Towards a carbon tax for Bangladesh

April 1, 2019

By  Sadiq Ahmed, Bazlul H. Khondker

Development context

Bangladesh is a strong actor in the effort to reduce global carbon emission (CO2). This is appropriate as it faces a major burden from global climate change. Although per capita carbon emission is low, total carbon emission in Bangladesh is growing. Consequently, as a good global team player, Bangladesh committed to reducing its carbon footprint in its Intended Nationally Determined Contributions (INDC) submissions in 2015.
The main source of CO2 emission is the use of fossil fuel in both combustible and non-combustible forms. On a long–term basis, CO2 emissions in Bangladesh grew at an annual average rate of 7.2% over 1970-2016. The CO2 trend for the more recent years (2004-2016) shows an even faster growth at 9.2% annually owing to the growing influence of urbanisation, industrialisation and use of electricity. From a sectoral perspective, the power sector is the dominant CO2 emitter, with emission growing at an annual average rate of 8.8% per year, which is significantly faster than the average rate of growth of CO2 for the economy. As a result, its share in total CO2emission surged from 22% in 1970 to 44% in 2016. Transport sector emission also grew faster than total CO2 emission, as a result of which its share in total CO2 emission nearly doubled from 7.9% in 1970 to 14% in 2016. Both also show emission growth spikes in the more recent years of 2004-2016. The growing contribution of these two rapid emitters is the primary reason for the spike in total CO2emission in the recent years. Emissions from buildings and industrial sector grew somewhat more slowly, causing their shares in total CO2 emission to fall. However, there was a similar spike in emission growth for industrial sector during 2004-2016.

The CO2 trend for the more recent years (2004-2016) shows an even faster growth at 9.2% annually owing to the growing influence of urbanisation, industrialisation and use of electricity.

This pattern of sectoral contributions to CO2 emission has major implications for the future outlook for CO2 emission. Under the business as usual (BAU) policy framework of the present time, the outlook for further growth of CO2 emission is highly unfavourable. As Bangladesh grows faster with concomitant increases in industrialisation and urban development, the demand for power will surge. Industrialisation and urbanisation will also lead to faster demand for transport services. Both these fast-growing CO2 emitters along with the spike in industrial emission in recent years will increase the overall growth of CO2 from the 9.2% in recent years (2004-2016) to 10% plus. Indeed, the observed GDP elasticity of carbon emission during 2004-2016 of 1.4 suggests that CO2 emission may grow at an annual pace of 11.2% under a GDP growth scenario of 8%.
However, international experience suggests that the CO2 elasticity of GDP tends to fall as income grows. Energy intensity of production typically tends to rise at low levels of income and then falls and stabilises at below one. Under these assumptions, the projected path of CO2 emission is flatter than in the BAU case. Even with moderated growth in CO2 emission over 2025-2041 periods, CO2 is projected to grow at around 10% per year. This rapid rate of CO2 emission will be inconsistent with Bangladesh’s global commitment to reduce the growth of CO2 emission and must be addressed speedily through a major reform of carbon reduction policies including reform of fuel prices and the introduction of carbon taxes.

The case for a carbon tax

A review of Bangladesh’s environmental policies shows that the overall environmental management including control of air pollution relies heavily on command and control type instruments comprising of laws, regulations and standards. There is very little use of incentive policies especially taxes and pricing policies. Indeed, by providing heavy subsidy on natural gas and fuel oil, Bangladesh provides an incentive for excessive consumption of fossil fuel. Therefore, fossil fuel pricing policies are inconsistent with the CO2 reduction objective. This is a fundamental contradiction in environmental management in Bangladesh that must be addressed soon.
International experience shows that environmentally sensitive countries have taken several measures to reduce the rate of growth of CO2 emission. One major policy initiative is the adoption of renewable energy for power generation. Globally, the share of renewable energy in power production has increased from 20% in 1990 to 25% in 2017. The EU countries have moved much faster than the rest of the world. Thus, its relative share of renewable energy for power production has expanded from 13% in 1990 to 30% in 2017. Germany and United Kingdom provided leadership to this transformation. As compared to these, the relative share of Bangladesh has gone down from 9.8% in 1990 to a mere 1.6% in 2017. The main reason for this decline is that almost all additional power generation since 1990 has relied on use of fossil fuel. In Bangladesh, there is only one hydropower station linked to the Kaptai dam. The installed capacity of 230MW reached in 1988 has remained fixed at that level since then. Progress with other renewable energy has not happened in any significant way. At the national grid level, solar and wind account for only 3MW of installed capacity (0.02% of total installed capacity). There is better progress with the non-grid sources, particularly at the household level where solar housing project and solar irrigation promoted through IDCOL has achieved better success. Nevertheless, as a source of power, wind and solar energy account for a mere 1% of total electricity generated in Bangladesh.
The government has put considerable emphasis to promoting non-hydro renewable energy. A Renewable Energy Policy was adopted in 2008. The policy set a target of 5% share of renewable energy for power generation for 2015 and 10% share for 2020. The 2015 target has been missed and the 2020 one will be too. Apart from excessive focus on mega power projects based on fossil fuels including LNG and coal, the policy framework for Renewable Energy is not conducive to the adoption of clean energy. A major contradiction is the continued subsidisation of fossil fuel. In countries that have moved ahead successfully with renewable energy the incentive policies were set properly. Use of fossil fuel has been taxed considerably to discourage its use. These taxes are as high as 70% in many European countries, especially the UK even though the UK is a major oil producer. India and China have also introduced a carbon tax to discourage the use of carbon emitting fossil fuel. If Bangladesh wants to promote wind and solar energy in power and other uses, it must set the policy framework for renewable energy accordingly. A key policy priority is to reform the fuel prices. It must eliminate the fuel subsidy and instead adopt a well-defined carbon tax to discourage the consumption of fossil fuel and promote the expansion of renewable energy.
Since use of fossil fuels is a major source of carbon emission, several countries have adopted a carbon tax. Simply defined, a carbon tax is levied on the carbon content of fuels. An alternative instrument to carbon tax is the use of Emission Trading Systems (ETS) whereby the government fixes the total volume of emission for each type of polluting industry and allocates these pollution rights to industries through an auction system. Conceptually the two instruments are equivalent. Global experience shows that while some countries have adopted either a carbon tax or an ETS, some countries have used both. The choice of instrument is based on a number of factors including administrative capabilities, pollution measurement and monitoring readiness and political economy considerations. The limitations of developing countries in the first two areas suggest a preference for carbon taxes on inputs.

Although only a limited number of countries have introduced a proper carbon tax or adopted an ETS scheme because of political opposition to the potential cost-cascading effects of a full-blown carbon tax, most oil importing countries impose a tax on gasoline over and above the normal VAT or sales tax.

Although only a limited number of countries have introduced a proper carbon tax or adopted an ETS scheme because of political opposition to the potential cost-cascading effects of a full-blown carbon tax, most oil importing countries impose a tax on gasoline over and above the normal VAT or sales tax. This is a special levy in the form of an excise tax that is usually set in relation to the carbon content of the liquid fuel. The cost-cascading effects are moderated by either levying the tax at the gas pumps only or by exempting sensitive sectors. Thus, a gasoline tax (petrol and diesel) at the pump gate raises the cost of transport but does not directly affect electricity and manufacturing production. Also, in this case other primary fuels such as natural gas, furnace oil, kerosene and coal are outside the tax net. While a gasoline tax is often conceived as a road-user charge earmarked for road maintenance (as in the USA), it is increasingly being used as an environmental tax to reduce consumption of fuel oil in transport. It is not surprising therefore that the tax rate is very high in OECD countries except USA, including countries that have not introduced a carbon tax. The UK for example imposes a tax rate of about 71% on gasoline as compared with only 23% in USA. India’s tax rate of 42% exceeds rates in Australia, Canada and USA showing its growing commitment to reducing carbon emission.

Approach to carbon tax in Bangladesh

The gasoline tax can be conceived as a part of a longer-term plan to introduce a proper carbon tax at a later stage. This is how it has progressed in some countries that have introduced a carbon tax. For example, in India the carbon tax emerged first in 2010 as a tax on domestic coal but was later broadened to include petrol and then diesel. So, essentially, the carbon tax in India emerged over a five-year period in different stages. The tax rates have also been adjusted gradually.
This pragmatic approach is best suited to the current political economy environment of Bangladesh. The pricing reform for natural gas is off the table and the government will not accept taxation of fuel oil or coal for electricity generation to avoid electricity cost escalation. Similarly, the government will oppose the taxation of kerosene to avoid pass-through effects on the poor. Consequently, the taxation of petrol and diesel presents the most promising option for introducing a carbon tax. The elimination of fuel oil subsidy at the pump gate through proper pricing policy is a first step in a sequential programme to reducing carbon emission from the use of fuel oil. This reform can then be combined with an excise duty on petrol and diesel that is in addition to the applicable VAT. The initial rate of the carbon tax can be determined based on expected carbon reduction, the amount of resources mobilised and the level of political comfort. The tax rate can also be varied in relation to international prices. Thus, the tax rate can be increased when oil prices are low and reduced when international oil prices go up. A similar approach is used in India.

Simulation results

To illustrate the importance of a carbon tax as an instrument for CO2 reduction, the associated research provides a quantitative example of how a specific carbon tax on gasoline might work. The simulations use two models: a model that estimates the revenue and CO2 reduction effects of a carbon tax on gasoline and a second model that incorporates the general equilibrium effects of this carbon tax for output and prices. Two Policy Scenarios are considered. A Low Policy Case (LPC), where the tax is imposed only on gasoline (petrol, octane and diesel); and a High Policy Case (HPC), where the tax is also imposed on furnace oil and kerosene.

The simulations use two models: a model that estimates the revenue and CO2 reduction effects of a carbon tax on gasoline and a second model that incorporates the general equilibrium effects of this carbon tax for output and prices.

In both cases the carbon tax has a strong effect on both CO2 reduction and revenue generation. Much of the effect comes from the diesel component as it dominates the volume of consumption in the transport sector and is also used in agriculture for irrigation purposes. For both Scenarios the CO2 reduction effects strengthen over the years as substitution of clean energy for diesel happens and there is a cumulative build up in the reduction of the use of diesel and gasoline. There are also efficiency gains from better technology and energy conservation in transportation and irrigation. The revenue effects are large even in the first year with a collection of Tk. 43 billion in the LPC, growing to Tk. 137 billion in FY2031. Revenues are higher in the HPC. Clearly, as far as carbon reduction and revenue gains are concerned, the proposed carbon tax is a win-win.
The output and employment effects depend upon the ease of substitution of clean energy for fossil fuel. In the short term, defined as two-three years, there is a decrease in GDP with the largest reduction in transport services, which in turn causes declines in industry and agriculture. It is assumed that efficiency improvements and substitution of clean energy /technology takes effect from FY2022 onwards. This is a reasonable assumption. Although presently Bangladesh is lagging behind on substitution prospects especially for renewable energy, globally the technology is out there and with proper pricing policies for fuel oil along with the carbon tax, private investment will help facilitate substitution prospects as well as create incentive for more efficient energy use and adoption of clean fuel technology. For example, solar power has already become popular in rural housing and irrigation. Availability of electricity has also caused a massive reduction in the use of kerosene. In transportation CNG has become popular which has lowered the demand for gasoline. Investments in electricity based light rail for mass transit are underway that will lower the use of diesel and gasoline for urban transportation.
As can be expected, the output loss and price increase effects are larger for HPC. However, once the substitution effects are underway, the output and employment losses are offset on average for both cases. Simulations also show that output loses can be offset by government investment in infrastructure using the revenues generated by the carbon tax. Importantly, increased government spending on social protection can help offset any adverse impact on the poor due to the carbon tax.
Although the CO2 reduction and revenue impact are stronger in the HPC, the differences are not dramatic. For both cases, diesel consumption dominates and is the most potent source of CO2 reduction and revenue mobilisation for the carbon tax on fuel oil. In terms of product mix, furnace oil consumption is the second largest after diesel. Regarding kerosene, the rapid decline of the past several years due to substitution to cleaner energy has made this a relatively insignificant source of CO2 emission for Bangladesh. The revenue impact is also not large. Since kerosene tax is politically very sensitive, continued focus on providing rural electrification and LPG for cooking might be the better policy alternatives than a carbon tax on kerosene.

Summary and conclusions

The use of carbon tax can be a major way to reduce carbon emission. Simulation analysis shows that with reasonable assumptions about demand elasticities of income and prices for oil products a carbon tax would bring about substantial reduction in CO2 emission. This reduction need not hurt GDP growth or adversely affect the income of the poor. The carbon tax not only lowers CO2, it also yields revenues. These revenues can be invested in clean fuel, clean technology and infrastructure projects that will help offset the loss of output from carbon taxes. Bangladesh is way behind the rest of the world in clean energy and clean technology. Proper pricing of fossil fuel along with the carbon tax will provide the incentives to reduce the consumption of these fuels and also motivate private investment in clean energy and clean technology. The carbon tax incidence is progressive in the sense that the cost of living increase is highest for the top ten percentile and lowest for the bottom ten percentile. Furthermore, the increase in cost of living for the poor can be offset through income transfers from additional social protection spending based on carbon tax revenues.
Thus, a proper combination of fossil fuel pricing, carbon tax and investments can make carbon tax a win-win policy package.

This article is based on a research study financed by the Adam Smith Institute under its Economic Dialogue for Green Growth (EDGG) program for Bangladesh. We are grateful to the country manager Suvojit Chattopadhyay for his support. The detailed research paper can be provided on request.

Sadiq Ahmed

Sadiq Ahmed is the Vice Chairman of the Policy Research Institute of Bangladesh. He was previously at the World Bank, serving as country director for Pakistan and Afghanistan and chief economist for the South Asia region. He also led key missions to Egypt, South Asia, and Southeast Asia. He completed his PhD in Economics from Boston University. He has worked on topics of poverty reduction, governance, private sector, trade and macroeconomic. He has authored more than 30 books, policy research papers and articles on various development issues.

Bazlul H. Khondker

Bazlul Haque Khondker is a Director at Policy Research Institute of Bangladesh. He is also a professor at the Department of Economics, University of Dhaka and the Chairman of the South Asian Network on Economic Modeling (SANEM). He holds a PhD in Economics from the University of Warwick, UK. His areas of expertise include social policy, development economics and economic modeling.