NARRATION TRANSCRIPT

MODULE 3: KEY DESIGN DECISIONS

FRAME 1

After completing the module, participants will be able to summarize main decisions to be taken in
defining the tax base, outline approaches for setting the tax rate and list options for determining the
tax rate trajectory.

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In this module, we look into considerations informing decision-making on tax base and rates.
Numerous countries have undergone the process of designing a carbon tax. Let’s have a look at the
tax design decisions some of these countries have made.

Consider the two tables. They show actual tax rates and emission coverage of four jurisdictions from
highest to lowest. Do you know how the four countries rank in each of the two categories? Simply
drag and drop them into the tables!

FRAME 3

Within the course of this module, we examine how to determine the tax base, how to set the tax rate
and look into the dynamics of the tax rate.

FRAME 4

The tax base of a carbon tax refers to the taxable products, activities and emissions. Defining the tax
base is among the first and most crucial decisions to be made in designing a carbon tax. Determining
the tax base requires making decisions on at least four issues. These are:

 The scope of taxation: which gases, which economic sectors and which activities the tax will
cover;
 The point of taxation in the supply chain;
 The legal entity that will be liable for tax payment;
 Possible thresholds of application.

FRAME 5

A first step in defining the scope of the carbon tax is deciding which emissions it will cover. The way in
which the scope is defined depends on how the carbon tax is to be applied. Where the tax is applied

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to the purchase and sale of fuel, policymakers need to decide which fuels to include. Where the tax is
applied to the act of producing emissions, such as burning or refining fuel, policymakers need to
decide which activities and greenhouse gases will be subject to the tax. Click on each of the
approaches for further discussion.

FRAME 5 – Layer Fuels

Many jurisdictions have applied carbon taxes to the purchase and sale of one or more specific
fuels, primarily oil, gas and coal, and their derivative products. Importantly, the tax is
calculated based on the carbon content of the fuels as a proxy for emissions, and not on
actual gases released from a factory’s chimney or a car’s tailpipe.

Targeting the purchase and sale of fuels can be attractive from an administrative perspective
and support cost-effectiveness. Fuels are often already subject to excise taxes, and carbon
tax administration can “piggyback” on the systems already in place for these.

Placing the point of taxation on fuel importers involves a smaller number of large entities
compared to the potentially large number of entities that combust the fuel, such as car and
truck owners. Each fuel is taxed according to the carbon it emits when burned.

Moreover, it is possible to tax fuel used for specific purposes, such as the United Kingdom
does, where the Carbon Price Support is applied to fuel used by electricity generators.

FRAME 5 – Layer Emitters

The tax can also target specific economic activities that involve emissions, regardless of the
type of fuel being used.

Chile, for instance, targets emissions produced through the use of large boilers and turbines.
South Africa’s carbon tax taxes fugitive emissions from fossil fuel combustion and emissions
from industrial processes.

This approach can be used for emissions resulting from fossil fuel combustion and
greenhouse gases other than CO2. In this way, jurisdictions may be able to ensure broader
coverage, especially where a large part of their emissions are not fuel-based, as in the case
of landfills, for example.

On the other hand, in the case of taxes tied to activities rather than on the purchase and sale
of fuels, jurisdictions may need to establish new systems for monitoring, reporting and
verification (MRV) of emissions.

FRAME 6

Determining the right coverage is very context-specific and thus requires a good understanding of
national circumstances. Coverage can reflect combinations of fuels and direct emissions. Here you
will find some of the most important factors to consider for determining the scope of taxation. Can you
match the description with the corresponding factor? Click on the factor you think the definition
corresponds to.

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FRAME 7

While approaches taken by jurisdictions will be context-specific, experience suggests there are four
broad approaches to implementing a carbon tax: expansive, policy-specific, complementary and top-
up. Click on each to read more.

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The generation of emissions from a given sector or activity typically involves a range of actors
operating at different points in the supply chain. In addition to determining which sectors or activities
will be subject to the tax, jurisdictions must therefore also define which of the involved entities will be
responsible for paying the tax. Though the number and characteristics of points in the supply chain
will differ across sectors, they can broadly be categorized by three distinct points of taxation. Hover to
read more.

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Let’s examine the case of fossil fuels! Here, several examples of actors in the fossil fuel supply chain
are highlighted. In which of the three categories do they fall? Drag and drop!

FRAME 10

The gasoline supply chain example illustrates how the behavioral effect of a carbon tax is strongly
influenced by where the tax is placed. There are three types of emissions associated with gasoline:

 emissions from combustion,

 emissions from processing at the refinery, and
 emissions from extraction or imports of crude oil.

To tax the combustion of gasoline, the government can place the tax anywhere in the supply chain,
from the point where the product leaves the refinery to the point of use. The incentive will work as
long as the price signal can be passed up and down.

However, fugitive emissions from extraction, such as methane, are not part of the carbon content of
fuel, so they must be taxed separately, at the source. The tax would be applied most effectively to
extraction companies, that is, at the upstream point.

Similarly, to tackle emissions from the refining process, policy makers should target refineries directly.

FRAME 11

A further important design decision concerns who is legally responsible for paying the carbon tax. The
options available depend on the scope and point of regulation, and in particular whether the tax is
placed on fuels or direct emissions.

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 FRAME 11 – Layer Fuels

Taxes on fuels will in most cases follow the existing rules applicable to the payment of excise
taxes. Two strategies are common:

Firstly, fuels that are not taxed at the time of production or import may be stored and
distributed by registered taxpayers in so-called “tax warehouses”. The moment the fuel is sold
to a non-carbon taxpayer, such as a gasoline station or business consumer, the tax must be
paid.

Secondly, fuel taxes are levied on consumers by means of tax collectors. To reduce the
administrative burden, authorities simply appoint fuel vendors, such as gas stations, as tax
collectors. These vendors, in turn, are responsible for charging consumers upon sale and
transferring the payment to the government.

FRAME 11 – Layer Direct emissions

For taxes levied on direct emissions, the liable entity can usually be defined in two ways.

Firstly, the entity that owns the emitting facility is liable for tax payment. In the case of multiple
owners, the obligation may be placed on the entity with the controlling share, or divided
between the entities based on their equity.

Secondly, the entity that has the authority to manage facility operations is liable for tax
payment.

FRAME 12

A threshold is a minimum level of activity that will trigger responsibility for paying the tax. Once an
entity reaches a minimum level of emissions per year, taxation will apply. Thresholds help reduce
costs of reporting and administration while ensuring a sufficiently broad emissions coverage. This way
jurisdictions establish a balance between cost effectiveness and environmental effectiveness. The
use of thresholds is common in the case of taxes applied to direct emissions. It is also applied when
the number of actors is relatively high, and their size and capabilities vary significantly.

FRAME 13

This graph of a hypothetical jurisdiction depicts the emissions associated with large, medium and
small emitters, defined respectively as firms with more than 100,000, 50,000-100,000, and less than
50,000 annual tCO2e emissions.

Notice that by focusing the tax on large and medium-sized emitters, for instance by applying a
threshold of 50,000 tCO2e per year, a carbon tax might cover 95 percent of the emissions. This would
limit the number of firms that must be monitored to approximately half of all emitters. The appropriate
threshold will depend upon the distribution of sizes of emitters in a jurisdiction.

However, a threshold can create an incentive to break up existing production facilities into smaller
units to avoid compliance obligations. Similarly, a firm just below the threshold may choose to stay
there, purposely curbing its growth. In practice though, firms are unlikely to make major decisions like
these solely based on the carbon price unless it is very high.

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FRAME 14

With respect to actors responsible for relatively low emissions, the expected costs of reporting can be
excessive relative to the actual taxes owed. The effective tax on the emitter can be understood to
equal the tax levied plus the reporting costs. Importantly, if small firms have limited financial and
human capacity to administer the carbon tax, or if the ability of the regulator to oversee smaller firms
is limited, policy makers may want to set a higher threshold. Thus, smaller firms or regulators are
protected from a disproportionate burden.

FRAME 15

Jurisdictions that apply their tax to fuels at the point of distribution have typically not applied
thresholds. There are common reasons making thresholds less necessary in the context of fuels. Do
you know the reasons?

FRAME 16

Ideally, a carbon tax would be applied to the sectors at the point where it is most environmentally
effective. In practice, the decision will be influenced by the administrative burden involved in applying
the price at different points in the supply chain. One important consideration informing the tax base
design is the ability to accurately measure, report and verify emissions.

Closely related are the costs and effort associated with administrating the tax more broadly. MRV and
administration considerations differ depending on whether jurisdictions focus the carbon tax on
targeting fossil fuels or direct emissions.

FRAME 17

So far, most jurisdictions that adopted a carbon tax have focused it on the use of fossil fuels. This has
the distinct advantage of allowing the carbon tax to “piggyback” on existing customs and excise taxes.
In these cases, MRV tends to be relatively simple and straightforward. Most jurisdictions will already
have systems in place for monitoring quantities of fuel produced, imported and sold. Carbon
emissions are thus easily calculated by applying an emission factor.

FRAME 18

A limited number of countries have targeted gas-emitting activities directly, most notably Chile,
Singapore and South Africa. For certain activities, reliable proxies and emission factors exist. For
instance, the measurement of emissions from electricity production by generators typically follows
well-established procedures in most jurisdictions.

In those sectors where reliable proxies and emissions factors do not exist, like agriculture and land
use change, monitoring emissions can be especially challenging. The ability and level of efforts
needed to monitor emissions meaningfully in a given sector can therefore be a key consideration in
determining sectoral scope.

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FRAME 19

Perhaps the most important element of carbon tax design is determining the tax rate. In practice,
jurisdictions have adopted tax rates ranging from 1 to 25 USD per ton of CO2e.

When deciding on the tax rate it is important to decide the goals. The rate can be designed to achieve
different purposes through various approaches. This section reviews four basic approaches:

 The social cost of carbon, or SCC;

 The abatement target;
 The revenue target; and
 The benchmarking approach.

FRAME 20

The SCC approach involves reducing emissions with an eye on balancing the costs and benefits of
emission abatement. In its broadest sense, the SCC refers to the global damages caused by emitting
one additional ton of CO2e. Reducing emissions avoids these costs and results in so-called marginal
abatement benefits (MAB). Based on this approach, a jurisdiction promoting economic efficiency
would set the carbon tax equal to the SCC.

Conceptually, policy makers set the carbon tax rate at the level where the marginal abatement cost
(MAC) equals exactly the marginal abatement benefit. At this point, the cost of an additional ton of
abatement equals the value of the abatement. If emitters abated more (that is, beyond A*), the cost of
abatement would exceed the cost of the tax payment. The shaded area represents the total gain in
value to society.

FRAME 21

Although climate change impacts are often the primary consideration in setting the SCC, jurisdictions
implementing carbon taxes may expect additional benefits from abatement. By adjusting the MAB
curve – and the implied SCC –, these jurisdictions may achieve a fuller representation of benefits from
reduced greenhouse gases:

 Health benefits, such as decreased incidence of diseases caused by air pollutants;

 Better land and soil quality;
 Enhanced energy security thanks to lower dependence on imported fuels; and
 Improved transportation systems.

In the diagram, the value to society would thus increase to the extent that the MAB curve incorporates
these benefits.

FRAME 22

To date, several governments have calculated the SCC and used it as input for their overall policy-
making processes. Estimates of SCCs vary considerably. For comparison, while the United States
estimated the SCC at about 50 USD per ton of CO2 for 2020, Germany regarded the SCC to be over
150 USD in the same year.

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SCCs are typically difficult to calculate given the quantity of potentially relevant cost factors. The
differences among the estimates stem in part from differences in the models used: the physical
impacts considered, the valuation of damages at national and global level, and the discount rates
applied.

SCC estimates typically increase over time. This reflects the expectation that concentrations of
greenhouse gases keep growing in the future and hence the damages associated with climate
change.

FRAME 23

In cases where the primary goal of the carbon tax is to meet a specific emission reduction target,
governments can decide to set the tax rate at the level that is expected to achieve the required
abatement. While with the SCC approach, the policy starts by setting the tax rate T* at the
intersection of the MAC and MAB curves, under the abatement target approach the reduction target
pursued is known, and the MAC can be used to set the tax T* without need for the MAB.

FRAME 24

Two considerations are relevant in this approach:

Firstly, where there is uncertainty about the estimated MAC, there will also be uncertainty about the
reduction level that will result from a specific tax rate. The MAC may be lower in contexts where
governments adopted policies complementary to the carbon tax, such as programs for public
information or technological development.

Secondly, it is assumed that liable entities will respond to the price signal of the tax by adopting all
abatement measures that have a lower cost than T* per tCO2e. If there is “stickiness” in the system,
the level of abatement can fall short of the expected level.

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To reach the Paris Agreement’s goal of keeping global temperature rise “well below” 2°c compared to
pre-industrial levels, ambitious abatement efforts are necessary. Today, about three quarters of
emissions covered by a carbon price are priced below 10 USD per ton of CO2e. According to the
High-Level Commission on Carbon Prices, this price level is considered too low to incentivize
emission reductions on the scale necessary to fulfill the Paris Agreement.

In 2017, the High-Level Commission published a report with the objective of identifying indicative
corridors of carbon prices to help meet globally agreed temperature targets. In the report, the authors
conclude that the carbon price level consistent with those targets is at least 40 to 80 USD per ton of
CO2e by 2020 and 50 to 100 USD by 2030.

Importantly, these figures imply that a supportive policy environment be in place.

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FRAME 26

In cases where the jurisdiction is driven primarily by raising revenue through the carbon tax, the tax
rate can be set so that it generates a specific level of revenue. Before the introduction of the tax, the
supply and demand curves, S and D, intersect at a point corresponding to the market price (P) and
quantity (Q). When the government introduces a tax on a commodity, the cost of production
increases, moving the supply curve from S to S1. With the new, higher supply curve, S1, the new
point of intersection is P2 and Q1. The tax revenue is, therefore, the product of the tax rate, T, and the
new (lower) quantity, Q1, that is, T × Q1.

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It is important to remember that any tax functions within the constraints of supply and demand. In
other words, it might be possible to increase revenues by increasing the tax.

However, as the demanded quantity decreases with a higher tax rate, eventually total revenue starts
to shrink. Either very high or very low taxes can lead to lower tax revenues than the intermediate tax
level, which typically maximizes the revenue.

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Make sense of the phrases by clicking the right option from each parenthesis!

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Benchmarking provides one of the simplest and lowest-cost approaches to examining options for
setting the carbon tax rate. It involves examining what other, similarly situated jurisdictions have done
in terms of the overall tax design they adopted, and particularly the tax rate they chose. Now, to
identify jurisdictions appropriate for tax design benchmarking, a number of factors should be
considered. Can you tell which ones?

FRAME 30

Some jurisdictions will set a single carbon tax rate that remains the same for an indefinite period of
time. In many cases, however, tax rates change according to a dynamic schedule or are otherwise
adjusted over time. Changing the tax rate can serve a number of purposes, such as gradually
allowing the economy to adjust over time, or to adapt to changing policy objectives and economic
conditions.

A common thread in these decisions is the tension between two important goals: predictability on the
one hand and flexibility on the other. While investors and entrepreneurs need predictable conditions
to develop businesses, policymakers typically seek to retain flexibility to react to new information,
changing political goals and public priorities.

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FRAME 31

While there are many approaches that can be used to address the question of whether and how
carbon taxes should change over time, policymakers are advised to follow a three-step approach:

 First, set the intended trajectory;

 Second, determine the procedures for possible adjustments; and
 Third, set the rules by which adjustments are made.

For example, the intended tax rate, at the time of adoption, can be static or increase by a pre-defined
value each year. Similarly, the tax legislation can include provisions for a periodic review of the tax
rate, or leave it to policymakers or respective authorities to make changes ad hoc.

Ideally, tax legislation informs not only when adjustments are likely to occur, but also according to
which criteria or principle. Some criteria are more formulaic by nature than others and thus require a
lesser degree of political discretion. Many jurisdictions combine these approaches based on their
priorities and circumstances.

FRAME 32

A fixed or static tax is one that simply stays the same after its implementation. This approach has the
advantage of giving a stable and highly predictable price signal. This stability facilitates private
investment.

However, the advantages of stable prices depend upon governments’ capacity to convince the liable
entities that they will not adjust the rates in response to political pressure.

The disadvantage of this approach is that it can give a substantial shock to the economy if the
introduction of the tax results in a sudden price increase of fuels. This is especially the case when
opportunities to adjust practices, such as production technologies, building design, etc., are not
readily available. Also, the static approach does not allow for adjustments even in the face of new
experience or changing policy objectives.

FRAME 33

Jurisdictions may choose to soften the impacts associated with suddenly putting a price on emissions
by starting at a relatively low level and gradually increasing it to the long-term tax level intended. To
achieve this gradual introduction, jurisdictions may set a specific trajectory for the carbon tax at the
time of implementation. Gradual increases allow the economy to accommodate rather than
experience a sudden major shock.

FRAME 34

Jurisdictions can also set a target rate for a given date in the future while leaving flexibility as to the
exact trajectory needed to reach that level. This is the approach taken by France, where in 2015 the
government set the carbon tax rates for each year up to 2020 when it was due to reach 56 EUR per
ton of CO2e. It also set the rate for 2030 at 100 EUR. Rates for the years 2021-2029 were to be
determined in subsequent legislation. The French carbon tax represents one way of implementing the
predictable flexibility concept.

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FRAME 35

The tax design can also include provisions for a periodic review of the tax conducted by a panel of
experts or government officials. Similar to an automatic formula, the government can review tax
performance, revenue raised and changes in emissions on a regular basis. Based on the conclusions
drawn from the review, it can make changes if the tax over- or undershoots its targets.

While this guidance approach provides more flexibility and discretion than a strict formula, it
potentially also allows for more political manipulation and ensuing uncertainty for liable entities.

FRAME 36

Jurisdictions can, of course, allow the political process to determine the adjustments to be made to
the tax rate, with caution. While investors deal in risk by default, the risk associated with political
processes is sometimes viewed with skepticism. Hence, liable entities facing a carbon tax might be
reluctant to make investments in emission-reducing technologies and practices if they think the
government will change the tax rate based on political rather than economic, technological or
environmental circumstances. The decision-making process should be transparent and designed to
minimize the negative effects of political influence.

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Whether jurisdictions adopt a static tax rate or a dynamic trajectory, many important developments
are difficult to foresee. Such developments may entail economic downturns, shifts in trade conditions
and technological advances. For this reason, jurisdictions may choose to build in rate adjustments
that are automatically triggered by certain conditions, for instance if abatement targets are not
reached. The tax design can include an adjustment formula that incorporates factors such as
progress in meeting emission reduction targets, revenue levels, inflation, exchange rate changes, and
ETS price levels or the social cost of carbon. Resorting to an objective or impartial formula reduces
the role of day-to-day politics and related uncertainty.

On the other hand, automatic adjustments may prove overly insensitive when economic conditions
call for more discretionary measures.

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