Climate Change, Carbon Pricing and Energy Tax Expenditures

Climate change is moving up policy agendas worldwide. Last year’s COP21 was yet another wake-up call that the international community needs to take urgent action to reduce greenhouse gas (GHG) emissions. The main outcome of the meeting, the Paris Agreement, was a significant milestone in this regard as participants from both developed and developing economies committed to concrete emission reduction targets and to keep global temperature increase “well below” 2 Degrees Celsius.

Carbon pricing will be critical to reach this objective. Nonetheless, as discussed by a recent OECD report, putting a price on carbon is still a highly neglected policy instrument worldwide. Even using a broad definition of carbon pricing – including carbon taxes, taxes on energy use, e.g. excise taxes, as well as emission permits – the report, covering 41 OECD and G20 economies, shows that carbon prices are often zero or very low.[1] Given the broad consensus about the high effectiveness and efficiency of putting a price on carbon compared to other environmental policy instruments, this is striking.[2]

Low effective carbon prices in the context of energy taxation are the results of two factors. One is obvious: zero or low statutory rates on carbon and energy. The other one is more opaque, but significant: tax expenditures (TEs).

TEs are government benefits granted through the tax code. They take different shapes and forms including exemptions, deductions, credits, rate reliefs or deferrals. They can target a specific group of taxpayers as well as specific activities or regions. In contrast to subsidies paid out as direct government spending, their magnitude is often unknown. At the same time, they are widespread – also in the context of energy taxation.

Tax benefits targeting the consumption and production of a particular type of fuel, such as the tax rebate on diesel across several EU Member States, are cases in point. Tax privileges reducing taxation in certain regions – such as those for France’s overseas regions and some regions in Italy that face lower energy tax rates than the rest of the country – provide further illustrations. Similarly, countries such as Canada, France, Germany and Israel offer energy tax reductions to primary industries such as farming, forestry, fisheries and mining (OECD, 2015).

Energy Tax Expenditures Are Costly

TEs for the production and consumption of energy are costly. The 1.8 billion USD in suspended excise taxes on aviation fuels for domestic flights in China, close to a billion USD in fuel tax exemptions for agriculture in South Korea, as well as 0.6 billion USD in energy tax relief for energy intensive processes in Germany are cases in point (OECD, 2016b). In addition, they hinder the effectiveness and efficiency of energy taxation.

The taxation of diesel in the EU provides an example. The different tax rates for diesel and petrol in many EU economies was originated after WWII. As petrol was used by the better-off – who were able to afford cars – and diesel by the transport sector (e.g. trucks), governments started to tax gasoline at higher rates. Nowadays, the situation is different. Diesel remains widely used in the transportation sector, but has also made growing inroads into the market for private cars. In fact, diesel cars today tend to dominate sales in countries with reduced tax rates on diesel compared to gasoline (e.g. Luxembourg, Belgium, Portugal, Spain, France and Greece). As a result, the original redistributive rationale of the scheme has been eroded. Instead, governments are providing an incentive for the use of diesel and reduce both the effectiveness and efficiency of energy taxation (Transport and Environment, 2015).

The Controversial Case for Energy Tax Expenditures

Policymakers frequently seek to make the case for TEs on energy taxation based on the need for compensation to those that would otherwise suffer disproportionally from the burden of energy taxes. More in concrete, the implementation of energy TEs is often said to mitigate the potential negative effects of energy taxation both on equity and competitiveness.

In terms of equity, high energy taxes – they argue – hit lower income households more than others and, thus, trigger negative distributive effects. Several TEs are implemented to mitigate this impact and to ensure energy access for the poor. Nonetheless, the alleged regressive effect of energy taxation is far from indisputable (Flues and Thomas, 2015). Moreover, many TEs are neither effective nor efficient to raise the progressivity of energy taxation, or any other tax scheme (Avram, 2014).

Flues and Thomas (2015) highlight that the incidence of energy taxation is country and fuel specific, and can be both progressive and regressive. In fact, Di Bella et al. (2015) indicate that a significant share of TEs on energy benefit high-income households. In Venezuela, the richest 20% of the population receive six times more fuel subsidies per person than the poorest third of the population. In Bolivia, the poorest 40% of households only capture around 15% of total fuel subsidies, and the situation is even worse in Haiti, where roughly 90% of fuel subsidies are captured by the richest 20% of the population. This leakage considerably jeopardizes their primary goal (i.e. increase the affordability of energy for lower income households) and, at the same time, exacerbates the already startling inequality in the region.

As for competitiveness, the argumentation is similar, but gets a bit trickier because of the higher mobility of capital and, hence, the role of tax competition between countries. Energy-intensive, trade-exposed (EITE) sectors may decide to relocate if they consider effective energy tax rates to be too burdensome (Metcalf, 2013). This, in turn, triggers two main effects: i) from a national perspective, the tax base is eroded; and ii) from a global point of view, the reduction of global GHG emissions is significantly jeopardized because of carbon emissions leaking to lower tax jurisdictions (Reinaud, 2008). The following quote from a 2012 policy paper by the UK Department for Business, Energy and Industrial Strategy illustrates this point: “… the cumulative effect of [energy and climate change] policies has contributed to a cost differential between the UK and other countries … without targeted support, this may: affect the competitiveness of businesses in sectors such as steel, paper and cement, make the UK a less attractive place to invest [and] increase the risk that these businesses move out of the UK to countries with less ambitious low carbon targets.”

While concerns around carbon leakage are well founded, the question to what degree carbon pricing would indeed lead companies to relocate is subject to debate.[3] In addition, TEs to compensate EITE sectors or firms often benefit the least productive among them, which cannot adapt themselves to higher energy prices and hence hinder the potential positive effect of energy taxation on innovation and productivity (Albrizio et al., 2014). Last but not least, TEs for energy intensive sectors run counter to the “polluter pays principle”[4] and hence jeopardize the primary goal of the tax scheme, i.e. to cut GHG emissions.

Energy Taxation is Critical. Energy Tax Expenditures Weaken Its Impact

Energy taxation is a critical pillar to mitigate climate change. TEs on energy taxes weaken its impact. Even if their stated goals – e.g. energy access for the poor, international competitiveness, economic development – appear to be benign, TEs on energy taxes are often poorly targeted, ineffective in reaching their objectives, and create several negative distributional and environmental externalities.

Concerns around a loss in competitiveness are well-founded, but must not lead to a back-door erosion of energy taxation. International coordination in the reduction of harmful TEs will be essential. Moreover, as suggested by a 2015 IMF working paper, “energy pricing reform is largely in countries’ own domestic interest and therefore is beneficial even in the absence of globally coordinated action.”[5]

Such reforms need to have energy TEs within scope. This does not imply that these schemes should never be used. But they should be better scrutinized in terms of their fiscal cost as well as their goal alignment, effectiveness and efficiency. They should also be made transparent to allow for an open debate and distinction between those privileges that we indeed want to grant through the tax system, and those that are not consistent with our policy goals – including the ones we committed to in Paris last year.


Albrizio, S., Botta, E., Koźluk, T. and Zippere, V. (2014). “Do Environmental Policies Matter for Productivity Growth?: Insights from New Cross-Country Measures of Environmental Policies”, OECD Economics Department Working Papers No. 1176, OECD Publishing.

Avram, S. (2014). “The distributional effects of personal income tax expenditure”, EUROMOD Working Paper Series No. 14, ISER.

Coady, D., Parry, I., Sears, L. and Shang, B. (2015). “How Large Are Global Energy Subsidies?”, IMF Working Papers No. 15/105, International Monetary Fund.

Dechezleprêtre, A. and Sato, M., 2014. The impacts of environmental regulations on competitiveness. Policy Brief, Grantham Research Institute on Climate Change and the Environment, London School of Economics.

Department for Business, Energy & Industrial Strategy of the UK (2012). “Energy-intensive industries: support for indirect costs of energy and climate change policies”, Policy paper.

Di Bella, C.G., Norton, L.D., Ntamatungiro, J., Ogawa, S., Samake, I. and Santoro, M. (2015). “Energy Subsidies in Latin America and the Caribbean: Stocktaking and Policy Challenges”, IMF Working Papers No. 15/30, International Monetary Fund.

Flues, F. and Lutz, J. (2015), “Competitiveness Impacts of the German Electricity Tax”, OECD Environment Working Papers No. 88, OECD Publishing.

Flues, F. and Thomas, A. (2015), “The distributional effects of energy taxes”, OECD Taxation Working Papers No. 23, OECD Publishing.

Metcalf, G. (2013). “Using the Tax System to Address Competition Issues with a Carbon Tax”, Discussion Paper No. 13-30, Resources for the Future.

OECD (2015). “OECD Companion to the Inventory of Support Measures for Fossil Fuels 2015”, OECD Publishing.

OECD (2016). “Effective Carbon Rates. Pricing CO2 through Taxes and Emissions Trading Systems”, OECD Publishing.

OECD (2016b). “Inventory of Support Measures for Fossil Fuels 2015”,

Reinaud, J. (2008). “Issues behind competitiveness and carbon leakage. Focus on Heavy Industry”, IEA Information Paper No 2, International Energy Agency.

Transport and Environment (2015). “Europe’s tax deals for diesel”.

Zhang, Z. and Baranzini, A. (2004). “What do we know about carbon taxes? An inquiry into their impacts on competitiveness and distribution of income”, Energy policy, 32(4), pp.507-518.

[1] OECD (2016) finds that 90% of carbon emissions from energy use are priced below EUR 30 per ton – a conservative estimate of the negative externalities from the emissions of a ton of CO2. 70% of emissions from the non-road sectors (including industry, electricity generation as well as residential and commercial sectors, and accounting for 85% of total carbon emissions from energy use) are priced at zero.

[2] See e.g. Albrizio et al. (2014) and Dechezleprêtre and Sato (2014).

[3] See e.g. Zhang and Baranzini (2004) who, based on a review of empirical studies on energy taxes (including carbon taxes), conclude that the impact on competitiveness is often smaller than assumed. See, also, Flues and Lutz (2015).

[4] See OECD (2016), p. 30.

[5] Coady et al. (2015), p. 20.