Carbon pricing involves considering the external costs of greenhouse gas (GHG) emissions associated with their sources through the pricing of carbon dioxide (CO2). This helps shift the burden of damage caused by emissions to responsible parties and encourages changes in economic behavior. Key characteristics of a successful carbon pricing system include fairness, stability, policy and goal alignment, cost efficiency, environmental integrity, and transparency. Despite challenges in addressing climate change impacts, such as policy inconsistencies and the potential for carbon leakage, effective carbon pricing is crucial.
Carbon pricing refers to strategies adopted to reduce the amount of carbon or greenhouse gas (GHG) emissions. It involves imposing a cost on carbon pollution to incentivize economic actors to reduce emissions. Various forms of carbon pricing include Carbon Tax, Crediting Mechanisms, Results-Based Climate Finance (RBCF), Internal Carbon Pricing (ICP), and Emission Trading Systems (ETS).
ETS, is a system where emission producers can trade emission units, and carbon tax, which sets a tax rate on emissions.
- Carbon Tax: Carbon tax, as one mechanism, is applied to each ton of carbon emissions to encourage the exploration of more efficient fuel alternatives. It also assigns a price to each ton of carbon pollution released, thereby promoting the use of more fuel-efficient options with lower emissions.
- Crediting Mechanisms: The global carbon credit market has diverse supply sources, demand, and trading frameworks. Supply comes from international and domestic mechanisms like the Kyoto Protocol and the Paris Agreement. Demand arises from international and domestic compliance obligations and voluntary commitments through crediting mechanisms for entities that successfully reduce emissions, which can be bought by other economic actors.
Although most carbon credits attract various types of buyers, there are still limited supply sources that can be matched with a single demand source. Generally, there are four broad market segments driving demand:
- International Compliance Market: Essentially responding to commitments made in international agreements, it includes countries that voluntarily buy/use credits or “mitigation outcomes” recognized in international agreements to help achieve their emission reduction commitments.
- Domestic Compliance Market: Involves entities buying qualifying credits to meet their obligations based on domestic laws, usually through ETS or carbon tax. This may include credits issued in international, domestic, or independent credit mechanisms, depending on domestic government rules.
- Voluntary Carbon Market: Comprising entities (mostly private entities) buying carbon credits to fulfill their voluntary mitigation commitments. Most entities issue credits based on independent credit standards, although some entities also buy credits issued in international or domestic credit mechanisms.
- Financial Market: In the context of the carbon market, results-based climate finance (RBCF) refers to the purchase of carbon credits by governments or international organizations to encourage climate mitigation or meet national targets. Results-based finance can also refer to broader payments as a reward for achieving emission reductions, without transferring credits or ownership. However, there is still an evolving overlap between compliance and voluntary markets, as well as international and domestic markets.
- Results-Based Climate Finance (RBCF): Results-Based Climate Finance provides funds to entities that achieve specific climate goals, with third-party (independent) verification to ensure goal achievement. Many RBCF programs aim to achieve verified GHG emission reductions while reducing poverty, improving access to clean energy, and offering health and societal benefits.
- Internal Carbon Pricing (ICP): Entities internally set their own emission prices, influencing their investment decisions and preparing for climate policy changes. ICP is a tool used by organizations internally to guide decision-making processes regarding the impact, risks, and opportunities of climate change. Carbon pricing is not just a tool for emission reduction; it is also an economic signal to emission producers. By pricing GHG emissions, entities can decide to change their activities, reduce emissions, or pay for their emissions. This can create flexibility and economic efficiency, enabling the achievement of environmental goals at the lowest cost to society.
- Emission Trading Systems (ETS): ETS sets emission limits for specific sectors and creates a market for emission allowances, allowing entities to buy and sell these allowances. By creating supply and demand for emission units, ETS establishes a market price for GHG emissions. The two main types of ETS are (a) cap-and-trade and (b) baseline-and-credit:
- Cap-and-Trade System: Applies an absolute limit on emissions in ETS, with emission allowances distributed, usually free or through auctions, for an amount equivalent to that limit.
- Baseline-and-Credit System: Sets a baseline emission level for each regulated entity, and credits are given to entities that have reduced their emissions below this level. These credits can be sold to entities exceeding their baseline emission levels.
Combination in Carbon Prices: Carbon tax directly sets a price on emissions, while crediting mechanisms issue carbon credits from project-based or program-based activities. These credits can be used to fulfill compliance obligations to international agreements or domestic goals. Results-Based Climate Finance (RBCF) provides funds to entities achieving climate goals with third-party verification.
Roles of Government, Business, and Organizations/Institutions: A growing consensus between government and business is emerging regarding the fundamental role of carbon pricing in transitioning to a decarbonized economy. Governments see it as an effective climate policy instrument, while businesses integrate it as an impact and opportunity evaluation factor. Long-term investors also leverage it to analyze the impact of climate policy on each investment portfolio.
The government plays a role in choosing the type of carbon pricing based on national and domestic political conditions. ETS and carbon tax are often used together as a hybrid approach. Many entities use carbon pricing in mandatory initiatives as the basis for their internal carbon pricing. Carbon pricing involves estimating the social cost of carbon, marginal reduction costs, and the market value of emission allowances. Financial institutions are increasingly using internal carbon pricing to evaluate planned investments and measure carbon footprints.
Various organizations and institutions have published guides and research to support the development of efficient and cost-effective carbon pricing instruments. Learning from existing carbon pricing initiatives serves as the basis for designing better solutions and promoting the transition to a low-carbon and sustainable global economy.
