## wpiea2021246-print-pdf

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### Key findings and executive summary
- A comprehensive mitigation strategy with carbon pricing as its centerpiece can:
  - Mobilize valuable government revenues.
  - Save lives by reducing local air pollution exposure.
  - Reduce poverty and increase employment in clean energy sectors.
- Carbon pricing impacts and mitigation benefits:
  - Carbon pricing burden on households is estimated at 2.7 percent of consumption on the average Mexican household.
  - Recycling carbon pricing revenues would offset most of this burden, and targeted transfers could make the reform pro-poor and pro-equity.
  - Economic efficiency costs of carbon pricing are estimated at 0.3 percent of GDP in 2030, which are more than offset by local air pollution and other domestic environmental benefits (before counting climate benefits).
- Mexico’s current commitments and context:
  - Mexico pledged to reduce GHG emissions by 22 percent below country-estimated baseline levels in 2030, or by 36 percent conditional on external support.
  - Mexico introduced a carbon tax in 2014 (with low rates and exemptions for natural gas) and has implemented a pilot emissions trading system (ETS) for power generation and industry.
  - To contain warming to 1.5°C or 2°C, global CO2 and other GHG emissions must be cut by 50 or 25 percent respectively below 2019 levels by 2030; containing temperature rises to below 2°C requires measures equivalent to a global carbon tax of around $75 per ton or more by 2030.
  - Observed global warming to date is 1.2°C and is caused by human factors.

### Emissions profile, trends, and targets
- Mexico’s emissions and sectoral breakdown (2018, excluding LULUCF):
  - 5.6 tons of CO2e per capita in 2018 (global average 6.3 tons per capita).
  - 700 million tons total (1.2 percent of global total); twelfth largest global emitter in 2018.
  - Energy-related CO2: 73 percent of GHGs.
  - By sector: power generation 27 percent; transportation 22 percent; industry 9 percent; buildings 3 percent; fugitive emissions 5 percent; industrial process emissions 9 percent; agriculture 14 percent; waste 7 percent.
  - By fuel (energy-related CO2): coal 11 percent; oil 53 percent; natural gas 36 percent.
- Power generation mix (2018):
  - Fossil fuels: 79 percent; coal 9 percent; gas 60 percent; oil 10 percent; hydro 10 percent; solar 1 percent; wind 4 percent; nuclear 4 percent.
- Historical and projected trends:
  - GHG emissions about 70 percent higher in 2018 than in 1990; emissions intensity of GDP fell by about a fifth over that period.
  - IMF BAU projection: emissions rise 7 percent from 2020 to reach about 721m tons in 2030 (IMF BAU includes no new mitigation policies beyond recent observed fuel use).
  - GDP projected to grow by approximately 25 percent in real terms between 2020 and 2030; CO2 emissions intensity of GDP declines 13 percent over this period.
  - Emissions fell an estimated 6 percent in 2020 due to COVID-19.
- Comparison with Mexican authorities’ BAU:
  - Mexico’s second-round NDC projects BAU GHG emissions of 991 million tons in 2030 (833 million tons including LULUCF absorption) compared with 721 million tons (including LULUCF) in the IMF BAU projections.
- Emissions target gaps and Paris alignment:
  - Averaging conditional and unconditional pledges implies cutting GHGs 14 percent below IMF-projected BAU levels in 2030.
  - A Paris-aligned approach could lower Mexico’s 2030 target from 704 million tons to, at most, 550 million tons in 2030, implying at least 22 percent below IMF-projected BAU levels and an 8 percent increase in its unconditional NDC.
  - IMF staff estimates that under current policies BAU GHG emissions will exceed:
    - current 2030 emission target by 10 percent, and
    - a Paris-aligned 2030 emissions target by 18 percent.
  - Recommended: make a net zero emission pledge for 2050; align the 2030 target with any long-term net zero target (e.g., linear emission reduction pathway).

### Carbon pricing instruments, design priorities, and quantitative assessment
- Design priorities:
  - Comprehensive coverage with a common price that rises steadily and predictably.
  - Alignment of the price path with mitigation targets is more important than tax versus ETS choice.
  - Remove exemptions (e.g., natural gas) so all fossil fuels in all sectors are taxed in proportion to carbon content.
- Instrument options:
  - Carbon tax: most effective form is a uniform tax on CO2 with a predictable ramp (illustrative ramp: start US$25 per ton in 2022 and ramp US$6 per year to US$75 per ton in 2030).
  - ETS: can be applied downstream at combustion or midstream to fuel suppliers; cap trajectory and price containment options (ceiling, floor) exist; auctioning allowances yields fiscal revenues comparable to a tax.
  - Hybrid approach: ETS for power and industry; carbon tax for transportation and buildings; align prices across instruments (e.g., ETS price floors equal tax trajectory).
- CPAT modeling approach:
  - Uses Carbon Pricing Assessment Tool (CPAT) projecting fuel use and CO2 emissions by major energy sectors, including power sector investment and dispatch, and price responsiveness of electricity demand and fuel use.
  - CPAT quantifies emissions, fiscal, local environmental, economic welfare, and distributional impacts.
- IMF staff projections and impacts for a carbon price rising to US$75 per ton by 2030:
  - Reduces CO2 emissions 23 percent below IMF-projected BAU levels in 2030.
  - Reduces GHGs excluding LULUCF by 21 percent in 2030.
  - Sectoral CO2 reductions: 57 percent from power; 28 percent from industry; 14 percent from transportation; 2 percent from buildings.
  - Energy price effects in 2030 relative to BAU: coal +300 percent; natural gas +87 percent; electricity +29 percent; other petroleum products +19–25 percent.
  - Revenue: could raise revenues of 1.8 percent of GDP ($26 billion) in 2030.
    - Revenue shares: Natural gas 36 percent; Gasoline 28 percent; Diesel and other oil products 30 percent; Coal 5 percent.
  - Health co-benefits (2021–30 cumulative): 11,600 premature fatalities avoided from local air pollution exposure.
    - 68 percent of avoided deaths are people over the age of 65 years.
    - 82 percent of avoided deaths are in urban areas.
    - 14 percent of avoided deaths due to reduced coal use; 73 percent due to reduced oil products use.
  - Economic efficiency cost: about 0.3 percent of GDP in 2030; domestic environmental co-benefits offset these efficiency costs.
  - Adding global climate benefits (valued at $75 per ton of CO2) increases environmental benefits from 0.3 to 0.9 percent of GDP (three times the economic efficiency costs).
- Fiscal and international context:
  - Carbon tax implemented in 2014 prices about a quarter of total GHGs at US$3 per excess ton of CO2.
  - Pilot ETS (from 2020) covers about 300 larger entities producing about 40 percent of Mexico’s GHGs; 2021 cap set at 273 million tons of CO2e; pilot allows banking within phase and up to 10 percent offsets.

### Complementary sectoral mitigation instruments and feebates
- Rationale:
  - Sectoral instruments can enhance mitigation where carbon pricing alone is insufficient or politically difficult.
  - Feebates (fees for above-average emission rates and rebates for below-average) can be revenue-neutral and cost-effective across sectors.
- Power sector:
  - Under US$75 carbon tax in 2030, combined behavioral responses account for ~65 percent of CO2 reductions in power; remaining ~35 percent from reduced electricity demand.
  - Cost-effective generation mix in 2030 under US$75: 2 percent coal; 42 percent gas; 9 percent hydro; 26 percent solar.
  - Feebate formula: CO2 price × [CO2/kWh ─ pivot point CO2/kWh] × electricity generation; illustrative US$50 per tonne feebate per kWh: coal fee 6.6 cents, diesel 4.3 cents, natural gas 0.2 cents; renewable subsidy 4.8 cents per kWh.
- Industry:
  - Energy-intensive sectors: steel, chemicals, metals, cement, glass, paper.
  - Emissions: ~60 percent from fuel combustion; 40 percent process emissions.
  - Feebate firm fee: [CO2 price] × [CO2/output ─ industry-wide average CO2/output] × [firm output].
- Transport:
  - Challenges: retail fuel price impacts modest; public resistance.
  - Current CO2 emission rate standard for cars: 136 grams CO2/km.
  - Electric vehicles share of new vehicle sales in 2018: 0.1 percent.
  - Vehicle feebate integration with registration tax: CO2 price × [CO2/km ─ fleet CO2/km] × [average lifetime vehicle km]; at CO2 price $400 per ton, subsidy for zero-emission vehicles $5,500 and tax on a 200 g CO2/km vehicle $2,600.
  - Recommend distance-based congestion charges.
- Buildings:
  - Oil combustion in homes: 4 percent of energy-related CO2; residential electricity (indirect) 7 percent.
  - Household electricity use: 61 percent appliances; 22 percent air conditioning; 17 percent refrigeration.
  - Feebate examples for appliances (e.g., refrigerators): CO2 price × CO2 per unit of energy × [energy consumption per unit ─ industry-wide average] × number of units.
- Extractives (fugitive emissions):
  - Suggested: tax on default leakage rates with rebates for verified lower leakage.
  - Illustrative $60 per ton emissions tax on fugitive emissions would equal about $1.2 per barrel of oil and $0.2 per thousand cubic feet of natural gas (about 2 and 6 percent of current supply prices respectively).
- Forestry:
  - Mexico NDC forestry commitment: unconditionally reduce CO2 emissions from forestry sector by 144 percent in 2030 from BAU baseline of 32 million tons to negative 14 million tons.
  - Landowner feebate: [CO2 rental price] × [carbon storage baseline ─ current carbon storage]; prefer rental payments over one-off payments; carbon price must rise over time.
- Agriculture:
  - Agricultural GHG composition: 50 percent enteric fermentation; 20 percent manure; 18 percent crops.
  - Proxy emissions taxes or feebates by hectare or nutritional value; alternative demand-side taxes on meat and dairy.

### Distributional incidence, revenue recycling, and just transition
- Household impacts and recycling:
  - A $75 carbon price in 2030 imposes a burden on the average household of 2.7 percent of consumption.
  - Burdens decline only slightly across higher income deciles; largely driven by indirect price increases.
  - Estimates exclude partially offsetting domestic environmental benefits and revenue recycling.
- Revenue recycling examples and impacts:
  - Shares of revenues needed to fully compensate income groups:
    - Bottom 10 percent: 7 percent of revenues.
    - Bottom 20 percent: 10 percent of revenues.
    - Bottom 30 percent: 17 percent of revenues.
  - Example pro-poor reform: 25 percent of revenues for targeted unconditional cash transfers (bottom four deciles, 75 percent coverage, 25 percent leakage) and 75 percent to reduce labor taxes by raising lower income thresholds.
    - Net effects: bottom four deciles net benefits ~3 percent of consumption; next three deciles roughly neutral; wealthier households worse off by 1.1 percent of consumption.
  - Revenue recycling through labor tax reductions can offset 85 percent of the burden on the average household.
  - Using all revenues for targeted transfers would enhance regional equity (rural poor benefit by about 7 to 27 percent of annual consumption) but reduce efficiency.
- Worker, regional, and institutional assistance:
  - Need national unemployment insurance, improved targeting of social benefits, strengthened active labor market policies, extended unemployment benefits, training and reemployment services, wage insurance or tax credits for older workers.
  - Suggested regional support: reclaim abandoned drilling sites; temporary budget support for local governments; geographically targeted investments, subsidies, or grants.
  - Use carbon revenues to reduce regulatory burdens, strengthen social protection, and promote competition to enhance employment impacts and reduce informality.
- Employment and climate risks (Box 4):
  - Informality prevalent; most labor-intensive sectors (2021Q1): Agriculture; Domestic trade and hospitality services; Construction—dominated by informal employment.
  - Climate change reduces labor productivity, raises migration, and threatens tourism and fisheries; mitigation aggregate employment impacts small but depend on labor market adjustment capacity.
  - ILO (2014) identifies high potential for green jobs in organic agriculture, green construction, and manufacturing in Mexico.

### Industrial competitiveness and border carbon adjustments (BCAs)
- Cost impacts:
  - A $75 carbon price in 2030 increases prices for iron/steel and cement about 14 percent; other metals about 8 percent (relative to BAU costs in 2030).
- Mitigation of competitiveness concerns:
  - Free allowance allocations for industry forgo fiscal revenue and become less effective at higher carbon prices; BCAs are an alternative.
  - A $75 BCA for EITE industries would raise revenues of about 0.9 percent of GDP in 2030 from import charges, approximately offset by export rebate outlays.
  - Under a domestic industry benchmark, bulk import charge revenue would come from U.S. exporters; under country-specific benchmarks slightly more from China than the U.S.; nearly all export rebates would be for exports to the U.S.
  - Effective incidence on trading partners likely much lower than formal revenues because import charges would be passed forward to domestic Mexican consumers.
- Trade-offs and international approaches:
  - Unilateral BCAs have limited global mitigation effect because trade-embodied emissions typically account for less than 10 percent of a country’s CO2.
  - An international carbon price floor among large emitters (e.g., G20 at 85 percent of global emissions) would be far more effective; could include equitable price floors and compensation mechanisms.
  - Mexico could promote regional price-floor dialogue with countries that have pricing in place (e.g., Argentina, Chile, Colombia).

### Investment needs and supporting policies for clean energy transition
- Investment needs:
  - Global model for 2°C: increase global energy investment in 2030 from 2 percent of GDP to 2.3 percent of GDP.
  - Mexico: BAU energy investment needs 1.7 percent of GDP; consistent with a 2°C target: 1.9 percent of GDP.
  - Share of low carbon energy supply investment needs to rise from 40 percent in 2020 to 70 percent in 2035 and 80 percent in 2050.
  - REmap 2030 estimate: up to 26 percent of power generation by 2030 from renewables, hydro, geothermal, and biomass.
  - Adding adaptation investment needs increases incremental investment by a further 0.3 percent of GDP.
- Supporting policies to mobilize low-carbon investment:
  - Public R&D support; targeted fiscal incentives (capital grants, tax credits, per-unit subsidies); regulations to address knowledge spillovers; public infrastructure investment (charging stations, transmission); price liberalization and enabling business environment; financial sector policies (green bond standards, prudential adjustments, portfolio shifts).
  - Policy design cautions: avoid inconsistencies and redundancies (e.g., simultaneous subsidies to renewables and fossil fuels); encourage competition in power markets; increase R&D support now and phase down as technologies mature; prefer production-based fiscal incentives and competitive tendering over rigid feed-in tariffs.
- Infrastructure lifetimes:
  - Energy infrastructure lifetimes 30–60 years; choices today determine emissions for decades; demand-side investments (buildings, transport, industry) have shorter lifetimes and can speed reductions.

### Main policy recommendations (summary)
- Define a net zero emissions target for 2050 and align the 2030 emissions target with long-run targets.
- Build off the existing carbon tax and/or ETS to establish a carbon price that covers all fossil fuel emissions and rises predictably over time, aligned with the 2030 target where possible.
- Recycle carbon revenues to offset household burdens, using targeted transfers and labor tax reductions to protect vulnerable groups and boost efficiency.
- Reinforce carbon pricing with sectoral instruments (feebates) in transport, power, industry, buildings, forestry, extractives, and agriculture.
- Integrate vehicle feebates into registration tax; consider feebates for power and industry to reduce firm burden while incentivizing emissions-rate reductions.
- Support liberalization of power generation, bolster public investment in low-carbon technologies and networks, and enhance competition to attract private investment.
- Provide just transition measures to assist vulnerable households, workers, and regions; develop national unemployment insurance and strengthen active labor market policies.
- Consider border carbon adjustments or other robust instruments to preserve international competitiveness with deeper domestic carbon pricing.
- Use carbon pricing revenues productively for Sustainable Development Goals, structural reforms, and to finance adaptation and mitigation investments.

*Source: IMF staff analysis and calculations in wpiea2021246-print-pdf*

### 2.7 percent of consumption on the average Mexican household. However, recycling carbon

### wpiea2021246-print-pdf - 2.7 percent of consumption on the average Mexican household. However, recycling carbon

### Key findings and executive summary
- A comprehensive mitigation strategy with carbon pricing as its centerpiece can:
  - Mobilize valuable government revenues.
  - Save lives by reducing local air pollution exposure.
  - Reduce poverty and increase employment in clean energy sectors.
- Carbon pricing impacts and mitigation benefits:
  - Carbon pricing burden on households is estimated at 2.7 percent of consumption on the average Mexican household.
  - Recycling carbon pricing revenues would offset most of this burden, and targeted transfers could make the reform pro-poor and pro-equity.
  - Economic efficiency costs of carbon pricing are estimated at 0.3 percent of GDP in 2030, which are more than offset by local air pollution and other domestic environmental benefits (before counting climate benefits).
- Mexico’s current commitments:
  - Mexico pledged to reduce GHG emissions by 22 percent below country-estimated baseline levels in 2030, or by 36 percent conditional on external support.
  - Mexico introduced a carbon tax in 2014 (with low rates and exemptions for natural gas) and has implemented a pilot emissions trading system (ETS) for power generation and industry.
- Global context:
  - To contain warming to 1.5°C or 2°C, global CO2 and other GHG emissions must be cut by 50 or 25 percent respectively below 2019 levels by 2030, followed by a rapid transition to zero net emissions.
  - Containing temperature rises to below 2°C requires measures equivalent to a global carbon tax of around $75 per ton or more by 2030.
  - Observed global warming to date is 1.2°C and is caused by human factors.

### Emissions and policy background
- Mexico’s emissions profile and global standing:
  - Mexico’s GHG emissions amounted to 5.6 tons of CO2e per capita in 2018, compared with a global average of 6.3 tons per capita.
  - Mexico was the twelfth largest global emitter in absolute terms in 2018, producing 700 million tons or 1.2 percent of the global total.
- Emissions by source (2018, excluding LULUCF):
  - Energy-related CO2 accounted for 73 percent of Mexico’s GHG emissions.
  - By sector: power generation 27 percent; transportation 22 percent; industry (manufacturing and construction) 9 percent; buildings (direct fuel combustion) 3 percent; fugitive emissions 5 percent; industrial process emissions 9 percent; agriculture 14 percent; waste 7 percent.
  - By fuel (energy-related CO2): coal 11 percent; oil 53 percent; natural gas 36 percent.
- Power generation mix (2018):
  - Fossil fuels accounted for 79 percent of power generation.
  - Generation shares: coal 9 percent; gas 60 percent; oil 10 percent; hydro 10 percent; solar 1 percent; wind 4 percent; nuclear 4 percent.
- Historical and projected trends:
  - GHG emissions were about 70 percent higher in 2018 than in 1990; emissions intensity of GDP fell by about a fifth over that period.
  - IMF BAU projection: emissions rise 7 percent from 2020 to reach about 721m tons in 2030 (IMF BAU includes no new mitigation policies beyond recent observed fuel use).
  - IMF assumptions and projections: GDP projected to grow by approximately 25 percent in real terms between 2020 and 2030; CO2 emissions intensity of GDP declines 13 percent over this period.
  - Emissions fell an estimated 6 percent in 2020 due to COVID-19.
- Comparison with Mexican authorities’ BAU:
  - Mexico’s second-round NDC projects BAU GHG emissions of 991 million tons in 2030 (833 million tons including LULUCF absorption) compared with 721 million tons (including LULUCF) in the IMF BAU projections.
- Legislative context:
  - General Law of Climate Change (2012) and subsequent NDC submissions set 2020, 2030, and 2050 targets; second-round NDC reaffirmed 2030 and 2050 commitments and updated BAU projections.

### Enhancing carbon pricing: conceptual and quantitative assessment
- Design priorities for carbon pricing:
  - Comprehensive coverage of emissions with a common price that rises steadily and predictably.
  - Alignment of the price path with mitigation targets is more important than the choice of tax versus ETS.
  - Mexico may need a more ambitious 2030 target if it follows other countries pledging net-zero by midcentury.
- Quantitative approach and modeling:
  - Analysis uses the Carbon Pricing Assessment Tool (CPAT), a flexible spreadsheet model projecting fuel use and CO2 emissions by major energy sectors, including a model of investment and dispatch in the power sector and assumptions about price responsiveness of electricity demand and fuel use.
  - CPAT quantifies emissions, fiscal, local environmental (e.g., air pollution mortality), economic welfare, and distributional impacts of carbon pricing.

### Role of complementary sectoral mitigation instruments
- Need for sector-specific instruments alongside carbon pricing:
  - Sectoral instruments can enhance effectiveness and speed of mitigation where carbon pricing alone is insufficient or where quicker scaling is possible with smaller burdens on households and firms.
  - Suggested sectors for complementary instruments: transport, power, industry, buildings, extractives (fugitive emissions), forestry, and agriculture.
- Examples of complementary measures:
  - Feebates in transport, power, industry, buildings, forestry, extractive, and agricultural sectors to reinforce carbon pricing.
  - Proxy pricing instruments or additional pricing to address emissions from extractives, forestry, and agricultural sectors.
  - Measures to liberalize power generation and support investment in low-carbon technologies to facilitate the clean energy transition.

### Transition policies: distributional incidence, revenues, and assistance
- Distributional incidence and revenue recycling:
  - Recycling carbon pricing revenues can neutralize most household burdens and make reforms pro-poor and pro-equity through targeted transfers.
- Worker and regional assistance:
  - Policies are needed to assist vulnerable households, workers, and regions affected by both the energy transition and climate impacts.
- Industrial competitiveness:
  - Measures discussed to address competitiveness impacts of carbon pricing on industry (design choices include border carbon adjustments and other instruments; Annex B provides a summary of design choices).

### Investment needs for clean energy transition and supporting policies
- Investment assessment:
  - Section VI estimates investment needs for the clean energy transition and supportive policies using methodology summarized in Annex C.
  - Complementary public investment is required to support the transition, alongside carbon pricing and sectoral instruments.

### Policy recommendations (selected)
- Implement a comprehensive carbon pricing strategy with a steadily rising, predictable price, and ensure broad coverage of emissions.
- Recycle carbon revenues to offset household burdens, using targeted transfers to protect vulnerable groups and make the reform pro-equity.
- Reinforce carbon pricing with sectoral instruments (e.g., feebates) in transport, power, industry, buildings, forestry, extractives, and agriculture.
- Support liberalization of power generation and bolster public investment in low-carbon technologies.
- Consider strengthening Mexico’s 2030 target if adopting a midcentury net-zero pledge.
- Provide worker and regional assistance and address industrial competitiveness impacts through appropriate policy design.

*Source: https://www.imf.org/-/media/files/publications/wp/2021/english/wpiea2021246-print-pdf.pdf*

### 13.5 percent below the 2020 BAU.

### wpiea2021246-print-pdf - 13.5 percent below the 2020 BAU.

### Emissions targets and progress
- Mexico pledged unconditionally to reduce GHGs by 22 percent relative to 833 MtCO2e BAU levels in 2030.
- Mexico pledged—conditional on external (financial and technical) support—to reduce GHGs 36 percent by 2030 relative to BAU levels, and by 50 percent by 2050 relative to 2020 levels.
- Averaging over conditional and unconditional pledges, meeting Mexico’s second-round NDC would imply cutting GHGs 14 percent below IMF-projected BAU levels in 2030.
- Alternate metric: Or 25.5 percent below NDC-projected BAU levels (including LULUCF absorption) in 2030.
- A Paris-aligned approach described would lower Mexico’s 2030 emissions target from 704 million tons to, at most, 550 million tons in 2030, implying at least 22 percent below IMF-projected BAU levels in 2030 and an 8 percent increase in its unconditional NDC.
- IMF staff estimates that under current policies BAU GHG emissions will exceed:
  - current 2030 emission target by 10 percent, and
  - a Paris-aligned 2030 emissions target by 18 percent.
- Recommended strengthening of commitments:
  - Make a net zero emission pledge for 2050; and
  - Align the 2030 target with any long-term net zero target (e.g., based on a linear emission reduction pathway over time from recent emissions to net zero).

### Current mitigation policies — carbon tax and ETS
- Carbon tax:
  - Implemented in 2014; lacks full coverage; current price is modest.
  - Form: excise imposed midstream on suppliers of fossil fuels; imposed on a fuel’s CO2 emissions in excess of the emission rate of natural gas (natural gas is exempt and part of other fuels’ emissions is also exempt).
  - The carbon tax prices about a quarter of total GHGs in Mexico.
  - Tax rate is US$3 per excess ton of CO2, or less if (as for coal) the tax exceeds 3 percent of a fuel’s price.
- Emissions Trading System (ETS):
  - Pilot ETS introduced in 2020 as part of a two-phase process to establish a fully operational ETS in 2023.
  - Applied downstream at point of fuel combustion; covers about 300 larger entities in the power and industrial sectors (annual emissions exceeding 100,000 tons of CO2 a year) that combined produce about 40 percent of Mexico’s GHG emissions.
  - Pilot phase established implementation and monitoring capacity; pilot lasts three years followed by transition to a fully-fledged ETS in 2023 with several hundred companies expected to participate.
  - 2021 emissions cap is set at 273 million tons of CO2e.
  - At present, emission allowances are freely allocated; transition to allowance auctions is under consideration.
  - Entities can bank allowances within the pilot phase (but not across phases) and meet up to 10 percent of their obligations through purchasing emission offsets (for mitigation projects in other sectors outside the ETS) rather than acquiring allowances.
  - Future legally binding emissions caps have not yet been established.

### Carbon pricing in international and national context
- Coverage vs. price: Of the 24 national and regional pricing schemes illustrated in the source, only seven have greater emissions coverage than the combined coverage of Mexico’s carbon tax and ETS, but only four have lower carbon prices.
- International momentum noted: major schemes implemented in China and Germany in 2021; EU ETS prices rising above US$70 per ton; Canada announced minimum carbon price will rise to US$135 per ton by 2030.
- U.S. Administration preference: investment and regulatory approach rather than carbon pricing.

### Fuel taxes, prices, and hypothetical $75/ton carbon tax impacts
- Effective carbon pricing is large for road fuels but not for fuels used in other sectors; natural gas use in power generation has a negative effective tax due to subsidy.
- Road fuel taxes:
  - Had Mexico unilaterally imposed a $75 per ton carbon tax in 2020, gasoline and diesel taxes would have been increased by 18 and 23 cents per liter respectively.
- Electricity:
  - Residential electricity consumption is subsidized (at 20 percent) in Mexico.
  - Had a $75 per ton carbon tax been in place in 2020, electricity prices would have increased by 4 cents per kWh (using 2018 power mix).
- Natural gas:
  - Natural gas prices in Mexico for the power and industrial sectors would have increased by 88 and 127 percent respectively with a $75 carbon price, but would still be lower than in several comparator countries, especially for industry.
- Supply costs and retail prices:
  - Supply costs for electricity are broadly comparable with other countries but residential electricity prices are on the low side because electricity is not taxed.
  - Natural gas supply costs and prices are lower in Mexico than in most comparator countries.

### Externality valuations and efficient fuel taxation
- IMF staff estimates of externality component charges:
  - Climate damage charge would be at least US$6.4 per GJ for coal and US$3.4 per GJ for gas.
  - Local air pollution damage: $0.9 per GJ for coal consumption in the power sector and $0.3 per liter for diesel.
- Annual average air pollution concentrations in Mexico are double the levels recommended by the World Health Organization.
- Conceptual tools: IMF staff developed conceptual and quantitative tools for assessing efficient fuel taxes on a country-by-country basis; results suggest fossil fuels in Mexico are substantially undercharged for externalities (climate damage, local pollution, and vehicle externalities).

### Comprehensive mitigation strategy elements (complementary measures)
- Carbon pricing as centerpiece plus complementary measures including:
  - (i) Reinforcing feebates or regulations at the sectoral level;
  - (ii) Public investment in clean energy infrastructure networks and market reforms (e.g., in power generation) to enhance competition and investment;
  - (iii) Productive and equitable use of carbon pricing revenues;
  - (iv) Just transition measures to assist vulnerable households, workers and regions;
  - (v) Measures to address industrial competitiveness; and
  - (vi) Pricing of other emissions sources beyond energy-related emissions.

### Conceptual rationale for carbon pricing
- Key attractions of carbon pricing:
  - Promotes the full range of opportunities for reducing energy use and shifting to cleaner energy sources across all covered sectors.
  - Automatically minimizes the costs of these responses by equalizing the cost of the last ton reduced across fuels and sectors.
  - Levels the playing field for clean technology investments by establishing a clear price signal.
  - Mobilizes a valuable source of revenue for climate, social, or broader fiscal objectives.
  - Generates domestic environmental co-benefits (such as reductions in local air pollution deaths).
  - Is straightforward to scale up administratively (building off established capacity for the carbon tax and/or the ETS).

*Source: wpiea2021246-print-pdf - 13.5 percent below the 2020 BAU.*

### 30.      To make headway on Mexico’s 2030 mitigation pledge, carbon pricing will need

### To make headway on Mexico’s 2030 mitigation pledge, carbon pricing will need

### Carbon pricing design principles and options
- Principles required to meet Mexico’s 2030 mitigation pledge:
  - (i) comprehensively cover emissions;
  - (ii) establish a rising and predictable price to induce the bulk of emissions reductions; and
  - (iii) avoid unnecessary inefficiencies due to emissions exemptions or overlapping policies.
- Policy instruments that can meet these principles:
  - Carbon tax;
  - Emissions Trading System (ETS);
  - Hybrid approach with taxes and ETSs covering different emissions sources.
- Institutional note: choice between instruments depends in part on which ministry is primarily responsible for mitigation policy (carbon taxes under finance ministry; ETS under environment ministry).

### Carbon tax: design and implications
- Most effective form: price all CO2 emissions at the same rate, with tax rate ramping up predictably each year.
- Requires removing existing exemption for natural gas so all fossil fuels in all sectors are taxed in proportion to their full carbon content.
- Illustrative ramping example:
  - If maximum acceptable tax rate in 2030 is US$75 per ton, tax could start from US$25 per ton in 2022 and ramp up by US$6 per year.
- Revenue treatment:
  - Revenues from the carbon tax accrue automatically to the finance ministry and could be used for general or climate purposes.
- Legal note:
  - Raising revenues for general budget purposes from a carbon tax may require amending the General Law of Ecological Balance and Environmental Protection and the General Law of Climate Change.

### Key elements of a comprehensive mitigation strategy (supporting measures)
- A balance between pricing and reinforcing measures—especially feebates or regulations—at the sectoral level.
- Public investment in clean infrastructure networks (e.g., electric vehicle charging stations, high-voltage transmission lines) and market reforms (e.g., in petroleum supply) to enhance competition and FDI.
- Recycling of carbon pricing revenues to boost the economy (e.g., lowering taxes on work effort and investment or funding socially productive investments), ensuring equitable distribution across households.
- Just transition measures for vulnerable groups (stronger social safety nets, tax reliefs for low-income households, assistance programs for displaced workers and at-risk regions).
- Measures to limit impacts of carbon pricing on industrial competitiveness (including potential use of border carbon adjustments).
- Measures aimed at broader GHG sources beyond energy-related CO2, including emissions from extractive industries, agriculture, and forestry.

### ETS: coverage, price dynamics, and fiscal opportunities
- Current ETS coverage: power and industry sectors (where emissions are generally more responsive to pricing).
- Extending ETS to transportation and buildings:
  - Would require applying it midstream to suppliers of fuels based on fuel carbon content.
- Cap trajectory:
  - A trajectory of progressively tighter emissions caps could be specified to align with the 2030 pledge but might lead to prices that exceed acceptable levels.
- Price containment and stability options:
  - Combine ETS with a ceiling price where extra allowances are put into the system at this price to prevent further price increases.
  - Combine ETS with an exogenous price floor (e.g., minimum price on allowance auctions) where the floor ramps up predictably over time.
  - Linking with other trading systems is another option but would largely determine prices outside Mexico.
- Fiscal treatment:
  - If allowances were fully auctioned (with revenues transferred to the finance ministry), ETSs would raise the same revenue as an equivalently scaled carbon tax.
  - Freely allocating allowances in lump sum provides windfall profits to firms and forgoes fiscal revenues; motivation is to address competitiveness concerns, but a border carbon adjustment may be more effective.

### Hybrid approach
- ETS could address emissions from power and industry; carbon tax could address transportation and building sectors.
- Cost effectiveness requires aligning carbon prices across tax and ETS (e.g., setting a trajectory of price floors under the ETS equal to the trajectory of carbon tax rates).
- Example of hybrid practice: EU power and industry covered by EU-wide ETS while several member states apply national carbon taxes to transportation and buildings.

### Quantitative assessment: IMF staff projections and impacts
- IMF staff projection: a carbon price of around US$75 per ton by 2030 is in line with Mexico’s conditional mitigation target for 2030, in the absence of other mitigation measures.
- Emissions impact of progressively increasing carbon price to US$75 per ton in 2030:
  - Reduces CO2 emissions 23 percent below IMF-projected BAU levels in 2030.
  - Reduces GHGs excluding LULUCF by 21 percent in 2030.
- Pathway to net-zero:
  - A price above US$75 per ton would be needed to stay on a net-zero emissions pathway by 2050.
- Sectoral distribution of CO2 reductions under US$75 carbon price:
  - 57 percent from power;
  - 28 percent from industry;
  - 14 percent from transportation;
  - 2 percent from buildings.
- Energy price effects under US$75 carbon price in 2030 relative to BAU:
  - Coal prices increase by 300 percent;
  - Natural gas prices increase by 87 percent;
  - Electricity prices increase 29 percent;
  - Price of other petroleum products increase 19–25 percent.
- Revenue estimate for US$75 carbon price in 2030:
  - Could raise revenues of 1.8 percent of GDP ($26 billion) in 2030.
  - Revenue shares by fuel:
    - Natural gas: 36 percent;
    - Gasoline: 28 percent;
    - Diesel and other oil products: 30 percent;
    - Coal: 5 percent.
  - Revenue estimate accounts for base erosion of pre-existing fuel taxes or profits from Pemex.
- Health co-benefits (2021–30 cumulative) from a carbon price rising to US$75 by 2030:
  - Would save 11,600 premature fatalities from local air pollution exposure.
  - 68 percent of avoided deaths are people over the age of 65 years.
  - 82 percent of avoided deaths are in urban areas.
  - 14 percent of avoided deaths are due to reduced use of coal; 73 percent due to reduced use of oil products.
- Economic efficiency cost and net welfare impacts under US$75 carbon price in 2030:
  - Economic efficiency cost equivalent to about 0.3 percent of GDP in 2030.
  - Domestic environmental co-benefits offset these efficiency costs.
  - Adding global climate benefits increases environmental benefits from 0.3 to 0.9 percent of GDP (three times the economic efficiency costs).
  - Climate benefits in this accounting are taken to be $75 per ton of CO2.

### Role of complementary sectoral mitigation instruments
- Need for reinforcing measures at sectoral level because they may be more acceptable politically though less efficient economically.
- Justification: sectoral measures can avoid political difficulties associated with significant increases in energy prices and resulting burdens on households and firms.
- Recommended instrument: revenue-neutral feebates (fiscal analogue of emission rate regulations):
  - Feebates provide a sliding scale of fees on products/activities with above-average emission rates and rebates for those with below-average rates.
  - Advantages of feebates:
    - Promote full range of behavioral responses for reducing emission rates.
    - Cost effective: reward proportional to reduction in emission rate.
    - Maintain approximate revenue neutrality as fees offset rebates when fleet average is updated.
  - Feebates can be implemented quickly with minimal administrative cost in sectors building off existing vehicle taxes and ETS capacity.

### Transportation: specific measures and metrics
- Road transportation challenges:
  - Difficult to decarbonize through carbon pricing alone due to modest impact on retail fuel prices and public resistance.
  - Mexico’s current CO2 emission rate standard for cars: 136 grams CO2/km.
  - Electric vehicles share of new vehicle sales in 2018: 0.1 percent.
- Feebate integration with vehicle registration tax:
  - Feebate formula: CO2 price × [CO2/km ─ CO2/km of the new vehicle fleet] × [average lifetime vehicle km].
  - Emission rate data by model currently used to administer CO2/km standards provides data needed to assess fees and rebates.
- Illustration of feebate impacts at a CO2 price of $400 per ton:
  - Subsidy for zero emission vehicles: $5,500;
  - Tax on a vehicle with 200 grams CO2/km: $2,600.
- Broader transport fiscal reforms:
  - Introduce distance-based charges varying with prevailing degree of road congestion (higher charges per km in congested conditions) to manage congestion efficiently and maintain funding as fuel tax bases erode.

*IMF staff: wpiea2021246-print-pdf*

### 47.      Ideally a complementary instrument for the power sector—that avoids a

### wpiea2021246-print-pdf - 47.      Ideally a complementary instrument for the power sector—that avoids a

### Power sector: carbon pricing versus feebates
- Combined behavioral responses under carbon pricing account for about 65 percent of the CO2 reductions in the power sector under a US$75 carbon tax in Mexico in 2030; the other 35 percent comes from reductions in electricity demand.
- Cost-effective generation mix in 2030 under a US$75 carbon tax: 
  - 2 percent coal
  - 42 percent gas
  - 9 percent hydro
  - 26 percent solar
- Carbon pricing:
  - Promotes a wide set of responses: (i) shifting from coal to gas; (ii) shifting from coal and gas to renewables; (iii) shifting to nuclear and CCS (excluded from IMF staff modelling); (iv) efficiency improvements lowering coal/gas per kWh.
  - Emissions reductions are cost-effectively allocated because the carbon price provides the same reward per ton of CO2 reduced across responses.
  - Increases electricity prices because generators pay for all emissions and pass costs forward.
- Feebates for the power sector:
  - Fee formula: CO2 price × [CO2/kWh ─ pivot point CO2/kWh] × electricity generation.
  - Incentivize any behavioral response that lowers plant emission rates; a generator gets the same benefit for any response that reduces CO2 by an extra ton.
  - Can be approximately revenue neutral if the pivot point reflects recent industry average emission rates; pivot point trajectory can be updated to preserve revenue neutrality.
  - Lower impact on electricity prices on average because a generator is not charged for their emissions on average.
  - Implementation capacity: minimal incremental capacity needed given Mexico’s pilot ETS monitors generation emissions.

- Illustrative US$50 per tonne feebate impacts (per kWh):
  - Fees: 6.6 cents (coal), 4.3 cents (diesel), 0.2 cents (natural gas).
  - Subsidy: 4.8 cents per kWh for renewables.
  - Fees rise and renewable subsidies decline as pivot point emission rate is updated over time.

### Industry
- Energy-intensive sectors: steel, chemicals, metals, cement, glass, paper.
- Emissions composition in industry: about 60 percent from fuel combustion in furnaces; 40 percent process emissions.
- Feebate design for industry:
  - Firm fee: [CO2 price] × [CO2/output ─ industry-wide average CO2/output] × [firm output].
  - Applies to both fuel combustion and process emissions.
  - Avoids a first-order burden on the average producer (average producer pays no charge on remaining emissions).
  - Can build on existing ETS monitoring procedures.

### Buildings
- Emissions shares:
  - Oil combustion in homes (space heating): 4 percent of energy-related CO2 emissions in Mexico.
  - Residential use of electricity (indirect): 7 percent of energy-related CO2 emissions.
- Household electricity use (2018): 61 percent appliances, 22 percent air conditioning, 17 percent refrigeration.
- Mitigation channels: insulation, cleaner/more efficient heating (including electric heating), energy-efficient lighting and appliances, digitalization (“smart” homes), renewable-based water heating.
- Market failures that hinder renovations: landlord-tenant split incentives, lack of upfront funds, uncertainty about energy savings, contractor quality uncertainty.
- Policy context: 2017 roadmap to reduce energy consumption by 35 percent in buildings and construct near-zero energy buildings by 2050; by 2030 all states to enforce an energy building code; no national retrofitting strategy for existing buildings.
- Feebate applications in buildings:
  - Appliance feebate formula: CO2 price × CO2 per unit of energy × [energy consumption per unit ─ industry-wide energy consumption per unit] × number of units.
  - Example metric for refrigerators: kWh per cubic foot cooled; number of units measured in cubic feet.
  - Possible feebates: taxes on oil-based heating systems and subsidies for electric heat pumps; integrate building performance feebates into property taxes.

### Fugitive emissions from extractives
- Leak sources: most oil fugitive leaks from extraction; natural gas leaks also from processing, transmission, storage, distribution.
- Mitigation possibilities: reinjecting gas or storage, using methane for on-site/regional power generation, compressing/liquifying for sale, improved maintenance of processing and distribution infrastructure.
- Pricing approach:
  - Use default leakage rates with rebates for firms demonstrating lower leakage via mitigation and continuous monitoring.
  - Fuel suppliers could be taxed on default leakage rates with rebates for verified lower leakage.
- Monitoring limitations: technologies provide discrete measurements at limited sites; improving but imperfect.
- Illustrative charge: an emissions tax of $60 per ton on fugitive emissions would apply charges (prior to mitigation) of approximately:
  - $1.2 per barrel of oil
  - $0.2 per thousand cubic feet of natural gas
  - These charges are equivalent to about 2 and 6 percent of current supply prices respectively.

### Forestry
- Main channels to increase carbon storage nationwide: (i) reducing deforestation; (ii) afforestation; (iii) enhancing forest management (planting larger trees, fertilizing, thinning, increasing rotation lengths).
- Co-benefits of expanding forest coverage: reduced water loss risk, floods, soil erosion, river siltation.
- Mexico NDC forestry commitment: unconditionally reduce CO2 emissions from the forestry sector by 144 percent in 2030 from a BAU baseline of 32 million tons of CO2 to negative 14 million tons.
- National feebate design for landowners:
  - Fee: [CO2 rental price] × [carbon storage on their land in a baseline period ─ stored carbon in the current period].
  - Rewards all three channels (reduced deforestation, afforestation, improved management) via reduced fees or increased subsidies.
  - Periods can be averaged across years to address lumpy changes due to harvesting.
  - Feebates can be scaled over time to be revenue-neutral in expected terms.
  - Administration: Ministry of Finance could use the registry of landowners from business tax collection; landowners expecting rebates may politically support the program.
- Payment design:
  - Prefer rental payments (carbon rental) over one-off upfront payments to avoid reversals and complex ex-post re-payment procedures.
  - Rental payment should equal carbon price × interest rate × number of years in a period.
  - Carbon price must rise over time to provide ongoing incentives.
  - Partial exemptions may be warranted for timber harvested for long-lived wood products because carbon is released with delay.
- Monitoring and verification:
  - Forest carbon inventories use satellite monitoring, aerial photography, and on-the-ground tree sampling.
  - Satellite images detect land-cover change (e.g., clear-cutting).
  - Carbon per hectare varies with productivity, species, management; LIDAR aerial photography can estimate wood volume cheaply; on-the-ground sampling still needed periodically.
  - Administrative costs can be limited (e.g., sampling every several years).
  - Feebates resemble environmental services payment programs (e.g., Costa Rica) though feebates have not been used previously in forestry.

### Agriculture
- Agricultural GHG composition:
  - 50 percent from enteric fermentation (livestock methane).
  - 20 percent from manure (nitrous oxide).
  - 18 percent from crops (nitrous oxide from soils, intensive fertilizer use).
- Mitigation channels: reduce livestock herds, reduce crop production for feed, promote dietary shifts toward plant-based and poultry diets.
- Pricing and acceptability:
  - Direct monitoring at farm level not practical; emissions can be proxied using farm-level data and default emission factors.
  - Proxy emissions taxes may face political opposition and risk carbon leakage by reducing competitiveness of Mexican farmers.
- Feebate options for agriculture:
  - Study feebates based on GHG-equivalent emission rates per hectare or per nutritional value; disaggregation (e.g., higher pivot points for beef, lower for crops) may improve acceptability but reduce incentives to shift activities.
  - Alternative: emissions fee with revenues recycled to agriculture as rebates proportional to farm output value; fees and rebates could be integrated into business tax collection for farmers.
  - Demand-side measures: taxes on meat and dairy products (domestic and imported) to promote household-level demand response.

### Transition policies — distributional incidence and revenue recycling
- Distributional concerns: carbon pricing can raise energy prices and impose burdens disproportionately on poorer households; most household burden occurs indirectly as industry energy cost pass-through raises consumer prices.
- Assessment methodology used:
  - Two-step approach: (1) input-output table calculates effects on consumer goods (adjusted for energy efficiency trends reducing energy per unit output); (2) map price increases to household budget shares using household expenditure survey data.
  - Input-output tables from GTAP; household survey from 2018 (Chepeliev 2020).
- Revenue recycling scenarios (for a $75 carbon price in Mexico in 2030) illustrated in Figure 19:
  - Pre-recycling: absolute and consumption-relative impacts on consumption deciles from price increases in energy and non-energy goods.
  - Mixed recycling: assume 25 percent of revenues used for a targeted transfer (target bottom 4 deciles with 75 percent coverage and 25 percent leakage) and 75 percent used to reduce labor taxes by raising lower income thresholds.
  - Fully targeted regional transfers: assume all revenues fund the same targeted transfer with shown impacts on urban (orange) and rural (green) households.
- Implication: targeted transfers and labor tax reductions can offset distributional burdens of carbon pricing; targeting design and coverage/leakage rates materially affect outcomes.

*Italicized final attribution: Source: IMF staff calculations and analysis in the provided content unit.*

### 66.      Modelling results show a $75 carbon price applied to all fossil fuel CO

### Modelling results show a $75 carbon price applied to all fossil fuel CO2 emissions in 2030 imposes a burden on the average household of 2.7 percent of their consumption

### Distributional impacts of a $75 carbon price in 2030
- Average household burden: 2.7 percent of their consumption.
- Burdens relative to consumption decline, but only slightly, for higher income deciles.
- Burdens are largely driven by indirect increases in the price of general consumption goods.
- Estimates overstate net household burden because they:
  - Ignore partially offsetting domestic environmental benefits, especially local air pollution mortality.
  - Ignore the benefits from recycling carbon pricing revenues.

### Revenue recycling options and distributional outcomes
- Fully compensating income groups would use the following shares of carbon pricing revenues:
  - Bottom 10 percent: 7 percent of revenues.
  - Bottom 20 percent: 10 percent of revenues.
  - Bottom 30 percent: 17 percent of revenues.
  - Note: Actual revenue needs would be larger if social protections involve significant leakage to higher income groups.
- Example reform that is pro-poor and equity-enhancing:
  - Use 25 percent of revenues for a targeted, unconditional cash transfer aimed at the bottom four consumption deciles (footnote assumptions: coverage rate of 75% and leakage rate of 25%).
  - Use 75 percent of revenues to reduce labor taxes through increasing lower income thresholds.
  - Net effects:
    - Bottom four deciles: net benefits amounting to about 3 percent of consumption.
    - Next three deciles: approximately no better or worse off.
    - Wealthier households: worse off on net by 1.1 percent of consumption.

### Regional equity and tradeoffs
- Using all revenues for a targeted transfer would enhance regional inequity because the rural poor would benefit more, by about 7 to 27 percent of annual consumption.
- Tradeoff: cash-transfer recycling enhances regional equity for poor rural households but reduces efficiency because transfers do not reduce the labor tax wedge.

### Net mitigation and alternative uses of revenues
- Revenue recycling through a reduction in labor taxes can offset 85 percent of the burden of carbon pricing on the average household.
- Revenues could alternatively be used for investments to meet Sustainable Development Goals which boost the economy and have important welfare benefits for the poor.
- Other just transition measures such as retraining and other employment support to carbon-intensive regions and industries may be needed.

### Worker and regional assistance (Section B)
- Mexico needs to develop:
  - A national system of unemployment insurance.
  - Improved targeting of social benefits.
  - Strengthened active labor market policies.
- Measures could include extended unemployment benefits, training and reemployment services, and financial assistance related to job search, relocation, and health care.
- Potentially useful features:
  - Outreach to increase awareness and take-up.
  - Tailoring job training to the needs of firms in energy-intensive sectors.
  - Wage insurance or tax credits, especially for older workers.
- Scale of support needs to be sufficiently generous.
- Attention should be paid to potential employment impacts of climate change on employment (see Box 4).

### Potential Employment Impacts of Climate Change and Mitigation (Box 4)
- Labor market characteristics:
  - Prevalence of informal employment across firm-size categories and economic sectors.
  - Large share of employees in informal contractual relationships at formal firms.
  - Main drivers of informality include excessive regulatory burden including labor regulation, and an insufficient social protection system.
- Most labor-intensive sectors (2021Q1 employment and output shares shown in figure): Agriculture; Domestic trade and hospitality services; Construction—these sectors are dominated by informal employment.
- Climate risks:
  - Climate change affects labor productivity and sectoral employment; larger impact on lower-income groups, informal workers, and the poor.
  - Higher temperatures potentially reduce worker productivity; frequent heatwaves reduce local employment, particularly for lower-wage work and non-farm labor; increases internal migration and emigration.
  - Tourism regions (Yucatan Peninsula and Caribbean coast) are exposed due to critical infrastructure vulnerability to flooding.
  - Agriculture and fisheries affected by higher temperatures and more frequent droughts; coffee production projected to decline as droughts become more frequent; concerns about emigration due to declines in agricultural productivity.
  - Gulf of Mexico hubs (eight major fishing ports and two industrial ports) expected to be adversely affected by more frequent extreme weather events; ocean acidification threatens fisheries.
- Health impacts:
  - Higher mortality from outdoor air pollution (stroke, heart disease, lung cancer, chronic respiratory diseases) affects lowest income groups more and adds pressure on Mexico’s health system.
- Impact of mitigation policies:
  - Aggregate employment impact of decarbonization policies is generally small.
  - Higher energy prices may adversely affect employment in high-pollution industries and less productive firms.
  - Environmental policies found to have positive effects on employment and productivity of low-pollution industries and more productive firms.
  - Net impact depends on labor market adjustment capacity.
  - ILO (2014) identifies high potential for green jobs in organic agriculture, green construction, and manufacturing in Mexico.
- Informality effects:
  - Carbon prices could reduce the share of informal firms through a cleansing effect.
  - Impact on informal employment within formal firms is ambiguous—could increase as firms offset higher production costs, or decrease if firms invest more in worker skills and raise labor productivity.

### Support to affected regions and firms
- Assistance should go beyond support to displaced workers because:
  - Firm closures affect communities with limited alternative employment opportunities and declining home values hinder mobility.
- Suggested measures:
  - Assistance for reclaiming abandoned drilling sites.
  - Temporary budget support for local governments to create jobs and bridge the transition.
  - Additional investments or geographically targeted policies (subsidies or grants to individuals or firms) to help regions engage in economically viable and sustainable opportunities.

### Use of carbon tax revenues to support structural reforms
- Using carbon tax revenues to reduce regulatory burden, strengthen social protection, and promote competition would:
  - Enhance positive employment impacts of mitigation policies.
  - Potentially reduce informality.
- Positive impact of green transition on employment stronger in countries with better quality institutions.
- Since carbon pricing acts as a withholding tax for informal firms, it may be more effective in reducing emissions relative to regulations in countries with larger informal economies.

### Industrial competitiveness impacts of carbon pricing (Section C)
- Carbon pricing increases industrial production costs via three components:
  - Direct tax payment or allowance purchase requirement for direct emissions.
  - Abatement costs to cut emissions (switching to cleaner but costlier technologies and fuels).
  - Indirect payment for carbon charges embodied in inputs, especially electricity.
- At modest abatement levels, direct tax payment expected to be much higher than abatement costs.
- A $75 carbon price in 2030 would increase prices:
  - Iron/steel and cement: about 14 percent (relative to BAU costs in 2030).
  - Other metals (aluminum, copper, titanium): about 8 percent.
- Competitiveness concerns may arise for Mexican firms exporting to world markets.
- Some studies suggest carbon pricing may not have significant impacts on competitiveness; firms may benefit from revenue recycling (e.g., reduced labor tax burdens).

### Cross-country differences and benchmarks
- Unit production cost increases tend to be larger for Asian EMEs (e.g., China, India) than for Mexico and other countries in the American region for a given carbon price due to higher embodied carbon in industrial products.
- Currently envisioned free allowance allocations for industrial firms become less effective with higher carbon prices and deeper decarbonization.
- Growing interest in border carbon adjustments (BCAs) as an alternative to free allowances:
  - BCAs impose charges on carbon content of imported products and may provide rebates for carbon embodied in exports.
  - BCAs can prevent deterioration in competitiveness and allow collection of revenue on domestic firms.
- For ETS countries, BCAs can take the form of an allowance purchase requirement for foreign exporters with rebates for domestic exporters.
  - A requirement that importers acquire allowances from the domestic ETS without changing total allowances may increase allowance prices and uncertainty.
  - An alternative is a separate pool of allowances aligned with domestic ETS price, operationally equivalent to an import tax.
  - Primary policy goal for Mexico: compensate industrial exporters for domestic carbon pricing without undoing mitigation incentives—export rebates based on exogenous industry emissions benchmarks may achieve this.

### Designing BCAs: trade-offs and features
- Key considerations and trade-offs in designing BCAs:
  - Limiting BCA coverage to EITE industries simplifies administration and focuses on most vulnerable industries.
  - Using domestic industry benchmarks to infer embodied carbon preserves international competitiveness for Mexican exporters and simplifies administration but might provoke legal challenges from trading partners with lower emissions intensity.
  - BCAs could be adjusted for carbon pricing in trading partners.
  - Current legal uncertainties under the WTO may be clarified as the EU and others implement BCAs; their experience should provide lessons.

### Revenue and incidence of a $75 BCA for EITE industries
- A $75 BCA for EITE industries would:
  - Raise revenues of about 0.9 percent of GDP in 2030 from import charges.
  - Be approximately offset by revenue losses from export rebates.
  - Under a domestic industry benchmark, the bulk of import charge revenue would come from U.S. exporters; under country-specific benchmarks slightly more revenue would come from China than the U.S.
  - Nearly all outlays for export rebates would be for exports to the U.S.
- Effective incidence:
  - The effective incidence on trading partners is likely much lower than formal revenues collected because much of the import charge would likely be passed forward to domestic consumers in Mexico as higher product prices.

### Limits of unilateral BCAs and international approaches
- Unilateral BCAs are not effective for scaling global mitigation action because they price emissions embodied in traded products, which usually account for less than 10 percent of countries’ total CO2 emissions.
- An international carbon price floor among large emitting countries would be far more effective due to much greater emissions coverage and coordinated action.
  - A price-floor arrangement could focus on a small group of large emitters (e.g., the G20 is 85 percent of global emissions).
  - It could be designed equitably with higher price floors for advanced countries and transparent compensation mechanisms for lower income EMEs, and flexibly to accommodate participants that achieve equivalent emissions cuts through other policies.
- Mexico could promote dialogue on a regional carbon price floor with potential participants that have carbon pricing in place (e.g., Argentina, Chile, Colombia) to prototype a price floor arrangement.

### Investment needs for clean energy transition (Section VI.A)
- Global model estimates for a 2°C target:
  - Increase projected global energy investment in 2030 from 2 percent of GDP to 2.3 percent of GDP.
- Corresponding energy investment needs for Mexico:
  - Business-as-usual scenario: 1.7 percent of GDP.
  - Consistent with a 2°C temperature target: 1.9 percent of GDP.
- Composition challenge:
  - Share of low carbon energy supply investment needs to rise from 40 percent in 2020 to 70 percent in 2035 and 80 percent in 2050.
- REmap 2030 estimate for Mexico:
  - Up to 26 percent of power generation by 2030 from renewables (wind and solar), hydropower, geothermal energy supplying, and biomass.
- Even if shifting supply investment toward low carbon sources requires higher investment in renewables, total energy cost would decline over time as renewables require less expenses for fuels.
- Adding investment needs for adaptation would increase incremental investment needs by a further 0.3 percent of GDP.

*Source: IMF staff analysis in the chapter text provided.*

### 83.      Energy infrastructure—for example, power plants and power grids—has an

### 83.      Energy infrastructure—for example, power plants and power grids—has an

### Investment horizons and needs
- Energy infrastructure has an expected lifetime of 30–60 years. Choices made today will thus determine emissions for decades.
- Extra investment in energy efficiency is also needed for:
  - buildings (for example, design, heating, cooling, appliances),
  - transportation (for example, electric cars), and
  - industry.
- Demand-side investments can speed up the reduction in carbon emissions because of their shorter life cycles compared with energy infrastructure (IEA 2018).
- Incremental investment needs would be greater if they also covered transportation and other infrastructure (water, sanitation, and telecommunication) that are essential to deliver the Sustainable Development Goals (SDGs), including SDG7 on clean energy access, and enhance the adaptive capacity to climate change (OECD 2017, IPCC 2018, and NCE 2018).
- Taken together, incremental investment needs for climate change mitigation and adaptation in Mexico amounts to 0.5 percent of GDP (April 2020 Fiscal Monitor, Chapter 2).

### Supporting policies for clean-technology investment
- Mexico has a large and diverse renewable energy resource base; with the right mix of policies (e.g., dealing with externalities and reducing risks for investors in renewable energy), the country can attract large-scale investment in renewables and set a pathway toward significantly reducing GHG emissions.
- Even with robust carbon pricing, investment in low-carbon technologies may be insufficient because of technology-related market failures and impediments, including:
  - Knowledge spillovers from R&D and technology diffusion that may prevent firms from capturing the full social benefits of developing and using new technologies;
  - Scale economies that may deter firms from investing in a clean technology until they are confident about the size of the market;
  - Network externalities where additional infrastructure needed for one investor (for example, to connect a remote renewables site to the power grid) could potentially benefit other firms;
  - Market distortions that might impede low-carbon investment (for example, unfavorable business environment, regulated energy pricing, incomplete property rights); and
  - Financial market imperfections reflecting limited financial instruments for low-carbon investments and the shorter-term horizons of investors.
- Approaches to address these impediments include:
  - public R&D support;
  - targeted fiscal incentives (e.g., capital grants, tax credits, per-unit subsidies, feed-in tariffs);
  - regulations (e.g., on renewable generation shares) to deal with knowledge spillovers;
  - public infrastructure investment (e.g., on charging stations for electric vehicles) to tackle network externalities;
  - price liberalization and creating an enabling business environment to reduce market distortions; and
  - financial sector policies to mobilize financing for climate change mitigation (examples: standards and prototype green bond contracts; amendment of prudential regulations and collateral eligibility criteria; shifts in portfolio choices of central banks and institutional investors).
- Policy design considerations and examples for Mexico:
  - Avoid policy inconsistencies and redundancies (for example, Mexico currently subsidizes renewables and fossil fuels at the same time). Preferential treatment of PEMEX and CFE insulates them from the improving competitiveness of renewables and might deter low-carbon investment from new entrants.
  - Encourage competition in the power market to foster investments in clean energy and encourage retirement of the less efficient power plants.
  - Increase R&D support now and gradually reduce support over time when technologies are widely deployed and used by firms and households. Public spending on energy R&D could focus on technologies currently furthest from the market with strong social benefits (for example, smart grids, infrastructure for electric vehicles, and batteries to store intermittent renewable power).
  - Shift subsidies as technologies mature: as electricity generated from renewables is currently cheaper than fossil-fuel-generated power, subsidies to renewables could be shifted from R&D to deployment and then progressively phased out.
  - Production-based fiscal incentives, such as fixed subsidies per kilowatt hour of renewable energy, are more flexible than (i) investment-based incentives; (ii) regulations that force adoption regardless of future costs; and (iii) feed-in tariffs guaranteeing minimum prices per kilowatt hour that do not permit supply responses to changing market conditions (Löschel and Schlenker 2017).
  - Mexico has moved away from pre-defined feed-in tariffs and has adopted tendering processes to reduce costs.
  - Increase public infrastructure investment to tackle network externalities (for example, funding of smart electricity grids to accommodate an intermittent supply of renewables). The new regulatory framework permitting the Mexican government to contract with private firms could alleviate the challenges of integrating wind into the power grid.
  - Policies in the financial sector can help mobilize financing for climate change mitigation. Recent cross-country proposals have focused on fostering financing of green projects and companies through (i) establishment of standards, prototype green bond contracts, and benchmark indices of securities that meet environmental norms; (ii) amendment of prudential regulations and collateral eligibility criteria; and (iii) shifts in the portfolio choices of central banks and institutional investors (see IMF 2019a for details).

### Summary — Main recommendations
- Define a net zero emissions target for 2050.
- Align the 2030 emissions target with the long-run targets.
- Build off the existing carbon tax and/or ETS to establish a carbon price that covers all fossil fuel emissions and rises predictably over time, insofar as possible aligned with the 2030 emissions target.
- Integrate a feebate into the vehicle registration tax system to promote adoption of clean vehicles.
- Consider feebates to reinforce mitigation incentives in the power and industry sectors without a significant tax burden on the average firm.
- Consider feebates to promote adoption of energy efficient appliances and (through integration into property taxes) energy-saving building renovations.
- Consider proxy emissions pricing schemes for the extractive and agricultural sectors and a feebate for the forestry sector.
- Use carbon pricing revenues for just transition measures and funding investments for Sustainable Development Goals.
- Consider more robust instruments for preserving international competitiveness with deeper carbon pricing, such as border carbon adjustments.
- Support low-carbon investments through enhanced competition; fiscal incentives that are appropriately scaled, targeted, and designed; and direct public infrastructure investment.

*Source: IMF staff content from the supplied chapter text.*

### ANNEX A. CARBON PRICING ASSESSMENT TOOL (CPAT)

### ANNEX A. CARBON PRICING ASSESSMENT TOOL (CPAT)

### Scope and purpose
- CPAT provides, on a country-by-country basis for 191 countries, projections of fuel use and CO2 emissions by major energy sector.
- The tool starts with use of fossil fuels and other fuels by the power, industrial, transport, and residential sectors and then projects fuel use forward in a baseline case.

### Baseline projection inputs and assumptions
- GDP projections: from the latest (post-COVID) IMF forecasts in the World Economic Outlook.
- Income and price responsiveness:
  - Assumptions about the income elasticity of demand and own-price elasticity of demand for electricity and other fuel products.
  - Fuel price elasticities are typically between about -0.5 and -0.8.
- Technological change: assumptions about the rate of technological change that affects energy efficiency and the productivity of different energy sources.
- International energy prices: projected forward using an average of IEA (which are rising) and IMF (which are flat) projections for coal, oil, and natural gas prices.
- Current fuel taxes/subsidies and carbon pricing are held constant in real terms in baseline projections.

### Data sources and parameterization
- Basic model parameterization uses data compiled from the International Energy Agency (IEA) on recent fuel use by country and sector.
- Carbon emissions factors by fuel product are from IEA.
- Non-carbon externalities per unit of fuel use in different sectors are based on methodologies described in Parry and others (2014, 2021b).
- Data on energy taxes, subsidies, and prices by energy product and country are compiled from publicly available and IMF sources, with inputs from proprietary and third-party sources.
- GDP projections adjustment: a modest adjustment in emissions projections is made to account for partially permanent structural shifts in the economy caused by the pandemic.

### Modeling the impacts of carbon pricing
- Impacts depend on:
  - (i) their proportionate impact on future fuel prices in different sectors;
  - (ii) a simplified model of fuel switching and electricity dispatch within the power generation sector;
  - (iii) various own-price elasticities for electricity use and fuel use in other sectors.
- The model projects how carbon pricing alters sectoral fuel prices, triggers fuel switching in power generation, and changes fuel use given assumed elasticities.

### Caveats and limitations
- The baseline abstracts from the possibility of mitigation actions (beyond those implicit in recently observed fuel use and price data).
- Assumed fuel price responses are plausible for modest fuel price changes but may not be for dramatic price changes that could drive major technological advances or non-linear adoption of technologies like carbon capture and storage.
- Fuel price responsiveness is approximately similar across countries in the model, though in practice responsiveness may differ across countries depending on energy system structure and regulations.
- The model does not explicitly account for:
  - upward sloping fuel supply curves;
  - general equilibrium effects (e.g., changes in relative factor prices that might feedback on the energy sector);
  - changes in international fuel prices that might result from simultaneous climate or energy price reform in large countries.
- Parameter values in the spreadsheet are chosen so results are broadly consistent with those from far more detailed energy models that, to varying degrees, account for the above factors.

*Source: ANNEX A. CARBON PRICING ASSESSMENT TOOL (CPAT) — wpiea2021246-print-pdf*

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_Source: https://www.imf.org/-/media/files/publications/wp/2021/english/wpiea2021246-print-pdf.pdf_