Can tax policy help the UK achieve net zero?

The UK was the first major economy committed to a legal requirement to achieve net zero by 2050. Our journey to net zero needs to be monitored.

Recognising that this is a long-term project involving successive Parliaments and politics of different types, The Climate Change Act 2008 established an independent, statutory body, the Committee on Climate Change (CCC), to monitor progress. Its role is “to advise the UK and devolved governments on emissions targets and to report to Parliament on progress made in reducing greenhouse gas emissions and preparing for and adapting to the impacts of climate change”. Politics must not be allowed to prevent progress.

The Department for Business, Energy and Industrial Strategy (BEIS) and HM Treasury (HMT) have a major role in the net-zero journey. Each published reports in October 2021, timed well for COP26, brimming with ideas and new policy proposals. Although quite long, they are worth reading. From BEIS, there is the 368-page Net Zero Strategy: Build Back Greener. From HMT, a more modest 135-page Net Zero Review explores the key issues.

The CCC responded to these reports with one of its own. Two points caught my eye: it wants more clarity about how the costs and benefits of decarbonisation are distributed across our economy; and it has asked HMT to look at “the full range of policy levers, including carbon pricing, taxes, financial incentives, public spending, regulation and information provision”. In assessing the BEIS document, it observes that the government has yet to put forward plans for a net-zero test, to ensure that all policy and planning decisions are consistent with the path to net zero. As a country, we need to establish some ways to measure progress.

The UK needs a credible net-zero tax policy to support delivery of the UK’s net-zero emissions target. This should be ranked right up alongside the government’s ambition for a digital tax system.

How does the government plan to use the tax system?

In October 2021, the Institute for Government also published a report, Net zero and the tax system, making similar observations and citing several instances where the UK’s use of environmental taxes sends conflicting signals to business and the public. The costs and where these will fall could become a deeply political problem and one that the political parties could be nervous about tackling ahead of the 2024 general election.

The broad opportunities for using policy levers are with the most polluting sectors of transport, construction, power generation and industrial emissions, but the government should continue to shape tax policy that supports decarbonisation in all sectors of the economy.

Consider cars as an example. The government has made a commitment to end the sale of new petrol and diesel cars by 2030. By 2035, all cars must be fully zero-emissions capable. This zero-emission vehicle mandate should improve consumer choice and gives a clear signal to investors. However, transport currently raises taxes of around £28bn from fuel duty and £7bn through vehicle excise duty.  

This £35bn hole will need to be plugged by taxes levied elsewhere. Road pricing and congestion charges have been discussed and are already being used at a local level in some areas. However, both have problems: they are of a minute scale compared with what will be lost from fuel duty, are opaque and often very unpopular. This does not win elections or come close to adding what is needed to the Exchequer.

There is some movement, for example in relation to encouraging adoption of electric vehicles (EVs). But even for these, the UK lacks an overall tax policy. Take the benefit-in-kind (BiK) rules for EVs where the government has increased the 0% company car tax BiK rate for zero-emission vehicles to 1% from April 2021 and 2% from April 2022.

Also, the VAT rules for the cost of EVs are particularly incoherent (see page 24). The VAT rate on electricity to charge EVs is higher for on-street charging (20%) than domestic (5%). VAT suffered by most businesses on buying a new car is an irrecoverable 20%, regardless of whether it is electric. In Norway, the VAT rate on EVs has been reduced from 25% to 0% – a really green incentive.

We need to know how government will tax transport yet encourage our move to a low-carbon future.

What is in the tax toolbox?

The main tools to direct change are grants, allowances and taxes. These should be considered strategically and holistically.

Regarding innovation, the UK has a vibrant research and development (R&D) industry, yet neither R&D tax relief nor the patent box has any requirement for a net-zero contribution. Is this a missed opportunity? Could the existing schemes be made more generous for R&D focused on decarbonisation?

In November 2021, HMRC published a list of all non-structural tax reliefs alongside the objective of each. This list has grown since the Office of Tax Simplification last compiled a list of tax reliefs in 2014, yet, having reviewed the current list, there is almost no mention of an objective in relation to tackling climate change.

The rate of corporation tax is due to increase to 25% in 2023 and will be part of a new two-rate system where smaller companies pay at a lower rate. Should we consider more rates allowing a discount for businesses that achieve green targets? Reporting and measurement would, of course, come into play, but our financial reporting teams are already looking at greener reporting, so perhaps this could work? As digital record keeping is adopted, would this give more impetus for identifying and labelling green transactions to attract tax reliefs?

I am probably getting carried away, but a more coherent strategy using existing taxes and tools, or those in the pipeline, would be simpler than creating new taxes. The plastic bag tax was a success in that it has virtually killed off the single-use carrier bag, but it is not a revenue raiser. The plastic packaging tax hopes to drive new product development, but at a cost. How about a reward for businesses that achieve a step-change in their behaviour more widely through reliefs or rate benefits?

Changing behaviour, creating new markets and international consequences

Government quickly realised that making a CO2-emitting manufacturing process more expensive to pursue in the UK by, for example, imposing a climate levy on a polluting activity, simply moves that activity overseas and creates an import opportunity. Poorer countries often have cheaper production costs. The finished goods, possibly manufactured using an even dirtier process, are imported instead. This makes a bad situation even worse. International cooperation is needed and the Organisation for Economic Co-operation and Development is looking at ways to tackle this.

Change cannot be forced overnight. Development takes time and some businesses will find it easier than others to switch to a more climate-friendly manufacturing process or invent a new product. For some, change may be possible immediately, while for others it will take longer.

Since 1 January 2021, the UK has had its own emissions trading system (ETS) replacing the UK’s participation in the EU ETS. The UK ETS works using a ‘cap and trade’ principle. The cap sets the total amount of carbon that can be emitted by a sector and is reduced over time, forcing overall emissions from the sector to fall.

A business within a particular sector is allowed so many free allowances for a year. It can buy more emission allowances if needed, or sell any surplus at auction or on the secondary market. The intention is that through gradually reducing the cap, market forces combined with further R&D will result in an overall move towards net zero. The question is whether these measures can move us quickly enough towards the goal.

So where does this leave tax policy in relation to net zero? It is clear that tax reform is needed and that the electorate is likely to expect climate change to be taken seriously. This is not going to be simple; it will be expensive and will require some difficult decisions, but a coherent strategy is needed.

The Confederation of British Industry (CBI) published its paper Greening the tax system – how tax policy could support net zero, which explored the challenges of policies discussed here. The paper included what it considers to be the nine guiding principles in greener tax policy design, including the polluter pays, ‘carrot and stick’, and international cooperation. 

The Tax Faculty Board has set in motion the production of its own white paper on how tax policy can be used to change both corporate and personal behaviours to accelerate us towards the net-zero goal. It will explore some of those CBI guiding principles, look at lessons that can be learned from other economies and use its in-depth knowledge of tax policies to put forward policy suggestions to government and the international community.

About the author

Anita Monteith, Head of Taxation Policy, ICAEW