Carbon levy: A fail-safe?

Despite decades of ‘reforms’, Pakistan has tragically failed to establish a pro-growth, anti-cyclical, and sustainable economic paradigm. This is primarily due to the overreliance on fiscal austerity and a flawed political economy, evident in macabre issues like bloated tax expenditure, bleeding SOEs, and pathetic public service provision.

On the one hand, this cookie-cutter approach limits development expenditure and extracts ruthlessly from a narrow tax base. On the other hand, current expenditure is rising sharply, particularly in terms of interest payments. Consider that in the past five years, the fiscal deficit averaged 7.0 per cent of GDP, while interest payments consumed 81 per cent and 400 per cent of tax revenue and development expenditure, respectively, for FY24.

The external trade account only adds to the gloom. A deteriorating investment climate is stifling sustainable exports and import substitution, compounded by looming global shifts like the EU’s CBAM and US reciprocal tariffs, which threaten to escalate the economic crisis. The CBAM, with its transition towards full integration, disproportionately affects Pakistan.

For example, the World Bank’s CBAM Exposure Index reveals that Pakistan’s electricity sector is 1.44 times more carbon-intensive than the EU average, leaving its exporters vulnerable to penalties. If tariffs are implemented, they could further strain the external accounts – especially given the lack of meaningful change in Pakistan’s climate policies.

Against this backdrop, the government seems hamstrung in its ability to spend on vital areas such as climate action. The climate division’s budget over the past five years reflects a troubling inconsistency. After peaking at Rs14,327 million in 2021-22, funding sharply declined to just Rs4,050 million in 2023-24, with a slight recovery in 2024-25. These fluctuations undermine long-term climate planning and indicate a lack of sustained political commitment to environmental priorities.

With recent negotiations, carbon taxation is gaining traction in Pakistan as part of the $1.3 billion IMF Resilience and Sustainability Facility (RSF) agreement, which is expected to include reforms such as formula-based fuel pricing and the introduction of a carbon tax.

Put simply, a carbon levy, when thoughtfully designed, can be a powerful lever in the fight against climate change, but its impact stretches beyond just emissions. Its effectiveness hinges not only on the right price and scope, but also on public trust and how the revenues are reinvested – whether into renewable energy, public transit or easing the burden on low-income households. Despite being rebuked due to valid concerns about economic strain, tangible examples show it can spark innovation, shift behaviour, and even boost green jobs. It’s not a one-size-fits-all solution, but as part of a broader, well-coordinated strategy, a carbon levy can help reshape the trajectory of how economies grow sustainably.

As per SDPI’s brief on ‘Carbon Taxation for Sustainable Industrial Transformation: Modalities around Equity and Revenue Recycling’, carbon pricing mechanisms like carbon taxes and emissions trading systems (ETS) have rapidly gained global support, with 75 jurisdictions covering 24 per cent of global emissions. In 2023 alone, these systems generated over $100 billion in revenue, highlighting their fiscal potential and effectiveness in driving environmental change. Implementation of these taxes is already underway in various countries.

Estimates suggest that an equitable and efficient carbon tax could fund renewable energy initiatives and hard-to-abate sectors while fostering economic growth. A $20/ton tax could yield 1.2 per cent of GDP annually, providing stable revenue for both climate and development goals. For economies with large informal sectors like Pakistan, it can also generate higher revenue with lower administrative costs.

Prima facie, this levy seems to offer a solution to Pakistan’s fiscal constraints, trade imbalances like CBAM, and climate challenges. However, viewing it as a panacea would be a superficial fix – a mere Overturn Window.

Pakistan faces multiple administrative, economic, industrial and regulatory hurdles in implementing an effective carbon tax regime. On the administrative front, the absence of robust Monitoring, Reporting, and Verification (MRV) systems, coupled with high risks of tax evasion, severely undermines emissions tracking and revenue collection.

Also, this is an undeniable fact that Pakistan’s tax administration has remained lethargic & corrupt. The tax-to-GDP ratio was recorded at around 9.6 per cent and 10.8 per cent in the first and second quarters, respectively – well below the tipping point of 15 per cent observed in middle-income developing countries and significantly behind the globe such as Azerbaijan (18 per cent), Cambodia (13.5 per cent), Sri Lanka (13 per cent) and the 28 per cent and above seen in mature Western economies. In this administrative climate, a blanket carbon levy, without the removal of structural bottlenecks, seems far-fetched, if not a fanciful figment.

Economically, high energy costs – such as the Rs70/litre petroleum levy – exert inflationary pressure, disproportionately impacting low-income households. And the power sector, on the other hand, due to inefficiencies in all dimensions has caused a large circular debt along with a dismayed tariff structure. According to the IEA, 2024 electricity rates averaged 6.3 cents/kWh in the U.S. and India, 7.7 in China, 4.7 in Norway, and 11.5 in the EU. In contrast, Pakistan’s energy-intensive industries paid around 13.5 cents/kWh, significantly higher than global averages. Plus, energy poverty remains a pressing issue, with over 40 million people still lacking access to electricity.

The political economy is further distorted by policies like fossil fuel subsidies, which amount to Rs1.3 trillion annually. These subsidies undermine market signals and directly contradict emission reduction goals.

To address climate change effectively, Pakistan should adopt a phased hybrid carbon pricing model, ensuring the absence of high-handed and haphazard administrative dispensation. In Phase 1 (2025–2026), a carbon levy of 1,500 PKR/ton CO2 will target high-emitting industries like cement and textiles, with gradual expansions in Phase 2 (2027–2029), increasing the levy to 2,500 PKR/ton and introducing differentiated rates for trade-exposed sectors. By Phase 3 (2030 onward), the system will combine carbon taxes and emissions trading, aiming for a carbon price of $50–75/ton CO2, potentially linking with regional carbon markets.

Revenue generated from the carbon levy should be allocated towards low-carbon R&D and green initiatives, like afforestation, and support Pakistan’s National Economic Transformation Plan (Uraan Pakistan). The carbon tax should align with the EU’s CBAM, ensuring that export sectors, such as textiles, are not penalised through double taxation. Introducing tax swaps to offset economic impacts by reducing labour or capital taxes for industries adopting renewable technologies will provide fiscal incentives without increasing the overall tax burden.

Sector-specific measures include mandating carbon reporting for large industries, launching an emissions trading system for the power and cement sectors, and enforcing stricter fuel standards by 2026. Incentives for electric vehicles should be introduced, using 10 per cent of carbon tax revenue for subsidies. A carbon credit mechanism should be established for hard-to-abate sectors, allowing industries to offset emissions via domestic carbon credits. Export sectors should be allowed to bank credits for future compliance with CBAM.

To ensure successful implementation, Pakistan should create a Climate Fiscal Framework in collaboration with the IMF, linking carbon taxation to the country’s Resilience and Sustainability Facility (RSF) commitments. Revenue from the carbon tax should be pooled into the Pakistan Climate Fund and managed by the Pakistan Climate Change Authority, with oversight from the Climate Change Council. Coordination with provincial governments will be crucial to ensure broad support and smooth execution. The initiative should focus on both emission reduction and revenue generation, with compensation mechanisms to mitigate economic impacts.

Pakistan must revamp its governance structure, particularly in the power sector, to minimise supply-side cost overruns. Without addressing these inefficiencies, the carbon levy could simply be passed on to consumers, exacerbating inflation and making Pakistani industries less competitive globally.

Carbon tax revenue could also be strategically allocated to reduce the tax burden on labour through reductions in personal income and payroll taxes. This fiscal policy approach would serve to neutralise the regressive effects of the carbon tax on households, while simultaneously enhancing labour market participation and overall economic efficiency.

Finally, Pakistan must adopt a pro-growth, anti-cyclical approach to ensure that fiscal policies, including carbon taxation, strengthen economic resilience during downturns, stimulate growth and protect industries in the long term, thus creating a solid foundation for a low-carbon, high-resilience economy. Done with precision, carbon taxation could position Pakistan as a leader in sustainable economic development.

Furqan Ali is a Peshawar-based researcher who works in the financial sector.

Arfa Ijaz is an environmental engineer anda research assistant at the Sustainable Development Policy Institute (SDPI), Islamabad.