Part 2 | Tax and Carbon: Carrot or stick? Virtual roundtable

Context

As the race to respond to the climate emergency and fund the green transition intensifies, the US' Inflation Reduction Act (IRA) and the EU's Green Deal (including its Carbon Border Adjustment Mechanism (CBAM)) have emerged as significant pieces of legislation, generating global debate about how best to reach net zero targets. As multinational companies navigate these twin policy landscapes, new challenges, tensions and opportunities are emerging.

KPMG International hosted this roundtable discussion to explore how multinational companies are responding to these policies, which approach is likely to be more effective (incentives or carbon pricing – or perhaps a combination of both), how low-income or vulnerable economies might be affected and how China, which currently dominates several environmental technology supply chains, may respond to exclusive subsidies and rising carbon costs.

The conversation, which focussed on perspectives from the UK, EU and Asia Pacific region, was held under the Chatham House Rule and was attended by nine expert participants (see below for a list of attendees). The write-up below summarizes the personal views of participants and does not necessarily reflect the view of any particular organization, including KPMG.

A previous roundtable focused on American and European perspectives – the write-up for which can be found here.

Executive Summary

• The green transition requires a mixture of policy tools and we mustn’t be dogmatic in this regard. Subsidies, pricing and regulation are all part of the mix and can work together.

• The IRA is generally perceived as being simpler and more generous than subsidies available in the EU but may not be as simple to implement as initially thought.

• There are concerns amongst some that subsidies may result in a surplus of capacity globally in certain green technologies (like solar panels and batteries) although there is an ever-increasing demand for these products at present.

• Effective carbon pricing can decouple economic growth from fossil fuel utilization as, for example, the Swedish experience has demonstrated.

• The EU CBAM is complex. The 2-year transitional period with only reporting requirements should give the EU Commission a chance to fine-tune regulations and engage in training and capacity building, but there are concerns about the impact on developing countries.

• Developing countries need to be part of a global conversation on carbon policy recognizing that they are not homogenous and each country has its own individual situation and priorities.

Use the carrot?
Does the IRA have the advantage of simplicity? Does it represent a failure to put a price on carbon? Will it create a surplus of capacity and increase carbon production?

Similarly, to the previous conversation involving participants from the US and Europe (held on 5 November 2023), it was expressed that the EU’s incentives are more complex than the incentives offered by the IRA.

However, one participant questioned: just how easy is it to apply the IRA incentives. There are significant strengths associated with the IRA including no budget caps, funding is technology neutral (any type of technology, is permissible as long as it achieves the aims of the relevant parts of the IRA) transferability, the ability to monetize immediately and the availability of funds for ten years provides a level of certainty. However, signs are emerging that the process is actually more complex than expected with thousands of pages of guidance and explanation.

Some participants highlighted that a flaw of the IRA is its failure to put a price on carbon. It may also encourage too much competition on subsidies. There were concerns expressed that the IRA may overstimulate manufacturing, which might end up creating a surplus of capacity.

Use the stick?
Does the EU’s CBAM create perverse incentives? What about carbon leakage? Is it opening up the debate in this space?

It was noted that the EU’s CBAM represents a strong carbon ambition and by imposing a charge on the embedded carbon emissions generated in the production of certain goods imported into the EU (subject to a credit for any actual carbon price paid), the CBAM tries to ensure the carbon price of imports is equivalent to the carbon price of domestic production. This should minimize the opportunity for carbon leakage.

It was also suggested that the EU is not trying to dictate environmental policy to other countries. While only a carbon price (through explicit carbon pricing like a carbon tax or an emissions trading system) is creditable against CBAM, if a country reduces emissions through say regulation or subsidies, that will also reduce any CBAM charge on imports into the EU. Nevertheless, the CBAM mechanism is complex and the EU Commission has been fielding many questions about how it works in practice as well as engaging in technical assistance. As the initial phase (from 1 October 2023 to 31 December 2025) involves only reporting and not the paying of the CBAM charge, it will give the EU Commission some time to gather information necessary to finalize various regulations and also to enable training for impacted importers.

Nevertheless, there was an argument around fairness for developing countries in this regard and the perpetuation of a cycle of inequality.

It was discussed that when attempting to tax ‘bad behaviour’ such as carbon production, perverse incentives can exist to maintain those revenue streams. One participant suggested that once you start using sticks to raise your revenue it can become difficult to do without them. If businesses respond accordingly, lowering carbon production for example, it becomes a challenge for governments to find alternatives to replace that income.

Sweden was used as an example where a country had successfully decoupled the commonly assumed correlation between carbon production and GDP growth. Carbon taxes in Sweden began in 1991 and have increased over time leading to a 33% reduction in emissions whilst simultaneously seeing a 90% rise in GDP.1 Neither has the success in driving decarbonisation resulted in a reduction in tax revenues. One participant suggested that there is a balancing act that can be navigated to avoid a cliff-edge-style drop in income generated from carbon taxes if a well-planned transition is in place.

Participants agreed that the EU is opening up the space for debate and encouraging others to create their own carbon markets. Examples were cited including developments in Vietnam and Indonesia. CBAM has triggered discussions that are necessary to get everyone thinking.

Participants discussed the bureaucratic complexity of measuring and verifying embedded carbon, under CBAM, and the potential this has to make it more difficult for SMEs to penetrate the EU market.

The view from China
What are the potential implications of the IRA and EU’s CBAM on Chinese markets? What do trade figures suggest and is competition on the way?

It was expressed that some believe both the EU’s CBAM and the IRA are working in a way that is not favourable to Chinese businesses. One impact of the IRA is to attract certain green business to the US – battery manufacturing is an example. Participants noted that current trade statistics show there has been a huge increase in demand for green technology – such as solar panels and batteries - especially following Russia’s invasion of Ukraine. This has led to a huge demand from Chinese manufacturers. It was suggested that China is currently in a leading position in terms of trading but there was recognition that significant competition is anticipated in the near future.2 Given the restrictions on inward investment under the IRA it was thought that Chinese companies could not benefit from it and would more likely concentrate investment in Asia and possibly Europe.

All hands on deck
Carrot or stick? We mustn’t be dogmatic about policy tools in the pursuit of a green transition.

One participant pointed out that, while both a subsidy approach and a taxing approach can drive decarbonization, measures like IRA should encourage investment and greater economic activity and capacity, so also increasing tax revenue. CBAM by contrast is likely to increase costs and therefore slightly reduce investment and growth. However, in efficiency terms, there is a concern that subsidies could result in a global oversupply (at least in certain green technologies like solar power and batteries) which would increase the cost of decarbonization above optimum levels.

Nevertheless, participants agreed that polarizing measures such as the EU’s CBAM and IRA, one against the other, makes little sense. Given the gravity of the climate emergency, it should be ‘all hands on deck’ to drive forward the green transition. There was a shared sense that we shouldn’t be dogmatic about policy tools. Electric vehicles were used as an example of the need to leverage all available tools: regulation (announced future bans on fossil fuel cars); public investment in charging stations; and taxation on the price of fuels. All these elements should work together to encourage the shift away from combustion engines.

It was questioned however whether some countries might perceive that they are being pressurised into putting a price on carbon, especially by carbon border adjustment measures like CBAM.

Who picks up the tab?
Do these measures fairly draw down public finance? How can you help ensure the cost burden isn’t unfairly felt by developing economies?

Participants suggested that the IRA has served as a wake-up call for Europe and we are, to some extent, seeing the emergence of international competition in giving out state aid. However, the allocation of public resources must be carefully considered at a time when most nations face financial crises.

It was highlighted that there was a need to look at the impact of measures on the Global South not as a whole but on a more individual basis as the effects will be felt very differently across developing economies.

It was discussed that when considering carbon pricing in general, governments could look to reduce current fossil fuel subsidies. There are different methods used to quantify fossil fuel subsidies but the IMF, for example, estimates that globally, total subsidies amounted to $7 trillion in 2022.3 However, such a move should be carefully considered to ensure the green transition is affordable for most people.

Participants agreed that if a global price on carbon is the necessary goal to accelerate the green transition, then it poses a dichotomy: ensuring it is low enough not to exclude developing economies yet high enough to be effective. Further consideration is needed here.

The role of regulation
Should regulation take place at the global level?

Some participants suggested that in the future potential regulations should be implemented globally with a critical mass of countries agreeing on a plan for carbon reduction.

It was proposed that this could be implemented on an industry-by-industry basis to create a framework for private investment into those spheres. It was agreed that this would require global institutional reform or a new global body. There was consensus that this would take time and a regional focus may be necessary in the interim.

Summary

Participants agreed that accelerating the green transition will require a mixture of both incentives and a price on carbon. Developing economies must be part of the conversation and their needs considered on an individual, rather than aggregate, basis. Reform to global institutions is necessary to manage a global approach and regional efforts are crucial in this interim.

The views and opinions expressed herein are those of the author and do not necessarily represent the views and opinions of KPMG International.

Contributors to the conversation included:

• Susanne Akerfeldt, Senior Adviser, Swedish Ministry of Finance

• Chen Ji, Senior Associate, CICC

• Marale Du Plessis, Corporate Tax Director, KPMG in New Zealand

• Becky Holloway, Programme Director, Jericho

• Neal Lawson, Partner, Jericho

• Patrick Lenain, Senior Associate, Council on Economic Policies (CEP)

• Chris Morgan, Head of the KPMG Global Responsible Tax Project, KPMG International

• Grant Wardell-Johnson, Global Tax Policy Leader, KPMG International

Footnotes

1https://www.government.se/government-policy/swedens-carbon-tax/swedens-carbon-tax/

2https://www.reuters.com/business/energy/europe-isnt-profitable-solar-industry-warns-hurdles-eus-green-tech-drive-2023-10-05/

3https://www.imf.org/-/media/Files/Publications/WP/2023/English/wpiea2023169-print-pdf.ashx