Carbon trading systems are considered a crucial taxation measure in the fight against climate change. Designing a level playing field is a major challenge for regulators, because international taxation is driven by sovereignty principles deployed in the residence concept and the underlying nexus required between a taxpayer and a jurisdiction.
When considering carbon emissions, the major challenge is finding the right nexus. Carbon dioxide emissions have no nationality, no residence, and no borders. We can directly see possible frictions between territorial taxation systems and border-free carbon emissions.
The state of play
On the international scene, supranational institutions are setting the tone for collaboration among countries. For example, in June 2022 the OECD launched the Inclusive Forum on Carbon Mitigation. The ministers of the different member countries work together to facilitate the exchange of information on climate change policies, and on carbon pricing mechanisms. In parallel, the IMF is also actively working on this.
Specifically, both institutions are highlighting the following benefits: carbon pricing mechanisms provide flexibility and contribute to reducing carbon dioxide emissions. To increase the impact and speed of the fight against climate change, the scope of carbon markets needs to expand, emissions trading systems (ETS) need to be globalised, and the carbon price needs to increase.
The latter point is already a reality. For instance, the Californian carbon price was around $17 at the beginning of 2020 and almost doubled by April 2022 to $31. New Zealand’s carbon price increase is even more impressive. In February 2020, companies could purchase allocations at around $13, while in October 2022, the allocation price rose by 530% to $82.
The voluntary carbon market (VCM) allows companies in countries without an ETS to participate effectively in carbon pricing schemes. The VCM continues to attract attention: it grew by 190% in 2021, and is forecasted to grow by 80% in 2022 to reach the size of $1.8 billion. Carbon credits have become an integral part of companies’ strategies to achieve their net zero pledge.
The evolution of ETS
Countries are creating ETS markets based on their considered needs and targets. For instance, the Canadian federal government is planning to adopt a sector-specific cap and trade system, or to modify the carbon pricing system (to set a ceiling) for the oil and gas sector, in order to drive these sectors to reduce their emissions by 40% by 2030.
Another important development in the international carbon markets was the launch of China’s national ETS system in 2021. At the time of writing, it covers electric power generation, but intends to integrate cement and aluminium by the end of 2022, and later iron and steel. As it stands, the Chinese carbon market is already the biggest ETS market (three times larger than the EU ETS), and China allocates 100% of its ‘free allocation’ for free. Once the free allocation regime reduces, we can expect the price on the China ETS to increase sharply due to market pressure.
Evolution of carbon pricing
As most ETSs rely on a cap system – which reduces over time – it is predicted that the price of carbon dioxide will continue to increase. The IMF stated that carbon prices could reach between $100 and $200 in 2030.
However, this scenario could be altered by policies that intend to absorb the decarbonisation burden. Such scenarios, presented by the International Energy Agency, estimate that the carbon price would not rise above $250 by 2050.
The route to multilateralism
In reaction to distortions across carbon markets, we have seen initiatives popping up like the EU carbon border adjustment mechanism (CBAM), where the objective is to apply a charge similar to a customs duty on carbon-intensive imports to the EU. Multilateralism is important to address those distortions, reason why the OECD’s Inclusive Framework has started to tackle carbon pricing just as it does for other global tax initiatives such as digital services taxes (DSTs) and the work on pillars one and two.
Can the current landscape enable a multilateral agreement? The need for an international consensus is crucial, and this consideration should grasp tax professionals’ attention for the following reasons.
First, without multilateralism, carbon taxation could easily be applied multiple times, leading to double or triple (or even more) taxation where the same emissions are ‘taxed’ in several jurisdictions.
Second, the network of double tax treaties (DTTs) does not cover environmental taxes. Third, consider the corporate tax impact of higher raw materials or energy costs – such as a contract manufacturer entitled to a targeted operating profit determined on a cost-plus approach, where a higher cost base leads to a higher profit before tax.
Therefore, multinational companies have a real incentive to learn how to navigate the different ETSs, ensure compliance with all the different schemes and adapt to emerging carbon pricing systems.
Carbon markets are accompanied by public funding allocated to sustainable development and innovation for highly-emitting sectors, and companies can greatly benefit from this. Carbon markets push for long-term thinking and a thorough commitment to emission reductions, and companies cannot avoid this anymore.
