What’s it all about and how governments use it to shape markets
It is no longer a question of if, but when, we will achieve a low carbon economy. Around the world, companies large and small are responding to the need for ambitious climate action to accelerate the transition to a low carbon economy in the coming years and decades. One important mechanism associated with facilitating this transition is carbon pricing as its main appeal is to quantify and internalize the costs associated with carbon emissions. By identifying and expressing the environmental costs associated with economic activities, carbon pricing incentivizes the allocation of resources to low carbon activities and innovations in the most capital-efficient way. This article will provide a basic understanding of carbon pricing: what it is, why it is useful, and how it is implemented by governments. Our next blog will focus on carbon pricing within private companies.
First and foremost, let’s understand ‘what is a carbon price’. It is an assigned monetary value that we associate with carbon emissions. If we think about the price of an item or service, this is the economic value we associate with that item or service. For example, we assign a price to pollution based on the net benefit for avoiding or mitigating each unit of pollution. So similarly, a carbon price is the monetary cost that is assigned to each unit of carbon emission. Just as the price of a service can vary depending on many factors, so too does a carbon price vary based on many inputs.
Broadly speaking, governments and companies are the direct users of carbon pricing. Each of these types of organizations may have very different motivations for why they establish a carbon price. For example, many governments or jurisdictions around the world have implemented carbon pricing policy in order to use market mechanisms to reduce carbon emissions. By assigning an economic cost to carbon emissions, governments aim to discourage the use of carbon-emitting fossil fuels to address climate change and ultimately reduce emissions. Businesses can (and do) also establish their own price on carbon to quantitatively evaluate their business activities and opportunities that may be associated with carbon emissions. Their motivations for establishing a carbon price may stem from many different drivers including financial, reputational, technological, and/or regulatory considerations. It is important to recognize that there are many reasons why businesses choose to implement a price on carbon, and regulation is only one of the motivating drivers.
How does carbon pricing work?
Furthering the analogy above, the price of a good or service includes the cost of providing that good or service. Similarly, a carbon price signal serves to make carbon emission costs explicit to market or organizational participants. Carbon pricing mechanisms unfold very differently at the market and government level than within companies. Below is an overview of market-level carbon pricing that is governed by regulatory mechanisms since these jurisdictional carbon pricing programs affect many businesses at once. Stay tuned for Part 2 in this blog series to learn how carbon pricing could work for individual organizations.
Governments pricing carbon:
Globally, there are 46 national and 32 subnational jurisdictions with carbon pricing initiatives that are either in effect or are scheduled for implementation. Together, these carbon pricing initiatives cover 22% of global carbon emissions and 45 billion USD revenue in 2019. The two main methods for jurisdictional carbon pricing is either a carbon tax or an emissions trading system, both of which have been implemented at similar rates around the world:
- A carbon tax is a direct price on carbon emissions where every ton of carbon pollution has a fixed cost associated with its emission. Individual companies are able to simply calculate the carbon tax, and lower their tax payment by lowering their emissions. This can be achieved by implementing lower emissions technologies or switching to more efficient processes or cleaner fuels.
- An emissions trading system (ETS), also known as a cap-and-trade system, targets specific sectors and establishes a market where individual organizations are given carbon permits, or allowances, for the ‘rights to emit [carbon emissions]’. There is an overall ‘cap’ on jurisdictional carbon emissions, and individual organizations in the targeted sectors have the ability to trade the ‘rights to emit’ allowances. Organizations that are able to more quickly lower their emissions, or that have better processes, can sell their extra allowances to other entities that emit more carbon pollution.
To summarize, a carbon tax sets the price of carbon dioxide emissions and allows the market to determine the quantity of emission reductions. Cap-and-trade sets the quantity of emissions reductions and lets the market determine the price. Both approaches can be used separately or at the same time. In a newly published paper (the largest-ever study of what happens to emissions from fuel combustion when they attract a charge), countries with carbon prices were the only ones that reduced emissions over time. On average, carbon dioxide emissions fell by 2% per year over 2007–2017 in countries with a carbon price in 2007 and increased by 3% per year in the others. If countries are keen on a low-carbon development model, the evidence suggests that putting an appropriate price on carbon is a very effective way of achieving it.
Companies thinking about surviving in tomorrow’s world should pay attention to these government carbon pricing schemes and consider opportunities to engage in policy advocacy given the scale and impact of these market mechanisms. The largest markets that are currently operating under one of these government carbon pricing schemes include the European Union and California. China is in the process of implementing its national cap and trade system, which has been piloted in the power sector in a number of its special economic zones over the last few years. Looking at the United States, the second-largest carbon-emitting nation, the outcome of the upcoming presidential election in November will likely result in large-scale climate legislation if Democratic party nominee, Joe Biden, wins; Biden’s climate plan includes achieving 100% renewable energy and net-zero emissions for the United States. In addition to Biden’s signal that his coronavirus economic recovery will include climate legislation, the recent European Union economic recovery stimulus also includes 750 billion euros that are earmarked for “green” climate-friendly investments. Is your company ready for mandatory emissions reductions and climate investments?
For simplicity's sake, carbon is used to represent all types of greenhouse gas emissions. Carbon emissions and carbon pollution has been used interchangeably.
1. Carbon Pricing Leadership Coalition. “What is Carbon Pricing?”. Retrieved from https://www.carbonpricingleadership.org/what.
2. Carbon Pricing Leadership Coalition. “Carbon Pricing in Action”. Retrieved from https://www.carbonpricingleadership.org/who.
3. World Bank. (May 27, 2020). “State and Trends of Carbon Pricing 2020”. Retrieved from https://openknowledge.worldbank.org/handle/10986/33809. License: CC BY 3.0 IGO.
4. Joe Biden campaign. (August 3, 2020). “Joe’s Plan for a Clean Energy Revolution and Environmental Justice". Retrieved from https://joebiden.com/climate/.