Pay the carbon tax and breathe freely

• Russia lags behind in the global race to reduce emissions. Tools to control greenhouse gas emissions are being actively developed around the world: 46 countries have already implemented or plan to implement such tools. None of the similar instruments has been implemented in Russia yet, although carbon credits of CO₂ equivalent were successfully sold in 2011, and government authorities are debating a carbon tax.
• Each country choses its own path in meeting the carbon emission reduction targets. Carbon taxes and emissions trading systems (ETS) are the most efficient emissions control tools. 25 countries have a carbon tax, and 38 countries operate an ETS; some of the countries, like the UK and Canada, use both mechanisms simultaneously.
• Carbon protectionism risks increase, which may result in substantial losses for the Russian exporting producers; they will be forced to bear additional costs when selling to Europe and other jurisdictions with high carbon taxes. For instance, the tax rate in Finland, Lichtenstein, Norway, Sweden, and Switzerland is above USD 50 per ton of the CO₂ equivalent.
• A balanced approach to implementation of emissions control tools can help Russian exporters to avoid losses when selling their products. Energy efficiency programs and tax benefits will allow businesses to offset additional fiscal load.
• As soon as the coronavirus crisis is over, regulating greenhouse gas emissions in Russia, and in particular, introduction of a carbon tax for large polluting enterprises, will regain its relevance. ACRA suggests a scenario of a gradual introduction of a carbon tax, which will contribute additional RUB 900 bln to the budget in the first three years. These funds may be used to solve environmental issues in the most polluted regions of Russia, and in particular as part of the Clean Air Federal Project.

Emissions control tools

Global climate change and the related risks are increasingly becoming the source of concern for economists. OECD projects that the slowdown of the global GDP growth due to climate change and outdoor air pollution damages may reach 3% as compared to 2060 forecast¹.

In view of the potential risks for the economy, many countries are establishing market mechanisms to encourage reductions in greenhouse gas emissions and thereby comply with the obligations² undertaken as part of the Paris Agreement³. In addition, there have been carbon protectionism cases around the globe with respect to those countries that have no emission regulations in place⁴. Therefore, market mechanisms for controlling emissions enable governments to avoid sanctions. Key tools to control CO₂ emissions that are currently in use are Emissions Trading Systems (ETS) and carbon taxes.

According to the World Bank, 58 emissions control tools (29 carbon taxes and 29 ETSs) have been developed globally that are already in use or planned to be used in 46 countries (Fig. 1).

By using these tools (together or individually), the government allows companies to choose a method to reduce their pollution impact: by reducing emissions through technological changes or by paying a carbon tax/buying credits for excessing the emission cap. The choice of emissions control tool by a country is largely determined by the structure of the national economy and its current capabilities.

None of the above tools has been implemented in Russia to date, despite a successful deal to sell carbon credits (in CO₂ equivalent)⁵ and active discussions of carbon taxes by government agencies⁶. The draft Strategy for the Long-Term Development of the Russian Federation until 2050 with Low Greenhouse Gas Emissions, published by the Ministry of Economic Development in March this year, there are no clear indications that Russia is planning to set up an ETS or introduce a carbon tax in the near future⁷.

¹ Economic interactions between climate change and outdoor air pollution. Working Party on Integrating Environmental and Economic Policies. Organisation for Economic Co-operation and Development (http://www.oecd.org/officialdocuments/publicdisplaydocumentpdf/?cote=ENV/EPOC/WPIEEP(2018)3/FINAL&docLanguage=En).
² Economic interactions between climate change and outdoor air pollution (https://unfccc.int/files/essential_background/convention/application/pdf/russian_paris_agreement.pdf).
³ The Paris Agreement is a document aimed at preventing climate change and keeping the increase in global average temperature to well below 2°C above pre-industrial levels.
⁴ US keeps wary eye on EU carbon border tax plans (https://www.cleanenergywire.org/news/us-keeps-wary-eye-eu-carbon-border-tax-plans).
⁵ Gasprom Neft closes a deal to sell carbon credits (https://ria.ru/20110518/376407067.html).
⁶ The Ministry for Economic Development refused to introduce the “Chubais Tax” (https://www.rbc.ru/business/28/10/2019/5db2f42d9a7947c0fc9653d1).
⁷ The draft Strategy for the Long-Term Development of the Russian Federation until 2050 with Low Greenhouse Gas Emissions (https://economy.gov.ru/material/news/minekonomrazvitiya_rossii_podgotovilo_proekt_strategii_dolgosrochnogo_razvitiya_rossii_s_nizkim_urovnem_vybrosov_parnikovyh_gazov_do_2050_goda_.html).

Emissions trading systems

An ETS uses the cap-and-trade principle, where a cap is a maximum emission limit set for a particular industry of the country's economy or for the entire national economy. Each company in the regulated industry is obliged to limit its greenhouse gas emissions at a set level. If the actual emissions by a company are below the cap, the company can keep its spare allowances (carbon credits) and use them at its own discretion: to freeze and use them for the company’s needs in subsequent years, or to sell the allowances on the market to other companies. If the company exceeds its emission limits, it can buy emission allowances from the regulator or from other companies at an auction. Some companies buy credits on a voluntary basis, even without exceeding the emission limit, in order to reduce their carbon footprint. This allows them to position themselves as sustainable development organizations.

In some cases, the regulator may grant free allowances to companies to facilitate emission reductions or in special economic situations. Usually, to calculate emissions and their limits, a special unit of measurement is used, the CO₂ equivalent, which all greenhouse gases are reduced to depending on their contribution to the greenhouse effect. The standard size of one carbon credit used in the market for convenience is one ton of the CO₂ equivalent, which is also called the Assigned Amount Unit.

Figure 1. Emissions trading systems and carbon taxes

Source: World Bank

The first emission reduction through emissions trading system was successfully tested in the USA in the 1990s as part of the Acid Rain Program — an initiative to control sulphur dioxide emissions. As a result, the emissions of this pollutant declined 43% between 1990 and 2007⁸. Ultimately, this method was chosen for combating global climate change. When the first ETSs were created, they were intended to trade carbon dioxide emissions only, as their contribution to the climate change is the highest. However, since 2008, the European Commission made it possible to trade credits on emission of other greenhouse gases: methane, nitrogen oxide, and others.

⁸ Fedorov Y.N., Averchenkov A.A. National Greenhouse Gas Emissions Trading Systems. Moscow, 2011 (http://www.ncsf.ru/files/publications/17_broshura_2011.pdf).

Currently, ETSs operate at both the supranational (European Union) and national (Switzerland, New Zealand) levels, as well as in individual regions, provinces or cities (California, Quebec). According to the World Bank, 29 ETSs have been developed around the world⁹. According to Reuters, the global market for CO₂ allowances was estimated at USD 164 bln in 2018, with an annual growth rate of 250 per cent¹⁰. The largest ETS in the world is the European ETS (EU ETS), which covers all EU countries as well as Norway, Iceland, and Liechtenstein. The total credits traded on the platform equaled USD 45.5 bln in 2018 (1.5x higher than in 2017).

The largest emitters are electricity, heat production, and transportation industries, which together generate two thirds of global emissions. The rest of emissions is mostly contributed by manufacturing and construction companies.

The majority of ETSs operate only in certain sectors of the economy, including power generation, oil refining, iron and steel, paper, and chemical industries, manufacturing of construction materials, cargo transportation and passenger air travel, and construction industry in many Asian countries.

It is worth noting that ETSs do not cover all of the human-generated emissions. The World Bank estimates that greenhouse gas emissions covered by ETSs account for only 13 per cent of total global emissions¹¹. The coverage of the EU ETS is 45 per cent, and it reaches 60 per cent in some provinces in China, while California and Quebec are leaders, with their emission coverage exceeding 80%.

The above values show that, the market for greenhouse gas emissions trading is being formed now and that countries gradually develop their approaches to pricing and market regulation.

Theorizing about how the value of an emission allowance is formed, one could assume that for the emissions reduction mechanism to function properly, pricing of allowance should reflect potential expenditures of companies for reducing their emissions (new equipment, changes in the technology processes, etc.). This logic suggests that emission allowances should be cheaper in the developing countries where ecological standards for manufacturing companies are lower. However, these assumptions are only partially true in practice.

The World Bank data show that the cost of emission allowances varies quite significantly by country/ region/ industry and depends on the toughness of the established emission cap, penalties for excessing this cap and the respective country obligations under the Paris Agreement. So far, however, policy and legislative decisions in a country remain the key driver for the cost of emission allowances. For example, a sharp increase in allowance prices in the EU ETS in the first half of 2019 was due to structural reforms in the European carbon market and the expected reduction of available allowances from 950 to 550 million units¹².

The International Bank for Reconstruction and Development and the World Bank estimate the price range of a carbon credit required to achieve the objectives set out in the Paris Agreement of USD 40 to USD 80 per ton of CO₂ equivalent by 2020 and of USD 50 to USD 100 per ton by 2030. Given that current prices range from USD 1.9 to USD 32 per ton, achieving the objectives of the Paris Agreement looks problematic (Fig. 2).

The regional ETSs in China (Chongqing, Tianjin, Shenzhen), where the carbon trading markets are in their early stages, have the lowest prices for emission allowances. A ton of CO₂ equivalent is below USD 5.

Similar prices are seen at RGGI auctions¹³, where low levels can be explained by limited demand for carbon credits. On the other hand, EU ETS has the highest carbon prices.

⁹  The International Carbon Action Partnership (ICAP) is an international forum for governments and public authorities that have implemented or are planning to implement emissions trading systems (ETS) (https://icapcarbonaction.com/en/partnership/about).
¹⁰  A brief explainer on carbon markets (https://news.globallandscapesforum.org/41410/a-brief-explainer-on-carbon-markets/).
¹¹  Pricing Carbon (https://www.worldbank.org/en/programs/pricing-carbon#CarbonPricing).
¹²  Carbon credit costs soar as EU toughens stance on environment (https://www.ft.com/content/d1d9fcf4-a7c0-11e9-984c-fac8325aaa04).
¹³  The Regional Greenhouse Gas Initiative (RGGI) is the first mandatory market program in the USA aimed at reduction of greenhouse gas emissions (https://www.rggi.org/).

Figure 2. Carbon prices in different ETSs, per ton of CO2-equivalent

Source: ICAP Allowance Price Explorer (https://icapcarbonaction.com/en/ets-prices).

In what follows, we review the most advanced ETSs around the globe, which, in ACRA’s opinion, should be used as an example when creating an ETS in Russia. We will focus on their operation history and mistakes in the pricing policy, coverage of greenhouse gas emissions in the ETSs as well as industries that are subject to restrictions on greenhouse gas emissions.

European ETS

EU ETS was established in 2005 based on the Directive 2003/87/EC of the European Parliament and Council of the European Union; it covers over 11 thousand industrial enterprises that generate the largest share of emissions. Industries covered by EU ETS include electric and thermal power industry, petrochemical, chemical, metallurgical, pulp and paper industries as well as manufacturers of construction materials (glass, concrete, and ceramics). The EU ETS also includes air transportation; however, only flights between airports located within the European Economic Area are subject to regulation until 2023¹⁴.

Emission allowance prices in the EU ETS are determined by supply and demand, which in turn depend heavily on legislative and policy decisions and developments in the countries that are part of the EU ETS. Following excessive emission allowances issued by governments in the EU ETS countries in 2008-2013, the price of one carbon credit fell from USD 33 to USD 6 per ton of CO₂ equivalent. In the period of 2013-2015, prices recovered slightly to USD 8.6 following a reform of the EU ETS. After the Brexit referendum and amid the news that UK’s allowances could be sold, the price fell back to USD 6 per ton in 2016. In 2017-2019, the price increase was driven by more tight emission control legislation in the EU and a substantial decrease in the number of available allowances (Fig. 3). In March this year, the EU ETS again confirmed its instability: due to the spread of the coronavirus and quarantine measures in a number of European countries, the EU ETS market experienced a sharp deficit in demand, which led to a collapse in prices to $17.5 per ton of CO₂ equivalent (roughly equivalent to the price level at the beginning of 2018)¹⁵.

Figure 3. Decline in the amount of emission allowances in the EU ETS

Source: Report from the commission to the European Parliament and the council: Report of functioning of the European carbon market, 2018 (https://op.europa.eu/en/publication-detail/-/publication/fa0fd864-0212-11e9-adde-01aa75ed71a1/language-en).

The incorporation of the ETS into the economic system of the European Union involved considerable difficulties and was challenged by both the enterprises and the population. The level of the cap, the volume of free allowances and the reliability of the information on actual emissions volumes drew major criticism in the early stages of ETS implementation. For instance, in 2006, the volume of allowed emissions (including free credits) was so much higher than the actual emission volume, due to which the carbon credit prices in the EU ETS slumped to USD 1.3 per ton by the end of the year.

In the ensuing years, European countries have been more thoughtful in their approach to recording emissions and the amount of free allowances provided. It is worth noting that free allowances continue to be allocated in the EU ETS countries in order to prevent the so-called “leakage” of emissions, i.e. where companies move their production facilities to countries with less strict emission requirements, which results in the global emissions not changing or even increasing. In the EU ETS, free allowances can be provided to reward companies that have significantly reduced their emissions. The planned amount of free allowances is about 43% of the total EU ETS allowances in 2013-2020.

The EU ETS rules have tough penalties for companies that exceed the cap. The penalty for excess CO₂ equivalent emissions was changing with the evolution of the system: from EUR 40 per ton in 2005-2007 to EUR 100 per ton in 2008-2009. Currently, penalty rates are set individually for each country in the EU ETS and depend on the size of the enterprises. Excess emission penalties contribute substantial funds to budgets of EU ETS countries: they totaled EUR 14.5 bln in 2018. Income from excess emission penalties is likely to increase in the coming years. JATO, an analytical company, projects that starting in 2021 car makers alone selling their cars in Europe will pay EUR 33.6 bln in excess emissions penalties¹⁶.

¹⁶ 2021 CO₂ targets would generate €34 billion in penalty payments within Europe (https://www.jato.com/2021-co2-targets-would-generate-e34-billion-euros-in-penalty-payments-within-europe/).

The Regional Greenhouse Gas Initiative

Established in 2008, the RGGI covers energy sector enterprises located in ten Northeastern United States (Connecticut, Delaware, Maine, Maryland, Massachusetts, New Hampshire, New York, Rhode Island, Vermont, and New Jersey).

The RGGI-based ETS did not work perfectly in its early years: emission limits were extremely high in the first three years of the operation (170.5 mln tons of CO₂ equivalent per year) due to calculation errors. Actual emissions were almost 40 per cent lower than the maximum allowed level, which had a significant effect on allowance prices: they were below USD 2 per ton of CO₂ equivalent in 2010-2011. Subsequently, the limit was reduced over three times and equaled 53 mln tons of CO₂ equivalent per year in 2019, which slightly supported the emission allowance prices (Fig. 2). It is noteworthy that the RGGI-based ETS covers only the energy sector, so the total emission coverage in the above states is quite small as compared to other ETSs at only 18%¹⁷. The total trading volume in this ETS was USD 259 mln in 2019.

¹⁷ Carbon Pricing Dashboard (https://carbonpricingdashboard.worldbank.org/map_data).

The Western Climate Initiative

The Western Climate Initiative (WCI) is a non-profit organization that manages trading in carbon credits both in and between California and Quebec. It was founded in February 2007 by governors of five U.S. states (Arizona, California, New Mexico, Oregon, and Washington). Subsequently, the WCI was expanded to include the states of Montana and Utah and the provinces of Canada (British Columbia, Manitoba, Ontario, and Quebec). WCI’s initial goal was to reduce emissions by 15% from the 2005 level by 2020. However, six U.S. states withdrew from the organization and stopped complying with their commitments. California that remained in the WCI has announced the establishment of its own ETS in January 2013 and kept the initial emission reduction target. Quebec joined the initiative in 2014.

The joint ETS of California and Quebec trades not only in CO₂ credits, but also in other greenhouse gases. Emission limits in this ETS are set for companies whose emissions exceed 25 million tons of CO₂ equivalent per year. In the first two years, the ETS in California covered the power industry, petrochemical companies, oil and gas companies, enterprises in the food, glass, and cement industries. Since 2015, the California ETS extended its requirements to producers of all fuel types except jet and marine fuels. The ETS in Quebec covers all industrial manufacturers, energy transportation companies as well as importers of fossil fuels.

The ETS in California currently covers about 600 companies. The total volume of emissions in CO₂ equivalent controlled by the system amounted to 342 mln tons in 2019 (77% of the 2012 level). Profits generated by the state are estimated by the World Bank at USD 3 bln. The ETS in Quebec covers 93 companies, and the total amount of emission allowances equals 57 mln tons of CO₂ equivalent. The ETS generates about USD 643 mln in revenues for the Quebec budget.

China: pilot projects and a nation-wide ETS

China is the global leader in greenhouse gas emissions, and the country’s emission volume only keeps rising every year. The critical level of environmental pollution in the country, due primarily to the prevalence of coal fuel in the energy industry, prompted the Chinese government to take measures to control emissions, including greenhouse gases. In 2010, the Chinese authorities incorporated creation of several ETSs in their five-year development plan, and in 2011, they ordered to launch seven pilot projects. The first ETS was established in Shenzhen in 2013; ETSs were launched in Shanghai, Beijing, Tianjin and Guangdong the same year, and in 2014, ETSs in Hubei and Chongqing were set up. Dedicated exchanges for trading in carbon credits have been set up in each of the pilot ETSs; emission reduction targets have been defined; and industries to be covered by the ETSs have been chosen (Table 1).

Table 1. Details of pilot ETSs in China (2018)

Source: International Emissions Trading Association

In late 2014, the National Development and Reform Commission of the People's Republic of China issued a document detailing the approach to the implementation of the national ETS and the schedule for its introduction. According to the document, the system should be implemented in three stages:

- Preparation (2014-2015): emission recording methods, technical standards and registries are defined;

- Operational improvement (2016-2020): launching a test of the nation-wide ETS and all related regulations entering into force;

- Stabilization (after 2020): operation of the ETS will be adjusted and scaled up; potential connections of China’s national ETS to other ETSs will be explored.

According to a study conducted by Chinese scientists¹⁸, China's national ETS is still in the preparation stage despite the launch of pilot projects. Experts estimate the efficiency of the projects as rather low due to the lack of liquidity.

In September 2019, China made some progress in the development of the nation-wide ETS: a plan for carbon credits allocation in the energy industry was published, which is intended to serve as a basis for other industries. Nevertheless, ACRA notes that due to the coronavirus pandemic the ETS implementation in China may be delayed.

ETSs in other countries

In addition to the four ETSs described above, additional 25 ETSs are in operation or planned for launch worldwide at the regional and national levels. These include nation-wide ETSs in Australia, New Zealand, Switzerland, Kazakhstan, Canada, and South Korea.

Incorporation of ETSs in the economic systems of Australia and Kazakhstan has not been very successful, and therefore they are now being updated. In New Zealand, the operation of an ETS in the country was controversial at the initial stage, and in particular, free allocation of credits was questionable as well as the "1-for-2" policy, according to which an allowance for one ton of greenhouse gases covered two tons of emissions. Subsequently, the 1-for-2 policy was abolished, and the ETS in New Zealand covers all industries now.

In Switzerland, an ETS was introduced in 2008 and acts as an alternative to the carbon tax. In January 2020, the ETS of Switzerland joined the EU ETS, which allows Swiss companies to trade their credits in the European market.

The ETS in Canada was launched in 2019 and uses a differentiated approach to the emission caps that are set individually for each industry. Canada also has regional ETSs (Quebec, Ontario, Nova Scotia, etc.).

An ETS in South Korea was launched in 2015, but its incorporation in the economy is gradual: in the first three years (2015-2017), 100% of allowances were allocated free of charge; currently, the share of free allowances has decreased to 97%, and it will decline to 90% going forward.

An attempt to introduce a national ETS in Russia was made in 2010-2011. Sberbank was responsible for selecting participants and also was the official operator of the CO₂ credits auction. However, as the system for selecting participants was non-transparent, as well as amid the collapse in carbon credit prices in the global market in 2011, the ETS did not take root in Russia. In total, Russian companies managed to sell allowances worth 250 mln tons of CO₂ equivalent, over 70% of which were purchased by Vitol.

Emissions tax

In some countries, the emissions tax, like the tax on fossil fuel consumption, has been in effect since the 1990s and is aimed at limiting the use of fossil fuels and reducing greenhouse gas emissions. The leaders in this area are the Scandinavian countries, as well as Poland. In Finland and Poland, a carbon tax was introduced in 1990. Norway and Sweden introduced similar taxes in 1991, a fee for the use of fossil fuels and a tax on CO₂ emissions for industrial enterprises and electricity producers, respectively, with Denmark following suit in 1992¹⁹.

As is the case with ETS, when a central or regional government imposes an emissions tax, it also sets a price per unit of emissions, which all polluting enterprises are required to pay.

In the fuel and energy sector, instead of an emissions tax, there is a tax on the consumption of fossil fuels whose rate depends on the amount of CO₂ emissions entering the atmosphere when a particular type of fuel is burned. While a tax on fossil fuel consumption encourages energy companies to switch to low-carbon fuels, an emissions tax encourages businesses to reduce their greenhouse gas emissions in order to reduce tax expenses. The rate of both types of tax acts as a gearshift that allows companies to adjust the speed at which they have to adapt to new conditions.

In theory, the carbon tax rate should reflect the cost to businesses of reducing greenhouse gas emissions. However, ACRA notes that in most countries the tax rate is currently very far from the potential costs of modernizing production. The Center for Energy Efficiency in Russia estimates that the cost of switching from coal to natural gas is USD 16 per ton of CO₂ equivalent, USD 30 per ton for a transition from coal to onshore wind farms, and up to USD 80 per ton offshore²⁰. The IMF estimates that on average an emissions tax rate of USD 40 per ton is enough to reduce emissions under the Paris Agreement.