Carbon pricing should be part of nothing less than a significant and broad package of post-COVID fiscal reforms, say Esin Serin and Josh Burke, as they outline what these reforms should look like.

Public debt is rising, exacerbated by COVID-19, and so the ratio of government receipts to GDP must increase. A fiscal adjustment is clearly needed to bring down the highest levels of public borrowing since the Second World War. Although the Chancellor has hinted at tax rises, it is too early to expect much other than a fresh COVID-19 rescue package in the looming 3 March Budget.

Nevertheless, there is a growing recognition that taxing greenhouse gas emissions – ‘bads’ – should be prioritised as these taxes are less distorting than labour or income taxes. Reforming existing environmental taxes is therefore a good place to start.

In recent weeks there have been numerous calls for a more prominent use of carbon pricing. Sources close to the UK government even suggested that the Treasury was considering expanding carbon pricing beyond the power and industrial sectors to include meat and cheese, although this was quickly rebuffed.

The underlying argument is sound: if carbon is not priced and fossil fuels are subsidised, the post-COVID-19 recovery will be distorted in favour of a high-carbon economy, with unavoidable future vulnerability to climate change – therefore carbon pricing will be important in driving a sustainable and resilient recovery. But the policy is no silver bullet, nor is it the sun around which all other policies should revolve. Indeed, as our own research suggests, as the UK gets closer to net-zero, the balance between carbon pricing and complementary policies will likely tip to the latter.

Increasing calls to ‘put a big fat price on carbon’ must recognise why carbon pricing falls short – which is often a reflection of current deficiencies in carbon pricing policy design and the messy tax landscape in which it operates. This will only get worse as the transition to net-zero and wider structural transformations over the coming decades (e.g. digitisation, automation and levelling up) gather pace. These changes, coupled with those induced by COVID-19, mean carbon pricing should be part of nothing less than a significant and broad package of fiscal reform. This was needed before COVID-19, and it is even more urgent now. So what should reform look like?

The case for broad fiscal reform

Looking at carbon pricing as part of a package of broad fiscal reforms has precedent. For example, the implementation of Ireland’s carbon tax was part of a larger fiscal regime redesign to reduce the country’s debt without increasing income taxes. Between 2010 and 2012, the carbon tax contributed 20–25 per cent of the tax hikes required under the Troika bailout plan which prevented additional increases in labour taxes. In conjunction with lengthy and detailed stakeholder engagement, the tax was better thought out and became more politically acceptable.

In contrast, the Gilets Jaunes movement in France is a good illustration of the consequences of poor reform. Carbon pricing (in the form of higher fuel taxes) may have been the lightning rod, but actually the underlying cause was the perceived unfairness of the overall tax reform package, which cut taxes for wealthier households at the same time as hiking up fuel prices. Thus, it is a little clumsy to use the Gilets Jaunes as evidence to suggest higher carbon prices are not possible – they are simply not possible in isolation. Extensive research by the Zero C Commission underscores how important this is, finding that public consent increased when a carbon tax was presented as part of a broader approach encompassing a coherent, system-wide programme of change.

Thus, as part of the overall fiscal package, it is appropriate to consider how reform can compensate for and ameliorate the potential regressivity of both carbon pricing and low-carbon policies. In the absence of mitigation measures, a carbon price on energy bills is regressive, hitting low-income households disproportionately as they tend to spend a larger share of their income on energy. Our research shows that with the introduction of a £50/tonne carbon price, lower-income households spend a much higher proportion of their income on the tax than better-off households, at 3.7 per cent for decile 1 compared with 1.3 per cent for income decile 10. Research by Owen & Barrett (2020) further illustrates the point. They found that the highest income homes in the UK require nearly five times more energy than the lowest, but only pay 1.9 times more towards policy costs because levies are only raised on energy bills.

Revenues from carbon pricing could fund reductions in other taxes or reduce regressive effects, but only if policymakers consider relaxing conventional fiscal thinking that sees all revenue treated as general tax. In this regard, revenue recycling directed to improving energy efficiency can make a substantial difference to the distributional impact of carbon pricing. For example, we show that using 33 per cent of revenues for energy efficiency can ensure fuel-poor households are not adversely affected by higher carbon prices. However, compensatory policies should at least in part pre-empt and cover any increases in energy bills arising from the carbon price. This is crucial to avoid any transitionary periods where high carbon prices increase energy bills before energy efficiency improvements are implemented.

Learning lessons for a UK emissions trading system

Before more expansive carbon pricing, policymakers must first optimise the UK’s main carbon pricing instrument – a UK emissions trading scheme, or ETS. After much debate over which carbon pricing instrument the UK will use, there is now certainty and the conversation can finally move on to perfecting the design of a UK ETS.

Notwithstanding the broad reform needed, the immediate priority is to link the UK’s domestic ETS with the EU ETS as this would allow access to a large, established and liquid EU carbon market leading to increased efficiency. There is wide agreement across academic and industry circles that a standalone UK ETS is an inferior choice compared to one linked to the EU ETS (see EU Environment Sub-Committee, 2021; CCC, 2020; GRI, 2019 and Vivid Economics, 2019). This was reinforced at a recent evidence session to the House of Lords, where all those giving evidence agreed that the main thing the Government should be doing to resolve their relationship with the EU over the short term with regard to the Trade and Cooperation Agreement is linking the UK and EU carbon markets.

Although there is an ambition to link with the EU ETS, this will ultimately be dictated by politics rather than technicalities. The lesson we can learn from a protracted linking agreement between the Swiss and the EU is that non-energy policy decisions carry significant weight and unduly influence outcomes. This is likely to be the case for the UK too.

To facilitate economy-wide decarbonisation, there is a need to further expand coverage of the carbon pricing framework in the UK. Some sectors such as agriculture and aviation, despite being significant emitters, currently face a low or no effective carbon price. This is not necessarily a call for a single explicit economy-wide carbon price, which tends to be politically challenging (see ESC, 2019; and GRI, 2019). The carbon price itself as well as the use of complementary policies will likely need to differ across sectors but ultimately, incentives to reduce emissions in all sectors will need to be aligned with net-zero.

Making UK carbon pricing more even and consistent

Currently, the incentive to cut emissions in the UK is uneven across sectors and economic activities due to a number of different carbon price instruments that are often overlapping and/or applied inconsistently (see CCC, 2020; ESC, 2019; and IFS, 2013).

Electricity prices in particular carry a disproportionate part of climate policy costs through a number of overlapping and confusing carbon charges, including costs of the ETS, the Carbon Price Support and the Climate Change Levy, as well as support costs for renewables and nuclear through Renewables Obligations and Contracts for Difference. This is problematic given the case for accelerating electrification in many sectors as part of the transition to net-zero and especially when it comes to home heating, where a rapid switch from natural gas to electric heating is required.

So it seems perverse that whereas electricity ‘pays for’ its own decarbonisation, gas is essentially subsidised through a reduced rate of VAT. There is an urgent need to reverse the situation as we move towards an increasingly electrified future. This need not increase costs to consumers. Here, Greg Jackson, Octopus CEO, makes an important point that shifting taxes from electricity to gas will be cost-neutral in the short term and will save households in the long term as we increasingly electrify our energy consumption.

Carbon border adjustment mechanism

Strengthening measures to prevent carbon leakage and maintain competitiveness will remain a challenge for countries like the UK that have relatively high carbon prices today and have committed to net-zero carbon targets over the next decades. Consequently, as more and more countries raise climate ambition and commit to much stronger nationally determined contributions (NDCs), we have seen a resurgence in the debate around Carbon Border Adjustment Mechanisms (CBAMs) and the role they may play in preserving the effectiveness of climate action in high ambition countries. In particular, the announcement made by the EU that a CBAM will be adopted by the end of 2022 has galvanised debates.

The intensifying interest in CBAMs signifies not only the failure to agree harmonised economy-wide carbon prices across jurisdictions, but also the increasing convergence of two key multilateral issues: trade and climate. These issues are particularly pertinent to the UK as it begins the complex task of implementing new domestic carbon pricing policy while simultaneously upholding agreements made under the new Trade and Cooperation Agreement with the EU and forging new free trade agreements with other countries.

The UK should proactively prepare for global regime change where trade relations are affected by climate ambition and the inevitable clash when climate meets trade at the border. While unilateral action makes little sense, with the EU pressing ahead, the UK should consider close multilateral cooperation and a common approach to the design and implementation of an EU CBAM. Failure to do so risks undermining the role of UK carbon pricing in supporting deep decarbonisation in sectors that would otherwise be at risk of carbon leakage and the UK may ultimately end up being forced into adopting a policy designed by others at a later stage.

We must learn lessons from the past and promote the co-benefits of decarbonisation

The recent clamour for higher and more expansive carbon prices will fail unless we learn lessons from past efforts – both good and bad – to price carbon. With fiscal consolidation inevitable the time is ripe to examine and reform the environmental tax landscape in its entirety. This must be driven by extensive engagement and communication with consumers which frames changes as part of a much more positive and attractive vision of the future where deep decarbonisation delivers a myriad of additional co-benefits. This is the only way to build support for carbon pricing and broader reform. Tinkering with carbon pricing in isolation will only be seen as technocratic fiddling incommensurate with the scale of the challenge that climate change poses.

The views in this commentary are those of the authors and do not necessarily represent those of the Grantham Research Institute.

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