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Designing a Carbon Tax Policy That Works

Sweden, a global pioneer in climate action, has embarked on a journey of carbon pricing. This strategy has yielded remarkable results. Since introducing its first carbon tax in 1991, Sweden has witnessed a 30% decline in carbon emissions from manufacturing. This begs the question: which carbon pricing policies have proven most effective? And how are different policies motivating emitters?

Two times the emissions from all Swedish international flights averted

Sweden has the highest carbon tax in the world, and research paints a clear picture of its effectiveness. The study titled The Effect of Carbon Pricing on Firm Emissions: Evidence from the Swedish CO2 Tax found a direct link between higher carbon taxes and lower company emissions, both in the short and long term.

Insight

Without carbon taxation Sweden’s carbon emissions from manufacturing would be around 30% higher in 2015. That is roughly 4,000 kton, almost two times the emissions of Sweden’s international flights in that year.

The effectiveness of a tax policy is linked to its design

Sweden has employed a diverse array of carbon pricing mechanisms to address industry-related emissions. Some of the policies were more effective than others. In practice all the carbon pricing policies were designed to motivate industries to embrace environmentally conscious practices with motivation: pollute less, pay less. Below, three distinct policies are presented:

POLICY 1

Cap

Sweden’s initial carbon tax in 1991-1992 included a cap limiting the carbon tax burden on companies in order to preserve their international competitiveness. If the combined carbon and energy taxes exceeded 1.7% of a company’s sales, the marginal tax rate effectively dropped to 0%. As a result, large emitters did not have to pay for additional units of carbon emission.

POLICY 2

Reduced rate

The second tax policy introduced had two tax rates. One rate per unit of CO2 emissions until a certain point. Thereafter the rate per additional unit of CO2 was lower. The first rate was up to 0.8% of sales, and exceeding emissions cost 25 % of the general manufacturing rate. This policy was used between 1993 and 2004. As a result, large emitters paid a lower rate for additional units of carbon emission.

POLICY 3

EU ETS

In 2005, the European Union Emissions Trading System (EU ETS) was created, which resulted in a new Swedish carbon taxation policy, without tax reductions or caps. Small emitters are still subject to the Swedish carbon tax system. Large Swedish emitters are now covered by the EU ETS. As a result, large emitters now have an incentive to reduce carbon emissions as they (a) may sell emission certificates when they reduce emissions and (b) have to buy more certificates if they increase emissions.

Manufacturing emissions during different policies

Insight

While periods of economic decline (such as 1992, 2000, and 2008) coincide with reductions in manufacturing emissions, these decreases primarily reflect production slowdowns rather than significant process improvements. During these periods the effect of carbon taxes on emissions is less visible as macroeconomic factors dominate.

How are carbon pricing policies motivating large and small emitters?

A succesful carbon tax policy is motivating both small and large emitters to reduce their carbon emissions from manufacturing. In this interactive research article a large emitter is defined as an emitter that has high enough emissions to sales to qualify for the exemption in the early 1990s and that from 2005 also is in EU ETS.

Annual CO2 tax payment of small and large emitters

Policy 1 - Cap

Annual CO2 tax payment

Large emitters

Small emitters

Annual manufacturing emission

Motivation barometer

Emitters motivation to
reduce emissions

Small

Large

Insight

Motivating all firms to reduce emissions requires a balanced approach: eliminate caps and tax reductions. However, to ensure competitiveness of large emitters it might be necessary to allow large emitters to sell emission certificates earned by reaching emission reduction targets.