metadata: authors: 0: author: Strand,Jon
count: World
docna: 0: docna: Supporting Carbon Tax Implementation in
            Developing Countries through Results-Based Payments for
            Emissions Reductions
docty: Policy Research Working Paper
subtopic: Climate Change Mitigation and Green House Gases,Taxation & Subsidies,Economic Adjustment and Lending,Public Sector Economics,Macro-Fiscal Policy,Public Finance Decentralization and
            Poverty Reduction,Energy and Environment,Energy Demand,Energy and Mining
teratopic: Macroeconomics and Economic Growth,Environment,Public Sector Development,Energy
abstracts: cdata!: This paper discusses compensation
            mechanisms to strengthen incentives for lower-income
            countries to adopt carbon taxes through donor-funded support
            programs. The paper considers two cases: the provision of
            climate finance when the host country uses the additional
            mitigation to meet its own greenhouse gas mitigation target
            (the "incremental cost price"); and a transaction
            in an international carbon market with the mitigation credit
            created by host country mitigation transferred outside the
            country (the “opportunity cost price”). Both offset the host
            country's deadweight loss from imposing a carbon tax,
            which is lower when the host country enjoys large
            co-benefits from mitigation. Formulas are derived for the
            incremental cost price and the opportunity cost price. The
            opportunity cost price is always larger than the incremental
            cost price, as the host country under the opportunity cost
            price must use additional, more expensive mitigation
            policies to reach its mitigation target. The paper discusses
            additional costs and barriers that deter hosts from adopting
            carbon taxes. These arguments can help to explain why few
            low-income countries have so far adopted carbon taxes, and
            why the necessary compensation for tax adoption may exceed
            theoretical assessments.
repnme: repnme: Supporting Carbon Tax Implementation in
            Developing Countries through Results-Based Payments for
            Emissions Reductions
display_title: Supporting Carbon Tax Implementation
            in Developing Countries through Results-Based Payments for
            Emissions Reductions
listing_relative_url: /research/2020/10/32497445/supporting-carbon-tax-implementation-developing-countries-through-results-based-payments-emissions-reductions
topicv3: Carbon Tax m1326372 1845,Energy and Extractives m1326595 507,Climate Change Mitigation m1327079 579,Taxation m1327615 1121,Host Country m1939429 4820
publishtoextweb_dt: 2020-10-19T00:00:00Z
historic_topic: Macroeconomics and Economic Growth,Environment,Public Sector Development,Energy
origu: DEC-Sustainability & Infrastruct (DECSI)
no_of_pages: 33
author_keys: 0: author_key: 1008099
model_extractions: Policy Research Working Paper 9443 Supporting Carbon Tax Implementation in Developing Countries through Results-Based Payments for Emissions Reductions _Jon Strand_ Development Economics Development Research Group October 2020
Policy Research Working Paper 9443

# **Abstract**

This paper discusses compensation mechanisms to strengthen incentives for lower-income countries to adopt carbon taxes through donor-funded support programs. The paper considers two cases: the provision of climate finance when the host country uses the additional mitigation to meet its own greenhouse gas mitigation target (the “incremental cost price”); and a transaction in an international carbon market with the mitigation credit created by host country mitigation transferred outside the country (the “opportunity cost price”). Both offset the host country’s deadweight loss from imposing a carbon tax, which is lower when the host country enjoys large co-benefits from mitigation. Formulas are derived for the incremental cost price and the opportunity cost price. The opportunity cost price is always larger than the incremental cost price, as the host country under the opportunity cost price must use additional, more expensive mitigation policies to reach its mitigation target. The paper discusses additional costs and barriers that deter hosts from adopting carbon taxes. These arguments can help to explain why few low-income countries have so far adopted carbon taxes, and why the necessary compensation for tax adoption may exceed theoretical assessments.

This paper is a product of the Development Research Group, Development Economics. It is part of a larger effort by the World Bank to provide open access to its research and make a contribution to development policy discussions around the world. Policy Research Working Papers are also posted on the Web at http://www.worldbank.org/prwp. The author may be contacted at jstrand1344@gmail.com.

_The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent._ Produced by the Research Support Team
# **Supporting Carbon Tax Implementation in Developing Countries through Results-Based Payments for Emissions Reductions**<sup>**1**</sup>

# **Jon Strand**

# **Consultant, Climate Change Group, the World Bank**

# **<u>Jstrand1344@gmail.com</u>**

JEL Classification Codes: H23; Q54; Q56 Key words: greenhouse gas mitigation; carbon taxation; deadweight loss; donor-supported tax implementation.

> 1 The author thanks Gabriela Mundaca, Klaus Oppermann and Michael Toman for very helpful discussions and comments on previous versions of the paper, and the World Bank Climate Change Group for supporting this research. The author is solely responsible for the content of the paper.
# **Supporting Carbon Tax Implementation in Developing Countries Through Results-Based Payments for Emissions Reductions**

# **1. Introduction**

The focus of this paper is to define and interpret methodologies for determining the size of payments by donor countries needed to induce low-income (L, or host) countries to implement or enhance domestic carbon taxes. Our particular objective is to study how much is needed to pay per unit of induced mitigation, for L countries to be willing to adopt the respective additional, donorsupported, carbon taxes.

The background for this work is that the current level of greenhouse gas (GHG) mitigation activity in L countries is far lower than what is required to reach the main mitigation targets for the 2015 Paris Agreement (PA). Comprehensive carbon pricing in many countries may well be a necessary component of policies to reach that goal. Today few L countries have any form of carbon pricing, and even fewer have broad-based carbon taxes. We assume that there is interest from the donor community to increase incentives for L countries to adopt carbon taxation, and as needed, to compensate these countries when doing so. The rationale is that comprehensive carbon pricing is the most cost-effective way to achieve substantial and meaningful GHG emissions reductions at manageable cost (see Appendix 3 for a summary of the rationale). In particular, it is a necessary condition for achieving renewable energy transition with deep involvement of the private sector.<sup>2</sup> Carbon taxation can also be beneficial for L countries by raising sorely-needed tax revenues.

How much L countries need to be paid for adopting comprehensive carbon taxation is less clear. This paper aims to clarify that issue, by deriving expressions for measures of the direct economic costs imposed on host countries when they implement comprehensive carbon taxation. Our discussion will focus mostly on factors explained by traditional economic theory, i.e., deadweight losses lowering production and consumption, but it will also recognize that other (more politicallyoriented) factors and issues can play a major role for many L countries.

> 2 See discussion in World Bank 2019a, and Strand 2020; see also an extensive literature which includes Acemoglu et al 2016, Aghion et al 2016, Cramton et al 2017, Tvinnereim and Mehling 2018, and Andersson 2019. A consensus in this literature is that comprehensive carbon taxation is necessary but not sufficient for “deep decarbonization”, which also requires support to renewable energy investments, in the L countries and globally.

2
There is reason to suppose that at least moderate rates of carbon taxation can provide net economic benefits for many lower-income countries (see Appendix 2). Why then have they not already implemented carbon taxes? The explanation likely involves political considerations. Like any other tax, a carbon tax redistributes resources in the economy, and it can be extremely difficult to achieve a sufficient degree of public consensus on those redistributional effects. They include both deadweight losses across the economy and sector-specific transition costs. In the real world these items are not as fungible as assumed in simple economic models.

This creates a case for external donor support of carbon tax implementation in developing countries even when domestic benefits exceed domestic costs at low tax rates, given an interest on the part of donors in increasing the size (for them and the world at large) of benefits from reducing risks of climate change. However, such support does not necessarily undo political barriers to tax implementation. Our focus here is on compensating for deadweight losses from carbon taxation, as these may be the most important barrier with moderate carbon tax rates.

To better characterize the compensation needed to offset those deadweight losses, two basic compensation formulas, or “price points”, will be derived:

- (i) The “incremental (marginal) cost price” (ICP). This is the price per ton of CO2e, reduced in the host country in response to a supported incremental carbon tax, that is needed to be paid to the client country, to make the client accept the tax. A premise for the ICP is that the GHG mitigation induced by the supported carbon tax can be used for compliance purposes by the host country, toward its (not yet fulfilled) Nationally Determined Contribution (NDC) under the Paris Agreement (PA).

- (ii) The “opportunity cost price” (OCP). This is the equivalent cost to the host country of implementing the donor-supported carbon tax, given that the supported tax _cannot_ be used for compliance purposes by the host country toward its (not yet fulfilled) NDC. In this case, credit for the achieved emission reductions is transferred to other parties, and is not available for host NDC compliance. See World Bank 2020a for discussion.

Both price points _represent a minimum compensation to the host country for implementing a given amount of GHG mitigation, based on the additional carbon tax enabled in the host country by the respective carbon tax support program_ . To repeat, the fundamental difference between the two 3
price concepts is that while the first opens up for claiming this mitigation toward the host country’s (unconditional) NDC, the second does not provide that option. It is then natural to presume that the OCP will be at least as high as the ICP; and that it is typically higher when the host country has not fulfilled its NDC before implementing a new program-supported carbon tax, and thus seeks donor-supported mitigation to meet its (not yet fulfilled) NDC.

We will also stress in what follows that the compensation principle stated in the previous paragraph is not the only possible principle for compensating the host country for implementing a carbon tax. Another compensation principle would be to let the payment depend (at least in part) on _the value for program funders of the resulting mitigation enabled by the supported carbon tax_ . A presumption behind the supported action is that the value to program funders is at least as high as the implementation cost for the host, and usually higher, perhaps much higher. For example, when the supported increase in the host country’s carbon tax is $10 per ton of CO2 e, the cost to the host country will typically be less than the amount of mitigation times $10,<sup>3</sup> while the value to the program sponsor or financer(s) easily could be (at least) the amount of mitigation times $40 or more, depending on what carbon price is optimal from a donor perspective. This indicates that there could be a substantial _net value surplus_ for funders related to such program implementation. We will throughout assume that this surplus is retained by the institution which implements the program and the donor countries which support it. A logical justification is that the money available for such funding is limited, and that more projects can be implemented in host countries for a given budget (and more mitigation accomplished) within this budget when the “minimum cost” rule is retained.

When deriving price points as compensation to host countries for implementing carbon taxes, we abstract from administrative and political economy problems and costs. The latter costs, while real, are likely to be more country-specific and difficult to account for in a general way. In Section 6 we discuss how these factors will typically increase program implementation costs and thus also the ICP and OCP price points. One approach might be to add “policy costs” as a given multiple or mark-up on the basic economic cost; but this fraction would vary between countries.

> 3 This is found from our derived formulas for the ICP, and in some cases for the OCP, in sections 2-4. The ratio of benefits to costs derived from our formulas does depend in part on the particular functional forms assumed in the analysis.

4
Another, even more fundamental, price point for compensating host countries when implementing comprehensive carbon taxes could be defined as the “development support price”. Some countries may develop plans to implement their own comprehensive carbon taxes independent of knowledge about carbon tax support programs, and in principle could be willing to implement such taxes even without support. However, these countries might not have the capacity to develop and implement a carbon tax; or it may be politically difficult to do it on their own. The donor community might then want to provide the necessary funding to cover the host country’s policy costs in order to overcome such barriers. Such a “development support price” ought to be lower (or at least no higher) than either of the two price points derived here.

We will in section 2 discuss the ICP and OCP in the most basic cases. We will revert to more general discussion of the ICP in section 3 for our main case, where the host country’s NDC is not yet fulfilled. A more general discussion of OCP follows in section 4. Section 5 uses basic data on specific countries to calculate illustrative compensation amounts using our price formulas.

The concepts of “unconditional” and “conditional” NDCs are useful for understanding the issues considered in the paper. While these concepts are not addressed in the Paris Agreement (PA) text, they are used by many PA signatories in their NDC documents submitted to the UNFCCC. The “unconditional NDC” is the target that a given country aims to attain by itself, without outside finance or technical assistance. The “conditional NDC” is assumed to require outside help for its achievement, and it is always as or more ambitious than the unconditional NDC plan. Note that for support to a lower-income host country for carbon tax implementation to be meaningful, the host country’s unconditional NDC must be “real:” the target must at a minimum correspond to the host country’s “business-as-usual” (BAU) emissions rate.

# **2. Price points for carbon tax implementation: Basics**

# **2.1 The “incremental cost price” (ICP)**

We will now derive rules for financial support per unit of induced GHG mitigation by a donorsupported carbon tax implemented in the host country, required for the host country to accept this carbon tax. We start with considering the ICP in the most basic and simple case. To recapitulate, the ICP assumes that the host country can use the resulting mitigation, induced by the supported carbon tax, toward fulfilling its unconditional NDC under the PA.

5
The most relevant case is here when the host country’s unconditional NDC mitigation target has not yet been reached (the country’s emissions level is higher than that target). We will, for simplicity, assume that the host country has imposed no other carbon tax before adopting the donor-supported tax, _tH_ .<sup>4</sup> Assume that the welfare (net utility) level of the L country related to its fossil-fuel energy consumption, before adopting any carbon tax, can be expressed by the following quadratic function (from (3.1) in Strand 2020)<sup>5</sup> _WL(0)_ represents host country welfare with no carbon tax in that country, _RL_ is the country’s fossil fuel consumption, and _p_ the (world) market price of fossil fuels. Maximizing (1) with respect to _RL_ yields the host country’s optimal GHG emissions before implementing the carbon tax _tH_ : From (1) and (2), the welfare level of the L country before receiving tax funding is: Consider imposing the donor-supported carbon tax _tH_ in the host country. Given that the revenue from this tax is retained by the host government, the objective function representing private agents in the host country can be expressed as (4) is maximized by private agents with respect to _RL_ to yield

> 4 This discussion builds heavily on section 5 in Strand 2020, on transformational policy-based mitigation finance. 5 This is a highly simplified representation of any actual such welfare function, and it can be expected to hold only over a relatively small domain for changes in fossil energy consumption (and carbon emissions). We are, in particular ignoring any “co-benefits”, utility-enhancing for the host country itself, which will be considered later.

6
The GHG mitigation induced by the carbon tax _tH_ is the last term in the equation to the right in (5), and equals _tH/γ_ . The per-unit support paid to the host country per mitigated unit, for imposing a carbon tax _tH_ , is what we call the “incremental cost price” (ICP). We denote this by _α1 tH_ , where _α1_ is a fixed coefficient (the “price point” parameter related to ICP). The total support, _Q1(tH)_ , is given by this rate times the amount of mitigation induced by this tax:<sup>6</sup> We will here study what value _α1_ needs to take to make implementing this carbon tax attractive to the L country.

The support payment _Q1_ is given from (6). Emissions are in this case assumed to be reduced to fulfill the country’s unconditional NDC before (or jointly with) implementing the tax.

Welfare for the L country, including tax implementation support payments, is: The second term in the square bracket represents the pure allocation loss, or “deadweight loss” (DWL), associated with implementing the comprehensive carbon tax _tH_ in the host country. This is the net welfare loss that follows from the activity-reducing impact of the carbon tax on the host economy. Note that (7) does not include any environmental costs or benefits related to imposing this carbon tax.

We seek the value that _α1_ must take for the host country to be willing to adopt a comprehensive carbon tax _tH_ , when GHG mitigation induced by this tax can be applied toward fulfilling the host country’s unconditional NDC. The net gain for the host country is

> 6 The result that the required ICP compensation is proportional to the square of _tH_ follows from the quadratic specification of (1), and (4). The” true” compensation formula may have other shapes; for example when using the Enerdata simulations as done in section 5, the compensation increases less rapidly in _tH_ .

7
The first term on the right-hand side of (8) expresses support payments, from (6), while the last term is the DWL. The condition on _α1_ for _GL1_ to be non-negative is<sup>7</sup> This means that the host country will implement the additional carbon tax _tH_ if the host country is paid (at least) half the new carbon tax, _tH_ . multiplied by the amount of mitigation induced by this tax.

# **2.2 The “opportunity cost price” (OCP)**

We next consider the second support price concept, the “opportunity cost price” (OCP), in its simplest form. The host country is now required to transfer the mitigation credit out of the country. We also assume that the host country has not yet fulfilled its unconditional NDC, and decides to use its own carbon tax, _tL_ , to achieve the NDC. It cannot use the mitigation induced by international financial support toward its NDC target, because in this case, the financial support comes with the agreement that the emission credit will be transferred out of the country. When applying the model introduced in section 2.1, the target (an NDC value maximizing host country welfare) would equal _tL/γ_ . Assume here that _tH ≤ tL_ (the mitigation induced by the donor-supported domestic carbon tax does not over-fulfill the host country’s NDC mitigation target). When the host implements its NDC mitigation target using its own carbon tax, _tL_ , and does not (yet) engage the supported carbon tax, _tH_ , its emissions level will be and its welfare level is

> 7 This is identical to (5.8) in Strand 2020.

8
When the country now adopts the supported carbon tax of _tH on top of_ its own national carbon tax _tL_ , fossil-fuel consumption (and carbon emissions) in the host country is The host country’s net economic welfare level, including the tax support, is now The condition for the host to accept the supported carbon tax is _WL2S ≥ WL2_ , which gives the following condition on the OCP compensation parameter (or “price point”), _α2_ : From (14), _α2_ must equal 3/2 or higher (given _tL ≥ tH_ as assumed). It must be at least three times as high as _α1_ , the ICP parameter from (9), which equals 1⁄2.

Stipulating that the donor-supported mitigation cannot be used by the host country for its own compliance purposes makes the necessary mitigation to reach its unconditional NDC target more expensive for the host country. OCP is (much) higher than ICP since the deadweight loss increases with the square of the (compounded) tax rate. The compounded carbon tax is in the OCP case increased to a level where the deadweight loss is much higher, as the total volume of mitigation is increased, and the unit cost per unit reduction in emissions is also higher.

# **2.3 Further comments**

The ICP and OCP price points are both derived assuming that the host country aims to fulfill its unconditional NDC target. The basis for the ICP price point is the DWL from implementing the supported carbon tax, _tH_ ; compensated via the ICP price point parameter, _α1_ , from (9).

9
The OCP price point is calculated assuming that the host country’s NDC is fulfilled _at the expense of the host_ . Compensation is then claimed on the basis of the DWL suffered when imposing the extra carbon tax, _tH_ , under this assumption.<sup>8</sup> This leads to an asymmetry in the calculation of the two price points. For ICP, fulfilling the host’s NDC requires compensation. This has intuitive appeal: the ICP reflects the cost of “helping” the host to reach its NDC target, fully or partially.

Under the OCP, the host is not helped to reach its NDC target. The mitigation induced by _tH_ must now in its entirety go beyond the NDC target. The host can then be considered to first reach its NDC target _on its own_ , and is donor-compensated only for the extra mitigation induced by the supported tax _tH_ . This compensation rate, represented by OCP, is found to be three times the host’s cost of simply reaching its NDC, represented by ICP.

# **3. The ICP: More general cases**

In sections 3-4 we will analyze the two price points studied in section 2, the ICP and OCP respectively, using a more general model where we introduce “co-benefits” which make the host countries themselves more interested in and receptive to carbon taxation. In section 4, we will also consider cases with reduced return to additional mitigation for higher carbon tax rates.

We now assume that the host country intends to implement its unconditional NDC, possibly by setting a national carbon tax, _tL_ , but this is not yet implemented when adopting the programsupported carbon tax. The welfare (net utility) function for the L country, replacing (1), is _vL_ is a negative externality related to fossil-fuel consumption in the host country, implying a “cobenefit” related to its carbon mitigation. Given competitive markets, the optimal carbon tax set by this country will equal _vL_ . The host country’s emissions level before facing the supported carbon

> 8 It is immaterial whether the host’s mitigation policy instrument (its carbon tax _tL_ ) is imposed before or after the program-supported tax ( _tH_ ), as the deadweight loss follows from the compounded effect of _tL + tH_ .

10
tax and before imposing any carbon tax of its own is given by (2). Assume in this case _tH ≥ tL_ ; the donor-supported carbon tax, _tH_ , is sufficient to implement the host’s NDC.

From (1a) and (2), the welfare level of the L country is, before implementing the carbon tax _tH_ and receiving the corresponding program funding: (3a) The carbon emissions of the L country after imposing this additional tax are The support per unit of induced mitigation as a “reward” to the host country for imposing a carbon tax at level _tH_ , is _α3tH_ , where _α3_ is the ICP price point in this case, considered as fixed by the host. The ICP is assumed to be set as a given ratio to the supported carbon tax _tH_ implemented in the host country. The total support to the host, _Q(tH)_ , is where _tH/γ_ is the amount of induced mitigation. The host’s utility level when implementing _tH_ is The net gain to the host country from receiving carbon tax implementation support is From (7a), the net DWL, represented by the last main term in the square bracket, is smaller than the corresponding loss in section 2, from (7). The reason is that now the host enjoys certain cobenefits when implementing the new carbon tax, which were assumed not to be present in section 2. _GL3_ in (8a) is non-negative when 11
When _vL_ > 0, (15) gives a lower value for _α3_ than (9) in the “base case” without co-benefits to the host. Intuitively, the optimal solution for the host, with no program-supported carbon tax _tH_ imposed, would be to select an own carbon tax _tL = vL_ , with a mitigation level _vL/γ_ . When this tax is not imposed, there is a welfare gain for the host from implementing a carbon tax. This welfare gain is optimized when the donor-supported carbon tax _tH_ equals _vL_ (and the gain is exactly eliminated by having _tH = 2vL_ ). This leads to a negative _α3_ when _tH < 2vL_ . There is then no DWL that needs to be compensated for the host in order to accept the supported carbon tax _tH_ .

We have in this section assumed that the host has not yet implemented its NDC when adopting the donor-supported carbon tax _tH_ . The host then gets “help” to implement its NDC by the tax implemented under the support program. We have before discussed whether receiving support in this fashion is appropriate. Here the case is “worse” as the host has a direct welfare gain from having the supported tax, _tH_ , imposed, as co-benefits are then being reaped.

An alternative case is where the host’s NDC has already been implemented by the host before accepting _tH_ . When the NDC is already fulfilled, there is no need for access to a supported carbon tax for such fulfillment, and such access has no value to the host. In this case _α3_ will be higher, at least 1⁄2 given _tL ≥ vL_ . We will not analyze this case further as the ICP price point is presumed to depend explicitly on access to crediting of the mitigation achieved by _tH_ .

When co-benefits are high, the host country has incentive to mitigate on its own (e. g. by setting its own carbon tax _tL_ ) before _tH_ is implemented. But this does not necessarily imply that a host will accept a carbon tax _tH_ without any economic compensation, even when the resulting mitigation can be used by the host toward NDC fulfillment, and GHG mitigation implies substantial cobenefits for the host. If that were the case, many hosts would have already implemented carbon taxes; while hardly any developing country has done so to date. Carbon pricing in the absence of financial support can be non-optimal, due to strategic behavior of the host country, or other factors (see section 6). We will claim that underpricing of carbon emissions by host countries is relevant, and more so when donor-supported tax implementation programs exist.

# **4.  The OCP: More general cases**

We will now consider a model for the OCP which is more elaborate than that presented in section 2.2. First, we assume as in section 3 that the host may enjoy co-benefits from mitigation. Secondly, 12
the host may now face decreasing returns to mitigation when implementing both its NDC with a domestic carbon tax, and the additional supported carbon tax. The type of cost increase focused on here is that the host is not able to apply an additional carbon tax to the entire economy, but instead to only a fraction of it (or to only particular sectors).

When the host country has not (yet) implemented any mitigation beyond its BAU level, carbon emissions after implementing _tH_ will be The host country needs to fulfill its NDC, and mitigation induced by _tH_ cannot be credited toward that target. The host country’s NDC mitigation target (involving only credited mitigation) is still given by (2), implying that required mitigation toward that target is _tL/γ_ . Assume that _tH ≤ tL_ (mitigation induced by _tH_ is not or exactly sufficient to fulfill the host country’s NDC target).

One realistic scenario is that the host may not have available sufficient “cheap” mitigation alternatives for implementing its entire NDC mitigation, when it adopts a carbon tax ( _tH_ ) whose mitigation impacts cannot be credited. One problem could be (strongly) decreasing returns in mitigation with rising (“non-transformative”) carbon pricing, as “low-hanging fruits” are reaped first (upon implementing _tH_ ) and are limited. The host country may also have political difficulties to get backing for additional and comprehensive carbon taxation (adding to _tH_ ), and may then need to resort to more expensive mitigation alternatives.

We represent this problem in a slightly different way, by assuming that mitigation toward NDC fulfillment for the host country is limited to a subset of sectors which represent a fraction _λ_ ≤ 1 of the host country’s total mitigation potential. For analytical simplicity we then assume that all sectors have the same basic economic structure. Welfare due to the sector in which mitigation can be performed can be represented by the following welfare function, modifying (1): _RM_ represents carbon emissions from the sector in which mitigation toward the host country’s NDC takes place. We represent mitigation in this sector by a sufficiently high carbon price _tM_ to implement the host country’s NDC target. Private utility stemming from this sector is 13
The private sector in the host country maximizing (18) with respect to RM yields The amount of mitigation toward the country’s NDC is _λtM/γ_ , while the mitigation required for the NDC is _tL/γ_ . NDC implementation then requires a marginal mitigation cost equal to _tM = tL/λ ≥ tL_ , in the implementing sector.

Social welfare for the host country is now affected by _tH_ , and _tL_ , in the following way: This utility for the host country must be compared to utility given that no support is provided. To derive the latter utility expression, assume that the host country would have available the option to set its own carbon tax _tH_ (for complete or partial implementation of its NDC), and resort to more expensive mitigation beyond that tax level. This means that an additional carbon tax in the mitigating sector would need to be increased by ( _tL – tH_ )/ _λ_ in order to implement the NDC. Welfare for the host country would be, in the absence of tax implementation support: The only difference between (20) and (21) is that mitigation induced by the supported carbon tax cannot be used for crediting toward the host country’s NDC in the former case, while such crediting would be allowed in the latter case.<sup>9</sup> Note that we now assume _tL ≥ tH_ . The key problem here is not that the supported carbon tax, _tH_ , is higher than (ideally) desired, but that the resulting mitigation cannot be claimed toward the host country’s NDC fulfillment. We find the following expression for the total welfare impact of implementing the supported carbon tax _tH_ in this case:

> 9 The host country is here thus always allowed to implement a comprehensive carbon tax _tH_ , but never any higher fully comprehensive carbon tax.

14
The condition for the carbon tax including its support to be acceptable for the host country is now: (23) generalizes (14) in section 2.2 in two ways, by adding two new parameters, _λ_ and _vL_ When _λ_ = 1 and _vL_ = 0, _α4_ coincides with _α2_ in (14). _λ_ < 1 and _vL_ > 0 are however relevant here. Then _α4 > α2_ in most relevant cases, and more so the lower _λ_ is.

_α4_ depends on four parameters, _tL tH, vL_ and _λ_ . Consider first a simple example where _tL = tH = vL_ , and _λ_ = 1⁄2. In this case, (from (15)) _α3_ < 0, while _α4_ = 1. Setting λ = 1⁄2 might appear as a reasonable example: a part of the host country’s economy with half of its total carbon emissions can be used for local mitigation purposes through carbon taxation. (This corresponds approximately to the share of coverage of the EU-ETS in Europe.) The NDC target is then optimal to reach for the host; and donor-supported mitigation is exactly sufficient to fulfill the host’s NDC target.

When instead _λ_ = 1⁄2 and _vL_ = 0, _α4_ = 2, four times the price point for ICP, which is 1⁄2.

When _λ_ = 1, and _tL = tH = vL_ , _α4_ = 1⁄2, while the ICP price point from (15) is negative.

To sum up, _α4_ is always higher than the ICP price point, _α3_ . _a4_ applies when the host does not have available a fully efficient and comprehensive carbon tax (economically, or politically), on its own for implementing its unconditional NDC, but must instead resort to more expensive mitigation opportunities.

Three further issues need mention. First, our basic results in this section do not depend on the host country needing to apply carbon taxation to fulfill its unconditional NDC. Various other policies (c-a-t schemes covering the relevant sectors; direct purchase of emissions reductions) have the same fundamental effect.

Secondly, in deriving _α4_ we assume maximal efficiency of implemented mitigation in a share _λ_ of the host economy. When efficiency is lower (as is likely when carbon taxation is not available), the derived OCP would be even higher.

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Thirdly, the OCP price point would increase also when there are (significantly) reduced mitigation opportunities in response to an increased carbon tax beyond the program-supported tax _tH_ . Reduced mitigation opportunities could occur in two ways: limitation on the sectors in which a carbon tax is allowed to be implemented; and reduced mitigation effectiveness at higher carbon tax levels. Both factors drive the carbon tax (required to fulfill the host country’s NDC) and the OCP price point to higher levels.

Table 1 sums up the most important information related to the different price points for ICP and OCP. All figures express the fraction of the carbon tax that needs to be compensated to the host (for acceptance) that we seek. The figures in Table 1 give key numbers from the discussion, as our parametric assumptions correspond to those we already have used. The leftmost numbers column contains the results from the simplified case in section 2 (with no co-benefits, and _λ_ = 1).

**Table 1: Price points for ICP and OCP, different parameter combinations**

|Price point<br>|Mathematical formula for<br>|<br>|Parametric ass<br>|umptions*<br>||
|---|---|---|---|---|---|
|category|price point|**_vL_ = 0,**<br>**_λ_ = 1**|_vL = tH_,<br>_λ_ =1|_vL_= 0,<br>_λ_ =1⁄2|_vL = tH_,<br>_λ_ =1⁄2|
|ICP|2<br>_H_<br>_L_<br>_t_<br>_v_<br>−|**1⁄2**|0|1⁄2|0|
||2<br>_H_<br>_t_|||||
|OCP|2<br>1<br>2(<br>)<br>2<br>_L_<br>_H_<br>_H_<br>_L_<br>_H_<br>_t_<br>_t_<br>_t_<br>_v_<br>_t_<br>λ<br>−<br><br><br>+<br>−<br><br><br><br>|**1.5**|1⁄2|2|1|

*The figures in bold type represent our BAU or benchmark cases in section 2.

ICP is either 1⁄2, our benchmark from section 2; or lower, possibly zero, when there are significant co-benefits. OCP varies from 1⁄2 to 2 depending on parametric alternatives. It can be either lower or higher than our section 2 benchmark, which is 1.5.

To conclude, when including only pure economic (DWL) losses, ICP is at most 1⁄2, and could be lower or even zero. OCP can be lower or higher than its benchmark level of 1.5, depending both on co-benefits and on possible inefficiency in mitigation beyond implementing _tH_ .

# **5. Implementing the pricing formulas: Some illustrative examples**

In this section we consider a few examples of how our formulas can be applied in practical cases. The examples considered here are for Mexico, Chile, Ukraine, Romania and Bulgaria. We stress 16
that the calculations do _not_ represent normative assessments of GHG mitigation policies in the countries named; they are _only_ illustrative numerical examples.

We base our calculations on the Enerdata data set MAC, which was set up to project mitigation implications of carbon taxes introduced at particular future dates.<sup>10</sup> Our calculations are based on the “Enerbase” simulations created by Enerdata, where it is assumed that no climate policy is applied up to 2025 in these countries under business as usual (and where LULUCF emissions are ignored).<sup>11</sup> In our application of Enerdata, we consider two different carbon taxes in 2025, namely $10 and $20 per ton of CO2 e. We phase in the carbon tax linearly over time: in the $10 case, for example, the tax is zero in 2020, $2 in 2021, $4 in 2022, etc.

The Enerdata framework is somewhat broader than the simple static framework considered in Sections 2-4. The most important difference is that with the Enerdata approach, the quantity of mitigation resulting from doubling the carbon tax is less than double that from the initially chosen carbon tax. This reflects a presumption that a significant amount of “low-hanging fruit” can be harvested as mitigation outcomes at relatively low carbon taxes. In the model framework laid out in Sections 2-4, by contrast, mitigation outcomes are proportional to the implemented carbon tax. Similarly, in the conceptual model in Sections 2-4, support payments tend to increase with the square of the carbon tax rate, since a higher carbon tax leads to a proportionally higher mitigation rate. Since mitigation in the Enerdata simulations increases by less than the carbon tax, support payments grow more slowly than the square of the tax rate.

Table 2 gives figures for mitigation effected in the five sample countries, due to imposing a carbon tax which increases linearly by year, from zero today up to either $10 or $20 per ton CO2e by 2025. Column 5 gives mitigation in 2025, relative to the BAU emissions rate in the same year, due to imposing these two alternative tax levels by 2025. The rightmost column gives the cumulative

> 10 For reference to Enerdata and the data sets referenced, see the following website: https://www.enerdata.net/.

> 11 The other relevant simulation alternative from Enerdata, called “Enerblue”, assumes that certain climate policies have already been implemented by the host countries which reduces the mitigation scope from using carbon taxation, and this reduces the needed support. This alternative is not invoked in our calculations, but might have been the better alternative if the host countries in question had already started to implement (or were expected to implement) their NDCs before support would be received. They would also give lower overall payouts to hosts as the induced mitigation amounts are smaller.

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amount of mitigation up to 2025, from gradually increasing the carbon tax over this period (in the $10 case, this annual tax will be zero in 2020, $2 in 2021, $4 in 2022, etc.).

**Table 2: Emissions and mitigation due to alternative carbon tax rates imposed gradually from 2021 to 2025, in five selected countries, under the Enerbase simulation alternatives**

**(Million tons CO2 e)**

|Country|Tax rate<br>imposed by<br>2025|BAU<br>emissions in<br>2025|Emissions in<br>2025 with<br>carbon tax|Mitigation<br>in 2025|Cumulative<br>mitigation by<br>2025|
|---|---|---|---|---|---|
|Mexico|$10|678|662|16|35|
||$20|678|654|24|53|
|Chile|$10|117.1|114.2|2.9|6.4|
||$20|117.1|112.9|4.2|8.4|
|Ukraine|$10|289|276|13|29|
||$20|289|271|18|40|
|Romania|$10|103.4|100.3|3.1|6.8|
||$20|103.4|99.1|4.3|9.5|
|Bulgaria|$10|53.8|51.6|2.2|4.8|
||$20|53.8|50.4|3.4|7.5|

We next calculate the amounts of carbon tax implementation support implied by our two derived cost prices, the ICP and the OCP, using these figures as our alternative cases. A formula similar to (6) (based on the compensation parameter _α_ times the applied carbon tax times the induced mitigation) can then be used to calculate the tax implementation support in any given year, including the last year, 2025. Given and our baseline price point values, _α1_ = 1⁄2 (for the ICP) and _α2_ = 1.5 (for the OCP), we arrive in Table 3 at a set of figures for tax implementation support in 2025.

# **Table 3: Tax implementation support payments in 2025 under the ICP and OCP, by host country and carbon tax alternative, in the numerical alternatives from Table 2**

# **(US$ Million)**

|Country|IC|P|O|CP|
|---|---|---|---|---|
||Tax=$10|Tax=$20|Tax=$10|Tax=$20|
|Mexico|80|240|240|720|
|Chile|15|42|44|126|
|Ukraine|65|180|195|540|
|Romania|16|43|46|129|
|Bulgaria|11|34|33|102|

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To calculate the needed externally provided aggregate payments over the period 2021-2025, we simply scale up the figures in Table 3 by a factor 2.2 (the sum of squared p values from 2021 to 2025, relative to the last squared p value = 100). This gives Table 4 for total payments for the entire support period 2021-2025.

# **Table 4: Tax implementation support payments under the ICP and OCP, by host country and carbon tax alternative, for 2021-2025**

# **(US$ Million)**

|Country|IC|P|O|CP|
|---|---|---|---|---|
||Tax=$10|Tax=$20|Tax=$10|Tax=$20|
|Mexico|176|532|528|1584|
|Chile|33|92|99|276|
|Ukraine|143|396|428|1188|
|Romania|35|95|105|285|
|Bulgaria|24|75|72|225|

These calculations are based on several strong assumptions. First, we use “baseline” values of our assessed cost compensation parameters, _α_ = 1⁄2 for the ICP, and _α_ = 1.5 for the OCP. These baseline values ignore co-benefits, which tend to reduce them. In addition, our applied compensation formulas ignore the other (implementation, revenue, distributional, political economy) issues noted in the introduction and considered further in section 6. For that reason, these figures can most likely be considered as lower bounds for the amounts required to compensate host countries for carbon tax implementation.

# **6. Practical issues related to implementing externally supported carbon price increases**

Our compensation formulas, (9) or (15) for the ICP, and (14) or (23) for the OCP, are theoretical conclusions which ignore obstacles to and practical complications with actual implementation of carbon taxes. They are however far from conclusive. Several issues make the problem of deriving “correct” compensation rules for carbon tax implementation more challenging in practice:

- a) The net fiscal impact for the receiving country government

- b) Competitiveness issues for energy-intensive sectors in the receiving country

- c) Distributional impacts

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- d) Political economy issues, making carbon pricing reform politically difficult to implement e) Other technical and practical barriers to carbon tax implementation.

Some of these implications are benign and favorable for setting and implementing a high carbon tax level. In particular, the positive fiscal impacts of carbon taxation for a host country government can be more favorable in cases where the country’s tax system seriously distorts the economy. Easily-earned revenues from carbon taxation can then substitute for distortive taxes and improve the allocation; an argument which should increase the country’s willingness to impose comprehensive carbon taxes.

The income distribution impacts of carbon taxation are often benign in low-income countries, since most fossil fuels tend to be consumed by these countries’ higher-income groups; see Dorband et al. 2019 for empirical support. While higher carbon taxation still erodes part of the public’s buying power, also among low-income groups, these groups can in most cases (at least in principle) be compensated through transfers of a moderate share of the government’s increased carbon tax revenue. The ability and willingness to implement such transfers is then important for determining the overall impacts of these taxes. A widespread problem here is that many governments lack this ability or willingness, making it a greater problem than it otherwise could be.

Competitiveness and political economy concerns, and technical and practical barriers, typically make it more difficult or costly to implement fossil fuel taxes in low-income countries. They often lead to less mitigation impact of a given carbon price rise than what is found from simple models (thus reducing the host country’s reward based on our derived compensation formulas), and (often more importantly) lead to high resistance against imposing meaningful carbon taxes, among the public and in governments of host countries.

It is difficult (without going into country-specific detail) to assess the rate at which our derived cost prices need to be “marked up” to ensure government preference for donor-supported carbon taxes. We will not introduce any particular formula to embed these factors in pricing principles for external support programs, leaving this to individual-country evaluation.

# **7. Conclusions**

We have in this paper derived “price points” for the “incremental cost price” (ICP), and the “opportunity cost price” (OCP), to be applied to donor-supported programs for carbon tax 20
implementation in low-income (“host”) countries. When not taking into account co-benefits of climate mitigation for hosts, the most plausible (economics-based) price points are 1⁄2 for the ICP, and 1.5 for the OCP. The reason why the OCP price point is higher is that it requires larger overall mitigation effort from the host, and this pushes the host’s mitigation costs, and the corresponding deadweight loss to the host economy, to higher levels.

The presence of co-benefits from own domestic climate policy reduces the price points because real (net) mitigation costs are reduced; and the resulting increased tax revenue should also make the tax easier to bear for the host government. But several factors also work to make such taxes more burdensome and complicated to implement, and are reasons why almost no low-income countries have so far adopted carbon taxes. In practice, implementation of such programs must be done through bargaining between the host and the program sponsor.

An issue not discussed in this paper is the possibility of strategic behavior of host countries in anticipation of donor-funded carbon tax implementation programs. Expectation of such (future) funding possibilities may reduce hosts’ interest to aim for ambitious NDC mitigation targets, and instead make countries wait to implement their own carbon taxes. But note that such a rule, for a given cost to the donor and given value to the host, only would shift a given total carbon tax from the donor-sponsored tax to the tax imposed by the host, so that the sum of the two taxes would be fixed. The cost to the donor would then be the same, for a given total tax imposed in the host country. This would also not solve the basic incentive problem versus the host, namely, to set a “correct” own carbon tax prior to any donor-sponsored compensation rule.

Finally, while we have discussed the host country’s achieving its own NDC target through an own imposed and comprehensive national carbon tax, a “starting-point” national carbon tax is not central for our argument. One could in principle think of other mechanisms than a national carbon tax for implementing the NDCs of host countries; both market-based mechanisms (such as capand-trade or feebate schemes) and non-market based (such as renewable investment support, or government emissions standards). All the results derived above should hold qualitatively also when other instruments than comprehensive carbon taxes are used for NDC implementation.

The success of such programs could be crucial for the achievement of sufficient climate policy progress at the global level in the years to come.

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