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Balancing Net-Zero Ambitions and the Needs of the Economy

Nov. 14, 2022, 8:00 AM

During the last few years, the world has endured multiple simultaneous crises. This year, global attention has quickly switched focus between the many pressing challenges—war, inflation, an energy crisis, high volatility across global markets, and an impending recession to name but a few. Yet climate change consistently remains top of mind for many global leaders.

COP26 marked a shift toward bottom-up action by companies, investors, organizations and citizens intent on taking charge of setting their strategies to confront harmful emissions, acutely aware that climate change was too big of a problem for national governments to tackle on their own. However, one year on, as conversations from COP27 occupy the news headlines—with some scientists claiming the tipping point to prevent temperatures rising above 1.5 C has already passed—is the world in a different place, and as such are businesses and governments having the correct conversations to fulfill their net-zero ambitions?

For some, the rise in energy prices driven by the Russian invasion of Ukraine will signal that the landscape has changed. This has fueled energy security concerns, which has led to calls to hold back on carbon pricing and to slow the shift away from fossil fuel. As a result, the revision of the EU Energy Directive has been slowed, and in many countries, coal-fired power stations scheduled for closure have been kept open.

Conversely, the increase in fossil fuel prices has made renewable energy more competitive, and many jurisdictions are realizing the need to move away from fossil fuel dependence—especially on imports. As an example, under the REPowerEU program, the European Commission wants to reduce the EU’s use of Russian gas to zero well before 2030, and believes a nearly two-thirds reduction is possible within a year.

Additional stakeholders joining the debate, each with their own perspective and preferred approach, has prompted this new debate: how best to get to net zero without damaging economies in a world in a state of geopolitical flux?

Approaches to Tackling Climate Change

There are several ways to tackle climate change—pricing carbon to internalize externalities (in other words, to ensure that the polluter pays the price rather than passing it on to society at large) and send a price signal to the market; regulation that prohibits or restricts emissions (such as from vehicles); targets (such as for the percentage mixture of renewable energy); and incentives, both through the tax system and by direct cash subsidies for certain activity.

Traditional theory places carbon pricing as the most efficient—but some recent studies challenge that and argue incentives and regulation can be equally effective. The US has traditionally favored incentives—for example, production tax credits for renewable energy—and now has launched the Inflation Reduction Act, which, among other things, makes certain green tax credits more attractive by making them transferable or refundable.

The EU has traditionally favored tax. With the Fit for 55 Package, it aims to increase the carbon price by reducing the allowances in circulation within the emissions trading systems and by expanding its breadth—to include at least maritime shipping in the current ETS, and potentially road transport and building in a new ETS.

Carbon pricing is a useful tool where alternatives are available, as it encourages switching to cleaner production, research into better processes, and use of cleaner inputs. But problems may arise if the alternatives are not available, which can create a deadweight cost that ultimately is passed on to the already struggling consumer.

There are, therefore, some instances where regulation may be better placed to impose controls—as found in the case of vehicle emissions. And there is clearly space for incentivizing research and switching to greener technology, especially when the initial costs are high.

Another problem with carbon pricing and certain types of regulation is that it risks driving carbon leakage—for example, a shift of production or purchasing from countries with high tax or regulation to ones with lower controls, to take advantage of cost savings. Carbon leakage means emissions do not reduce overall, but output moves from one jurisdiction to another.

Hence, the EU is proposing to introduce a carbon border adjustment mechanism, which will put a charge on certain imports (such as iron, steel, and aluminum) to equalize the cost of embedded carbon for foreign producers with the cost for EU producers and so reduce the incentive to shift sourcing or production. But the initiative is not without criticism, with some labeling the measures as constituting green protectionism, while there are also challenges in ensuring the system will meet with World Trade Organization compliance. Keep in mind the last thing the world needs now are trade wars!

Going Forward

Given the urgency and numerous opinions on the best route to achieve our global net-zero ambitions, it is probably not profitable to lose crucial time arguing over methods. The idea of a carbon club to share knowledge and approaches presents an interesting idea. As an example, at a July summit, the G-7 released a press statement on the creation of such a club. The announcement supported outcome-focused cooperation based on sharing best practice, transforming industries jointly, a just transition, and support for developing countries. Focusing on the decarbonization pathway rather than the explicit cost of carbon may offer more flexibility for countries to decide what approach is most suited to their individual circumstances and broaden the overall appeal of membership.

There remains an important discussion on the best approach to hasten the transition to net zero—a discussion that becomes more important in the current fragile economic and geopolitical climate. With time working against us, a one-size-fits-all approach may need to give way to bespoke measures, with each country understanding the methods most suited to it. The notion of a carbon club provides an interesting and timely option where the method of getting to net zero is not the important factor; more, the key is the path to get there, and ensuring it is verifiable.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Chris Morgan heads the Responsible Tax Program at KPMG.

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