numbers, not adjectives — D. J. C. MacKay

7  Carbon Fee and Dividend

Carl Edward Rasmussen, March 14, 2025.

Carbon fee and dividend (CFD) puts a fee on fossil fuels, and redistributes the funds equally between all citizens in regular payments.

The goal of CFD is to create economic pressure to reduce climate change in an effective and revenue neutral way.

CFD is generally favoured by economists, as a fair and efficient way to reduce fossil fuel use. Variants of CFD are currently in operation in some Canadian provinces and in Switzerland. But it is probably fair to say that these schemes have limited popularity. The main reason appears to be a lack of awareness and understanding of CFD, in particular a misplaced view that this is just another tax. Significant contributors to this view are that in some systems only a fraction of the revenues are returned, and the dividends are not returned as explicit payments, but rather as tax relief or reduced health insurance costs, thus obscuring the mechanism from the citizens.

7.1 Possible reasons why Carbon Fee and Dividend is unpopular

Disclosure: I am personally in favour of CFD. I’ve included this section because I think there are a lot of misconceptions about CFD.

CFD is regressive, because poor people tend to use a larger fraction of their income on energy related expenses than the well off. Simply not true. While poorer people do tend to use a larger fraction of their income on energy, better off people absolutely use much more energy. And since the dividend is equal for all citizens, less well off people will be net beneficiaries of CFD. CFD is actually progressive.

Governments can’t be trusted. Perhaps a valid point, but hardly an argument for resisting a good idea.

CFD is a tax. That depends a bit on how exactly you define the word tax. In its pure form, CFD is revenue-neutral.

Treasuries don’t like hypothecated taxation. Hypothecated tax is a system where the funds collected are earmarked for certain uses. The treasuries are confusing tax and CFD (see above). The purpose of tax is to generate revenue to fund the essential services of government. The purpose of CFD is to reduce the use of fossil fuels. They’re different, please don’t confuse them.

Industry opposition: price. Some fossil fuel intensive industries, including fossil fuel producers, claim that CFD will make their products more expensive. Sure, that’s the entire point. Fossil fuel use has the negative side effect of causing damaging climate change, we have to stop that.

industry opposition: competitiveness. CFD may make some destroy the competitiveness of certain industries if other regions don’t implement it. Yes, this is a completely valid objection, and needs to be fixed.

Carbon leakage. This is a similar objection to the one above.

Complexity of implementation. Carbon fee and dividend is not hard to implement. Fees can be collected either at the point of entry of the fossil fuels into the economy, ie well or import terminal or at the point of purchase for fuel or electricity. Suitable fee systems are already in place in most countries. Payment systems for dividends would have to be created, but these are simple because the dividend is equal for all citizens.

7.2 National and international systems

Carbon fee and dividend as discussed above is for national implementation. But climate change can not be solved by national initiatives. Even if a country managed to become carbon neutral, the effect on the climate would be modest. Efforts to limit greenhouse gas emissions only make sense if they’re orchestrated, including large numbers of countries. How do we achieve that?

I will first state the prevailing answer to this question, before sharing my own, more compelling view. The usual answer is that nations should raise economic barriers, applying fees against countries who don’t implement comparable CFDs. Such schemes are usually called Carbon Border Adjustment Mechanisms (CBAM), and EU is currently working on such a system (to support their EU wide Emission Trading System, EU-ETS. (The EU-ETS is a Cap and Trade system, not a CFD, but also requires equalisation at the borders.) The goal of CBAM is to implement a fee on imported goods corresponding to the difference in any carbon fee paid in the country of origin, and what would have been paid in the EU-ETS. The reasoning then goes, that non-EU governments would surely much prefer collect and keep fees themselves, than let EU have the money. This puts pressure on non-EU countries to implement their own carbon tax at the same level as the EU-ETS.

At first, this may sound like a compelling mechanism, but unfortunately there are at least a couple of major obstacles which will prevent this from working. Firstly, CBAM requires a large and complex administrative system in order to document the carbon footprint and carbon fee already paid for every exported product. Many countries with less developed and reliable bureaucracies than the EU, don’t have the practical means to implement such complex systems. And secondly, different countries have very different GDP per capita. This means, that if a carbon tax was set to equal magnitude in different countries, then in rich countries it would have a trivial impact while in poorer countries it would be crippling. So that is unlikely to work well.

A more compelling answer is to use the same CFD mechanism at the country level, with countries now playing the role of citizens. The system works precisely as before, the same motivation the same good properties. The only difference being that the system isn’t imposed by a government, but by mutual agreement.

In detail: countries agree on a price per emitted tonne of CO₂e. At the end of the year, the contries report the CO₂e emissions, funds are collected and immediately divided out according to the number of citizens in each country. A consequence of international CFD is that only the average per capita CO₂e emission plays any role. Above average emitters are net contributors, below average emitters net beneficiaries. And every country (not just big emitters) feel an economic pressure to emit less. The price of emitting carbon is the same in every country, so no border adjustment mechanisms are necessary.

7.3 Practical considerations

Carbon fee and dividend on the international level is an elegant and practical mechanism to address climate change. It forms the basis for the Themis Mechanism, short and longer descriptions. To complete the description we need to adress three issues, which are covered in the Themis Mechanism: First we need a way to determine the common emission price, this is done by voting. Second we need to be able to deal with free-riding countries who decide not to join, which is done by trade barriers. And thirdly, we can give back to the individual countries autonomy to determine by themselves whether they want to implement CFD at the national level; contries are sovereign and can implement any mechanism they like, as long as they honour their international CFD obligations.