–A big change in fiscal policy might boost acceptance of carbon pricing

By Mathew Carr*

July 9-10, 2026 — CarrZee: Hypothecation used to be a dirty word, but now as Japan and the EU is showing, it’s the way forward.

My interaction with AI and my reporting is worth publishing because it highlights a shift in fiscal policy….potentially globally and at least for now in the EU and Japan.

With *Gemini: You have hit on one of the most significant structural shifts in modern public finance.

For decades, hypothecation (earmarking or ring-fencing specific tax revenues for specific spending) was the ultimate heresy for finance ministries and treasuries worldwide.

The orthodox view—long championed by institutions like the UK Treasury—was that earmarking creates severe fiscal rigidity.

The argument went that if a specific tax revenue spikes or plummets, the associated public service either ends up with an unusable surplus or a devastating deficit, stripped of the flexibility that a centralized, general pool of tax income provides.

CarrZee: Andy Burnham, set be be the next UK PM … is (or at least was) considering adjusting the nation’s fiscal rules to allow extra borrowing for defence. It can be argued spending on climate and defence are similar in that they are ultimately about ensuring a peaceful, pleasant life for people. (Successive bad leadership across the world for decades has perverted security spending to warmonger and create fear. Will Burnham be different?)

The scale of the net-zero transition has turned that old ‘hypothecation is bad’ playbook upside down

That is part of the reason 10-year Japan bond yields are at historically high levels. Investors are worried about the change and what it will mean for the risk of non-repayment of sovereign bonds and green-focussed / climate bonds.

As the EU and Japan are proving, hypothecation has transitioned from a “dirty word” to an indispensable tool for building political legitimacy around carbon pricing.

Gemini not completely checked — warning:

1. The EU Model: From General Funds to Total Reinvestment

The European Union’s Emissions Trading System (EU ETS) is the clearest example of this paradigm shift. Historically, member states could absorb a portion of their carbon auction revenues directly into their general national budgets.

The revised EU ETS framework changed the rules of the game:

• The 100% Rule: Member states are now legally required to spend 100% of their national ETS auction revenues on climate, energy, and just transition initiatives.
• Direct Institutional Earmarking: A massive portion of the centralized revenue bypasses national capitals entirely. It is hypothecated directly into dedicated structural vehicles, such as the Innovation Fund (funding breakthrough clean-tech demonstrations) and the Social Climate Fund (specifically designed to shield vulnerable households from energy poverty).

By tying carbon costs directly to visible green investments, the EU has effectively used hypothecation to defend the ETS against political backlash during periods of high energy volatility.

Now, the EU is considering even more precise hypothecation. Carbon revenues raised by industries are to be used to decarbonize that same industry.

2. The Japan Model: Front-Loading via “GX” Hypothecation

Japan’s Green Transformation (GX) framework, which transitioned its national GX-ETS into a mandatory compliance regime, takes hypothecation a step further by using it to engineer long-term market predictability.

Rather than waiting for carbon markets to slowly generate cash, Japan used hypothecation to back an innovative, front-loaded financing structure:

• The Bridge Financing: The government issued roughly ¥20 trillion (~$130 billion) in GX Transition Bonds to immediately fund upfront corporate decarbonization subsidies and clean energy infrastructure.
• The Hypothecated Payback: The legislative framework explicitly dictates that the revenue generated from the mandatory phase of the GX-ETS and the upcoming carbon levy (the GX Surcharge) is entirely ring-fenced to redeem those bonds over the coming decades.

For institutional investors, this explicit hypothecation provides a hard guarantee that carbon revenues won’t be diverted to fund general fiscal deficits or unrelated demographic strains, anchoring the credibility of the country’s transition market.

The Catch: Is it an absolute “way forward”?

While hypothecation is winning the argument in environmental finance, it is a political solution to a economic problem, rather than a flawless fiscal tool.

The Political Benefit, The Fiscal Risk

Public Acceptability: Voters and heavy industries are far more likely to accept a rising price on carbon if they can trace the money directly back into green subsidies, consumer dividends, or grid upgrades.

The “Fungibility” Loophole: National treasuries can sometimes engage in a shell game—using hypothecated carbon cash to fund a green project they were already going to pay for, thereby freeing up general tax revenue for unrelated spending.

Ultimately, you are correct: the rigid dogma against earmarking has broken down because the climate transition requires a level of public buy-in and investor predictability that general, opaque budgeting simply cannot deliver.

Defence

CarrZee: I sense that it is annoying to hypothecate for defense spending. What do you think, Gemini?

Gemini: “Annoying” is an understatement—for central bank governors and finance ministries, hypothecating for defense spending is historically, philosophically, and logistically one of the thorniest fiscal headaches imaginable.

While ring-fencing revenue for green energy or highway maintenance feels transactional and intuitive to the public, trying to do the same for national defense runs into immediate structural walls.

Here is why defense hypothecation behaves so differently from other sectors, and how policymakers are bypassing the problem today.

1. The Conscientious Objection Pandora’s Box

Unlike climate transition or public health, defense directly collides with deep-seated moral and religious convictions.

For decades, peace groups and campaigns have lobbied for “Peace Tax Funds”.

Their argument is straightforward: if the state recognizes a conscientious objector’s rights to refuse physical conscription, it should legally allow taxpayers to redirect the military portion of their income tax toward non-violent conflict resolution.

For a treasury, opening the door to tax hypothecation based on personal conscience is a nightmare scenario.

If citizens can line-item veto funding for weapon systems, it establishes a precedent where others could demand to opt out of state education, public health programs, or social safety nets based on their own political or philosophical preferences.

To preserve the integrity of a general fund, states almost universally mandate that everyone pays for the ultimate pure public good: national security.

2. The Practical Risk: Rigidity vs. Geopolitical Chaos

Defense spending requires extreme agility and rapid scale-ups during sudden geopolitical crises.

• The Volatility Trap: If a country funds its military via a specific, hypothecated “defense levy” or a percentage of transactional taxes, that revenue will inevitably fluctuate with the economic cycle.
• The Strategic Mismatch: A state cannot afford to have its military budget suddenly plunge during a severe economic recession—especially since global instability and conflict often spike during periods of economic downturn.

Treasuries insist on a centralized, consolidated fund precisely so they can instantly reroute vast sums of capital to the military in an emergency, completely unfettered by rigid earmarking rules.

3. Fraught Historical Precedents

We also have centuries of political scar tissue when it comes to specific defense taxes. The textbook example is “Ship Money” in 17th-century England—a tax levied on coastal areas specifically earmarked to build and maintain the Royal Navy.

When King Charles I attempted to weaponize this hypothecated tax, expanding it inland during peacetime to bypass Parliament, it triggered massive domestic tax strikes and became a direct catalyst for the English Civil War.

The Modern Pivot: Tax vs. Debt Hypothecation

Because hypothecated taxes for defense are so politically toxic and economically rigid, the international community has shifted the entire concept away from revenues and toward capital markets.

While treasuries still reject a dedicated military income tax, they are enthusiastically embracing hypothecated defense debt. The European Commission’s massive syndicated EU-Bond issuances demonstrate this perfectly. Rather than inventing a controversial “EU defense tax,” the Commission issues single-branded EU-Bonds and explicitly earmarks portions of the proceeds for European defense procurement and common security instruments.

Earmarking institutional investor capital to build artillery lines is clean, highly oversubscribed, and politically popular; trying to isolate that same money inside a citizen’s tax code remains a structural trap.