Fiscal policies for climate change can affect the distribution of resources within a society and the competitiveness of low- and high-carbon sectors in the economy. For instance, they can lower the competitiveness of domestic energy intensive trade exposed (EITE) industries, or have regressive redistributive effects in economies where the poor spend a larger share of their income on energy consumption than the wealthy. Governments can implement policies to address distributional and competitiveness concerns and obtain public and industry support for climate-related fiscal instruments.

What are the key policy instruments? 

Governments can modify fiscal instruments for climate change to provide targeted assistance for selected stakeholders to address competitiveness concerns:

  • Border Tax Adjustments (BTA): BTA imposes a tax on imports and/or on exports to match the excess carbon price on domestic producers compared to foreign producers. When BTA applies to exports, domestic producers can claim a rebate. A well implemented BTA system maintains both abatement incentives and competitiveness.
  • Exemptions: exempting EITE industries from carbon pricing, either in full or partially,  reduces fiscal pressure on these sectors, preserving their competitiveness but also withholding any abatement incentives.
  • Output-Based Rebating (OBR): OBR provides a rebate to EITE industries in proportion to their share of output in the domestic market. These rebates offset the tax burden imposed by carbon pricing on EITE sectors, maintaining their competitiveness. The carbon price still applies, but there is a diminished incentive to reduce emissions .
  • Reductions of pre-existing taxes: Governments can use revenues from carbon pricing to reduce other taxes, such as corporate income taxes or energy taxes on EITE sectors. This policy maintains abatement incentives.
  • Support for adoption of low-carbon alternative technology: There is a wide range of technological options available to reduce carbon emissions in EITE sectors. Governments' targeted financing can foster the adoption of these technologies while providing some relief on EITE industries. These incentives could come from carbon pricing revenue recycling.

Measures also exist to address distributional concerns. Important examples include:

  • Cash transfers: revenues from carbon pricing can finance cash transfers to households or individuals to make the measure progressive or at least non-regressive. Evidence indicates that sometimes even a share of about 10-15% of revenues could compensate the poorest 20% of the population for the energy price increase.
  • Rate differentiation in feed-in tariffs: Governments can change feed-in tariff rates that concentrate incentives in areas where energy access is particularly poor.
  • Reductions of pre-existing taxes: Governments can use revenues from carbon pricing to reduce other taxes, such as income taxes on poor households or labor taxes.

What are the challenges and opportunities ahead?

Choosing the best corrective measures to fiscal instruments for climate policy presents various challenges.

  • The competitiveness and distributional effects, as well as the political feasibility, of fiscal instruments for climate change are not easy to predict and depend on, for instance: the design of the measure, such as whether and how much revenues are used for cash transfers to underprivileged households; the country context, e.g., whether the poor have access to renewable energies, such as solar panels, or relatively low energy technologies, such as energy efficient cooking stoves; and the time frame considered. For example, while exempting vulnerable industries from carbon pricing can maintain their short-term competitiveness, it can undermine their long-term ability to compete against foreign industries that receive green incentives.
  • Trade-offs exist between measures. For instance, broad-based cuts of more distortive taxes can benefit the economy as a whole, but may only partially safeguard the competitiveness of vulnerable sectors. Conversely, exemptions help vulnerable sectors, at least in the short term, but fail to internalize the social cost of carbon emissions and do not provide abatement incentives.
  • Other countries can constrain the use of fiscal instruments.  For instance, the WTO law compatibility of BTA is uncertain but may depend on the specific features of the instrument.

What are good practices and what can be learned from them?

As governments use various strategies to address the competitiveness and distributional effects of fiscal instruments for climate change and improve their political feasibility, good practice is emerging.  Examples include: 

  • British Columbia: The tax rate of British Columbia’s carbon tax has steadily increased from C$10/tCO2e to C$30/tCO2e until 2012. Phasing-in carbon pricing can lower vulnerable sectors' abatement costs, maintaining their competitiveness. British Columbia addresses competitiveness concerns also by reducing more distortive corporate taxes with revenues from carbon pricing.
  • Denmark: In 1995 Denmark imposed taxes on sulfur and carbon emissions. Revenues were used to subsidize companies’ investments in green technology and reduce labor taxation to address competitiveness and related political economy concerns.
  • Germany: Since 1990 Germany has in place a feed-in tariffs systems that, for extended periods, had very generous tariffs and forced utilities to accept energy generated via green technologies. These features aimed to foster technological innovation and allow entry in the market. The scheme  drastically raised the renewable energy share in the country, drove down the cost of clean production, and built a political constituency for carbon pricing.
  • Iran: In 2011 Iran implemented a fuel subsidy reform that increased the free market price of diesel by about 2000%. The Iranian government distributed per-capita electronic cash transfers to households to address distributional concerns and ease the political economy of the reform. 
  • Peru: Peru’s feed-in tariffs targets off-grid applications to address distributional concerns of inequitable access to electricity by varying tariffs by region, technology used, ownership type, and size of the plant. 
  • Sweden: in 1992 Sweden implemented an emission charge on nitrogen oxides (NOx). A benchmarked refund system complemented this charge where plants with average emissions per unit of output received a rebate. The scheme provides abatement incentives to plants while protecting their competitiveness.
  • Thailand: In 2006 Thailand implemented a feed-in tariff scheme that differentiates tariffs by region, plant type, and technology used. Tariff rates are differentiated to address distributional and political economy concerns.

Peer exchange among Finance Ministries offers the opportunity to have a constructive debate on how to best identify and steer the distributional and competitiveness effects of fiscal policies for climate change and improve their political feasibility.