Why should developing countries implement carbon pricing when even advanced economies fall woefully short?

By Jonas Teusch, Economist, and Konstantinos Theodoropoulos, Statistician, OECD Centre for Tax Policy and Administration

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Taxing energy use for sustainable development

Why should low-income countries implement carbon pricing policies to reduce carbon emissions when  the world’s most advanced economies are falling woefully short of the prices needed to reach the objectives of the Paris Agreement? Indeed, more than 70% of emissions from OECD and G20 countries are completely untaxed, and more than half remain entirely unpriced even when accounting for emissions trading systems. Carbon emissions of most developing and emerging economies pale in comparison to OECD and G20 countries. For example, the 15 selected developing and emerging economies1 analysed in a recent OECD report Taxing Energy Use for Sustainable Development account for less than 4% of global emissions, whereas OECD and G20 countries collectively account for more than three quarters of global carbon emissions.

Against this background, does it matter that none of the 15 selected countries currently price carbon explicitly, and 83% of carbon emissions remain entirely untaxed?

Well-designed carbon pricing reforms can be in the best interests of developing and emerging countries

There are many reasons why well-designed carbon price reforms can be in the best interests of developing and emerging economies, enabling them to respond to multiple pressing challenges beyond climate change. For example, carbon pricing can help tackle local pollution and can support the mobilisation of domestic revenue needed to finance vital government services. While the low level of emissions generated by developing and emerging countries can mean that their ability to slow down climate change in the near future through their own actions is limited, making progress with carbon pricing would help put pressure on large polluters to step up their game. It would also increase developing countries’ ability to participate successfully in a decarbonising global economy.

Carbon taxes or emissions permit trading encourage cleaner investment and consumption choices for all public and private spending, which is not only an effective and efficient way to reduce CO2 emission, but can also future-proof investments. A long-term commitment to carbon pricing and phasing out fossil fuel subsidies ensures that investments will flow into assets that are aligned with low-carbon development objectives and that those assets will remain valuable once the transition to a carbon-neutral economy accelerates around the world. 

Furthermore, there are fewer dirty legacy assets in developing countries than in the developed world. Countries like Côte d’Ivoire, Ecuador, Ghana, and Uganda for example, are not currently using coal. This means that by committing to gradually rising carbon prices in the aftermath of the pandemic, developing countries can avoid many of the transition costs that the developed world is facing today, such as stranded assets and stranded jobs in coal regions. Carbon price reform or other environmental instruments such as a ban on coal use, could even enable some countries to leapfrog the most polluting fossil fuels altogether.

Equally, carbon pricing can strengthen efforts to improve domestic revenue mobilisation. While the revenue potential varies across countries, the recent OECD analysis of 15 developing and emerging economies finds that, on average, these countries could generate revenue equal to around 1% of GDP if they set carbon rates on fossil fuels equivalent to EUR 30 per tonne of CO2. With tax-to-GDP ratios averaging 19% in the 15 countries (compared to 34% in the OECD), carbon pricing could increase tax revenues by around 5% on average.

Revenues from carbon pricing could then be used to provide targeted support to improve energy access and affordability, enhance social safety nets, and support other economic and social priorities. This is all the more relevant as the impacts of the COVID-19 crisis in the developing world have been exacerbated by the fact that too many citizens do not benefit from an adequate social safety net. As a result many have lost all forms of stable income, which has in turn increased the risk of losing access to essential energy services. But in Egypt, where a successful fossil fuel subsidies reform generated fiscal savings, the government was able to allocate more funds to education and health and implement an economic stimulus package to recover from the crisis.

Cutting carbon emissions substantially reduces local air pollution, and these co-benefits counterbalance some of the short-term costs of climate action, e.g. related to higher energy and food prices. Carbon pricing can also help to tackle the high levels of informality in developing countries, where 70% of all employment is informal, as carbon taxes are harder to avoid than direct taxes on personal or corporate income.

In short, carbon pricing is more than good climate policy. In fact, carbon pricing, and energy tax and subsidy reform in general is at the nexus of several UN Sustainable Development Goals (SDGs). While carbon pricing, including fossil fuel subsidy reform, contributes to SDG 12 (responsible production and consumption) and SDG 13 (climate action), it also supports SDG 3 (good health and well-being) and SDG 7 (affordable and clean energy), and with the right design, leads to reduced inequalities (SDG 10) and more sustainable cities and communities (SDG 11).

Adverse impacts of carbon pricing are not a law of nature

If carbon pricing has so many benefits, why do we not see more of it? The barriers are not administrative: almost all countries have experience with fuel excise taxes, meaning that the implementation of carbon price reform is within reach in administrative terms.  Governments simply need to align excise taxes with the carbon content of the fuels. A carbon tax of EUR 30 per tonne of CO2, for instance, corresponds to a gasoline tax of 7 eurocents per litre of gasoline, and a coal tax of some 6 eurocents per kg. Such fuel-based carbon taxes could be collected from the fuel suppliers in the same way as existing excise taxes.

The barriers to carbon pricing lie in making sure that change is equitable and aligned with the country’s development objectives, which is also critical to building broad public support for carbon price reform. Egypt’s success with fossil fuel subsidy reform is encouraging as it shows that adverse impacts on vulnerable households and business can be alleviated. Naturally, carbon pricing is not the silver bullet and needs to be part of a larger portfolio of climate and fiscal policies. Kenya, for instance, is currently taking steps to ensure that people and businesses will have affordable access to cleaner alternatives. Broader efforts at encouraging electrification were highlighted as one promising avenue. Kenya does not have a carbon tax, but levies fuel excise taxes and has successfully phased out most fuel subsidies.

The potential for better use of carbon pricing is substantial. It is time to make progress towards pricing carbon and preparing the ground for a cleaner, healthier, more resilient and inclusive recovery from the COVID-19 crisis.

1. The 15 countries studied are Côte d’Ivoire, Egypt, Ghana, Kenya, Morocco, Nigeria and Uganda in Africa; the Philippines and Sri Lanka in Asia; and Costa Rica, Dominican Republic, Ecuador, Guatemala, Jamaica and Uruguay in Latin America and the Caribbean.