What is a carbon tax and how does it work?

Quick Answer: A carbon tax is a fee charged by a government on the greenhouse gas emissions produced by burning fossil fuels or other carbon-intensive activities. It works by putting a direct price on each tonne of CO2 (or CO2-equivalent) emitted, making higher-carbon choices more expensive and lower-carbon alternatives more competitive. Carbon taxes are one of the main policy tools governments use to reduce national emissions in line with climate targets.

What is a carbon tax?

A carbon tax is a price set by government on carbon dioxide emissions, typically expressed as a cost per tonne of CO2 or CO2-equivalent (CO2e). The logic is straightforward: when emitting carbon has a financial cost, businesses and individuals have an incentive to reduce it.

The tax is usually applied at the point of emission or at the point where the fuel enters the economy, such as when a company purchases fossil fuels or operates carbon-intensive processes. The cost then flows through the supply chain, making higher-emission goods and services more expensive relative to lower-emission alternatives.

Carbon taxes are distinct from carbon markets (such as emissions trading schemes), where companies buy and sell permits to emit. A carbon tax sets the price and lets the volume of emissions adjust. A carbon market sets the volume and lets the price adjust. Both are forms of carbon pricing, but they operate differently in practice.

How does a carbon tax work in practice?

Governments set a fixed rate per tonne of CO2e emitted. In the UK, the Carbon Price Support mechanism applies to fossil fuels used in power generation, sitting alongside the UK Emissions Trading Scheme (UK ETS). In other countries, such as Canada and Sweden, broader carbon taxes apply directly to fuel use across sectors.

The rate can be flat or escalating. Many carbon tax regimes include a pre-announced schedule of rate increases, giving businesses time to plan. Sweden's carbon tax, for example, started at around SEK 250 per tonne of CO2 in 1991 and has risen to over SEK 1,300 per tonne (roughly £95-100) by the mid-2020s, making it one of the highest rates in the world (World Bank, 2024).

Revenue raised from carbon taxes is handled differently depending on the government. It may be:

• Returned to citizens as a dividend or rebate
• Invested in clean energy infrastructure
• Used to reduce other taxes (a "revenue-neutral" approach)
• Directed into general government funds

How the revenue is used affects public and business acceptance of the tax, but does not change its core function of pricing emissions.

What is the difference between a carbon tax and an emissions trading scheme?

Both are carbon pricing mechanisms, but they work through different levers.

A carbon tax sets a fixed price per tonne of CO2e. Businesses know exactly what they will pay, which makes financial planning predictable. The trade-off is that the total volume of emissions is not capped, so the environmental outcome depends on how strongly the price signal changes behaviour.

An emissions trading scheme (ETS) sets a cap on total emissions and issues permits up to that cap. Companies that emit less can sell unused permits; those that emit more must buy additional ones. The total volume of emissions is controlled, but the price fluctuates with market demand.

In practice, many jurisdictions use both. The UK operates the UK ETS for large industrial emitters and power generators, while other carbon pricing mechanisms apply to sectors outside the scheme.

Why does a carbon tax matter for businesses?

For most businesses, a carbon tax affects costs indirectly through energy bills and supply chain prices rather than as a direct levy on the company itself. However, as carbon pricing regimes expand in scope and rate, direct exposure is increasing.

The EU's Carbon Border Adjustment Mechanism (CBAM) is a clear example of this shift. Introduced in 2026 (with a transitional reporting phase from 2023), CBAM requires importers of certain carbon-intensive goods into the EU to pay a carbon price equivalent to what would have been paid under the EU ETS if the goods had been produced in Europe. This means that UK and non-EU businesses exporting to Europe now face direct carbon pricing exposure, even if they operate outside a domestic carbon tax regime.

For businesses subject to supply chain due diligence, procurement requirements, or customer sustainability questionnaires, understanding your own carbon footprint is increasingly a prerequisite for demonstrating compliance. Schemes like PPN 006 (for UK public sector suppliers) and frameworks like EcoVadis already require carbon data. As carbon pricing spreads, having an accurate, auditable emissions inventory becomes relevant to commercial risk, not just reporting.

This is where tools like Seedling become practically useful. Knowing your Scope 1, 2, and 3 emissions gives you the foundation to assess your exposure to carbon pricing, identify where your highest-cost risks sit, and make informed decisions about reduction priorities.

What are the arguments for and against carbon taxes?

Carbon taxes are well-supported in economic theory but contested in practice. The main arguments on each side are worth understanding clearly.

Arguments in favour:

• They create a direct financial incentive to reduce emissions at the source
• They are relatively simple to administer compared to permit-based systems
• They provide price certainty, which supports business investment decisions
• Revenue can be recycled to support lower-income households or fund clean technology

Arguments against:

• A flat rate can be regressive, placing a proportionally higher burden on lower-income households and energy-intensive industries
• If set too low, the price signal is too weak to change behaviour meaningfully
• Carbon leakage is a risk: businesses may relocate production to countries without a carbon price, shifting emissions rather than reducing them
• Political resistance makes it difficult to set and maintain rates high enough to drive the required transition

The carbon leakage problem is one reason mechanisms like CBAM exist: to level the playing field for domestic producers and prevent emissions from simply moving across borders.

How carbon taxes connect to your emissions data

A carbon tax creates a financial consequence tied directly to emissions volume. The higher your emissions, the greater your exposure, whether through direct taxation, energy costs, or supply chain pricing pressure.

Accurate carbon accounting is the starting point for managing that exposure. Without a reliable picture of where your emissions sit across Scopes 1, 2, and 3, you cannot identify which parts of your operations carry the most financial risk under current or future carbon pricing, nor can you model the impact of reduction initiatives with any confidence.

As carbon tax rates rise and carbon border mechanisms expand, the gap between businesses with good emissions data and those without will become increasingly visible in commercial terms, not just in sustainability reports.