Energy/CO₂ taxation and emissions trading

Environmentally motivated energy taxation and an emissions trading system intend to correct the market price of energy consumption / pollution so that it reflects the full social cost of production. According to basic behavioural and economic theory, both instruments thus create incentives to reduce energy use, stimulate demand for more energy-efficient products, and promote a shift to cleaner fuels and renewable energy. The ultimate environmental target of a carbon tax or emissions trading system is to reduce CO₂ emissions in order to mitigate adverse climate change impacts.

Worldwide implementation status
Taxes on energy of some kind can be found in almost every country worldwide. Germany and some other countries have also implemented an ‘ecological tax reform’ by using the revenues to reduce taxes or social security contributions on labour. Explicit carbon taxes on the other hand have been implemented only in some European countries (Finland (1990), Sweden (1990), Norway (1991), Denmark (1992), the Netherlands (1996), Slovenia (1997), Italy (1999), the UK (2000), Switzerland (2008) and Ireland (2010) (cf. Andersen 2011)) as well as in Costa Rica (1997) (cf. Meyer 2010, p. 6), India (2010) and Australia (2012). Moreover, several local or regional initiatives have been launched in the United States (cf. Sumner et al. 2009) and Canada.
In most cases carbon/energy taxes have been introduced on a national level. However, there are also examples of regional or local tax schemes, particularly in countries with federal systems (e.g. Spain, USA).
Emissions trading systems can also be found on various levels: trans-national (Europe (EU-ETS, 2005)), national (USA (SO₂ Reductions and Allowance Trading under the Acid Rain Program (1995)), regional (USA (Regional Greenhouse Gas Initiative (RGGI), an initiative by the Northeast and Mid-Atlantic States of the U.S. (2009)) and even local (Tokyo (2010)).
Next to these compliance markets, there is a growing market for voluntary offsets, enabling companies and individuals to buy carbon offsets on a voluntary basis.

Governance level
Energy and carbon taxes / emissions trading systems can be implemented at a national, trans-national or regional level.

To be most effective with regard to environmental/energy efficiency targets, an energy/ CO₂ tax or an emissions trading system should ideally cover all relevant sectors of the economy (i.e. residential, industry, commercial and public sector).

Related sectors

• services
• residential
• industrial

All kinds of energy efficiency actions and technologies will benefit from the increased financial gains due to an Energy/ CO₂ tax or an Emissions trading system.

• Low Energy Building
• Ultra Low Energy Building
• Zero/Plus Energy Building

• Thermal comfort 
• Site 
• Microclimate
• Building form 
• Orientation
• Building envelope
• Shading
• Colour
• Natural ventilation
• Passive cooling
• Passive heating
• Mechanical ventilation
• Cooling
• Heating
• Domestic hot water
• Lighting
• Vertical transportation
• Building integrated power generation
• User behaviour
• Building energy management
• Optimisation during the design process

Depending on actual tax design, the target group is either end-users (i.e. with regard to carbon taxes: downstream sources of emissions) or energy providers (i.e. with regard to carbon taxes: upstream sources of emissions) or both. Regarding mandatory emissions trading systems, the usual target group is power generators and the energy-intensive industry. Voluntary emissions trading systems, however, may include all sectors of the economy as well as individuals.

Related target groups

• User
• Utility

Carbon taxation and emissions trading systems directly benefit low-carbon and particularly renewable energy sources by creating a comparative cost advantage vis-à-vis energy from carbon intensive sources, thus improving their competitiveness on energy markets.

By increasing the price of energy (from carbon intensive sources), energy/CO₂ taxation and emissions trading systems stimulate the demand for energy efficient solutions and thus indirectly benefit property development companies, system suppliers, architects, engineering consultants, installation contractors, manufacturers and retailers who offer such solutions and technologies

Direct beneficiaries

• User

  Energy/CO₂ taxation and emissions trading systems directly benefit those investors and end-users who invest in energy efficiency improving measures.

• Installation contractor

Indirect beneficiaries

• System supplier

• Architect

• Engineering consultant

• Manufacturer

• Energy Service Company

  Also energy efficiency service companies (ESCO’s) and consultants may benefit due to increased demand for their services.

• Property development company

• Retail company

Relevant barriers

• Economic and financial barriers: Taxation of (carbon intensive) energy products or emissions trading raises energy prices, which then more accurately reflect the social cost of energy use. In consequence, investments in energy efficiency become financially more attractive to end-users since these not only offer a way to cope with higher energy prices but also promise higher cost savings in the long run.
• Lack of interest and motivation in energy efficiency-improvement: By raising the price for energy products, carbon/energy taxes / emissions trading systems directly affect end-users “where it hurts”, i.e. their disposable income/capital. In consequence, the policy raises awareness regarding the real (i.e. social) cost of energy use within society, putting the topic of energy efficiency and energy conservation on the individual, corporate and public agenda.

Relevant incentives

• Saved energy costs: As a consequence of higher energy prices, private, commercial, public and industrial investors and end-users will have higher benefits from energy efficiency and also become more aware of technological and behavioural options to decrease their energy use and thus reduce associated costs.
• Directly increasing earnings or profits for actors on the supply side: Energy efficiency consultants as well as manufacturers and retailers that supply energy efficient solutions within the building components market may experience increasing turnover and profits due to higher demand for their products.

Using energy / CO₂ taxation or an emissions trading system to send the right price signals is a necessary means to promote energy efficiency but will not be sufficient to overcome all market barriers for energy efficiency by far. These are often not related to the energy prices, such as lack of information or the investor-user dilemma.
Therefore, the introduction of energy / CO₂ taxation or an emissions trading system can only be really effective when combined with the provision of sectors-specific policy packages to increase energy efficiency. These will include amongst others easily accessible information (e.g. via campaigns, individual advice or efficiency labels), financing schemes for energy efficiency investments and additional positive financial incentives in the form of tax credits or direct grants (cf. Kosonen & Nicodème 2009). Such combined programmes can be organised and funded for example through an energy efficiency fund fed from the revenue of the tax or ETS. In addition, the setting of binding Minimum Efficiency Performance Standards (MEPS) for buildings can further secure the demand for energy efficient technologies and thus add to the saving potential.
Particularly in countries that have installed or are subject to an emission trading system, policy makers need to bear in mind the alignment of the design of carbon taxes in order to avoid double taxation (cf. Schlegelmilch & Bunse 2008).
In order to compensate for unwanted distributional effects and negative impacts on the labour market, energy / CO₂ taxation could be designed in accordance with the concept of an environmental tax reform (ETR). ETR proposes revenue neutral shifting of tax burden from income or labour to environmentally harmful behaviour such as the unsustainable use of (carbon intensive) energy.

The effective implementation and enforcement of an energy / CO₂ tax or an emissions trading system requires a competent, sufficiently funded and well-staffed authority with the capacity to co-ordinate and process the respective system. Also, energy / CO₂ taxes and emissions trading systems are only meaningful when there are no subsidies on energy prices or production.

• Review of country-specific emission/energy consumption patterns (sector, energy source, end-user)
• Draft definition of the policy and execution of an ex-ante impact assessment, using different scenarios and designs 
• Consultation of stakeholders and scientific experts in order to increase acceptance for the policy
• Tax: Definition of the tax base (including exemptions and tax credits/tax reductions) and legally liable entities under consideration of social, (fiscal), environmental and economic targets. Setting of an appropriate tax rate. Definition of processes and the agency/agencies responsible for collecting the tax (e.g. energy companies to collect and transfer to tax authorities).
• Emissions Trading System: Definition of the emission reduction target and cap, of the emissions and sectors covered, of the trading period, of the way of allocating certificates (for free or auctioning; auctioning is preferable as it will avoid windfall profits for ETS participants who get free allowances but include the allowance market price in the price of their products, as was the case with electricity generation in the EU until 2012 (Oeko Institut 2010), of trading conditions (e.g. linkage to other schemes, acceptance of certificates from Joint Implementation or Clean Development Mechanism projects). Definition of processes and the agency/agencies responsible for issuing and collecting the allowances/certificates. 
• Implementation of the system
• Periodical revision and adjustment with reference to environmental targets

Quantified target
While it is possible to define quantified targets for a tax in terms of yearly energy savings or generated revenue (mostly in order to aide the setting of a tax rate level in an ex-ante impact assessment) their actual achievement largely depends on market actors’ choices regarding the balance between tax payments, behavioural changes and energy efficiency investments.
An emissions trading system on the other hand sets a clear target for the amount of emissions to be reduced, however, the price for emissions certificates is not predictable and will be generated by the market. Additionally, the number of participants and number of units involved in an emissions trading system has to be set prior to the start of an emissions trading period.

Co-operation of countries
Governments with the intention of introducing carbon/energy taxation / emissions trading systems could benefit from drawing on experience from other countries that have already implemented such policies. This policy benchmarking practice can be particularly beneficial between countries with similar economic and institutional structures. Moreover, multilateral agreements on aligning national tax policies / emissions trading systems may facilitate the introduction and help to avoid decreases in the international competitiveness of domestic industries as well as tax evasion/carbon leakage.

Monitoring
For evaluation purposes of energy/CO₂ taxation a broad database of factors that influence energy consumption is necessary, and this should be built parallel to the tax introduction. Best evaluation practice has shown that for the assessment of energy consumption on a household level, the monitoring of data, not only on the total energy consumption, but also on the use of appliances, general behavioural patterns, type of household by size and income asf. are most useful, while on an industrial level data on the overall consumption of different sectors is sufficient (cf. INFRAS 2007, p. 19). For the tertiary sector, the type of business or building should also be monitored.
In emissions trading systems, the monitoring is of great importance. Each installation covered has to be monitored, as the emissions from installations are the basis for the individual right to emit, as well as for the allocation of certificates. Additionally, the sum of all installations’ emissions shows the development of the status quo for reaching the reduction target. As monitoring every single installation is quite extensive, an overall monitoring concept has to be cost-efficient and periodical adaptations and enhancements might be necessary.
For both energy/CO₂ taxation and emissions trading systems, the actual energy prices including the measures and the level of taxation respectively carbon price should be monitored as a basis for evaluating their impact on energy prices.

Evaluation
In order to evaluate the different impacts of an energy/CO₂ tax or an emissions trading system, the use of Computable General Equilibrium (CGE) models and other econometric approaches (such as e.g. time series analyses before and after introduction of the schemes to evaluate energy price elasticities of energy demand and calculate the energy savings using these) but also Input-Output-Analyses have proven to provide sound and meaningful results. Overall, the availability of relevant data rather than the choice of method is crucial in this respect. With regard to timing, impacts on the energy demand side should be evaluated within 1-3 years after the introduction of the instrument while structural impacts require a longer period of 5 years to emerge (cf. INFRAS 2007).
Impacts that should be considered are, on the one hand, the additional costs to energy consumers from the increase in energy prices but also from energy efficiency investments induced. On the other hand, financial savings from energy savings, reduced social security cost or reduced other taxes, or direct compensation payments or financial incentives received for energy efficiency investments that the state pays out of the revenue from taxation or the auctioning of emission rights need to be included.
Energy (cost) savings from such incentive programmes for energy efficiency can be evaluated directly using bottom-up methods.
For the overall economy, savings on energy supply and from reduced unemployment can be evaluated, but so can the wider changes in GDP. Reduced greenhouse gas emissions are another important benefit that should be evaluated.
In addition, is it useful to quantify the impact on the state’s budget. This includes not only the tax or auctioning revenue and its use, but also secondary effects from reduced unemployment or increased VAT on energy efficiency investment.

Relevant individual dynamics and side-effects

• Dynamic market transformation and/or innovation: Putting an energy or CO₂ tax on fossil fuels and other energy activities sends a strong price signal to end-users. Assuming utility maximizing behaviour and rationality on their part, consumers will adapt to higher energy prices depending on the specific demand elasticity. If - as in most cases in the short term - demand for an energy product is inelastic (i.e. is not substitutable), end-users will tend to opt for more energy efficient solutions or - in case of a carbon tax - choose cleaner energy sources, thus promoting technological innovation as well as medium to long-term transformation of energy supply markets. This creates long-term price elasticity. If demand for an energy product is already elastic in the short term however, carbon/energy taxation may nonetheless alter consumption patterns and hence lead to an overall reduction of energy use. An emissions trading system also aims at innovation in technologies, in order to meet caps or save costs in the trading. A prerequisite for technical innovation spurred by emissions trading is, that the emission reduction targets are high enough (i.e. caps are set low enough) and emission certificates are expensive enough, so that technical innovation becomes necessary/economic.
• Avoiding lost opportunities: By raising the cost of energy production/consumption an energy/CO₂ tax or emissions trading system stimulates energy saving behaviour and provides incentives for investments in energy efficient solutions. This way it may help to avoid lost opportunities such as retrofit without thermal insulation and the purchase of less energy efficient appliances or equipment.
• Minimising rebound effects: In fact, energy/CO₂ taxation may help to mitigate rebound effects that are a consequence of other energy efficiency improving measures or policies. To this end, the tax may be designed in a way that rates are adjusted according to the rate of energy efficiency improvements, so that overall energy bills remain stable. However, the volume of energy or CO₂ tax will increase in this way, creating leeway for financing even further energy efficiency policies and other public policy objectives, or for reducing other taxes. An emissions trading system can also be designed to minimise rebound effects, however, experience shows that this is quite complex. The reduction targets as well as the certificate prices have to be in such a constellation, that both provide an incentive to increase energy efficiency (i.e. high certificate prices and an ambitious reduction target).
• Minimising snap-back effects: As the price signal created by an energy/CO₂ tax or emissions trading system provides only a general incentive to save energy, the only way to contribute to minimising snap-back effects through these policies directly is to keep the price signal intact. This means the systems should aim to increase energy prices to consumers in real terms at the same rate as energy consumption is reduced through energy efficiency. However, other policies and measures, particularly Minimum Efficiency Performance Standards (MEPS) for buildings are needed to really prevent markets from falling back to energy-inefficient practices and products.
• Minimising free-rider effects: In order to avoid free rider effects on the system itself, policy makers need to make sure that all relevant target groups are covered by the energy/CO₂ tax or emissions trading system. For minimising free-rider effects regarding energy efficiency improvement actions that investors and users would have taken anyway, it is obvious that the effectiveness in stimulating additional action and energy savings will be the higher, the higher the level of energy/CO₂ tax or prices for emissions allowances/certificates is.
• Creating Spill-over effects: In general, a tax or carbon price can merely contribute to a favourable framework for energy efficiency improvements by correcting energy prices. Hence, all actions triggered by this financial incentive could be considered spill-over effects from the original measure, although a direct causal link may be difficult to establish. In particular, market dynamics for energy-efficient buildings and equipment induced by an energy/CO₂ tax or an emissions trading system are likely to create economies of scale for these technologies and solutions. This will reduce their costs and increase demand for them, and thereby create spill-over effects. If an emissions trading system leads to technological developments that aid reductions outside of the policy area (Barker et al., 2007), spill-over effects can be maximised. The possibility for that might be higher, if an emissions trading system covers a number of countries that possess important economic power.

Sustainability aspects
An energy tax scheme can promote sustainability for instance by exempting energy production or consumption from renewable energy sources from the tax, thus supporting the transition towards a sustainable energy supply system. Moreover, if primary energy is used as the tax base, the policy provides incentives for more efficient energy conversion thus improving resource efficiency.
Emissions trading systems per se support cleaner production and a more efficient use of energy or the use of renewable energy by increasing the price for a carbon-intensive use of energy. Emissions trading systems can also support health aspects (e.g. SO₂ trading which is, however, a different system).

Co-benefits
Carbon taxation as well as emission trading systems provide society as a whole with public health benefits due to air quality improvement. Furthermore, if tax revenue or funds from auctioning emission allowances are used to lower the cost burden on labour (e.g. by decreasing social security contributions or the income tax rate), the policy can have positive effects on the labour market.

The following barriers are possible during the implementation of the policy:
Delays in legislation may occur due to political processes and lobbying as well as political resistance/opposition from target groups.
There may be a lack of administrative capacity in order to ensure compliance/enforce the policy.
Emissions trading systems may see high volatility of carbon prices.

The following measures can be undertaken to overcome the barriers:
Thorough and timely policy planning including the consultation of stakeholders and scientific experts is key in order to avoid delays in legislation.
The gradual implementation of a tax / emissions trading system provides those targeted with the opportunity to minimize adaptation costs and thus may help to overcome political resistance.
A timely set up of a sufficiently staffed and well endowed organisation helps to avoid problems of enforcing the policy.
For emissions trading systems, in order to limit fluctuations in the prices for allowances/certificates and therefore in the price signal to consumers, the cap should regularly be adapted to both the effects of energy efficiency improvements and low-carbon electricity generation and cap-setting should be co-ordinated with the respective sectoral policies, but also to reflect changes in GDP (cf. Hermann & Matthes 2012 for the need to adapt the cap for the EU ETS). Another option could be setting a minimum floor price for allowances/certificates.

Due to the multitude of design options with regard to tax base, liable entities, tax rate and revenue recycling as well as country specific context factors (such as the embeddedness of a carbon/energy tax into the broader tax system and energy demand elasticities), it is clearly not possible to make universally valid statements about the energy saving potential of energy/CO₂ taxation. An ex-post evaluation of the impact of the 1996 Dutch energy tax on household energy demand in 2004 showed that the policy led to a small but significant yearly average reduction in electricity (8%) and gas (4.4%) (cf. Berkhout et al. 2004). Moreover, a survey of empirical ex-post evaluations of the effects of CO₂-based taxes showed that they do in fact reduce emissions (cf. Agnolucci 2004).
Generally, certainty of energy saving impacts will be much higher if a part of the tax revenue is used to fund sector-specific energy efficiency policies.
On the other hand, an emissions trading system can define the absolute amount of emissions and therefore also the emissions reduction vs. the baseline trend. However, the economic advantage of emissions trading systems is their freedom in the ways to reduce emissions. These can be energy efficiency improvements but also renewable energies or carbon capture and storage, and even options to reduce other greenhouse gases, depending on the scope of the ETS. The impact on energy savings is therefore uncertain.
Again, certainty of energy saving impacts can be increased if emissions rights are auctioned and the revenue is used to fund sector-specific energy efficiency policies.

From an administrative/governmental perspective, the implementation of an energy/CO₂ tax is, compared with other instruments (such as an emission trading system) that target energy prices or with regulatory/command-and-control approaches, the lowest-cost policy option to reduce energy consumption. Although administrative and company costs of energy/CO₂ taxes may - due to considerations of companies’ competitive abilities in the tax design - be higher than for other tax forms, they are nonetheless generally cost-efficient (Agnolucci 2004, p. 52).
In view of the policy’s basic objective, target groups will naturally face higher costs for energy use. These cost increases may however be fully or partly offset by means of revenue recycling (e.g. grants for energy efficiency investment, reduction of contributions to social security systems to reduce labour costs, tax refunds, asf.). In general, the target group specific net increase in energy costs will differ depending on tax design, i.e. tax base, liable entities, tax rate and revenue recycling approach.
In practice, emissions trading systems can also be run at low administrative costs. For example, the administrative effort of Germany for the European Emissions Trading in the first trading period (2005-2007) amounted to 0.089 per cent. This was a lower percentage than for the administrative costs of the Ecological Tax Reform (0.13 per cent) (Schlegelmilch & Bunse 2008).

When accurately designed in accordance with the principles of environmental tax reform and properly implemented, energy/CO₂ taxes are suitable policy instruments to cut CO₂ emissions/save energy without curbing economic development. If revenues are retransferred to reduce labour costs, small positive or no significant macroeconomic effects on production and employment in either direction are to be expected. On the other hand, significant reductions in energy consumption/pollution are possible (cf. Bosquet 2000).
Denmark for instance had introduced an energy tax back in 1977, which was amended in 1992 by a carbon tax and all measures were reviewed and strengthened in 1996 (“The Green Tax Package”) and again in 2009. The main part of generated revenue has been recycled by reducing employers' labour market contributions and ATP (supplementary labour market pension) payments. An evaluation study in 2000 found insignificant but positive effects on employment, gross value added and balance of payments (cf. The Danish Energy Agency 2000, p. 29). Moreover, based on data for the period 1995 to 2000 the same study estimated a 5% reduction in CO₂ emissions from 1995 to 2005.
The general aim of an emissions trading system is to reduce emissions where it is most cost-effective. In so far as energy efficiency improvements are cost-effective, the system will reduce overall energy costs to the economy. In addition, the price signal will have similar effects as for energy/CO₂ taxation.