How Do Climate Change Taxes and Incentives Work?

Climate change taxes are financial policies governments use to influence behavior by assigning a cost to activities that produce greenhouse gas emissions. This makes polluting more expensive and cleaner alternatives more attractive. This market-based approach encourages investment in clean technologies and energy efficiency. The revenue generated can fund other climate initiatives or offset economic impacts on consumers.

Major Types of Carbon Pricing

A carbon tax is a direct method of carbon pricing, setting a fixed price emitters must pay for each ton of greenhouse gas released. This price is applied to the carbon content of fossil fuels like coal, oil, and natural gas. The tax is usually levied “upstream” on fuel suppliers, who then pass the cost to consumers through higher prices for gasoline, electricity, and other goods.

For example, a utility company might switch from coal to renewable sources to lower its tax burden. This price certainty allows businesses to better plan for future investments in cleaner technologies, knowing the exact cost of their emissions.

An alternative model is the emissions trading system (ETS), commonly known as cap-and-trade. This system sets a firm limit, or “cap,” on the total greenhouse gas emissions allowed within a jurisdiction or industry over a set period. The government then issues or auctions off a corresponding number of emission allowances, where one allowance represents the right to emit one ton of carbon dioxide equivalent.

Companies covered by the program must hold enough allowances to cover their total emissions. Those that can reduce their emissions at a low cost can sell their excess allowances to companies for whom it is more expensive to cut emissions. This trading establishes a market price for carbon, which fluctuates based on supply and demand. The declining cap ensures that total emissions fall over time.

Existing Federal Climate Related Taxes and Fees

The United States has several long-standing federal excise taxes that, while not always created with climate change as their primary focus, function as a form of pollution tax. One of the most prominent is the federal excise tax on motor fuels, set at 18.4 cents per gallon for gasoline and 24.4 cents per gallon for diesel fuel. These taxes are collected from fuel producers and importers and are a source of funding for the Highway Trust Fund.

Another established federal tax targets the coal industry. An excise tax is imposed on domestically produced coal at its first sale. The rate is the lower of $1.10 per ton for coal from underground mines or $0.55 per ton for coal from surface mines, with a cap of 4.4% of the coal’s selling price. Revenue from this tax is directed to the Black Lung Disability Trust Fund.

The federal government also levies a tax on certain ozone-depleting chemicals (ODCs). This tax applies to the sale or use of these chemicals by manufacturers, producers, or importers. The tax amount is calculated based on the weight of the chemical multiplied by a base tax amount and an ozone-depletion factor. This policy was designed to accelerate the phase-out of substances harmful to the ozone layer.

State Level Climate Tax Initiatives

Several U.S. states have moved forward with their own carbon pricing programs. California’s cap-and-trade program, which launched in 2013, is one of the largest in the world. It covers sources like large industrial facilities, power plants, and fuel distributors, which account for about 85% of the state’s total emissions. The California Air Resources Board (CARB) sets an annual statewide emissions cap and sells allowances at quarterly auctions.

In the Pacific Northwest, Washington implemented a “cap-and-invest” program through the Climate Commitment Act, which began in 2023. This system is similar in structure to California’s, setting a declining cap on emissions from the state’s largest emitters. Washington’s model directs revenue from these auctions toward climate mitigation, adaptation, and environmental justice projects throughout the state.

On the East Coast, a group of northeastern and mid-Atlantic states participate in the Regional Greenhouse Gas Initiative (RGGI). Established in 2009, RGGI was the first mandatory market-based program in the U.S. to reduce greenhouse gas emissions. It specifically targets carbon dioxide emissions from fossil fuel-fired power plants with a capacity of 25 megawatts or greater.

Climate Related Tax Credits for Individuals

The federal government offers several tax credits to encourage individuals to make climate-friendly choices, many of which were expanded by the Inflation Reduction Act of 2022.

The Clean Vehicle Credit provides up to $7,500 for a new, qualified plug-in electric or fuel cell vehicle. To qualify, buyers must meet income limitations: a modified adjusted gross income of up to $300,000 for married couples filing jointly, $225,000 for heads of household, and $150,000 for other filers. The vehicle’s manufacturer’s suggested retail price (MSRP) is also capped at $80,000 for vans, SUVs, and pickup trucks, and $55,000 for other vehicles.

The credit is split into two $3,750 parts, contingent on the vehicle meeting battery component and critical mineral sourcing requirements. A separate credit of up to $4,000 is available for qualified used vehicles, which have stricter income limits and a maximum price of $25,000. Buyers can also transfer the new vehicle credit directly to the dealer at the point of sale, turning it into an immediate rebate.

For homeowners, the Energy Efficient Home Improvement Credit helps offset the cost of energy-saving upgrades. The credit is 30% of qualified expenses, with a total annual cap of $3,200. There are specific annual limits within this total, including a $2,000 cap for electric or natural gas heat pumps and a combined $1,200 limit for other improvements like new windows, doors, and insulation. This credit can be claimed annually for new improvements made through 2032.

A separate incentive, the Residential Clean Energy Credit, targets the installation of systems that generate clean energy. This provides a 30% tax credit for the cost of new, qualified clean energy property, including solar panels, wind turbines, geothermal heat pumps, and battery storage systems with a capacity of at least 3 kilowatt-hours. This 30% credit is available for property installed from 2022 through 2032, after which it will phase down. Unlike the home improvement credit, there is no annual dollar limit, except for fuel cell property.

Climate Related Tax Incentives for Businesses

Businesses have access to federal tax incentives to spur investment in clean energy. The two primary incentives have been the Production Tax Credit (PTC) and the Investment Tax Credit (ITC). The PTC is a per-kilowatt-hour credit for electricity from qualified renewable sources, while the ITC is a credit based on a percentage of the investment cost. A project can claim either the PTC or the ITC, but not both. Beginning in 2025, these are replaced by tech-neutral clean electricity credits that follow the same structures.

The Inflation Reduction Act of 2022 modified these incentives. For projects over 1 megawatt, the full credit value is contingent on meeting prevailing wage and apprenticeship requirements; otherwise, the credit is significantly reduced. The law also introduced bonus credits, such as a 10% increase for projects meeting domestic content requirements or for those in designated “energy communities.” These requirements and bonuses carry over to the new credit system.

The Section 45Q tax credit encourages carbon capture and sequestration (CCS). This credit is provided for each metric ton of qualified carbon oxide captured and securely stored or used. The Inflation Reduction Act increased its value, offering up to $85 per ton for industrial capture with geologic storage and up to $180 per ton for direct air capture with permanent storage, provided wage and apprenticeship requirements are met.

The Commercial Clean Vehicle Credit provides up to $7,500 for qualified vehicles under 14,000 pounds and up to $40,000 for heavier vehicles. The credit is calculated as the lesser of either 15% of the vehicle’s cost (30% if not gas-powered) or the incremental cost compared to a comparable gasoline vehicle. Unlike the individual credit, this commercial version has no income caps or battery sourcing requirements, making it a straightforward incentive for fleet upgrades.