Analysis: To tax or to subsidise, that is the question when it comes to protecting Ireland's climate and future energy security

By Aisling Finucane, Eoin McLaughlin and Fergal O'Connor, UCC

Inflation is a major challenge to the global economy. Of particular importance is "fossilflation", with increased energy prices a key factor driving inflation in Europe in particular. Governments around the world are attempting to use their budgets to come up with new and creative ways to alleviate pressures on citizens from the cost-of-living crisis that high inflation has ushered in.

In Ireland, the 2023 Budget has been moved forward to give the government more time to prepare. As the exchequer coffers are flush, for now, with an increased corporation tax as well as the consideration of a proposed windfall tax on energy suppliers, a number of one off payments are planned, such as universal energy credits as well as more targeted measures such as increases to social welfare payments.

One template for action is the recent Inflation Reduction Act (IRA), signed into law by US President Joe Biden in August 2022. The IRA aims to reduce inflation by tackling several drivers of inflation in the US, and one of the most pressing relates to energy production. Particularly, the IRA is considered in many quarters to be primarily a climate act.

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Key parts of the act are subsidies to promote clean energy, tax credits for renewable energy, assistance to keep nuclear plants in operation, incentives to buy electric vehicles, and make homes more energy efficient. A major part of the motivation of the IRA is the belief that investing in clean energy and energy efficiency by lowering and stabilising the price of energy can be deflationary in the medium to long run. Getting new sources of clean energy online to replace fossil fuels can be encouraged by either a carrot (subsidies) or a stick (taxes) approach – and up to recently the primary focus has been the stick.

Pricing Carbon

Taxes on pollution and permits that allow businesses to emit a limited amount of pollution are two ways advocated by economists to reduce pollution. Carbon taxes place a price on carbon emissions paid to and set by the government. Trading emissions permits are similar but the price put on carbon is set by a traded market, similarly to how shares trade on a stock market.

These emissions permits are issued by a regulatory body, recognising that some pollution will take place and setting an allowable level for a business. If you invest in clean technology and do not use all of your permits you can sell them on the market to help fund the investment, while if you pollute more than your allocated amount you must go to the market and pay for more permits, encouraging you to act more environmentally aware next year. The total permits awarded to businesses falls each year, with the aim of gradually reducing pollution and improving the environment.

Figure 1 – EU ETS Futures Price Photo: Supplied

What is glaringly absent in the American IRA is any attempt to introduce carbon taxes or emissions trading schemes in the US, despite widespread support for carbon taxes amongst US economists. 'Flexible market mechanisms’, like emissions trading, were originally advocated by the US to address global warming during the 1997 Kyoto Conference. They had a successful experience in using permits to reduce acid rain from SO2 previously and preferred market-based policies over the mandatory measures favoured by the EU at the time. Ireland introduced a carbon tax in 2010 and it also participates in the EU Emissions Trading System (ETS) – the EU's flagship policy for reducing carbon emissions by putting a cap on annual carbon emissions that reduces each year and setting a price on carbon.

One of the great ironies in environmental policy is that while the EU followed the advice of the US and established the world’s first international emissions trading system in 2005, the US has not implemented a federal emissions trading system. California has an emissions trading system linked with Quebec, allowing carbon allowances to be traded between the two jurisdictions, and a separate emissions trading systems encompassing the eastern US states is also in force.

Now, almost 20 years after the introduction of the EU ETS, the US has now done a volte face in the implementations of the IRA by focusing on subsidies to drive reductions in carbon emissions, rather than taxes or market mechanisms. What does this mean for the EU and Ireland Inc.?

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To tax or to subsidise, that is the question

An issue for this budget is whether to subsidise clean activities and innovations, or continue to rely on the ‘stick’ of making business pay for emissions through taxes. The idea behind taxes/prices on carbon is to make polluters pay for environmental damage (there are plans afoot to increase the carbon tax in the coming budget) and stimulate investment in new technologies.

But the argument for subsidies is that the new technologies need direct help to develop. There might be no point introducing taxes/prices if there is no support for developing new technologies. Subsidies can provide incentives to address environmental problems. However, it has been argued that subsidies can promote economically inefficient and environmentally unsound practices and in the long run only a carbon price is efficient.

For context, Germany relies on heavy subsidies for renewables and on a weak price for carbon allowances from the EU ETS, while the UK used a carbon tax to underpin the weak carbon price. German emissions hardly declined compared to the UK, whose carbon emissions declined by 55 percent within five years of increasing the price on carbon.

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From RTÉ News, Chair of Climate Change Advisory Council raises concerns about government's emissions targets

Whether to use subsidies or taxes are central to current debates. Recent calls for the suspension of the EU ETS as a response to the energy crisis from the Polish prime minister have echoed calls from the Italian business lobby earlier in the year. Given the direction of change across the Atlantic, perhaps this is something that should be heeded, and greater focus placed on renewable investment, however, this is not possible without EU-level consensus.

Ultimately, what is needed in Budget 2023 is a long-term plan on how to adapt to current circumstances and generate investment in domestic clean energy generation to guarantee Ireland’s future energy security. This is important in light of Ireland's high energy import dependence, mainly from oil imports, and also because natural gas is still the most important source of Ireland's electricity generation. This investment will help deliver on Ireland's Climate Action Plan 2021, which indicated that €125 billion of investment is needed in low-carbon technologies and infrastructure by 2030.

More information on the Government's Review of the security of energy supply of Ireland's electricity and natural gas systems is available here

Aisling Finucane is Lecturer in Economics and Finance in the School of Economics at UCC. Prof Eoin McLaughlin is a Professor in Economics at the Cork University Business School at UCC. He is a former Irish Research Council awardee. Dr Fergal O'Connor is a Lecturer and programme director for the MSc. Finance (Banking and Risk Management) at the Cork University Business School at UCC.

The views expressed here are those of the author and do not represent or reflect the views of RTÉ