## clnea2022006

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### Introduction: urgency, rationale, and current landscape
- Urgency of emissions reductions
  - Global greenhouse gas (GHG) emissions need to be reduced by 25 to 50 percent over this decade to get on track with containing global warming to 1.5–2oC.
  - In a business-as-usual (BAU) case without additional mitigation measures, global GHGs are expected to grow to 56 billion tonnes of carbon dioxide equivalent (CO2e) in 2030.
  - CO2 emissions from coal, oil, and gas combustion account for 37, 22, and 12 percent of these emissions respectively; other GHGs (for example, methane from extractive industries and agriculture) account for 29 percent.
  - About 130 countries, covering 90 percent of GHGs, have set or proposed zero net emissions targets for around mid-century, but near-term ambition and policy action falls well short of what is needed.
- Rationale for carbon pricing
  - Gradually raising fossil fuel prices through carbon pricing should be the centerpiece of mitigation strategies from environmental effectiveness and economic efficiency perspectives.
  - Economic rationales:
    - Emissions reductions: pricing promotes behavioral responses to reduce energy use and shift to low-carbon fuels.
    - Clean energy investment: expectation of rising fuel prices incentivizes innovation and adoption of low-carbon technologies if a clear, credible path of rising prices is specified.
    - Fiscal: pricing mobilizes revenue usable for economic and distributional objectives.
  - Carbon pricing generates domestic environmental co-benefits (for example human health improvements from reductions in local air pollution).
- Current carbon pricing landscape
  - Instruments: carbon taxes or emissions trading systems (ETSs).
    - Carbon taxes usually implemented through a tax on the carbon content of fossil fuel supply.
    - ETSs require firms to acquire allowances for emissions or carbon content of fuel supply; government controls allowance supply and market trading establishes the emissions price.
  - Implementation status (national level): 30 carbon taxes and 9 ETSs have been implemented.
  - Coverage and price variation:
    - GHG emissions subject to carbon pricing vary from below 30 percent in some cases to more than 70 percent in others (for example, Canada, Germany, Korea, Sweden).
    - Economywide average prices vary from below $5 to over $100 per tonne.
  - Note: China's system currently takes the form of a tradable emissions intensity standard with no fixed cap on emissions.
- Benefits: quantitative update (CPAT estimates)
  - A $50 carbon price would cut CO2 emissions in Group of Twenty (G20) countries by around 15-35 percent below BAU levels in 2030.
  - Fiscal potential: carbon prices of $50 per tonne would raise revenues of about 0.5–2 percent of GDP in 2030.
  - Welfare costs from a $50 carbon price in 2030 are mostly between 0.1 and 0.6 percent of GDP.
  - Domestic environmental co-benefits (principally reductions in local air pollution mortality, but also road congestion and accident externalities) substantially exceed mitigation costs in some cases (for example, China, Indonesia, Turkey) before counting climate benefits.

### Design choice: carbon taxes versus ETSs (administration, coverage, priorities)
- Uncertainty and practical trade-offs
  - Taxes provide price certainty; ETSs provide emissions certainty.
  - For the same carbon price, taxes and ETSs have the same revenue potential if ETS allowances are auctioned.
  - ETS price volatility can cause dynamic inefficiency and deter private innovation/adoption of clean technologies.
  - Design mechanisms to reduce uncertainty: tax trajectories, ETS price floors, banking/borrowing, cap adjustments.
- Administrative, coverage, and priority points
  - Comprehensive coverage should include CO2 across all fuels and sectors; coal and power/industrial sectors are usually priorities.
    - Reduced coal use would account for about 50 percent or more of the fossil fuel CO2 reductions from comprehensive carbon pricing for 12 G20 countries.
    - Reduced emissions from power and industry would account for 60 percent or more of emissions reductions from comprehensive carbon pricing for all G20 countries.
  - Carbon tax administration:
    - Easy to administer and can be applied midstream into existing fuel tax collection systems; all but one of the 21 existing national carbon taxes are applied midstream.
    - Can be applied upstream at point of fuel extraction with rebates for fuel exports.
  - Sectoral application: taxes could be applied downstream to large emitters in power and industry.
- Point of regulation and compliance scale
  - Point of regulation (upstream, midstream, downstream) should not matter for the impact of the carbon tax on fuel prices, fuel use, or emissions, except where fuel price regulations prevent full passthrough.
  - Compliance costs are moderately larger for downstream systems; example: about 13,000 firms would be covered in a downstream pricing system in the United States compared with 2,000 in a midstream pricing system (Calder 2015).
  - In the EU ETS, exempted small-scale emitters with annual emissions less than 50 kilo-tonnes account for about 7 percent of emissions from power and industry sectors.

### Allocation of policy revenues/rents: efficiency and distributional considerations
- Empirical patterns
  - Carbon tax revenues fully used for general purposes in 16 carbon tax schemes; partially or fully earmarked for environmental spending in only five cases.
  - In early phases of some ETSs (for example, EU, Korea), allowances were freely allocated; other ETSs (for example, California, Germany) auctioned allowances from the start.
  - Where ETS allowances are auctioned, revenues are more often earmarked for environmental spending—in five of the seven ETS schemes.
- Efficiency tradeoffs of revenue uses (high-level)
  - Public investment: potentially significant impact on economic efficiency; can disproportionately benefit low-income households; modest administrative burden; politically popular.
  - Tax reductions: can improve incentives for work and investment; minimal administrative burden; politically popular with beneficiaries.
  - Deficit reduction: lowers future tax burdens and macro-financial risk; administrative burden minimal; politically less supported.
  - Universal lump-sum transfers: progressive but forgo efficiency benefits; new capacity may be needed; mixed political feasibility.
  - Means-tested transfers: effective for low-income groups; administrative burden low if existing capacity used; generally popular.
  - Direct assistance for household energy bills: forgone efficiency benefits; low administrative burden if existing capacity used; politically popular.
- Key efficiency point
  - Productive uses of revenues (tax reductions improving labor/investment incentives, and public investment in health, education, infrastructure) can produce large efficiency gains offsetting higher energy price effects.
  - Earmarking for environmental investment can be efficient if integrated into robust public investment management systems.
- Distributional considerations
  - Carbon pricing prior to revenue allocation tends to be mildly regressive when measured against household annual consumption.
  - Much of household burden comes indirectly from pass through into consumer goods; budget shares for these goods are more evenly distributed across incomes than shares for electricity and fuels.
  - Revenue recycling can make reform distribution neutral or progressive.
  - ETSs with free allowance allocations can generate windfall profits accruing to shareholders concentrated in higher income households.
  - Auction revenues from ETSs can be earmarked for just transition assistance (example: German ETS).
- Quantitative recycling examples (illustrative country cases)
  - China ($50 carbon tax)
    - Recycling: 85 percent of revenues used for proportionate reduction in labor taxes and 15 percent for a targeted transfer for the poorest 25 percent of households.
    - Note: In China bottom income deciles do not pay labor income tax.
  - United States ($75 carbon tax)
    - Recycling: 50 percent of revenues used for increasing personal income tax thresholds and 50 percent for a general labor tax reduction.
  - Turkey ($50 carbon tax)
    - Recycling: 85 percent of revenues used for labor tax transfers and 15 percent for a targeted transfer for the poorest 25 percent of households.
  - Argentina (illustration)
    - Recycling: 75 percent of revenues used for labor tax reductions and 25 percent for targeted transfers to bottom 30 percent of households.
    - Note: In Argentina bottom income deciles do not pay labor income tax.
  - Distributional targeting outcomes:
    - Recycling schemes considered benefit the bottom four income deciles on net.
    - Alternatively, the bottom four deciles can be fully compensated for price increases by recycling 25-30 percent of carbon pricing revenues in targeted measures.

### Compatibility and interactions with other instruments
- Carbon taxes
  - Compatible with overlapping non-pricing instruments (emission rate regulations, feebates, clean technology subsidies); combined these instruments further reduce emissions without lowering the emissions price.
- ETSs
  - Overlapping instruments under an ETS lower the emissions price (emissions fixed by the cap), undermining ETS revenue and investment incentives.
  - Mitigations: underpin ETS with a price floor; adjust cap over time to account for overlapping instruments.
  - Example: California uses regulatory framework plus an ETS with a price floor.
- Practical hybrids and interactions
  - Some countries apply taxes and ETSs simultaneously to different sectors or the same sources (examples: Denmark, Finland, France, Ireland, Norway, Portugal, Sweden; Canada; United Kingdom).
  - Price-stabilizing features (price floor, price ceiling, “price collar”) can make ETSs resemble taxes; taxes could include tradable elements to resemble ETSs.

### Broader emissions sources and offsets
- Extractive emissions: comprehensive monitoring of methane leaks not presently feasible; proxy pricing based on fuel supply combined with mandated monitoring or default emissions factors with rebates is practical (example: Norway).
- Agricultural emissions: pricing methane from livestock could be based on farm outputs/inputs and default emissions factors; methane from agriculture less responsive to pricing than extractives; revenues may need to be returned to farmers or combined with border adjustments.
- Process emissions: GHGs from industrial processes can be priced via smokestack monitoring or default factors (example: HFCs); CO2 from industrial processes can be covered under downstream ETSs.
- International transportation fuels and long-lived investments:
  - Carbon taxes may provide certainty suitable for deployment of zero-emission vessels (ship lifetime typically around 30 years), but a pure tax could raise more revenue than efficiently absorbed by the IMO.
  - Feebates: tax operators in proportion to emissions-rate deviations from a benchmark and cap revenue to needed R&D.
- Forestry and sequestration:
  - Feebates or carbon taxes with negative payments for sequestration can penalize deforestation and reward afforestation/forest management that increase carbon storage.
- Offsets caution:
  - Concerns include non-additionality and impermanence (examples: reforestation projects that would have occurred anyway or forests later burning).
  - Evidence suggests systematic non-additionality concerns (example: an EU study found 85 percent of offsets allowed into the EU ETS were non-additional).

### Global coordination regimes
- Design rationale
  - An internationally coordinated pricing regime could focus on a small number of large emitters to cover bulk emissions and establish a minimum carbon price to scale mitigation and address competitiveness concerns.
  - Differentiated price floors proposal: $75, $50, and $25 per tonne for high-, medium-, and low-income countries, respectively, would be sufficient to align global CO2 emissions in 2030 with keeping global warming below 2oC with just six participants (Canada, China, India, EU, United Kingdom, United States), assuming G20 NDCs are met and participants adhere to the more stringent of the price floor or their NDC.
- Flexibility and instruments
  - Countries unable to implement pricing could achieve equivalent reductions through other approaches mapped into carbon price equivalents.
  - Initial coverage could focus on power and industry.
  - Carbon tax aligns naturally with international price coordination; ETSs can be accommodated by underpinning with a floor price or setting caps to generate expected domestic prices.
  - Linking ETSs can improve cost effectiveness but perpetuates design features and reduces domestic policy autonomy; equity considerations (permit trading ratios) and concrete trajectories of caps/prices would be required.

### Argentina ($50 carbon tax): political economy, competitiveness, and design
- Political economy
  - ETSs may be more politically feasible than taxes where permits are freely allocated to affected firms.
  - Free allocation in the EU ETS fell from 80 percent in 2013 to 30 percent of allowances in 2020.
  - Distributional and political risks arise because benefits (revenue recycling, co-benefits, climate benefits) are diffuse while costs are concentrated.
  - Design and communication tools to build support: revenue recycling, communications strategies, stakeholder analysis, and “soft earmarking” of revenues partly to environmental and social objectives.
- Competitiveness impacts and policy options
  - Direct cost increases: typically between 5 and 10 percent for aluminum and steel; up to 30 percent for cement.
  - Large indirect cost increases can arise from charges on carbon embodied in electricity inputs.
  - Unilateral competitiveness assistance options under a carbon tax:
    - Partial exemptions (tax firm emissions above a threshold) — lowers average charge and undermines mitigation incentives.
    - Output-based rebates — operationally similar to a tradable emission rate standard (example: federal backstop in Canada).
    - Border carbon adjustments (BCAs) — charge embodied carbon in imports net of foreign pricing and possibly rebate exporters; initial BCA based on domestic emissions factors may lessen disproportionate effects on developing countries.
  - ETS approaches: free allowance allocation commonly used but does not compensate for abatement costs; BCAs could be implemented (allowance purchase requirements for imports) but WTO-compatibility uncertainties may be larger for ETSs.
- Price levels, alignment, and harmonization
  - Carbon tax: government can align price trajectory with emissions targets through periodic forward-looking tax adjustments.
  - ETS: alignment automatic if cap is set to meet mitigation commitments (example: EU ETS cap reduced by 2.2 percent a year in line with 2030 targets for power/industrial sector).
  - Wide divergence in pre-existing carbon charges suggests scope for harmonizing combined carbon prices while scaling up levels; total CO2 tax per tonne may still differ to reflect domestic environmental externalities.
  - Interaction with fuel tax reforms: under an ETS carbon price automatically adjusts to keep emissions the same; under a carbon tax the carbon charge must be manually adjusted.
- Compatibility with overlapping mitigation instruments
  - Carbon taxes: compatible with overlapping non-pricing instruments; these instruments further reduce emissions without lowering the emissions price.
  - ETSs: overlapping instruments lower emissions price; mitigations include price floors or cap adjustments.
  - Efficiency recommendation: have the ETS play the central role with complementary regulations for “hard-to-abate” sectors (transport, buildings).

### Conclusion: comparative judgment and policy package
- Summary judgment
  - Absent political constraints, carbon taxes have practical appeal: provide certainty over future emissions prices, generate revenues accruing to finance ministries, and can build off existing fuel tax collection.
  - ETSs help achieve emissions targets with emissions certainty and suit environment-ministry-led policy, but exhibit price volatility, raise limited or earmarked revenues, and may be impractical in capacity-constrained countries.
  - No single carbon pricing instrument fits all; policymakers will choose based on national circumstances.
- Carbon taxes — advantages and design features
  - Provide price certainty that promotes clean-technology innovation and adoption.
  - Revenues usually accrue to finance ministries for general purposes (for example, cutting other taxes, general investment).
  - Tax trajectories can be aligned and periodically adjusted to maintain consistency with emissions goals.
  - Compatible with reinforcing mitigation instruments (for example, feebates) for hard-to-abate sectors and potentially with border adjustments.
  - Revenue use can provide robust assistance for low-income groups while leaving bulk for cutting other taxes or boosting productive investments.
  - Can be extended to broader emissions sources via existing business tax regimes; where monitoring limited, proxy taxes or feebates may be needed.
- ETSs — appeal and limitations
  - Help achieve emissions targets with certainty over emissions levels.
  - Free allowance allocation can build political support.
  - Price stability mechanisms have not prevented significant price volatility.
  - Revenues from ETSs have tended to be earmarked rather than accruing for general budgetary use.
  - ETSs are not automatically compatible with reinforcing mitigation instruments; legal obstacles to border adjustments may be greater than for carbon taxes.
  - Offsetting provisions in ETSs may increase emissions on net and do not automatically prioritize cost-effective projects.
  - Linking ETSs can improve cost-effectiveness, but a formal international carbon price floor is more effective at scaling global mitigation and accommodating alternative national approaches.
- Role of carbon pricing within a broader policy package (required complements)
  - Reinforcing instruments like feebates, especially for hard-to-abate sectors.
  - Productive and equitable use of carbon pricing revenues.
  - Just transition measures for vulnerable groups.
  - Pricing of broader emissions sources (including proxy approaches where monitoring is limited).
  - Public investment in enabling infrastructure underprovided by the private sector.
  - Extensive public communication and stakeholder consultation.
  - ETSs can be designed (for example through price floors and allowance auctions) to mimic some advantages of taxes.

_Imf staff._

### Introduction

### clnea2022006 - Introduction

### Urgency of Emissions Reductions
- Global greenhouse gas (GHG) emissions need to be reduced by 25 to 50 percent over this decade to get on track with containing global warming to 1.5–2oC.
- In a business-as-usual (BAU) case without additional mitigation measures, global GHGs are expected to grow to 56 billion tonnes of carbon dioxide equivalent (CO2e) in 2030.
- CO2 emissions from coal, oil, and gas combustion account for 37, 22, and 12 percent of these emissions respectively, with other GHGs (for example, methane from extractive industries and agriculture) accounting for 29 percent.
- About 130 countries, covering 90 percent of GHGs, have set or proposed zero net emissions targets for around mid-century, but near-term ambition and policy action falls well short of what is needed.

### Rationale for Carbon Pricing
- Gradually raising fossil fuel prices through carbon pricing should be the centerpiece of countries’ mitigation strategies from environmental effectiveness and economic efficiency perspectives.
- Economic rationales for carbon pricing:
  - Emissions reductions: Pricing promotes the full range of behavioral responses for reducing energy use and shifting to low carbon fuels.
  - Clean energy investment: The expectation of rising fuel prices incentivizes innovation and adoption in new low-carbon technologies, especially if a clear and credible path of rising prices is specified.
  - Fiscal: Pricing mobilizes a valuable source of revenue which can be used for achieving various economic and distributional objectives.
- Carbon pricing generates domestic environmental co-benefits, for example human health improvements from reductions in local air pollution.

### Current Carbon Pricing Landscape
- Carbon pricing instruments: carbon taxes or emissions trading systems (ETSs).
  - Carbon taxes usually implemented through a tax on the carbon content of fossil fuel supply.
  - ETSs require firms to acquire allowances for their emissions or the carbon content of their fuel supply; government controls allowance supply and market trading establishes the emissions price.
- Implementation status (national level): 30 carbon taxes and 9 ETSs have been implemented; EU ETS prices emissions in EU and European Free Trade Association countries; many subnational schemes also operate (largest being California’s ETS).
- Coverage and price variation:
  - GHG emissions subject to carbon pricing vary from below 30 percent in some cases to more than 70 percent in others (for example, Canada, Germany, Korea, Sweden).
  - Economywide average prices vary from below $5 to over $100 per tonne.
- At present, China’s system takes the form of a tradable emissions intensity standard with no fixed cap on emissions.

### Benefits of Carbon Pricing: Quantitative Update
- Carbon pricing can produce large emissions reductions, though likely insufficient by itself to meet aggressive mitigation pledges; non-pricing measures (for example, feebates) will be needed.
- CPAT estimates:
  - A $50 carbon price would cut CO2 emissions in Group of Twenty (G20) countries by around 15-35 percent below BAU levels in 2030, but this is below commitments many countries have made in their nationally determined contributions (NDCs).
- Fiscal potential:
  - Carbon prices of $50 per tonne would raise revenues of about 0.5–2 percent of GDP in 2030—revenues are larger in countries with higher emissions intensity of GDP.
- Welfare and co-benefits:
  - Welfare costs from a $50 carbon price in 2030 are mostly between 0.1 and 0.6 percent of GDP depending primarily on the carbon price, the BAU emissions intensity of GDP, and the proportionate reduction in emissions induced by pricing.
  - Domestic environmental co-benefits (principally reductions in local air pollution mortality, but also road congestion and accident externalities) substantially exceed mitigation costs in some cases (for example, China, Indonesia, Turkey) before counting climate benefits.

### Basic Design Issues: Taxes versus ETSs
- Under uncertainty:
  - Carbon taxes provide certainty over emissions prices while emissions are market-determined; ETSs provide certainty over emissions while prices vary with market conditions.
  - In the absence of uncertainty, a tax rate could be set to induce the same emissions outcome as an ETS cap given the marginal abatement cost schedule; for the same carbon price, both instruments would have the same revenue potential if ETS allowances are auctioned.
  - Price volatility in ETSs has been significant and can cause dynamic inefficiency and deter private innovation/adoption of clean technologies.
  - Policymakers can design mechanisms to reduce uncertainty in both systems (for example, tax trajectories, ETS price floors, banking/borrowing, and cap adjustments).
- Practical trade-offs:
  - Carbon taxes: advantages in administration, price certainty, exploiting fiscal opportunities, and application to broader emissions sources; typically under finance ministries and can be integrated midstream into existing fuel tax collection systems.
  - ETSs: more natural for environment ministries, provide more certainty over emissions, and free allowance allocations can garner firm support.

### Administration, Coverage, and Priorities
- Comprehensive coverage should include CO2 emissions across all fuels and sectors, though coal and the power and industrial sectors are usually priorities.
  - At the fuel level, reduced coal use would account for about 50 percent or more of the fossil fuel CO2 reductions from comprehensive carbon pricing for 12 G20 countries.
  - At the sectoral level, reduced emissions from power and industry would account for 60 percent or more of emissions reductions from comprehensive carbon pricing for all G20 countries.
- Carbon tax administration:
  - Easy to administer and can be applied midstream (after fuel refining and processing) into collection procedures for existing fuel taxes; legal and administrative infrastructure largely exists given fuel taxes are well established in over 160 countries.
  - All but one of the 21 existing national carbon taxes are applied midstream.
  - Carbon taxes can also be applied upstream at point of fuel extraction, integrating into regimes for coal, gas, and oil producers plus fuel imports; rebates could be provided for fuel exports.
- Sectoral application:
  - In principle, carbon taxes could also be applied downstream (at point of fuel combustion) to large emitters in the power sector and industry.

*Source: clnea2022006 - Introduction.*

### 2. Reductions by Sector

### 2. Reductions by Sector

### Design choice: Carbon taxes versus Emissions Trading Systems (ETSs)
- Point of regulation can be upstream, midstream, or downstream; the point of regulation should not matter for the impact of the carbon tax on fuel prices, fuel use, or emissions (aside from cases where fuel price regulations prevent full pass through of carbon charges into fuel prices).
- Carbon taxes
  - Revenues typically accrue directly to finance ministries as with existing fuel taxes and hence can be used for a broad range of purposes including reducing other distortionary taxes like those on labor, funding productive public investments, or for deficit reduction.
  - Changes to rates or coverage can often be made as part of a budget and related finance bill.
  - Rebates should be provided to downstream firms that adopt abatement technologies like carbon capture (though these technologies are rare at present).
- ETSs
  - Generally under the purview of environment ministries, typically require more sophisticated administration and may have more limited coverage.
  - Usually applied downstream to large stationary sources in the power and industrial sector; can be extended midstream to transportation and building fuel suppliers (examples cited: German and Korean ETSs; proposed for inclusion in the EU ETS).
  - New capacity is required to monitor downstream emissions and supervise allowance registries and market trading.
  - May not be viable in countries with limited institutional capacity or where permit trading markets would be concentrated due to a limited number of firms.
  - Changes to ETS rules tend to require changes to regulations and legislation, which may involve a lengthy process of notice and consultation.
- Practical interactions and hybrids
  - Some countries apply carbon taxes and ETSs simultaneously to different sectors or even the same emissions sources (examples cited: Denmark, Finland, France, Ireland, Norway, Portugal, Sweden; Canada; United Kingdom).
  - Price-stabilizing features (price floor, price ceiling, “price collar”) can make ETSs resemble carbon taxes; carbon taxes could include tradable elements to resemble ETSs.
- Administrative scale examples and constraints
  - Compliance costs are moderately larger for downstream systems due to the greater number of taxpayers—example: about 13,000 firms would be covered in a downstream pricing system in the United States compared with 2,000 in a midstream pricing system (Calder 2015).
  - In the EU ETS, exempted small-scale emitters with annual emissions less than 50 kilo-tonnes account for about 7 percent of emissions from the power and industry sectors.

### Allocation of Policy Revenues/Rents: Efficiency considerations
- Empirical patterns in revenue use
  - Carbon tax revenues have been fully used for general purposes in 16 carbon tax schemes and partially or fully earmarked for environmental spending in only five cases (Annex Table 2.1).
  - In early phases of some ETSs (for example, EU, Korea), allowances were freely allocated to affected firms; other ETS cases (for example, California, Germany) auctioned allowances from the start.
  - Where ETS allowances are auctioned, revenues are more often earmarked for environmental spending—this applies, at least partially, in five of the seven ETS schemes (Annex Table 2.1).
- Efficiency tradeoffs of different revenue uses (high-level summary of Table 1)
  - Public investment
    - Impact on Economic Efficiency: Potentially significant (high fiscal multipliers, especially for low-carbon investments)
    - Impacts on Income Distribution: Can disproportionately benefit low-income households (depends on implementation)
    - Administrative Burden: Modest; requires strong public investment management
    - Political Feasibility: Can be popular, with green investment especially favored in climate-concerned countries
  - Tax reductions
    - Impact on Economic Efficiency: Can improve incentives for work effort and investment and reduce incentives for the black economy and tax evasion
    - Impacts on Income Distribution: Can be designed to be progressive (for example, via increases in personal income tax thresholds)
    - Administrative Burden: Minimal
    - Political Feasibility: Popular with beneficiaries (for example, households for personal cuts, firms for corporate income tax cuts)
  - Deficit reduction
    - Impact on Economic Efficiency: Lowers future tax burdens and macro-financial risk
    - Impacts on Income Distribution: Depends on country circumstances
    - Administrative Burden: Minimal
    - Political Feasibility: Does not garner political support
  - Universal lump-sum transfers
    - Impact on Economic Efficiency: Forgoes efficiency benefits (for example, no enhanced incentive for work effort)
    - Impacts on Income Distribution: Progressive (disproportionately benefits the poor)
    - Administrative Burden: New capacity may be needed (but should be manageable)
    - Political Feasibility: Mixed
  - Means-tested cash transfers or social assistance
    - Impact on Economic Efficiency: Forgoes efficiency benefits, but typically requires only a small share of revenues
    - Impacts on Income Distribution: Effective at helping low-income groups if transfers are well targeted or if social safety nets are comprehensive
    - Administrative Burden: Low if builds on existing capacity, otherwise significant
    - Political Feasibility: Generally popular
  - Direct assistance for household energy bills
    - Impact on Economic Efficiency: Forgoes efficiency benefits; reduction in environmental effectiveness depending on design
    - Impacts on Income Distribution: Provides partial relief for households (but does not help with indirect pricing burden)
    - Administrative Burden: Low if builds on existing capacity, otherwise significant
    - Political Feasibility: Generally popular
- Key efficiency point
  - Productive uses of revenues (tax reductions that improve labor and investment incentives, and public investment in health, education, infrastructure) can produce large gains in economic efficiency that help offset negative effects of higher energy prices on economic activity.
  - Earmarking for environmental investment can be efficient if investments are fully integrated into robust public investment management systems.
  - Using revenues for deficit reduction can be efficient depending on economic conditions.
  - Returning revenues in universal or targeted lump-sum transfers to households or firms forgoes certain efficiency benefits.

### Allocation of Policy Revenues/Rents: Distributional considerations
- General distributional pattern
  - In principle, a carbon tax and an ETS—if applied to the same sectors, with the same price, and prior to allocation of revenues—would impose the same distributional burdens across household income groups because carbon pricing has the same effect on prices regardless of instrument form.
  - Distributional burdens, when measured against households’ annual consumption, tend to be mildly regressive (imposing a slightly larger burden relative to consumption on lower income households than wealthier households).
  - Much of the household burden comes indirectly from pass through of carbon charges into prices of consumer goods; budget shares for these consumer goods are more evenly distributed across household income groups than shares for electricity and fuels.
- Implications of revenue allocation choices
  - Carbon tax revenues can be recycled to make the overall reform distribution neutral, or progressive, through targeted measures.
  - An ETS that grants free allowance allocations can generate windfall profits that accrue to shareholders and workers in those industries (shareholders concentrated in higher income households).
  - Auction revenues from ETSs can be earmarked for just transition assistance (example: German ETS uses auction revenues for assistance to vulnerable households, workers, and regions), which enhances acceptability but largely forgoes some efficiency benefits.
- Quantitative examples of recycling designs used in illustrative country cases (Figure 8 notes)
  - China ($50 carbon tax)
    - Recycling: 85 percent of revenues are used for a proportionate reduction in labor taxes (proportionate to pre-policy consumption) and 15 percent for a targeted transfer for the poorest 25 percent of households.
    - Note: In China bottom income deciles do not pay labor income tax.
  - United States ($75 carbon tax)
    - Recycling: 50 percent of revenues are used for increasing personal income tax thresholds and 50 percent for a general labor tax reduction (proportionate to pre-policy tax burden).
  - Turkey ($50 carbon tax)
    - Recycling: 85 percent of revenues are used for labor tax transfers and 15 percent for a targeted transfer for the poorest 25 percent of households.
  - Argentina (illustration in Figure 8)
    - Recycling: 75 percent of revenues are used for labor tax reductions, and 25 percent for targeted transfers to bottom 30 percent of households.
    - Note: In Argentina bottom income deciles do not pay labor income tax.
- Distributional targeting outcomes
  - Recycling schemes considered in Figure 8 benefit the bottom four income deciles on net (detailed percent changes and sectoral components are shown in Figure 8).
  - Alternatively, the bottom four deciles can be fully compensated for price increases by recycling 25-30 percent of the carbon pricing revenues in targeted measures.

*Source: IMF staff.*

### 4. Argentina ($50 carbon tax)

### 4. Argentina ($50 carbon tax)

### Political economy
- Political feasibility differences:
  - ETSs may be more feasible politically than taxes where permits are freely allocated to affected firms.
  - Firms in energy- and carbon-intensive sectors may prefer freely allocated permits due to windfall gains.
  - Example: free allocation in the EU ETS fell from 80 percent in 2013 to 30 percent of allowances in 2020.
- Distributional and political risks:
  - Benefits of carbon pricing (revenue recycling, domestic environmental co‑benefits, climate benefits) can be diffuse; costs (higher energy costs, employment impacts) can be concentrated on specific firms and sectors.
  - Anticipation of negative distributional outcomes creates incentives for opposition; targeted measures and thorough stakeholder analysis (e.g., quantifying stakeholders’ “carbon positions”) are critical.
- Design and communication to build support:
  - Revenue recycling, communications strategies, identification of key stakeholders, and “soft earmarking” of revenues partly to environmental and social objectives can increase political acceptability.
  - Carbon taxes can be designed to mimic free allocation by using revenues for targeted relief to firms.

### Competitiveness
- Key concern: burdens on energy-intensive, trade-exposed (EITE) industries with relatively high embodied carbon and limited ability to pass cost increases to consumers.
- Estimated direct cost increases:
  - Direct cost increases typically between 5 and 10 percent for aluminum and steel; up to 30 percent for cement.
  - Large indirect cost increases can arise from charges on carbon embodied in electricity inputs.
- Unilateral competitiveness assistance options under a carbon tax:
  - Partial exemptions (tax firm emissions above a threshold, e.g., South Africa) — lowers average charge and undermines mitigation incentives.
  - Output-based rebates (returning revenues as rebates to EITE industries) — operationally similar to a tradable emission rate standard (example: federal backstop in Canada).
  - Border carbon adjustments (BCAs) — charge embodied carbon in imports net of foreign pricing and possibly rebate exporters; initial BCA based on domestic emissions factors may lessen disproportionate effects on developing countries.
- ETS approaches:
  - Free allowance allocation commonly used but does not compensate for abatement costs.
  - BCAs could be implemented (in the form of allowance purchase requirements for imports) but WTO compatibility uncertainties may be larger for ETSs.

### Price levels
- Alignment mechanisms:
  - Carbon tax: government can align the price trajectory with emissions targets; requires periodic forward-looking adjustment of tax rates to maintain alignment.
  - ETS: alignment automatic if cap is set to meet mitigation commitments (example: EU ETS cap reduced by 2.2 percent a year in line with 2030 targets for power/industrial sector).
- Heterogeneity and harmonization:
  - Wide divergence in pre-existing carbon charges across countries and fuels/sectors suggests scope for harmonizing combined carbon prices while scaling up levels.
  - Total CO2 tax per tonne may still differ to reflect domestic environmental externalities (local pollution, road congestion).
- Interaction with fuel tax reforms:
  - If fuel taxes are reformed, under an ETS the carbon price automatically adjusts to keep emissions the same; under a carbon tax the carbon charge must be manually adjusted.

### Compatibility with overlapping mitigation instruments
- Carbon taxes:
  - Compatible with overlapping non-pricing instruments (emission rate regulations, feebates, clean technology subsidies); when combined with a pure carbon tax these instruments further reduce emissions without lowering the emissions price.
- ETSs:
  - Typically less compatible with overlapping instruments — overlapping instruments under an ETS lower the emissions price (emissions are fixed by the cap), undermining ETS revenue and investment incentives.
  - Mitigations: underpin ETS with a price floor; adjust the cap over time to account for overlapping instruments if price stability is the objective.
  - Example: California employs regulatory framework plus an ETS with a price floor so emissions reductions are achieved and a robust price signal maintained.
- Efficiency recommendation:
  - From an economic efficiency perspective, best to have the ETS play the central role with complementary regulations for “hard-to-abate” sectors (transport, buildings).

### Broader considerations — Pricing broader sources of GHGs
- Extractive emissions:
  - Comprehensive monitoring of methane leaks not presently feasible; proxy pricing based on fuel supply combined with mandated monitoring or default emissions factors with rebates is practical (example: Norway).
- Agricultural emissions:
  - Pricing methane from livestock could be based on farm outputs/inputs and default emissions factors to promote emissions-intensity reductions and shifts from livestock to crops.
  - Methane emissions from agriculture are less responsive to pricing than for extractives; revenues may need to be returned to farmers or combined with border adjustments to address competitiveness concerns.
- Process emissions:
  - GHGs from industrial processes can be priced via direct smokestack monitoring or default emissions factors (example: HFCs in refrigerants, foams, aerosols, fire extinguishers).
  - CO2 from industrial processes can be covered under a downstream ETS; some countries tax HFCs and similar gases.
- International transportation fuels and long‑lived investments:
  - Carbon taxes may provide certainty suitable for promoting deployment of zero-emission vessels (ship lifetime typically around 30 years), but a pure tax could raise more revenue than efficiently absorbed by the IMO.
  - Feebates, taxing operators in proportion to emissions-rate deviations from a benchmark and capping revenue to needed R&D, could maintain price signals and promote international acceptability.
- Forestry and sequestration:
  - Feebates or carbon taxes with negative payments for sequestration are more amenable than pure carbon taxes or ETSs; these can penalize deforestation and reward afforestation/forest management that increase carbon storage.
- Offsets caution:
  - Offsets allow entities to pay for mitigation projects elsewhere, but concerns include non-additionality and impermanence (e.g., reforestation projects that would have occurred anyway or forests later burning), which can increase overall emissions.
  - No automatic mechanism ensures cost-effective projects receive offset payments; evidence suggests systematic non-additionality concerns (example: an EU study found 85 percent of offsets allowed into the EU ETS were non-additional).

### Global coordination regimes
- Rationale and design:
  - Internationally coordinated pricing regime could focus on a small number of large emitters to cover bulk emissions and on a minimum carbon price to scale up mitigation and address competitiveness concerns.
  - Differentiated price floors to account for equity: $75, $50, and $25 per tonne for high-, medium-, and low-income countries, respectively, would be sufficient to align global CO2 emissions in 2030 with keeping global warming below 2oC even with just six participants (Canada, China, India, EU, United Kingdom, United States), assuming G20 NDCs are met and participants adhere to the more stringent of the price floor or their NDC.
- Flexibility and alternatives:
  - Countries unable to implement pricing could achieve equivalent emissions reductions through other approaches mapped into carbon price equivalents.
  - Initial coverage could focus on power and industry, where most emissions reductions under comprehensive pricing come from.
- Instruments and linking:
  - Carbon tax is most naturally aligned with international price coordination, though ETSs can be accommodated by underpinning with a floor price or setting caps to generate expected domestic prices.
  - Linking ETSs across jurisdictions can improve cost effectiveness but perpetuates design features (price ceilings/floors), reduces domestic policy autonomy, and creates administrative complexity and uncertainty; equity considerations (e.g., permit trading ratios) and concrete trajectories of caps/prices would be required.

*Source: clnea2022006 - 4. Argentina ($50 carbon tax).*

### Conclusion

### Conclusion

### Summary judgment
- Absent political constraints, carbon taxes have practical appeal: they provide certainty over future emissions prices needed to promote emissions-saving investments, generate revenues that accrue automatically to finance ministries, and can build off existing fuel tax collection.
- ETSs may also be appealing but have limitations: they help achieve emissions targets with more certainty and suit situations where mitigation policy is under environment ministries, yet they can exhibit significant price volatility, raise limited or earmarked revenues, and be impractical in some capacity-constrained countries.
- Policymakers will choose between and within carbon pricing instruments depending on national circumstances; there is no “one carbon pricing instrument that fits all.”

### Carbon taxes — advantages and design features
- Provide price certainty that promotes clean-technology innovation and adoption.
- Revenues usually accrue to finance ministries for general purposes (for example, cutting other taxes, general investment).
- Tax trajectories can be aligned and periodically adjusted to maintain consistency with emissions goals.
- Compatible with reinforcing mitigation instruments (for example, feebates) for hard-to-abate sectors like buildings and transport, and potentially with border adjustments.
- Revenue use: can provide robust assistance for low-income groups while still leaving the bulk for cutting other burdensome taxes or boosting productive investments.
- Can be extended to broader emissions sources by building off existing business tax regimes in some cases; where monitoring is limited, proxy taxes or feebate variants may be needed (for example, for extractives or agriculture) or schemes that reward carbon sequestration (for example, forestry).

### Emissions Trading Systems (ETSs) — appeal and limitations
- Help achieve emissions targets with greater certainty over emissions levels.
- Free allowance allocation can build political support and has been a key decision factor for many countries.
- Price stability mechanisms in existing ETSs have not prevented significant price volatility.
- Revenues from ETSs, when raised, have tended to be earmarked rather than accruing for general budgetary use.
- ETSs are not automatically compatible with reinforcing mitigation instruments; legal obstacles to border adjustments (for example, for export rebates) may be greater than for carbon taxes.
- Incorporating broader emissions sectors under ETSs through offsetting provisions may increase emissions on net and provides no automatic mechanism for prioritizing cost-effective projects in the offsetting sector.
- Linking ETSs into a global carbon market could improve cost-effectiveness across countries, but reinforcing the Paris Agreement with a formal international carbon price floor is more effective at scaling up global mitigation, could address international equity concerns, and better accommodate alternative national approaches.

### Role of carbon pricing within a broader policy package
- Designed and implemented appropriately, carbon pricing can be the centerpiece of climate mitigation strategies for most countries.
- Carbon pricing promotes a full range of behavioral responses for reducing emissions, mobilizes revenue, and imposes generally manageable transitional costs that can be offset by revenue recycling and domestic environmental co-benefits.
- Regardless of instrument choice, additional measures are necessary given the difficulty of pricing and its impact on energy prices, compounded by the current macroeconomic context.
- Policy package elements needed alongside pricing:
  - Reinforcing instruments like feebates, especially for hard-to-abate sectors.
  - Productive and equitable use of carbon pricing revenues.
  - Just transition measures for vulnerable groups.
  - Pricing of broader emissions sources (including proxy approaches where monitoring is limited).
  - Public investment in enabling infrastructure underprovided by the private sector.
  - Extensive public communication and stakeholder consultation.
- ETSs can be designed (for example through price floors and allowance auctions) to mimic some advantages of taxes.

_Imf staff._

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_Source: https://www.imf.org/-/media/files/publications/staff-climate-notes/2022/english/clnea2022006.pdf_