This paper analyzes the co-benefits of introducing a time variant carbon (C) tax scheme in Nepal, a hydropower resourceful country, by using a bottom up integrated energy system model based on the MARKet ALlocation (MARKAL) framework with time horizon of 2005–2050. It discusses the effects of C tax on energy mix, environmental emissions, energy supply security, energy efficiency, energy system cost, and employment benefit. The study shows that the C tax (that gradually increases from US$ 13/tCO2e in 2015 to US$ 200/tCO2e by 2050) results in a reduction of the cumulative emission of greenhouse gases by 83.9 million tons CO2e (12%) as compared to that in the base case. With the introduction of the C tax, there would be a need for additional hydropower capacity of 945 MW by 2050 as compared to the capacity in the base case. The emission of local pollutants consisting of sulphur dioxide (SO2), nitrogen oxides (NOx) and non-methane volatile organic compound (NMVOC) in 2050 would be reduced by 12%, 7% and 1% respectively under the C tax scenario. Total amount of imported energy would decrease by 13%, which corresponds to a reduction in discounted net fuel import cost by 5% during the study period. Furthermore, the C tax would result in new employment generation of 151 thousand man-years associated with the additional hydropower capacity requirement.