm5801/cmselect/cmpubacc/937/93703.htm#_idTextAnchor000>. 

    [21] Rosa Hodgkin and Jill Rutter, ‘Net Zero and the Tax System’ (Institute for Government, October 2021). <https://www.instituteforgovernment.org.uk/publications/net-zero-tax>.