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.

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.

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. 

How 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.

  • 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.

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 Organisation for Economic Co-operation and Development (OECD), distills six key characteristics of successful carbon pricing based on the practical experience of different jurisdictions:

  • 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.

Challenges in Designing Effective Carbon Pricing

A well-designed carbon pricing mechanism can spur innovation and investments in low-carbon technologies that offer competitive advantage. But achieving the right design can also entail certain challenges:

  • Carbon leakage. Some schemes have had the effect of hindering business competitiveness. When there is an  inconsistent patchwork of carbon pricing policies and regulations at the regional and global levels, the result can be carbon leakage—that is, the phenomenon by which carbon-intensive industries or firms shift operations to lower-cost jurisdictions. According to the Partnership for Market Readiness (PMR), however, this practice can be discouraged through targeted and well-designed policies—such as product or investment tax credits, research and development support, and business support services.

  • Policy overlap or inconsistency. Carbon pricing instruments can be significantly more effective if they are properly aligned with complementary policies, such as energy efficiency policies, emissions performance standards, and research and technology policies, among others. Policy makers must work carefully and deliberately to avoid potential overlap of and interaction between policy instruments, which could undermine the effectiveness of carbon pricing mechanisms. The Carbon Pricing Leadership Coalition (CPLC) has detailed information about the need for consistency across policies and measures to mitigate climate change.

  • Ineffective use of revenues. Carbon pricing instruments can raise significant revenues, but the effectiveness of many carbon pricing initiatives depends on how these revenues are spent. Revenues can be recycled to reduce other conventional taxes, protect lower-income households, support cleaner technologies, address fairness and competitiveness concerns, or channel public funds toward other public policy objectives. But as CPLC explains, each of these approaches has costs as well as benefits, and some are better suited to specific policy environments than others.

Guidance on Carbon Pricing

Substantial guidance on carbon pricing is available. In addition to FASTER Principles for Successful Carbon Pricing, governments, businesses, and other stakeholders can consult the two publications authored or coauthored by the World Bank’s Partnership for Market Readiness (PMR):

  • Jointly with the International Carbon Action Partnership (ICAP) PMR published the Emissions Trading in Practice: Handbook on Design and Implementation, a guide for policymakers that distills best practices and key lessons from more than a decade of practical experience with emissions trading worldwide. This handbook is intended to help decision makers, policy practitioners, and stakeholders design and implement a successful ETS. It explains the rationale for an ETS and sets out a 10-step process for designing such a scheme, with each step involving a series of decisions or actions that will shape major features of the policy.

  • PMR also published the Carbon Tax Guide: A Handbook for Policy Makers. This guide is offered as a practical tool to help policymakers determine whether a carbon tax is the right instrument to achieve national policy goals. In addition, it is a resource to support the design and implementation of a tax that suits the specific needs, circumstances, and objectives of national policy. The guide provides both conceptual analysis and important practical lessons learned from implementing carbon taxes around the world.

 For in-depth literature on carbon pricing, visit the PMR website and the CPLC resource hub.

Carbon Pricing under Article 6 of the Paris Agreement

The success of carbon pricing at national and regional levels has encouraged development of international carbon markets. Article 6 of the Paris Agreement, which outlines a framework to hold global temperature rise to well below 2ºC, includes provisions that would allow countries to cooperate to achieve their Nationally Determined Contributions (NDCs), specifically through carbon pricing to meet mitigation commitments.

  • Articles 6.2 and 6.3 introduce provisions that allow countries to cooperate with one another to reduce emissions. In other words, country A can transfer its emission reduction to country B, which can then count this reduction toward its NDC. Under this arrangement, existing national and regional instruments can join together to form an international carbon market—one whose large size and greater cost-effectiveness would allow countries to adopt more ambitious goals for emissions reduction.

  •  Article 6.4 establishes a mechanism by which countries both mitigate GHG emissions and contribute to sustainable development. Although its architecture and modalities are still under discussion, the mechanism aims to expand the scope of carbon pricing programs globally by incentivizing mitigation activities by both public and private entities. It too allows for countries to cooperate and transfer emission reductions to other countries for inclusion in the second country’s NDC total, and it, too, seeks to encourage more ambitious goals for emissions reduction.

It is not yet clear how these Article 6 provisions will be put into effect. But once operational, the new mechanisms will help carbon pricing deliver on its potential for cost-effective decarbonization and adaptation. There is substantial pressure to move rapidly toward consensus on the rules that will guide the new mechanisms, given that the Paris Agreement guidelines, including the modalities for operationalizing cooperative approaches to reduce emissions under Article 6, are scheduled to be finalized by December 2018.