What is Carbon Pricing?

The phrase “put a price on carbon” is becoming increasingly common in corporate and government conversation as discussions of how to address climate change move from concern to action. The World Bank Group, business groups, and investors have called on governments and corporations around the world to support carbon pricing to bring down emissions and drive investment into cleaner options.

So what does it mean to put a price on carbon, and why do many government and business leaders support it?

There are several paths governments can take to price carbon, all leading to the same result. They begin to capture what are known as the external costs of carbon emissions – costs that the public pays for in other ways, such as damage to crops and health care costs from heat waves and droughts or to property from flooding and sea level rise – and tie them to their sources through a price on carbon.

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.

There are two main types of carbon pricing: emissions trading systems (ETS) and carbon taxes.

An ETS – sometimes referred to as a cap-and-trade system – caps the total level of greenhouse gas emissions and lowers the cap over time. Companies are allowed a limited, and falling, number of emissions permits. Those industries with low emissions are able 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.

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.

The choice of the instrument will depend on national and economic circumstances.

Carbon pricing is a necessary part of a larger package of policies that can reduce greenhouse gas emissions.

Some of examples of complementary policies include:

  • Performance standards: Many countries set fuel efficiency standards for vehicles and energy efficiency standards for buildings, including for lighting, windows, ventilation and heating and cooling systems.
  • Fiscal instruments: Some countries offer tax exemptions or tax breaks for appliances and energy efficiency improvements. Auto feebates, found in several European countries, combine a surcharge on energy inefficient cars with a rebate on more energy efficient vehicles.
  • Renewable portfolio standards: Renewable portfolio standards, found in countries including Germany and Chile and in several U.S. states, require electricity providers to include a minimum share of clean energy in their output mix.
  • Trade policies: Cutting tariffs on green goods such as solar panels, wind turbines, and energy-efficient light bulbs can help ensure access to the best technologies available globally.
  • Law enforcement: In Brazil, enforcing and clarifying existing laws has proved to be an effective, low-cost strategy to reduce deforestation.