A smart carbon tax: the silver bullet for the (just) energy transition?

There is a broad consensus among economists that, globally, over time, reaching net zero greenhouse gas emissions by 2050 will cost less than not reaching net zero.[1] In that very broad, long-term, high-level sense, it is clear that there is no conflict between carbon neutrality and economic interests. But if everybody thought it was already in their economic interests to aim for net zero today, we would probably not be so far off track from achieving that goal as we currently are.[2]   

Researchers working within the framework set by the Intergovernmental Panel on Climate Change (IPCC) have mapped out four indicative pathways to net zero.[3] They all involve at least halving global consumption of fossil fuels by 2040. That is not quite the future that most oil majors, and governments with a stake in the industry, seem to be planning for.[4] Others argue that net zero in 2050 is compatible with fossil fuels still dominating the global energy sector at that time, but that this would depend on massive shifts in investment – for example, into new technology to reduce the carbon footprint of fossil fuel extraction, hydrocarbon supply chains and use of fossil fuels. The majority of the industry is as yet not visibly committed to such shifts.[5]

To persuade people to take action that seems to be against their economic interests, at least in the short term, you need to change the balance of incentives.

Again, the economists have a straightforward answer: you put a price on carbon. You make it more expensive to produce and/or consume fossil fuels and products with a heavy carbon footprint. People then pay up front for the otherwise unpriced damage caused by their emissions, which means that they have a reason to choose lower carbon products and forms of energy.

There is no shortage of support for the principle of carbon pricing, which has been endorsed by royalty, the European Commission and senior bankers, to name but a few.[6] However, in practice, existing carbon price mechanisms have had limited effect, and there are serious risks in seeking to decarbonise with policy instruments that could impose significant costs on those least able to afford them. Any tax based on consumption risks having a regressive effect, and people with proportionally more carbon-intensive lifestyles often lack the financial means to switch to lower carbon options. The gilets jaunes protests in France began with an increase in carbon taxes.[7]

Carbon pricing may take the form of a straight tax on emissions, or of an emissions trading scheme. The former is arguably the better approach. For example, setting a tax rate is not always easy, but it is easier to make adjustments to a tax than to a market mechanism, where it can be difficult to recover from an initial miscalculation of the optimum number of emissions allowances to issue at the outset, as in the case of the EU Emissions Trading Scheme (EU ETS).

The ideal carbon tax would be economy-wide, and have three further key features. 

• The price of emissions would start considerably higher than in most current carbon pricing schemes, and increase over time in a carefully calibrated way.[8]  
• To ensure popular support, government would pay back some or all of the tax receipts in the form of a “carbon dividend” in a fiscally redistributive way.[9]
• To make it possible to start with a national, rather than a global version of the tax, and to avoid exporting the taxing country’s emissions to countries without a carbon tax, it would be necessary to charge a “border carbon adjustment” tariff on goods imported from jurisdictions with no equivalent tax.

Such an approach has plenty of heavyweight intellectual support.

• Just over a year ago, the Wall Street Journal carried a self-styled “largest public statement of economists in history” in which no fewer than 3,558 US economists espoused something along these lines that was proposed from a US perspective. This is the “Baker-Schultz” plan, re-branded in February 2020 as the “Bipartisan Climate Roadmap”.[10]
• In October 2017, leading UK regulatory economist Dieter Helm put a carbon tax at the heart of his report to the UK government on how to address the rising cost of energy in the context of its climate change policy goals.[11]
• In July 2018, the UK think tank Policy Exchange produced The Future of Carbon Pricing: Implementing an independent carbon tax with dividends in the UK, with a foreword jointly authored by a former Labour Chancellor of the Exchequer and a former Conservative Foreign Secretary.[12]

Of course, any attempt to implement such a tax would need to address a great many issues, both in terms of high level design and practicalities.

• Do you just tax fossil fuels, or do you also tax products in whose manufacture fossil fuels have been consumed? In the case of fossil fuels, at what point(s) in the chain between the upstream producer and the final downstream user should the tax be levied? For example, you could impose a tax on upstream hydrocarbon producers or refinery operators that was based just on the emissions from their activities, rather than from the presumed activities of end-users of refined petroleum products, such as electricity generators or motorists.
• At whatever point(s) a tax is applied, at what rate should it be levied? What assumptions about the emissions intensity of downstream processing and/or use should underpin the calculation of that rate? How do you ensure that the imposition of the tax, and any increase in the rate, has the desired effect of incentivising changes in behaviour (i.e. shifts to lower carbon technology)? Will taxing the ultimate consumer more heavily incentivise the upstream or midstream operator to reduce emissions from flaring or fugitive methane? If I fill up my car with fuel from a retailer who promises to offset the emissions that my driving will cause, should I get a rebate on the tax element of my purchase?
• Tax law has a natural tendency to become complicated. Take for example the Climate Change Levy (CCL) legislation, that supplements the EU ETS in UK domestic law. In outline, this is quite a simple scheme: electricity and certain fossil fuels are “taxable commodities” and a levy is charged on “taxable supplies” of them. But quite quickly, the desire to incentivise, protect, or discourage particular activities turns the scheme into an abstruse and intricate mesh of exemptions, exclusions, and exceptions from exemptions or exclusions.
• Both fossil fuels and products manufactured using them are traded internationally, but carbon taxing is currently national (or in the case of the EU ETS, regional), and is likely to remain so for the foreseeable future. In order to encourage other countries to adopt similar regimes, and to stop its domestic industry being undercut until they have done so, a taxing country will want to impose a carbon border adjustment on imports. This may involve charging tax at a point further down the value chain than would be the case with domestic industry. For example: you apply a domestic carbon tax on electricity, which increases the costs of aluminium smelters, so you need to apply the carbon border adjustment to imports of aluminium from a country that does not levy a similar carbon tax on electricity or aluminium production.
• But suppose there are two aluminium producers in the aluminium exporting country: one powered entirely by renewable energy, and the other by a coal-fired power station. And suppose that some of the aluminium that reaches the aluminium importing country arrives in the form of finished products. If two identical stepladders are imported, one made of “brown” aluminium and the other of “green” aluminium, the tariff charged on the latter should be lower.

This prompts some further reflections on the kind of system that is needed. 

• To work well, our hypothetical carbon tax needs to be very granular. That means handling a lot of data, and mining that data for insights – for example, about how particular applications of the tax affect the behaviour of particular groups or economic sectors.
• You will also need to be able to keep records. Suppose somebody is awarded a rebate but it turns out they should not have had it. Suppose you want to allow people to borrow against their future carbon dividends in order to invest in making their homes more energy efficient. You may well want to track supply chain emissions – including for the oil & gas industry itself.   
• Very soon, you are looking at information flows that are too numerous and diverse to be managed by a central counterparty.
• This points to a system that can facilitate large numbers of transactions automatically, within set parameters – in other words, smart contracts.
• That system must be very secure, and capable of encouraging parties who do not have direct contact with each other to trust each other.
• Above all, you need a system that records, in immutable form, every transaction that is made within it.

This sounds like a job for some kind of distributed ledger technology (sometimes, but strictly inaccurately, referred to by the generic label “blockchain”). No jurisdiction in the world has yet implemented the ideal version of a carbon tax. But if and when they do, it should arguably be a data-rich, deeply digitalised, regime that can be integrated with smartphones and the internet of things: capable of tracking individual products through the supply chain, and perhaps distinguishing between hydrocarbons from different sources on the basis of the emissions intensity of the processes by which they have been extracted, transported and refined.

The Policy Exchange paper referred to above highlights the role of “blockchain” in this regard. It also points out that the UK’s withdrawal from the EU provides it with a potential opportunity to strike out on a new course in terms of carbon pricing. Research by the UK energy regulator Ofgem shows that even the UK’s existing carbon pricing tools, the much-criticised EU ETS and its domestic supplement, the Carbon Price Support element of the CCL, have been the single most effective regulatory driver of decarbonisation in the UK power sector.[13]

However, a government consultation issued in May 2019 on the future of UK carbon pricing was essentially focused on how to replace the EU-derived existing regime with something similar but UK-only.[14] It made no reference to the kind of ideas put forward by Policy Exchange, the 3,558 US economists, or Prof. Helm as regards a carbon tax. It is to be hoped that the new government will be prepared to reconsider this approach and look seriously at some of those ideas.[15] At the same time, the UK government will need to think how to respond to the EU’s plans, as part of the European Green Deal proposals of the new European Commission President, Ursula von der Leyen,[16] to establish an EU border carbon adjustment to avoid “carbon leakage” through the importing of cheaper products of energy intensive industries from countries with weaker carbon emissions controls.[17]   

In the energy sector, distributed ledger technology, smart contracts and related innovations are not just of interest to wonkish proponents of better carbon pricing. Oil companies and others in the sector have a keen interest in all these developments, because they have the potential to save them huge amounts of money.[18]

• By exploiting existing sub-surface data, upstream oil and gas players can make the exploration process less hit-and-miss by identifying good prospects and likely dry holes before drilling. Earlier this year, the UK Oil & Gas Authority released 130 terabytes of data about the North Sea. They think that making good use of this data could reduce exploration costs by 20%.[19] 
• Using blockchain and smart contracts they can reduce the costs and cost-overruns of building new infrastructure – some would argue, by up to 50%.
• There is potential to make upstream facilities operate more efficiently by making better use of all the data they gather.  Wood MacKenzie estimate that US shale producers could reduce operating expenses by 10% and add $25 billion of value by putting mature wells on smart production management systems.[20]
• Physical oil and petroleum product trading can be made much more efficient by replacing the old paper-based trade finance system with a distributed ledger.[21]  

It is perfectly possible to find oil and gas industry veterans who are sceptical of these developments. But their reason is not that they doubt the technology. Their response tends to be more along the lines of: “It sounds great, but when the oil price is high, we don’t need to cut costs, and when it’s low, we have other things to worry about”.

However, a digitalised carbon tax could provide the constant, incremental pressure that is needed to get the industry to exploit the power of digitalisation to decarbonise.   

And the industry needs to do this, because it faces all sorts of other challenges. By some measures, its energy return on investment is declining.[22] It may become vulnerable to climate change litigation. It may face competition from lower carbon alternatives that are cheaper and more effective substitutes for what it offers than are currently available.[23] But if the industry saves costs, it will become less risky, and it will be more able to invest in areas where its expertise will be crucial, like hydrogen and carbon capture and storage, that can give it a longer-term future.

Bring on the smart carbon tax of the future, then, and everyone should be a winner. In the meantime, even if the fully digitalised and personalised kind of platform outlined above lies too far in the future to be relied on as the only way forward, there is still plenty of scope to make more widespread use of carbon pricing, at higher and therefore more incentivising levels, and with redistribution and carbon border adjustment elements – and there is a strong case for doing so urgently.

The author is extremely grateful to the World Energy Council (Austria) and the Organisation for Security and Co-operation in Europe for inviting him to speak on the subject of “carbon neutrality vs. economic interests” at the 2^nd Vienna Energy Strategy Dialogue in November 2019 (which was themed around “The Impact of Big Data in Energy, Security and Society”). This article is a version of his contribution on that occasion.

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[1] The proposition that, as regards climate change, mitigation of undesirable outcomes before they materialise is cheaper than adaptation to them once they have arrived, was authoritatively stated in the Stern Review of the Economics of Climate Change, commissioned by the UK government and published in 2006. The UK government’s independent advisory body on climate change, the Committee on Climate Change, found in its 2019 report recommending the adoption of a “net zero” target for UK greenhouse gas emissions in 2050 that this would not cost any more than the previous statutory target of an 80% reduction against 1990 levels (itself partly triggered by Stern’s conclusions).

[2] The gap between the emissions trajectories of current and announced policies and what is needed to avert unacceptable adverse impacts of climate change has been highlighted in many places, including the IPCC’s 2018 special report on Global Warming of 1.5ºC and the UN Environment Programme’s 2019 Emissions Gap Report.

[3] See page 90 of the Committee on Climate Change report on net zero for graphics and full citation.

[4] See for example The Production Gap Report (2019), produced by the Stockholm Environment Institute and others.

[5] See for example the International Energy Agency’s 2020 report, The Oil and Gas Industry in Energy Transitions, and a number of publications by consultancy Thunder Said Energy.

[6] See for example the article by Gillian Tett in the Financial Times, UK edition for 24 January 2020, “The world needs a Libor for carbon pricing”.

[7] See for example the article by Philip Stephens in the Financial Times, UK edition for 24 January 2020, “How populism will heat up the climate fight”.

[8] See the Report of the High-Level Commission on Carbon Prices chaired by Joseph Stiglitz and Nicholas Stern (Carbon Pricing Leadership Coalition, May 2017): https://www.carbonpricingleadership.org/report-of-the-highlevel-commission-on-carbon-prices. Among the Commission’s conclusions: “Countries may choose different instruments to implement their climate policies, depending on national and local circumstances and on the support they receive. Based on industry and policy experience, and the literature reviewed, duly considering the respective strengths and limitations of these information sources, this Commission concludes that the explicit carbon-price level consistent with achieving the Paris temperature target is at least US$40–80/tCO₂ by 2020 and US$50–100/tCO₂ by 2030, provided a supportive policy environment is in place.” (Emphasis added.)

[9] For an analysis of the different ways of implementing a “carbon dividend”, see D. Klenert, L. Mattauch, E. Combet, O. Edenhofer, C. Hepburn, R. Rafaty and N. Stern, “Making Carbon Pricing Work for Citizens”, Nature 8 (2018), 669-677.

[10] The “Economists’ Statement on Carbon Dividends” was signed by, amongst many others, 4 former Chairs of the Federal Reserve, 27 Nobel Laureate Economists and 15 Former Chairs of the Council of Economic Advisers. See now also https://clcouncil.org/Bipartisan-Climate-Roadmap.pdf.

[11] Helm’s report was commissioned by the then Secretary of State for Business, Energy and Industrial Strategy, Greg Clark. At the time of writing, the government had yet to issue a substantive response to it.

[12] See https://policyexchange.org.uk/wp-content/uploads/2018/07/The-Future-of-Carbon-Pricing.pdf.

[13] Ofgem, State of the Energy Market 2019, page 129 (figure 5.10).

[14] See https://www.gov.uk/government/consultations/the-future-of-uk-carbon-pricing.

[15] At the time of writing, a government response had not yet been issued in respect of the majority of this consultation.

[16] See https://ec.europa.eu/info/strategy/priorities-2019-2024/european-green-deal_en.

[17] For commentary, see Sandbag’s report, The A-B-C of BCAs An overview of the issues around introducing Border Carbon Adjustments in the EU. The ultimate relationship between the UK as a whole and the EU ETS remains to be determined, but the agreement between the UK and the EU on the UK’s withdrawal from the EU requires the EU ETS rules to continue to be applied in Northern Ireland as part of the basis for continuing the operation of the Single Electricity Market on the island of Ireland. If the EU border carbon adjustment is implemented as part of the EU ETS regime, the UK may be under pressure to adopt a similar measure.

[18] For a general survey of the distributed ledger technology and its potential applications in the energy sector, see https://www.dentons.com/en/insights/guides-reports-and-whitepapers/2018/october/1/global-energy-game-changers-block-chain-in-the-energy-sector.

[19] See https://www.ogauthority.co.uk/news-publications/news/2019/the-oil-and-gas-authority-launches-one-of-the-largest-ever-public-data-releases/.

[20] See https://www.woodmac.com/press-releases/digitalisation-in-us-lower-48/.

[21] There are various examples in the publication cited in note 19 above, but see also https://www.gazprom-neft.com/press-center/news/gazprom-neft-and-s7-airlines-become-the-first-companies-in-russia-to-move-to-blockchain-technology-i/.

[22] See https://www.sciencedaily.com/releases/2019/07/190711114846.htm.

[23] See https://www.climateliabilitynews.org/2019/12/23/climate-litigation-threat-financial-filings/.