Carbon pricing: the polluters pay
Credits to ISUFS
Imagine paying less if you choose to drive a Tesla or use a solar-powered heating system – what would you opt for? Carbon pricing policies, which are now an effective enabler in addressing climate change, are successful because humans do not like to pay extra charges.
What is carbon pricing?
Carbon pricing is an approach to reducing carbon emissions that uses market mechanisms to pass the cost of emitting on to emitters. Greenhouse gas emissions carry a lot of external costs such as: damage to crops, health care costs from heat waves and droughts, loss of property from flooding and sea level rise. By clearly externalizing these costs putting an additional price on carbon-based products, people will choose cheaper and more sustainable solutions. In simple, it applies “the polluters pay” principle.
Why carbon pricing?
Carbon pricing is one of the most powerful policy tools available to tackle climate change because creates an economic incentive to shift to cheaper and cleaner sources of energy. A price on carbon allows shift the burden for the damage from greenhouse gas emissions back to those who are responsible for it and who can avoid it. Instead of dictating who/where/how should reduce emissions, a carbon price provides an economic signal to emitters, and allows them to decide to either transform their activities and lower their emissions or continue emitting and paying for their emissions. In this way, the overall environmental goal is achieved in the most flexible and least-cost way to society.
Which kind of carbon pricing?
There are two main methods for carbon pricing models. One focuses on the emissions quantity and the other on the emissions price.
Method 1 - Quantity
governments cap the amount of emissions that a company can produce;
companies that want to emit in excess of the allowed amount need to purchase the permit in an initial auction;
companies can trade these permits in a market where prices fluctuate depending on supply and demand, exactly as a commodity.
In this framework, there is certainty about emissions that are allowed (set by the government) but uncertainty about the price (which depends on the market). Some real examples include:
Emissions trading systems (ETS): set a cap on total direct GHG emissions from specific sectors and creates a market were the rights to emit above the limit are traded;
Crediting mechanism: a government or private project that results in emission reductions that can be bought or sold. Entities seeking to lower their emissions can buy the credits to offset their actual emissions;
Results-based climate finance (RBCF): a framework where funds are disbursed by the provider of climate finance to the recipient upon achievement of a pre-agreed set of climate results. Independent institutions verify the proper achievement of set goals.
Method 2 - Price
The carbon-based fuel is taxed at source (when it comes out of the ground or, if imported, at the border) which makes it much more expensive. In this context, there is certainty about the price but uncertainty about emissions because there is no cap on the amount of carbon units being created. The implication is that carbon-based fuel prices will increase, and companies will look for cheaper alternatives (i.e. clean energy). A real example is carbon tax, which put a direct price on GHG emissions and requires economic actors to pay for every ton of carbon emission produced. In this context, there is an incentive to lower emissions by switching to more efficient processes or cleaner fuels.
What else?
Some governments and firms have introduced an internal carbon price, placing a monetary value on greenhouse gas emissions to quantitatively account for this factor into their investment decisions. This approach encourages investment in low-carbon technologies and prepares institutions to operate under future climate policies and regulations. In general, there are two forms of carbon pricing:
assigning a shadow price to carbon use. Entities determine a theoretical carbon price that can help support long-term business planning and investment strategies. This helps a company prioritize low-carbon investments and prepare for future regulation. Companies like Google and Microsoft did it.
charging an internal carbon fee to each company’s business units for their emissions. The fee creates a dedicated revenue or investment stream to fund the company’s emissions reduction efforts.
How is it in reality?
In 2020, the implemented or scheduled carbon pricing initiatives are estimated to cover 12 GtCO2e (giga tonnes of carbon equivalent), representing 22.3% of global greenhouse gas emissions.
Table 1. Map of implemented and scheduled carbon pricing initiatives in 2020 (in green ETS and in blue carbon tax)
Although there are 61 carbon pricing initiatives selected and 46 national jurisdictions covered by these initiatives, there are several barriers to the wide-scale adoption of carbon pricing. One of the most relevant, concerns industrial competitiveness due to pricing differentials between jurisdictions. Even though he global average price of carbon is below 10$ per ton, some countries have imposed higher carbon prices. In Sweden, the carbon tax is priced at 119$ per ton – the highest in the world. This price is far less in other countries such as Canada where the CO2 costs per unit is around 20$. Meanwhile many countries, Turkey included, have imposed no policy at all.
The result is that countries with carbon prices are competing with countries with lower (or no) carbon prices. One of the main risks that this can generate, is businesses decide to relocate their industrial activities to avoid carbon pricing policies. This scenario would undermine the original goal – to reduce carbon emissions – replacing it with the so called “carbon leakage”, which is a mere shift of carbon emissions from certain regions to other regions with lower carbon prices. In theory, this would be a “lose-lose” scenario - a loss of competitiveness without any environmental gain. In practice, there is little evidence to date that carbon pricing has resulted in the relocation of the production of goods and services or investment.
Final thoughts
Regardless of competitiveness issues, carbon pricing is an effective approach to reducing emissions because backed by an economic incentive. Businesses facing carbon costs will look to efficiencies to reduce their emissions other than fostering innovation and investment. William Nordhaus, a 2018 Nobel prize winner, stated that the industries and businesses that face charges on emissions are likely to be the ones who innovate and invest in low-carbon solutions. And they must do so because carbon pricing alone will not solve the climate crisis: it is the efficiencies, innovations and investments that will make the real difference, ensuring long-term sustainable growth. With the right policies in place, carbon pricing is only one of the many key enablers of a transition to a low-carbon economy.
