Carbon pricing: how best to use the revenue?

Headline issue 

Putting a price on greenhouse gas emissions – carbon pricing – is a powerful tool to encourage reductions in emissions and innovations in low-carbon technologies across all sectors of the economy in a market-friendly way. It can also raise considerable amounts of revenue for governments, which in turn raises a crucial question: how should these new revenues be spent?

This Policy Brief examines the arguments for the three main classes of spending proposals. It also discusses the merits of formal earmarking or ‘hypothecation’ of revenues. The pros and cons of different proposals are likely to have different weights in different countries, so this brief concludes with some thoughts about the questions policymakers need to answer before they decide which proposals to adopt.

Key findings 

• Carbon pricing should be part of a comprehensive policy framework to reduce
  greenhouse gas emissions. This framework is likely to include new spending commitments, which could be funded, to some extent, by revenues raised from carbon pricing.
• Rich countries could also use carbon pricing revenues to increase the flow of finance to developing countries to help them mitigate greenhouse gas emissions and adapt to climate change impacts, as promised under the UNFCCC.
• It may be necessary to cushion adverse side effects of carbon pricing by making
  financial transfers. Governments need to consider whom, if anyone, to compensate on the grounds of equity or political pragmatism.
• The impact of carbon pricing across income groups depends on particular
  characteristics of households’ energy consumption and the existing tax-benefit system.
• Carbon pricing revenues can also be used to reduce the economic disincentives inherent in tax-benefit systems. This can in principle give rise to a ‘double dividend’ – the environmental benefit and the reduction in deadweight economic losses from other taxes or benefits.
• Governments need to consider carefully where the greatest distortions arise in the rest of their tax-benefit systems and why they are present in the first place.
• Governments need to distinguish between the merits of reducing some forms of capital taxation on the grounds of efficiency and the merits of compensating firms hit by carbon pricing for pragmatic political reasons.
• Following a single, simple rule for carbon pricing revenues – one that does not vary over time or according to circumstance – is unlikely be the optimal approach. In particular, strict earmarking, or ‘hypothecation’, of carbon pricing revenues is unlikely to be a good idea in the long run, given their uncertainty and time-varying spending needs.
• The potential revenues of carbon pricing give societies many attractive
  options for pursuing a range of goals (related to the environment or otherwise) in addition to the environmental benefits of carbon pricing.