What Is a Carbon Tax?

Carbon dioxide is one of the main factors causing climate change. A carbon tax is an increasingly common government tax on a company’s carbon emissions that are released when a company produces a good.  Carbon taxes aim to incentivize companies to reduce their carbon dioxide emissions, thereby helping to slow global warming.

Carbon taxes are intended to reduce the amount of carbon a company produces by making it more expensive to continue emitting carbon than to simply decarbonize their production process. This works in two ways:

1. Carbon taxes increase costs for manufacturers, so there is a baseline incentive to reduce carbon emissions to reduce tax payments.
2. Higher tax payments may result in the company increasing the price consumers pay for the product. This reduces consumer demand for the product, which may prompt companies to reduce carbon in order to reduce taxes, and thus product prices.

Under carbon tax regulations, companies must pay a specific price per tonne of carbon (or other greenhouse gas) emissions. As of 2021, 65 carbon taxes or other similar initiatives have already been implemented internationally, in countries such as Canada, China, Russia, South Africa, the UK and Mexico.

More recently, some countries are pushing for carbon-border taxes, in which not only are manufacturers in the country subject to a carbon tax, but also importers. For example, the EU passed a new carbon tax on goods imported into the EU that will be fully implemented by January 2026.

Carbon Emissions in the Supply Chain

Carbon emissions can be broken down by industry, showing which activities produce the most carbon. While 25% of global greenhouse gas emissions are produced by the electricity and heat production sector, other industrial activities are still a major source of carbon emissions. This includes construction, electronics, automotive, and fashion. Agriculture accounts for 25% of annual global greenhouse gas emissions (Global Greenhouse Gas Emissions Data).

The vast majority of industry’s emissions are not from the final manufacturing process, but are rather from processes hidden within the supply chain, such as transportation of goods or the production of raw materials. For example, the metal mining process is much more carbon-intensive than actually producing a phone or watch.

In order for carbon taxes to truly reduce carbon emissions, they must focus on creating a green supply chain, rather than small scale taxes on product production. To address this issue, emissions have been separated into scope 1, scope 2, and scope 3. 

• Scope 1 emissions are emissions that are produced from activities that are actually owned by the company (for example, the manufacturing of cars within a factory owned by the manufacturer). 
• Scope 2 emissions are indirect emissions produced by the company through the purchase of electricity, steam, or heating and cooling.
• Scope 3 emissions are emissions produced as a result of the company’s actions, but that are produced by sources that the company does not own or control directly (for example, purchased goods from a supplier or transportation of final products).

Carbon taxes must be coordinated across the supply chain in order to address scope 3 emissions in addition to scope 1 and 2.

Increasingly, companies are designing or redesigning their supply chains with carbon taxes in mind, as carbon taxes can impact suppliers, manufacturers, retailers and recyclers.

Greening the Supply Chain: Where Do Emissions Come From?

The biggest impact of carbon taxes is that more companies will work to “green” their supply chain in order to reduce carbon emissions at each step. To do so, companies must identify where in the value and supply chains the bulk of their emissions are coming from. This process will likely include more communication with suppliers and other organizations within the chain.

Businesses can respond to carbon taxes by making tactical decisions in three areas: transportation, location, and lot sizing decisions.

Transportation

Transportation is one of the biggest carbon-producers within most supply chains. This includes transportation at all stages of production, including transport of raw materials as well as transport of finished goods. 

Emissions from ground transportation largely depend on truck type, vehicle route, and the volume of the freight being transported. Emissions from other transportation methods, such as planes, trains or ships, are also dependent on the vehicle type, route and volume of freight.

Carbon taxes may push companies to change transportation methods throughout the supply chain (for example, changing the truck’s route or using a ship instead of a plane) to reduce emissions.

Location

A 2019 study argues that in supply chains including three or more actors (eg. manufacturer, supplier and retailer), the logistics and facility location are the most important business decisions to respond to carbon taxes (Xu et al. 2019). 

When acting under a high carbon tax, companies benefit from sourcing materials locally and performing less frequent deliveries, even if this increases production or logistical costs. Additionally, distributors may be pushed to sell products on a more local scale in order to reduce transportation emissions. 

Local sourcing and distribution, as well as less frequent deliveries, is not always possible or economically practical. Thus low carbon taxes are unlikely to prompt companies to make these changes. More research is needed to understand how high carbon taxes should be to properly and fairly incentivize companies to reduce emissions.

Lot Sizing Decisions

Lastly, carbon taxes may affect how companies make decisions about the size of their product lots being transported or stored. If large quantities of products are transported, less frequent deliveries can be made, but inventory holding costs are increased. Making smart operational decisions can aid companies in reducing carbon emissions without significantly increasing costs.

All of these parts of the supply chain (transportation and inventory holding) produce carbon emissions, so companies must make a tradeoff decision between infrequent orders of large quantities (lower ordering costs but increased inventory holding costs, or more frequent orders of lower quantities (higher ordering costs but lowered inventory holding costs) (Benjaafar et al. 2013).

Impacted Consumer Prices

As manufacturers face increased costs due to carbon taxation, they may increase the price of their products in order to offset the costs. The goal of a carbon tax is to push consumers to pick cheaper products (products from manufacturers with lower emissions, lower taxes, and thus cheaper products). However, one of the main arguments against carbon taxation is that consumers will face outrageous prices for everyday goods while companies still rely on fossil fuels.

While fear of increased prices may cause negative public perceptions of carbon taxes, research is increasingly showing that pricing of consumer goods may only experience increases of about 1-4% depending on the product.

 Lower than expected price increases may be partially caused by where in the supply chain emissions are being taxed. For example, it is expensive for manufacturers of raw materials that the average consumer does not buy (eg. metal mining) to go carbon neutral. It is far less expensive for manufacturers of products that only use those materials in small amounts (eg. as part of a phone) to reduce their own emissions, so finished products may not be that much more expensive.

Increased Supply Chain Communication

Carbon taxes will increase collaboration throughout the supply chain. Specifically, carbon taxes will require increased communication and knowledge of a company’s suppliers. In fact, a 2020 study found that a carbon tax’s effectiveness is dependent, in part, on cooperation within supply chains (Liu & Hu 2020).

It is difficult for manufacturers to calculate emissions if they produce many different kinds of products, or if they have poor communication with suppliers. Increased communication with suppliers will help manufacturers calculate emissions and see opportunities to reduce their carbon footprint.

Companies that rely on suppliers overseas or large companies who don’t have a close relationship with their suppliers will need to keep a closer eye on suppliers to ensure their processes are in line with the manufacturer’s carbon-reduction goals. One method for this is to employ a third party to perform an environmental supplier audit to measure and keep track of supplier emissions.

Complying with carbon taxes will likely require more long-term partnerships with suppliers. For example, manufacturers may benefit from providing education on carbon reduction to their suppliers.

Positive Brand Image

By publicizing their carbon-reduction goals (for example, to become net-zero carbon by a certain date), companies can promote a positive public image of their brand. Now more than ever, consumers care about buying eco-friendly products. 

Even if the impetus for decarbonization in the supply chain is simply because of government regulations, it is important to show customers that your brand is taking the reduction of carbon emissions seriously.

Companies can achieve these publicicized goals by creating specific targets for emissions and introducing them throughout the supply chain.

Increase in Recycled Products

Carbon taxes may incentivize companies to reduce their carbon emissions by depending on recycled materials, such as recycled plastics or fabrics. Using recycled materials reduces carbon emissions linked to the production of new materials. 

Manufacturers can also contribute to lowering carbon emissions by ensuring their products can be recycled safely and effectively. This requires coordination across the supply chain from producers of raw materials to manufacturers to recyclers.

These changes in production help to create a circular economy in which industry reuses and recycles raw materials. The circular economy reduces carbon emissions, minimizes waste, and addresses resource scarcity in a world of finite raw materials.