As we continue to reflect on the COP26 climate challenge and the requirement for the UK to achieve a net zero emissions balance by 2050, we are increasingly drawn into discussions considering tax and how it is currently playing a role.

How might it need to drive further changes in behaviour by business and individual taxpayers? There is a new vocabulary to learn, emerging science and technologies to get to grips with, along with new taxes to contemplate. In due course a roadmap will be needed showing how and when tax revenues might be expected to rise, and then fall over time (if they do their job properly).

In this article we have rounded up some explanations, facts and figures to explain a few of the terms used most frequently in discussions. This includes some of the major taxes, levies and tolls currently raising climate-focused revenue in the UK.

Net zero

Net zero relates to carbon emissions. To achieve net zero, the carbon emitted into the atmosphere must be no more than the carbon removed from it. The UK is now legally committed to achieve net zero by 2050.

Other emissions of concern

Although most carbon is released in the form of carbon dioxide (CO2), other gas emissions are also harmful to the planet (eg, methane, nitrous oxide and fluorinated gases). These are not included in the net-zero target, although clearly methane, for example, is also one to watch. Weight-for-weight, methane is more than 20 times more potent than CO2. Over the time horizon the UK is focused on, methane has a more damaging impact on global warming. Natural gas is mostly methane.

Sources of emissions

The majority of emissions come from homes, transport, agriculture, industry and aviation. Almost all of these will require substantial investment to make the changes needed to reduce emissions into the atmosphere.

It might be easier to reduce emissions in some categories than others. Road transport is an area visited often in discussions involving taxes and tolls. Homes are a particular challenge because so much of the UK’s housing stock is old. In older housing poor insulation needs to be addressed before heating system upgrades can be effective.

Carbon capture

Part of the solution will be to change how we use land so that it absorbs more CO2 from the atmosphere, for example by investing in peat bogs or planting trees. But it is also possible to use technology to capture and store CO2 rather than simply releasing it into the atmosphere. For a very accessible article, see the Grantham Research Institute on Climate Change and the Environment article What is carbon capture and storage and what role can it play in tackling climate change?

Carbon sequestration

Carbon sequestration is the actual process of capturing and storing CO2 from the atmosphere in a carbon pool. It can be achieved biologically, for example by trees and other plants, which do this through photosynthesis (the process by which they use sunlight, water and CO2 to create oxygen and energy for their growth). It can also be achieved using technology or geology.

Carbon tax

The World Bank defines a carbon tax as a form of explicit carbon pricing. It refers to a tax directly linked to the level of CO2 emissions and is often expressed as a value per tonne CO2 equivalent (per tCO2e).

Major sources of tax revenue

It is worth being aware of figures when discussing how taxes might be used to help the UK achieve net zero. The system has historically adopted the ‘polluter pays’ principle.

Unfortunately, as taxpayers pollute less, we need to find other ways to raise revenue for the UK’s annual spending needs.

The Institute For Fiscal Studies (IFS) estimates that total government revenue for the year 2021/22 will be £819.3bn. Environmental taxes have historically made a substantial contribution to this total. Recent government statistics show environmental taxes have raised significant sums but that these are falling. It seems we are becoming greener, but clearly this revenue will need to be replaced if we want to keep spending.

It is worth noting some of the largest components of the above, such as the receipts from tax on hydrocarbon oils – mainly fuel duty. Fuel duty is forecast to raise £26bn (2.7% of government revenue) in 2022/23. There are different rates of fuel duty payable on different types of fuel.

Within transport taxes, air passenger duty was raising increasing sums each year until 2019 (£3.8bn), although it dropped to £0.9bn in 2020 due to the pandemic. Motor vehicle duties (car tax) are the other largest contributor here, raising around £7bn each year, although rates paid differ significantly between older cars using ‘dirtier’ fuels and newer or less polluting vehicles. 

Pollution taxes raise just over £1bn each year, with landfill tax being the biggest – although this is falling, presumably as behaviour changes.

UK emissions trading system

On 1 January 2021, a UK Emissions Trading Scheme (UK ETS) replaced the UK’s participation in the EU ETS. This is the main UK tax that applies to greenhouse gas emissions and it applies to energy-intensive industries, the power generation sector and aviation. This tax raised £1.4bn in 2020.

Emissions trading schemes work on a ‘cap-and-trade’ principle. A cap is set on the total amount of certain greenhouse gases, such as carbon dioxide, that can be emitted by a sector. The cap for a sector decreases over time so forcing innovation or those emitting the gas to compensate somehow, which ensures that total emissions must fall.

Any business carrying out an activity covered by the UK ETS must have a greenhouse gas emissions permit and must monitor its emissions. It will be given a free allowance through the scheme, but can also buy further emission allowances at auction or on the secondary market, through which it trades with other participants as needed. If a business exceeds its allowance without buying more, it is fined. Each year, with limited exceptions, a business’s CO2 emissions and activity level must be verified by an independent accredited verification body.

Carbon leakage

Carbon leakage occurs when a business decides to move its production from a country with stringent policies, to a more lenient country, and could lead to an increase in greenhouse gas emissions. This effectively shifts the problem elsewhere, but it is still a problem for planet Earth. It is clear that a common global approach is the only solution.

Carbon price support

The UK also has a carbon tax, the carbon price support (CPS). This, together with the ETS, makes sure that the carbon price paid by generators meets the carbon price floor (CPF). The price floor sets a minimum price per tonne of CO2 emissions, which has been £18 per tonne of CO2 since 2016. The original intention was that this should be increased and should have reached £30 pounds per tonne of CO2 by 2020.

Consequently, we have a carbon tax as well as the UK ETS applying to many sectors.

Carbon credits under the woodland carbon guarantee scheme

Investment in woodlands is increasingly popular and is seen by some as an opportunity to generate the potential for tax-free income, either immediately or in the future.

Trees capture (or sequester) CO2. The owner of the woodlands calculates how much CO2 they can capture.

In England, it is possible to sell woodland carbon units (WCUs) to the government under the woodland carbon guarantee (WCaG) scheme.

The WCaG provides the owner with the option to sell WCUs to the government for a guaranteed price every five or 10 years up to 2055/56. Alternatively, the owner can choose to sell the WCUs on the open market. In other UK nations, it is possible to have a planting scheme verified to create WCUs, but they can only be sold on the open market.

As explained by Julie Butler in her article in the April 2022 issue of TAXline, under current guidance, profits arising from the commercial occupation of woodlands are not chargeable to either income tax or corporation tax and the sale of voluntary carbon credits (such as those under the WCaG) is not currently chargeable to VAT. Profits from the sale of trees in commercial woodlands are also exempt from capital gains tax.

The government’s direction of travel

In a keynote speech at a Bright Blue conference on Tax Reform in the 2020s on 27 April 2022, Lucy Frazer MP, Financial Secretary to the Treasury, said: “The government is committed to carbon pricing as one of the most efficient tools for decarbonisation … and it’s clearly going to play a key role in helping us get to net zero.

“Carbon pricing – or in other words applying a cost to carbon emissions to encourage polluters to reduce the amount of greenhouse emissions they produce – is ‘fair’ because it makes sure that polluters pay.

“In addition, it provides funds that government can deploy on other priorities – including environmental objectives.

“The problem is that different ambitions in different countries create space for the risk of ‘carbon leakage’.”

Back in March, the Spring Statement said little on the ‘polluter pays’ approach, and instead offered some limited tax incentives. To support the decarbonisation of non-domestic buildings, the government accelerated the introducing of targeted business rates exemptions for eligible plant and machinery used in onsite renewable energy generation and storage, and a 100% relief for eligible low-carbon heat networks with their own rates bill. And, to help households improve energy efficiency and keep energy costs down, it announced a time-limited zero VAT rate for the installation of energy-saving materials.

The UK’s approach of offering tax incentives alongside punitive taxes is not unique – a topic we’ll return to in the next issue of TAXline.

About the author

Anita Monteith, Head of Taxation Policy, ICAEW