Point of Regulation: Upstream vs Downstream
Where in the supply chain should you apply a carbon tax? This seemingly technical question has major implications for how many entities you need to regulate, how easy it is to administer the tax, and how visible the price signal is to end users.
The Three Points of Regulation
A carbon tax can be applied at different points in the supply chain:
Upstream (at the fuel source)
The tax is applied when fossil fuels first enter the economy. This means taxing:
- Coal at the mine or import terminal
- Oil at the refinery or import
- Natural gas at the processing plant or import
Midstream (at distribution)
The tax is applied to fuel distributors, wholesalers, or large industrial users. This captures fuels as they move through the supply chain but before they reach final consumers.
Downstream (at the point of emission)
The tax is applied directly to entities that burn fuels and release CO2. This includes power plants, factories, and even individual households.
Think of it like taxing sugar in soft drinks. You could tax the sugar at the sugar mill (upstream), at the beverage factory (midstream), or at the retail store (downstream). Each approach catches different numbers of entities and has different effects on visibility and compliance.
How the Approaches Compare
| Feature | Upstream | Midstream | Downstream |
|---|---|---|---|
| Number of taxpayers | Few (tens to hundreds) | Moderate (hundreds to thousands) | Many (potentially millions) |
| Administrative burden | Low | Moderate | High |
| Coverage | Comprehensive | Good | Can be incomplete |
| Builds on existing taxes? | Often yes (fuel taxes) | Partially | Rarely |
| Direct incentive to emitters | Indirect | Moderate | Direct |
Why Most Carbon Taxes Go Upstream
Most carbon taxes are applied upstream or at the midstream level. Here is why:
1. Fewer regulated entities
By taxing at the fuel source, you can cover the entire economy while monitoring only a few hundred fuel suppliers rather than millions of individual emitters.
Example: In a typical country:
- 5-20 oil refineries or importers
- 2-10 natural gas distributors
- 10-50 coal mines or importers
Compare this to millions of households, thousands of businesses, and hundreds of factories that would need to be monitored under a downstream approach.
2. Build on existing systems
Fuel excise taxes already exist in most countries. These taxes are collected from fuel suppliers, and the infrastructure is already in place. A carbon tax can simply be added to the existing system.
3. Automatic pass-through
When the tax is applied upstream, it automatically becomes part of the fuel price. Every downstream user pays the carbon cost without needing a separate carbon tax system to monitor them.
4. No direct emissions measurement needed
You do not need to measure actual emissions. Since we know the carbon content of each fuel, you can calculate CO2 from fuel volumes. If a refiner sells 1 million liters of diesel, we know exactly how much CO2 that will produce.
Upstream taxation is why carbon taxes are often recommended for countries with limited administrative capacity. You can achieve broad coverage without building complex new monitoring systems.
When Downstream Makes Sense
Despite the advantages of upstream taxation, there are situations where downstream regulation may be appropriate:
When you need direct measurement
Some emissions cannot be calculated from fuel use. Industrial process emissions (like CO2 from cement production) require direct measurement at the facility level.
When you want to reward efficiency
Upstream taxation treats all users of a fuel the same. Downstream taxation can recognize that some facilities are more efficient than others. A highly efficient power plant pays less per unit of electricity produced.
When aligning with an ETS
If you have an emissions trading system covering certain sectors, you may want those same entities to pay the carbon tax directly (or be exempt to avoid double coverage).
Many carbon pricing systems use a hybrid approach:
Upstream for transport fuels: Gasoline and diesel are taxed at the refinery or distributor level. This captures millions of vehicles without needing to monitor each one.
Downstream for large emitters: Power plants and major industrial facilities are regulated directly. They report actual emissions and pay based on measured output.
Sweden uses this approach. Transport and heating fuels face an upstream carbon tax. Large industrial facilities are covered by the EU Emissions Trading System, which operates downstream.
Canada's federal carbon pricing similarly applies the fuel charge upstream while the output-based pricing system covers large industrial emitters downstream.
The advantage: you get comprehensive coverage (upstream) plus accurate measurement for major emitters (downstream) plus the ability to align with emissions trading where needed.
The Tax Cascade Effect
When taxes are applied upstream, they cascade through the supply chain. Here is how it works:
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Tax is applied: A coal importer pays $25/ton CO2 equivalent on coal imports.
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Costs increase: The importer raises prices to cover the tax.
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Price signal flows: Power plants pay more for coal, raising electricity costs.
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End users respond: Factories and households face higher electricity bills, incentivizing efficiency and switching to lower-carbon alternatives.
It is like dropping a stone in a pond. The upstream tax creates a ripple that spreads through the entire economy. Every downstream user feels the price signal, even though they never interact directly with the tax authority.
Challenges with Upstream Taxation
While upstream taxation has many advantages, it is not without challenges:
Less visible to end users
Consumers see higher fuel prices but may not realize why. This can make it harder to build public understanding and support for the policy.
Uneven cost pass-through
Different industries have different abilities to pass costs on to customers. Some may absorb costs instead of passing them through, weakening the incentive signal.
Cannot reward downstream efficiency
If two factories buy the same amount of fuel but one uses it more efficiently to produce more output, the upstream tax treats them the same. Only downstream regulation can distinguish between them.
Exemptions are harder
If you want to exempt a particular activity (like agriculture), it is easier to do this downstream than upstream. With upstream taxation, you need to create rebate mechanisms.
Making the Choice: Key Questions
When deciding where to apply a carbon tax, consider:
1. How many entities would be covered at each level?
If upstream coverage means monitoring 100 entities versus 10,000 downstream, the administrative savings are significant.
2. Does existing infrastructure support the approach?
If fuel excise taxes are already collected from refiners, adding a carbon component is relatively simple.
3. Are there significant process emissions?
If industry emits CO2 from processes (not just fuel burning), you may need downstream regulation for those sectors.
4. Do you need to align with an ETS?
If certain sectors are already in an emissions trading system, you may want consistent downstream treatment.
5. What exemptions or rebates are needed?
Some exemption mechanisms work better with one approach than another.
British Columbia's carbon tax is applied upstream at the wholesale level. Fuel distributors pay the tax when they sell to retailers. This keeps the number of regulated entities manageable (about 100) while covering virtually all fossil fuel use in the province.
To provide relief for specific sectors, BC uses rebates and credits administered through the income tax system, rather than exempting fuels at the point of sale.
Point of Regulation for Different Fuels
Different fuels may be regulated at different points:
| Fuel | Typical point of regulation | Why |
|---|---|---|
| Gasoline/diesel | Refinery or distributor | Few players, existing excise tax system |
| Natural gas | Distributor or large users | Pipelines simplify tracking |
| Coal | Mine or importer | Few sources, easy to monitor |
| Heating oil | Distributor | Similar to gasoline system |
| Aviation fuel | Airport fuel suppliers | Centralized distribution |
Looking Ahead
Now that we understand where to apply the tax, the next lesson explores how to set the tax rate. What level is high enough to drive emissions reductions? How should rates change over time? These questions are central to carbon tax effectiveness.