What Is Carbon Pricing and How Does It Work?
The expression "put a price on carbon" has become well-known, with countries and businesses increasingly committing to putting a price on carbon pollution as a means of reducing emissions and encouraging investment in cleaner alternatives.
So, what does putting a price on carbon mean, and why do so many politicians and business leaders favor it? Governments can price carbon in a variety of ways, all of which lead to the same conclusion. They begin to capture what is known as the external costs of carbon emissions – costs that the public pays for in other ways, such as crop damage and health-care costs from heat waves and droughts, or property damage from flooding and sea-level rise – and link them to their sources via a carbon price.
A carbon price serves to shift the responsibility for the damage back to those who cause it and can mitigate it. Instead of mandating who and how to cut emissions, a carbon price sends an economic signal to polluters, allowing them to choose whether to stop polluting, reduce emissions, or continue polluting and pay the price. As a result, the overall environmental aim is met in the most flexible and cost-effective manner possible for society. The carbon price also encourages clean technology and market innovation, resulting in the development of new, low-carbon economic growth engines.
Emissions trading systems (ETS) and carbon taxes are the two primary methods of carbon pricing.
An ETS, also known as a cap-and-trade system, sets a limit on total greenhouse gas emissions and permits low-emitting companies to sell their excess allowances to higher-emitting industries. An ETS provides a market price for greenhouse gas emissions by creating supply and demand for emission allowances. The cap ensures that the required emission reductions are made in order for emitters to stay within their pre-allocated carbon budget (in aggregate).
A carbon tax places a direct price on carbon by imposing a tax on greenhouse gas emissions or, more typically, the carbon content of fossil fuels. It differs from an ETS in that the carbon tax's emission reduction effect is not pre-determined, but the carbon price is.
The instrument chosen will be determined by the country's and economy's situation. Fuel taxes, the elimination of fossil fuel subsidies, and laws that may include a "social cost of carbon" are all indirect ways of more precisely pricing carbon. Payments for emission reductions can also be used to price greenhouse gas emissions. Emission reductions can be purchased by private entities or sovereigns to compensate for their own emissions (so-called offsets) or to fund mitigation efforts through results-based financing.
More than 40 countries, cities, states, and provinces have already implemented carbon pricing schemes, with more planned to do so in the future. The carbon pricing plans currently in existence cover almost half of their emissions or about 13% of annual global greenhouse gas emissions.