Using Carbon Revenues – World Bank Report August 2019
* Executive Summar*y Carbon pricing is increasingly recognized as an important source of government revenue. If used wisely, carbon revenues can support further climate mitigation, industry competitiveness, and pursuit of further economic and development objectives. This report lays out a framework that can assist governments in using carbon revenues to pursue these objectives, drawing insights from a range of practical experiences. Carbon revenues have grown in recent years. As of April 2019, there were 57 carbon prices either in place or scheduled for implementation. These initiatives cover around 11 gigatons of carbon dioxide equivalent (GtCO2 e), representing around 20 percent of global emissions per year, an increase from 13 percent of global emissions in 2016. As a result, the estimated revenues generated from carbon pricing have increased from US$ 22 billion in 2016 to US$ 44 billion in 2018 (World Bank 2019a). Carbon revenues are expected to increase further in 2019 and the years following, and this growth has the potential to unlock fiscal opportunities, particularly in developing countries.
These opportunities stem from both the possible expansion to new jurisdictions and increases in price. *Most carbon prices are currently well below the US$ 40–80/tCO2 e 2020 level recommended by the Carbon Pricing Leadership Coalition’s HighLevel Commission on Carbon Prices (CPLC 2017). * A recent International Monetary Fund (IMF) policy paper suggests that a US$ 70/tCO2 carbon price would raise revenues equivalent to around 1–3 percent of gross domestic product (GDP) by 2030 in most countries considered (IMF 2019), and around 2–4 percent of GDP in major developing countries, including China, India, and* South Africa*. Carbon pricing operates as part of a broader fiscal landscape that requires consideration of complex relationships and trade-offs. Government objectives in the fiscal context often include consideration of efficiency, equity, and long-run growth. Policy makers face trade-offs between objectives when choosing how to spend tax revenue. The circumstances are no different when exploring the different options for carbon revenue use. In addition, when balancing these trade-offs, policy makers must account for public opinion, as a lack of public acceptance for a policy can undermine its effectiveness and threaten its existence over time. Many forms of revenue use will require only limited new governance arrangements as they take advantage of existing structures for revenue allocation. Many countries have existing tax and social security systems for example that can be used for revenue allocation, reducing the need for additional structures. In cases where revenue allocation structures are not in place—and there are many participants involved—there may be a case for a new cross-ministerial committee or an independent board to govern new programs. In addition, governments may need to prepare for practical challenges that can be associated with carbon revenue use, such as the potential for revenue volatility. Further, they should develop structures to ensure accountability, including processes for stakeholder engagement and for monitoring, reporting, and evaluation procedures. Carbon revenues can either be allocated to general government revenue or be tied to specific purposes, through legal earmarking or hypothecation. Tying carbon revenues to a particular use provides greater visibility of the link between carbon pricing and public services, and greater certainty around funding. Nevertheless, there are benefits to directing revenues into the general fiscal pool, as this allows greater flexibility to alter revenue uses as circumstances and priorities change. Regardless of whether revenues are tied to a specific purpose, it is ultimately the specific use of revenues that is most important for outcomes. Data for revenue uses are often incomplete, and categories can be inconsistent. Nonetheless, in 2017/18, we estimate that the majority of global revenues (excluding foregone revenues) have been allocated to environmental projects (42 percent). Other revenue allocations include assigning revenues to the general budget (38 percent), development-related topics (12 percent), cuts to other taxes (6 percent), and direct transfers for households and businesses (3 percent). See figure 1 for more details. This report assesses the use of carbon revenues to prevent carbon leakage and reduce national debt. The use of free allowances under emissions trading systems (ETS) or carbon tax exemptions is a common form of compensation to address carbon leakage. These allocations represent revenue forgone and therefore do not enter the calculations in figure 1. We also consider debt reduction as an option for revenue use; however, due to data limitations this is included in “general budget” in figure 1.
Our report focuses on six main options: 1. Tax reform, to target higher economic growth alongside lower pollution; 2. Climate mitigation, by encouraging investment in low-carbon technologies; 3. Pursuit of other development objectives, such as in education and health; 4. Prevention of carbon leakage, to achieve carbon pricing’s environmental and economic objectives; 5. Assistance for individuals, households, or businesses affected by carbon costs, through transfers or programs; 6. Debt reduction, to lessen the debt burden on future generations. Carbon revenues can finance tax reforms to support increased economic growth.
• When optimizing tax policy, there is a positive trade-off that can be made by replacing distortionary taxes, such as those placed on labor and business income, with externality-correcting taxes, such as those on greenhouse gas (GHG) emissions. By replacing distortionary taxes, carbon pricing can yield a “double dividend,” simultaneously addressing negative environmental impacts while improving economic growth. Tax reform in the form of carbon pricing offers greater benefits in the presence of a large informal sector. This is because unlike conventional taxes (such as those on labor or profits), fuel taxes (such as those based on GHG content) apply in the informal sector, and a decrease in the gap between the taxes in the formal and informal sector incentivizes economic agents to join the formal economy (CPLC 2017). However, there are several challenges associated with employing tax revenues for tax reform. For example, tax cuts can be less visible to the public than funding for climate mitigation projects, and they tend to be less targeted than direct transfers. Therefore, tax reform may not (or may not be perceived to) adequately compensate those most impacted by carbon pricing. Carbon revenues can finance additional policies or programs aimed at reducing emissions.
• There are different reasons why a government may want to fund these policies. Emissions may remain above target levels due to the presence of market failures distorting the price signal. In addition, policy makers may seek to reduce emissions in sectors not covered by the carbon price. In such cases, carbon revenues may be used for these purposes so as to further pursue the objective of emissions reductions, for instance through supporting the transition to renewable energy or the planting of carbon forests. Despite the advantages offered by these projects, ensuring the best use of funds for them can prove complex and may be associated with high administrative costs if existing programs are not in place. Carbon revenues provide an important source of funds for developing countries seeking to finance development objectives.
• Developing economies face challenges in generating a sufficient tax base due to large informal sectors. Carbon pricing can offer a relatively efficient alternative for raising revenue, as it tends to be levied on relatively few large entities, can often be incorporated into existing processes, and is less easily evaded than other taxation. These additional revenues can provide a useful source of funds for spending on areas such as health, education, or infrastructure projects and therefore assist in the pursuit of the United Nations’ EXECUTIVE SUMMARY 9 Sustainable Development Goals. Such spending can increase support for carbon pricing where funds are spent on issues of high public concern. Carbon revenues can be used to address the potentially negative impacts of carbon pricing on competitiveness for domestic industry, reducing the risk of carbon leakage.
• The impact on competitiveness can be mitigated under an ETS by forgoing potential revenue and providing free allowances to emissions-intensive, trade-exposed (EITE) sectors. Similarly, these impacts can be addressed under a carbon tax by providing tax discounts or exemptions to vulnerable sectors. These provisions could be effective in limiting the negative impact of a carbon price on businesses in the short term and could reduce the risk that emissions increase in uncovered jurisdictions. However, identifying the sectors that require compensation can be difficult. Careful design is required to ensure the measures target the sectors most affected and do not offset the environmental aims of carbon pricing. Carbon revenues can be used to help individuals, households, or businesses deal with the impacts of carbon pricing through direct transfers or other policies and programs.
• Where energy costs make up a larger share of income in low-income households than in high-income households, a carbon price is likely to be regressive. In such cases, governments may choose to use carbon revenues to compensate the low-income households through direct transfers. Evidence suggests that only a small share of revenues is needed to do so. Alternatively, if there is little evidence for a disproportionate impact on low-income households or individuals, governments may opt to compensate individual taxpayers via equal per capita transfers or tax credits. Revenues can also be employed to assist workers in sectors or regions that are highly affected by a carbon price. For instance, in managing the impact of phasing out coal production, the German government has implemented a variety of supportive policies, including early retirement support, retraining programs, and support for economic development in affected areas. While compensating those adversely affected by the carbon price can be perceived as a fair policy, transfers and other assistance may not lead to the same efficiency gains as tax cuts. Carbon revenues can pay down the existing stock of debt, if not used for tax reforms or increased spending.
• Public debt represents a deadweight burden on the economy, as interest payments reduce the amount of revenue available for investment into public capital or tax reductions. By reducing the stock of public debt, countries can free up resources in future periods and also mitigate the risks associated with financial shocks. Diverting carbon revenue funds toward debt reduction is uncommon, potentially due to the lack of visibility around positive outcomes in the short term, which may be more of a focus for governments. • In practice, countries do not need to choose only one option for revenue use but can implement a package of spending initiatives. For instance, a country could aim to use revenue for a mix of climate mitigation projects, tax reform, free allocations to support industry competitiveness, and pursuit of other development objectives. Jurisdictions including the European Union, Switzerland, and British Columbia have all taken a package approach, with revenues supporting multiple objectives. The appropriate package of policies and programs will differ based on country-specific factors, and the mix of these uses may also evolve over time.