3. Using the Tax System Directly to Reduce Harmful Emissions by Pricing Carbon

3.1 Carbon Taxes and Carbon Trading

Following the widespread adoption of the Paris Agreement^[1] by 196 parties, countries have committed to national actions known as ‘nationally determined contributions’,^[2] which represent each country’s plan for reduce GHG emissions. Many parties, Australia included, have committed to net zero by 2050. As recognised in the OECD’s report Pricing Greenhouse Gas Emissions,^[3] there are a variety of policy tools in the ‘net-zero toolbox’,^[4] and a key instrument is explicit carbon pricing, by way of either carbon taxes or emissions trading systems, or a combination of the two.^[5] A government’s choice of instrument is determined by a number of factors, political feasibility being critical.^[6]

The negative effects of pollution are not properly priced by the market, giving rise to what is known as an externality or spillover effect. The market does not charge entities for the act of emitting GHGs. Rather, the harm is absorbed and born by all. Correcting this market failure requires government intervention, the main alternatives being direct regulation and Pigouvian taxes. In 2008, the Garnaut Climate Change Review undertook detailed analysis and made recommendations to the federal government regarding potential responses to the challenge of climate change.^[7] In the resulting 2011 policy document Securing a Clean Energy Future, the government recognised that ‘a carbon price is the most environmentally effective and economically efficient way to reduce pollution’.^[8]

The rationale for imposing a charge on emissions includes that the carbon price (representing the harm to the environment and the flow-on consequences) is thereby internalised so that firms will take this into account in making decisions, such as setting output levels and deciding whether to invest in cleaner technologies and fuels. By pricing the pollution, there is an incentive to reduce it. Another rationale is that the carbon price may also flow through to the price to consumers for the resulting product or service, making low-emissions options relatively less expensive.

Carbon pricing mechanisms ordinarily operate by placing a cost on the emission of one tonne of carbon dioxide equivalent (‘CO2-e’) gas. By using this CO2-e measure, the level of intensity of the effect of a particular GHG on the environment can be taken into account.^[9]

Carbon pricing can take the form of a carbon tax or an emissions trading scheme, where each places a cost on the emission of each tonne of CO2-e but through different mechanisms. A carbon tax levies a fixed amount per tonne of covered emissions whereas a carbon trading system requires emitters to surrender one permit for each tonne of emissions. Both systems rely on a legal requirement for covered entities (usually facilities that emit above a specified minimum threshold) to report their emissions annually. The World Bank has estimated that in 2024, around 24% of global emissions were covered by either carbon taxes or emissions trading systems.^[10]

A carbon tax can be applied upstream on the supply of fuels, where the tax payable is based on the emissions that will be produced when that fuel is used, or downstream based on the actual emissions from the covered activity. One benefit of a carbon tax is that the carbon price is predictable, since it is a fixed rate set by the government. On the other hand, since a carbon tax does not directly limit the level of emissions but rather imposes a cost on them, the government may need to adjust the tax rate to achieve the desired level of emissions.

The alternative of emissions trading is based on the government issuing a fixed number of permits per year equal to the emissions cap, where these permits are then traded between market participants, thereby producing a carbon price. A covered entity must surrender the number of permits to cover their reported emissions for the year. In this way emissions trading systems control or cap emissions but the carbon price is determined by the market.

Emissions trading systems often also allow for a proportion of emissions to be met by the surrender of carbon credits or offsets, being units that each represent one tonne of carbon emissions that have been avoided, reduced or removed from the atmosphere (such as carbon stored in soil and forests).^[11] Such offsets are also traded, both privately and on markets. Recent work by the United Nations Framework Convention on Climate Change (‘UNFCCC’) under article 6 of the Paris Agreement aims to establish mechanisms for such offsets to be traded internationally.^[12]

Australia has not adopted a broad-based carbon tax. Instead, an emissions trading scheme known as the Carbon Pricing Mechanism operated briefly from 1 July 2012 until its repeal with a change of government, effective 1 July 2014. The Government has since then relied on a variety of incentives to encourage emissions reductions but moved more recently to restructure existing policy mechanisms to create a targeted emissions trading system called the Safeguard Mechanism.^[13]

The Safeguard Mechanism was significantly reformed in 2023 such that each facility that is covered by the scheme (which are high-emitting large facilities in the industrial and mining sectors, called ‘Safeguard Facilities’ in the rules) will have a baseline emissions level that will decline over time. This baseline works as an emissions cap for the Safeguard Facility — if emissions fall below the baseline for the year, the facility will be issued with Safeguard Mechanism Credit units (‘SMCs’), which can be retained or traded. This type of scheme is often referred to as a baseline-and-credit emissions trading system due to this feature. If emissions are above the baseline for the year, the facility must surrender SMCs to cover the excess.

Facilities are also able to meet any excess emissions with offsets called Australian Carbon Credit Units (‘ACCUs’) issued under the ACCU Scheme (originally known as the Carbon Farming Initiative).^[14] Entities can register projects to undertake carbon abatement or sequestration actions that are covered by an approved scheme method. Once underway, the project reports the emissions avoided or sequestered, and the government issues ACCUs to the project operator, who can then either retain or sell the offsets. ACCUs are largely generated from land-based activities that sequester or avoid emissions, such as soil carbon and revegetation projects. Safeguard facilities now hold the majority of issued ACCUs.^[15]

SMCs and ACCUs are intangible assets that are documented on a centralised government register and can be held and traded between facilities and other market participants, thereby producing a carbon price. In order to ensure that income tax effects of such trading and surrendering are consistent across participants, division 420 was inserted into the ITAA 1997, applicable to Registered Emissions Units (‘REUs’) which include SMCs and ACCUs. These rules are modelled on the tax treatment of trading stock and, in general, treat the various transactions as revenue in nature. In effect, these rules allow a tax deduction for the cost of units that are surrendered by Safeguard Facilities, so that the carbon cost is treated as an additional business expense. Taxpayers operating a project under the ACCU Scheme will effectively include the value of received ACCUs as part of business income. For taxpayers that buy and sell units, including market traders, the combined effect of the provisions includes the profit on sale of an REU in assessable income and allows a loss on the sale of an REU as a deduction. Taken as a whole, these provisions ensure that the tax system deals with REU transactions in the same way as other business transactions, and by achieving this neutrality, the tax system should not distort or interfere with the functioning of the Safeguard Mechanism and ACCU Scheme.

3.2 The Fuel Tax System

According to the most recent inventory of Australia’s GHG emissions, the transport sector is the third largest contributor and produced 22.4% of total GHG emissions for the year to June 2024.^[16] Energy taxes applied to fossil fuels, such as upstream fuel excise taxes on fuels used in the transport sector, can be part of the climate policy mix and also raise government revenue. As discussed above, the increased price reflecting the tax will influence the users of fuel to reduce consumption, which then would reduce emissions. The OECD includes fuel excise tax as a climate policy instrument and notes that almost all countries tax gasoline and diesel used in road transportation.^[17]

In Australia, fuel excise is a simple tax that applies at a flat rate per litre upstream (at the point of importation or first sale of the refined product) to petroleum and diesel fuels.^[18] Although diesel emissions per litre are higher than petroleum fuel, which would therefore justify a higher rate of tax from a climate perspective, most countries, including Australia, apply the same per litre excise tax rate.^[19] The rate is indexed up every six months and passed 50 cents per litre in late 2024.

Australia’s fuel tax system combines fuel excise with a fuel credit system. This has the effect of excluding certain uses of transport fuels from the tax. The OECD recognises that these features represent ‘support’ for fossil fuel use,^[20] and some have classified these exclusions as subsidies,^[21] though this characterisation is contested. The design of the fuel tax system makes clear that although fuel excise is an energy tax, the objective of the tax is not to internalise the climate cost of the use of the transport fuels.

The fuel tax credit system operates to refund the fuel excise to business taxpayers in specified circumstances. The interaction of the excise and refund systems reveals that the laws were designed on the premise that the fuel tax is a contribution to the cost of maintaining the road network. In fact, fuel tax revenues were earmarked for road funding from 1929 until 1959.^[22] Although this formal connection to road funding has been severed, features of the credit system still reflect this connection, and the federal government provides grants to the states and territories to fund roads, which come from consolidated revenue that includes the net fuel excise.

Fuel excise is incorporated into the cost of fuels when it is levied upstream, but certain business users of the fuel can claim a refund of the excise through the fuel tax credit system created under the Fuel Tax Act 2006 (Cth) (‘FTA’). Fuel tax credits are not available for either the private use of vehicles (FTA s 41-5) or the business use of light vehicles on public roads (FTA s 41-20). In comparison, fuel tax is wholly creditable (and refundable) for the use of fuel in vehicles travelling on roads that are not public roads (such as roads at a private mining site) as well as for fuel used in a vehicle that is not related to the travelling on roads (ie fuel that runs other elements of the vehicle such as refrigeration). Credits are also available for fuel used in non-vehicle equipment such as generators. As the consumption of fuels in these activities creates the same level of pollution as using the fuel in travelling on public roads, it is clear that the fuel tax is not designed as a carbon or environmental tax. Viewed from an environmental tax perspective, exempting certain uses of these fuels from the tax would clearly be a subsidy.

The connection between the fuel excise and credits system to road use is also illustrated by the special rules that apply to heavy vehicles used on public roads. Rather than receiving a full refund of the excise, the credit to heavy vehicle users is reduced by the ‘road user charge’ so that only a partial credit is available (FTA s 43-10). Heavy vehicle users also contribute to road costs by way of heavy vehicle registration charges imposed by the states and territories, which are partly based on the size of the vehicle.