Climate change is expected to cause major shocks to the macro stability of most  economies. The public policy response needs to be wide-ranging, and include the use of fiscal instruments to foster green innovation, support green markets, and reduce climate-harmful activities. While increasingly used by developing countries to meet their NDCs, the environmental, economic and debt sustainability impact of fiscal instruments depend on their design, their combined use, the specific country context, and the sector considered. Peer exchange among Finance Ministries can support best practices to address climate change via fiscal instruments.

What are the key policy instruments?

Fiscal instruments for climate change can act on the revenue or the expenditure side.

Revenue side: Greenhouse gas (GHG) emissions impose an external cost on society and government budgets. For instance, they reduce agricultural yields, increase health care costs, and damage coastal infrastructures via sea level rise. Carbon pricing instruments make polluters internalize this cost, incentivising them to invest in green technologies and reduce emission generating activities while increasing social welfare and improving debt sustainability. The price signal leaves flexibility to polluters on how and to what extent to mitigate GHG emissions, thus allowing for cost-effective mitigation.  To date, about 20% of GHG emissions are covered by carbon pricing.

The price of GHG emissions can be increased with three types of fiscal instruments:

  • Emission trading scheme (ETS): an ETS limits the total amount of GHG emissions released in a jurisdiction, and the amount is expected to decrease over time. Polluters receive emissions permits that are exchanged on the market for a price. The price is freely determined by the market, and thus fluctuates, but authorities can establish minimum and maximum prices. To date, there are 25 ETS in place worldwide.
  • Carbon tax: the price is set by establishing a tax rate on GHG emissions or the carbon content of fossil fuels. The price signal is stable and increases over time. Contrary to an ETS, it does not directly cap emissions released in a jurisdiction.  To date, there are 26 carbon taxes in place in the world.
  • Reductions of fossil fuel subsidies: fossil fuel subsidies are a negative carbon price, i.e., they reduce the price of carbon emissions and counteract the abatement incentives set by ETS and carbon taxes. Although subsidies are not linked to the carbon content of the fuel, phasing them out increases the price of GHG emissions. 

Expenditure side: Governments can use expenditure side instruments to spur green innovation or investments in adaptation and environmental services. Companies may underinvest in green innovation because they are not able to fully internalize the benefits of their investments, or may invest in R&D that has higher private returns but less value for society. Past investments can condition future ones, potentially leading to carbon lock-in.

Fiscal instruments such as direct incentives or subsidies can spur the supply of or the demand for green technologies:

  • Supply-side subsidies: subsidies can increase the capacity to produce green innovation. Governments can, for instance, provide tax credits, grants or subsidized loans to companies that invest in green R&D, incentivizing investments that otherwise would not take place. 
  • Demand-side subsidies: these can increase the demand for green innovation, fostering its production and diffusion. In electricity generation, feed-in tariffs are a common type of demand-side subsidy, under which the authority: i) commits to purchase energy at a price and for a specified period from electricity producers adopting low-carbon technology (e.g., solar panels); ii) guarantees connection to a network. In 2015, 108 countries had feed-in tariffs into place.
  • Other expenditure side instruments: governments can use expenditure to incentivize behavior that mitigate climate change or improve resilience. A popular expenditure policy is payments for ecosystem services (PES), under which private entities receive a payment under the condition of voluntarily providing an ecosystem service, such as forest conservation.

What are the challenges and opportunities ahead? 

There are tradeoffs in the choice of fiscal instruments for climate policy in terms of their environmental effectiveness, efficiency, and impact on debt sustainability. Tradeoffs exist between expenditure and revenue side policies that go beyond the apparent fiscal appeal of the latter. For instance, economy-wide instruments such as carbon taxes can efficiently address carbon emission externalities, but alone they may not resolve sector-specific market failures like underinvestment in R&D for renewable energy, for which subsidies for green technology can be a useful complement. Tradeoffs also exist between specific instruments. For instance, the price signal stability under a carbon tax is better suited to drive abatement investments, but ETS with decreasing allowances ensure that total emissions decrease over time.

The environmental effectiveness, efficiency and debt sustainability effects of fiscal instruments can be different in the short- and long-run. For instance, revenue side policies can be more effective in the short term, but should be complemented with subsidies or incentives to produce significant long-term abatement. The optimal policy mix, therefore, varies depending on policymakers’ planning horizon.

Climate-fiscal policies also require significant adaptation to the country context, and it is common to find overlapping or counteractive incentives in place. For instance, the effective carbon price applied in a jurisdiction also depends on existing energy taxes. Similarly, the optimal size of demand-side subsidies may depend on the presence of fuel subsidies.

While fiscal instruments can advance mitigation efforts, the fiscal system also needs to be climate-resilient. Finance ministries can decide at an early stage to make preventive investment in adaptation, thereby reducing the rate of depreciation on the capital stock. Relying on remedial action in the wake of climate change means some economic output will always be lost. Climate change can also induce extreme weather events that critically damage the capital stock and cause a sharp drop in economic output. Fiscal buffers and financial contingencies are needed as part of the fiscal system. All these have implications to the overall fiscal status and influence climate-fiscal policy. Specific country conditions will again determine the optimal mix of preventive and remedial actions.

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

As governments increasingly use fiscal instruments to address climate change, good practice is emerging both on the revenue and the expenditure side.

Examples on the revenue side include:

  • Chile: in 2014 Chile adopted a carbon tax covering a significant share of the country emissions (about 55%) at a non-negligible tax rate (5 US$ per ton of carbon emissions).
  • India: in 2010 India implemented a carbon tax on coal where emissions were priced upstream, i.e., on the carbon content of the fuel. Upstream carbon taxation is administratively simpler than downstream taxation, i.e., direct taxation on carbon emissions, which requires more detailed emissions data.
  • Sweden: in 1991 Sweden adopted a carbon tax with a  clear upward trend in tax rate, reaching the current US$ 139/tCO2e. The steady rise of the tax rate reflects the increasing social cost of carbon emissions. This cost increases, for instance, due to the accumulation of GHG in the atmosphere.
  • British Columbia: in 2008 British Columbia implemented a revenue-neutral carbon tax and used part of the revenues to cut more distortive taxes, such as personal income taxes and corporate income taxes, and benefiting from efficiency gains.
  • China: In 2017 China launched an ETS that will soon be the largest in the world, expecting to cover about 3 billion tCO2e.
  • Kazakhstan: in 2018 Kazakhstan has relaunched its ETS after a period of suspension. The renewed scheme comprises an allowance reserve of about 35.27 million permits that authorities can sell in case of undesirable increases of market prices.
  • UK: The UK has introduced a carbon price floor, i.e., a mandated minimum carbon price, to support its ETS. The price floor was initially expected to increase over time but since 2016 is frozen at about US$ 25/tCO2e. Price floors can raise the price applied in the market and improve the price signal by reducing price variability.

Examples on the expenditure side include:

  • Brazil: in the 70s Brazil began a long-term subsidy program to support the use of ethanol as fuel. These long-term investments allowed the ethanol industry to develop despite fluctuations in oil prices, leading to a greener transport sector.
  • Ghana: Ghana has implemented a feed-in tariff program with a fixed, long-term, tariff rate that reduces uncertainty, and is therefore well suited to stimulate investments in green technologies.
  • Indonesia: Indonesia feed-in tariffs scheme offers targeted rates (i.e., higher rates) in regions where producing energy is more expensive to foster the diffusion of renewable energy.
  • Mexico: Mexico has adopted a Payment for Ecosystem Service that targets the highest-risk land, and it is thus better able to address deforestation risks than systems that utilize, for instance, a first come first served selection method.

Peer exchange among Finance Ministries offers the opportunity to have a constructive debate on how to best adapt fiscal instruments to reach individual NDCs.