An important moment in time: Phase 2 of the carbon tax is coming

By Louis Botha

It was reported that the recently concluded COP29 left many developing countries feeling frustrated and disappointed at the commitment by developed countries to provide climate finance of USD300 billion per year by 2035. However, South Africa’s Minister of Forestry, Fisheries and Environment, Dion George, was quoted as saying that despite this, the agreement on carbon markets reached at COP29 will allow South Africa and other developing economy countries to initiate new carbon market projects. According to the Minister, this will facilitate investments in green technologies and economic opportunities.

Considering this, the upcoming implementation of phase 2 of South Africa’s carbon tax regime (Phase 2) takes on greater significance. On 13 November 2024, National Treasury (NT) published the “Carbon Tax Discussion Paper: Phase Two of the Carbon Tax” (Discussion Document), which proposes that phase 2 of the carbon tax be implemented from 1 January 2026. The implementation of phase 2 has been delayed on several occasions and at least partly due to the economic effects of the Covid-19 pandemic and concomitant lockdown.

The Discussion Document is extremely comprehensive – a full 66 pages – and addresses in some detail the proposed amendments to the Carbon Tax Act, 15 of 2019 in implementing Phase 2 and the rationale for these proposals.

In this article, we touch on just two of the most important amendments proposed as part of Phase 2:

• Firstly, the proposed changes to the basic tax-free allowance, which affects all carbon taxpayers and applies to all emissions.
• Secondly, proposed changes to the carbon offset allowance, which will likely have a direct impact on the amount of carbon offsets generated by South African projects and on South Africa’s carbon market. Internationally, carbon offsets are more commonly known as carbon credits.

Basic tax-free allowance

Currently, this allowance is set at 60% and as stated in the Discussion Document “is the only free allowance for which industry does not need to make investments to qualify for during the first phase of the carbon tax…”

The effect of this allowance is to reduce the maximum effective rate of carbon tax and it has been in place since the Carbon Tax Act came into effect in 2019. In other words, even though the carbon tax rate for 2024 is R190 per tonne CO2e above the prescribed threshold, the maximum effective rate for 2024 is R76 (R190 less 60% allowance). In other words, if a carbon taxpayer’s activities result in 4 tonnes of greenhouse gas (GHG) emissions above the prescribed threshold, the maximum carbon tax liability will be R76 x 4 = R304. It can reduce further if any other allowances apply, but it will not be more than this.

However, the Discussion Document proposes to reduce this allowance to 50% in 2026 and then by 2.5 percentage points every year thereafter. This means that the maximum effective carbon tax rate will increase. According to the Carbon Tax Act, the carbon tax rate for 2026 will be R308. If the basic tax-free allowance reduces to 50% in 2026, the maximum effective rate would be R154 per tonne CO2e above the prescribed threshold, double the maximum effective rate of R76 for 2024.

During one of the workshops held by NT as part of the public consultation process on the 2022 Taxation Laws Amendment Bill, NT acknowledged that without this 60% allowance, the effect of the carbon tax on businesses would be devastating. This was in the context of the discussion on the proposed carbon tax rate increases from 2023 to 2030, which was hotly debated at the time. While the proposal in the Discussion Document will thus gradually reduce as opposed to eliminating the allowance, how it affects businesses, especially those in hard-to-abate industries, remains to be seen.

A hard-to-abate sector is one where the nature of the sector’s activity makes reduction of GHG emissions through technology prohibitively expensive or impossible. Examples of this are the iron, steel, chemicals and aviation industries. In the aviation context for example, the development of and research into the use of sustainable and cleaner fuels remains ongoing.

Carbon offset allowance

This is the one that matters for South African carbon market projects and the trading of carbon offsets (carbon credits). As it stands, this allowance makes it possible for taxpayers to reduce their carbon tax liability by 5% or 10% of their total GHG emissions. As the Discussion Document explains “it enables industry to invest in mitigation projects at a lower cost to what would be achieved in their own operations and to incentivise mitigation in sectors that are not directly covered by the tax…including agriculture, forestry and other land use (AFOLU) and waste.”

For entities in hard-to-abate sectors, the carbon offset allowance is one of the few options available to reduce their carbon tax liability in the medium to long term. In this regard, it is encouraging that the Discussion Document proposes increasing the maximum carbon offset allowance by 15 percentage points. One is inclined to agree with the Discussion Document where it states that this proposed increase “…will provide much needed flexibility to the hard-to-abate sectors and stimulate carbon market activities in South Africa.”

This proposed increase of the allowance will hopefully also increase foreign investment into South Africa into carbon market projects. Currently, the regulations on this allowance only allow for offsets generated from South African-based approved projects to qualify for the carbon offset allowance. In addition, the projects have to be approved under the Paris Agreement Crediting Mechanism, VERRA’s Verified Carbon Standard or the Gold Standard. However, the Discussion Document adds that the framework for implementation of a local carbon offset standard will be published before the end of the current financial year.

What’s next?

The due date for comments on the Discussion Document is 13 December 2024. Any comments received will likely be considered by NT when the 2025 Budget Review is published in February next year along with the Budget Speech. While any proposed changes to the Carbon Tax Act will still be published in draft legislation and go through a public consultation process, it is best for the public to comment on the Discussion Document where possible, instead of waiting for the draft legislation. Given that the implementation of Phase 2 has been postponed several times, it seems unlikely that there will be another postponement.