Carbon Pricing

What is Carbon Pricing?

Carbon pricing is an approach to reducing carbon emissions (also referred to as greenhouse gas, or GHG, emissions) that uses market mechanisms to pass the cost of emitting on to emitters. Its broad goal is to discourage the use of carbon dioxide–emitting fossil fuels in order to protect the environment, address the causes of climate change, and meet national and international climate agreements (1).

A key aspect of carbon pricing is the “polluter pays” principle. By putting a price on carbon, society can hold emitters responsible for the serious costs of adding GHG emissions to the atmosphere; these costs include polluted air, warming temperatures, and various attendants ills (threats to public health and to food and water supplies, increased risk of certain dangerous weather events). Putting a price on carbon can likewise create financial incentives for polluters to reduce emissions (1).

Why Price Carbon?

Climate change is one of the greatest global challenges of our time. It threatens to roll back decades of development progress and puts lives, livelihoods, and economic growth at risk. Humans have been driving global warming through the extensive burning of fossil fuels. We are already seeing changes in the climate that our current economies were built on. The intensity of extreme weather-related events has also increased. If the world warms by just 2°C—warming which may be reached in 20 to 30 years—we could see widespread food shortages, unprecedented heat-waves, and more intense storms (2). To stay below 2°C, the Intergovernmental Panel on Climate Change (IPCC) says the world will need to get to zero net emissions before the end of this century (3). That means action now. Carbon pricing is an essential part of the solution (1, 2).

Benefits/Importance of carbon pricing

The benefits of carbon pricing are very significant. It is one of the strongest policy instruments available for tackling climate change. It has the potential to decarbonize the world’s economic activity by changing the behavior of consumers, businesses, and investors while unleashing technological innovation and generating revenues that can be put to productive use. In short, well-designed carbon prices offer triple benefits: they protect the environment, drive investments in clean technologies, and raise revenue (1).

A price on carbon helps shift the burden for the damage back to those who are responsible for it, and who can reduce it. Instead of dictating who should reduce emissions where and how, a carbon price gives an economic signal and polluters decide for themselves whether to discontinue their polluting activity, reduce emissions, or continue polluting and pay for it. In this way, the overall environmental goal is achieved in the most flexible and least-cost way to society. The carbon price also stimulates clean technology and market innovation, fueling new, low-carbon drivers of economic growth (2).

Main Types of carbon pricing

There are two main types of carbon pricing (2):

Emissions Trading Systems (ETS)
Carbon Tax

1. Emissions Trading Systems (ETS): An ETS – sometimes referred to as a cap-and-trade system–caps the total level of greenhouse gas emissions and allows those industries with low emissions to sell their extra allowances to larger emitters. By creating supply and demand for emissions allowances, an ETS establishes a market price for greenhouse gas emissions. The cap helps ensure that the required emission reductions will take place to keep the emitters (in aggregate) within their pre-allocated carbon budget (2).

2. Carbon Tax: A carbon tax directly sets a price on carbon by defining a tax rate on greenhouse gas emissions or – more commonly – on the carbon content of fossil fuels. It is different from an ETS in that the emission reduction outcome of a carbon tax is not pre-defined but the carbon price is (2). Under a carbon tax, the government sets a price that emitters must pay for each ton of greenhouse gas emissions they emit. Businesses and consumers will take steps, such as switching fuels or adopting new technologies, to reduce their emissions to avoid paying the tax. A carbon tax differs from a cap-and-trade program in that it provides a higher level of certainty about cost, but not about the level of emission reduction to be achieved (4).

Emissions Trading or Carbon Tax?

Two kinds of market instruments can deliver an explicit price on carbon: emissions trading and carbon taxes. They have much in common. Both emissions trading and carbon taxes aim to internalize the costs carbon emissions impose on society by placing a price on these emissions that can (2, 5, 6):

Change the behavior of producers, consumers, and investors so as to reduce emissions, but in a way that provides flexibility on who takes action, what action they take, and when they take that action;
Stimulate innovation in technology and practice;
Generate environmental, health, economic, and social co-benefits; and
Provide government revenue that can be used to reduce other taxes or support public spending on climate action or in other areas.

The key distinction is that with a carbon tax the government sets the price and allows the market to determine the quantity of emissions, whereas with emissions trading the government sets the quantity of emissions and allows the market to determine the price. Hybrid systems, which combine elements of both approaches, also exist in different forms, for example, an ETS with a price floor and ceiling, or tax schemes that accept emissions reduction units to lower the tax liabilities (2, 5, 6).

How Different Carbon Pricing Instruments Work

Carbon pricing instruments can take many forms. A wide range of approaches and paths allows governments, businesses, and institutions to select the method best suited to the broader policy environment (1).

A carbon tax puts a direct price on GHG emissions and requires economic actors to pay for every ton of carbon pollution emitted. It thus creates a financial incentive to lower emissions by switching to more efficient processes or cleaner fuels (i.e., less pollution means lower taxes). This approach provides a lot of certainty about price because the price per ton of pollution is fixed; but it offers less certainty about the extent of emissions reduction.
An emission trading system (ETS)—also known as a cap-and-trade system—sets a limit (“cap”) on total direct GHG emissions from specific sectors and sets up a market where the rights to emit (in the form of carbon permits or allowances) are traded. This approach allows polluters to meet emissions reductions targets flexibly and at the lowest cost. It provides certainty about emissions reductions, but not the price for emitting, which fluctuates with the market.
Under a crediting mechanism, emissions reductions that occur as a result of a project, by a business or government, or policy are assigned credits, which can then be bought or sold. Entities seeking to lower their emissions can buy the credits as a way to offset their actual emissions. This approach requires a formally recognized third-party verifier to sign off on the emission reduction before it is credited.
Under a results-based climate finance (RBCF) framework, entities receive funds when they meet pre-defined climate-related goals, such as emissions reductions. Like crediting mechanisms, this approach requires the involvement of independent verifiers (in this case, to confirm that a goal has been met). By linking financing to specific results, RBCF facilitates carbon pricing and the creation of carbon markets, helps polluters meet climate goals, and stimulates private sector investment.
Under internal carbon pricing, governments, firms, and other entities assign their own internal price to carbon use and factor this into their investment decisions. Used as part of a broader decarbonization efforts, this approach encourages investment in low-carbon technologies and prepares institutions to operate under future climate policies and regulations. Internal carbon pricing generally takes two forms:
The first assigns a shadow price to carbon use—that is, determines its hypothetical cost. Entities calculate this price for their activities with the goal of managing climate risks and identifying opportunities in operations, projects, and supply chains to lower emissions and avoid locking their investments in long-lived high-carbon capital and infrastructure. For example, the World Bank Group has announced plans to apply a shadow carbon price to relevant investment projects using a price consistent with the recommendations of the High-Level Commission on Carbon Prices.
The second form is an internal carbon fee that companies voluntarily charge their business units for their emissions. Funds generated from this fee are channeled back into cleaner technologies and greener activities that support low-carbon transition (1).

How to Structure an Effective Carbon Pricing Mechanism

Although the design of carbon pricing schemes will vary depending on specific policy objectives and contexts, effective schemes share some common characteristics. The FASTER Principles for Successful Carbon Pricing, a guide jointly developed by the World Bank and the Organization for Economic Co-operation and Development (OECD), distills six key characteristics of successful carbon pricing based on the practical experience of different jurisdictions (1):

Fairness. Effective initiatives embody the “polluter pays” principle and ensure that both costs and benefits are fairly shared.
Alignment of policies and objectives. Carbon pricing is not stand-alone mechanism. It is most effective when it meshes with and promotes broader policy goals, both climate and non-climate related.
Stability and predictability. Effective initiatives exist within a stable policy framework and send a clear, consistent, and (over time) increasingly strong signal to investors.
Transparency. Effective carbon pricing is designed and carried out transparently.
Efficiency and cost-effectiveness. Effective carbon pricing lowers the cost and increases the economic efficiency of reducing emissions.
Reliability and environmental integrity. Effective carbon pricing measurably reduces practices that harm the environment (1).

References:

Contact

Quick links