Table of Contents
Introduction
Carbon pricing and emissions trading are policy tools that put a monetary value on greenhouse gas emissions. They turn pollution into a measurable cost or a tradable commodity, so that emitting carbon dioxide and other greenhouse gases is no longer free. This chapter focuses on how these tools work, why governments use them, and how they interact with renewable energy and sustainability goals.
Why Put a Price on Carbon?
In most economies, companies and individuals can emit greenhouse gases without paying directly for the damage they cause to the climate, ecosystems, and human health. These damages are examples of external costs, also called externalities, because they fall on society rather than on the polluter.
Carbon pricing aims to correct this problem by making emitters pay for each unit of emissions. When emitting becomes more expensive, low carbon technologies such as renewables, energy efficiency, and cleaner fuels become relatively more attractive. In economic terms, carbon pricing sends a price signal that encourages polluters to change behaviour, invest in cleaner technologies, and reduce emissions where it is cheapest to do so.
Key idea: Carbon pricing makes greenhouse gas emissions more costly, which shifts investment and behaviour toward low carbon options.
Two Main Approaches: Carbon Taxes and Emissions Trading
There are two primary families of carbon pricing instruments. One is carbon taxes. The other is cap and trade schemes, which are the most common form of emissions trading.
A carbon tax directly sets a price per unit of emissions, usually per tonne of carbon dioxide equivalent, written as $tCO\_2e$. The tax is applied to fuels or activities based on their carbon content or their emissions. The total amount of emissions is not fixed by the tax itself, but the cost of emitting increases in line with the tax level.
Emissions trading systems set a limit, called a cap, on total emissions from a group of emitters, such as power plants and large industrial facilities. This cap is divided into allowances or permits, each giving the holder the right to emit one tonne of $CO\_2e$. Companies must hold enough allowances to cover their emissions, and they can buy and sell allowances among themselves. The cap determines the total quantity of emissions. The market for allowances determines the carbon price.
Fundamental contrast: Carbon tax fixes the price per tonne of emissions. Emissions trading fixes the total quantity of emissions and lets the market determine the price.
Basic Mechanics of a Carbon Tax
A carbon tax is usually applied upstream on fossil fuels such as coal, oil, and natural gas. The government measures or estimates the emissions associated with each fuel and sets a tax rate per tonne of $CO\_2e$.
If a fuel contains carbon that will emit $E$ tonnes of $CO\_2e$ when burned, and the tax rate is $P$ currency units per tonne, then the carbon tax paid on that fuel is:
$$ \text{Carbon tax paid} = E \times P $$
For example, if burning 1 litre of diesel emits approximately $2.68$ kg of $CO\_2$, which is $0.00268$ tonnes, and the tax is $50$ dollars per tonne $CO\_2e$, then the carbon tax per litre is:
$$ 0.00268 \times 50 = 0.134 \text{ dollars per litre} $$
The tax is usually added to the existing fuel price. Fuel suppliers pass some or all of this extra cost to consumers in the form of higher prices. As a result, energy users face higher costs for more carbon intensive fuels and have an incentive to save energy or switch to cleaner options.
Carbon taxes can also apply directly to measured emissions from large facilities if reliable emissions monitoring exists. However, for simplicity and coverage, many systems tax fuels at the point of production or import.
Basic Mechanics of Emissions Trading (Cap and Trade)
In an emissions trading system with a cap and trade design, the government or a regulator first decides the total amount of emissions allowed in a certain period, often a year, for the participating sectors. This total is the cap, measured in tonnes of $CO\_2e$.
The cap is divided into allowances. One allowance is usually equal to 1 tonne of $CO\_2e$. The regulator distributes these allowances to companies, either by auctioning them or by giving some of them for free, for example to help industries that are exposed to international competition.
At the end of each compliance period, each company must surrender enough allowances to cover its verified emissions. If a company emits less than its allowances, it has surplus allowances that it can sell. If it emits more, it must buy extra allowances. This creates a market where the price of allowances is determined by supply and demand.
Core rule in cap and trade: Each covered installation must surrender allowances equal to its actual emissions, otherwise it faces penalties.
Over time, the regulator can lower the cap, which reduces the number of allowances in the system and usually increases the carbon price. This is how an emissions trading system delivers emissions reductions. The environmental outcome is driven by the cap, and the economic cost is determined by the resulting market price.
Measuring and Reporting Emissions
Both carbon taxes and emissions trading depend on accurate measurement, reporting, and verification of emissions, often called MRV. For carbon taxes on fuels, emissions are often calculated using standard emission factors that link fuel quantity to emissions. For example, each tonne of coal of a certain grade will have a known approximate carbon content, which can be used to estimate $CO\_2$ emissions when burned.
In emissions trading systems, MRV is usually more detailed and strictly regulated. Companies must monitor their emissions using approved methods, report them regularly, and have their reports checked by independent verifiers. This process builds trust that each allowance really corresponds to one tonne of emissions.
Errors or fraud in MRV would undermine the environmental integrity of the policy, so rules are detailed and penalties for misreporting are common. Good MRV is also important for linking different systems across borders, which will be described later.
Price Signals and Economic Behaviour
The central purpose of carbon pricing is to create a clear price signal that affects economic decisions. When companies and consumers face a cost per tonne of emissions, they can compare this cost to the cost of reducing emissions.
If a company can reduce one tonne of emissions by changing its process or using cleaner energy at a cost that is lower than the carbon price, it has a financial reason to do so. For instance, if the carbon price is $40$ dollars per tonne and installing more efficient equipment reduces emissions at $25$ dollars per tonne, it is profitable to make that investment.
Conversely, if a reduction cost is higher than the carbon price, it might be cheaper in the short term to continue emitting and pay for allowances or the tax. In an emissions trading market, companies that can reduce emissions cheaply may sell extra allowances to companies for which reductions would be expensive. In this way, emissions reductions occur where they are cheapest, which is often called cost effective mitigation.
Economic logic: Emissions reductions take place where the cost of reducing 1 tonne of $CO\_2e$ is lower than the prevailing carbon price.
This mechanism can strongly support renewable energy. Renewable power becomes relatively more competitive when fossil fuels carry an added cost per tonne of emissions. Over time, this can shift investment away from carbon intensive energy and toward cleaner options.
Revenue Use and Recycling
Many carbon pricing schemes generate public revenue. A carbon tax directly collects tax payments. An emissions trading system raises revenue when allowances are auctioned. What governments do with this revenue shapes both the economic and political effects of carbon pricing.
One option is to return revenue to households through tax cuts, lump sum payments, or reduced social security contributions. This is often called revenue recycling. It can help to offset higher energy prices, especially for low income households, and can maintain public support.
Another option is to invest revenue in climate and energy programmes, such as funding renewable energy projects, improving public transport, or supporting energy efficiency in buildings. In some systems, part of the revenue is used to help industries adapt to higher energy costs, for example by supporting innovation or providing temporary support for trade exposed sectors.
The choice of revenue use affects distributional outcomes, that is, how different groups in society are affected. It also influences the broader economy, for instance by allowing governments to reduce other distortionary taxes like labor taxes or corporate taxes.
Carbon Pricing, Competitiveness, and Leakage
A common concern about carbon pricing is its potential effect on the competitiveness of domestic industries. If a country applies a carbon price that its trading partners do not, energy intensive and trade exposed industries may face higher costs compared to foreign competitors. This can lead to a risk of carbon leakage, which means that emissions-intensive production shifts to jurisdictions with weaker climate policies, which can reduce the environmental effectiveness of domestic action.
To address these concerns, governments use several strategies. One strategy in emissions trading systems is to provide some free allowances to the most trade exposed sectors, which reduces their compliance costs without fully removing the incentive to reduce emissions. Another strategy is to negotiate international agreements so that more countries implement carbon pricing or equivalent policies.
A more recent approach is the idea of border carbon adjustments. Under such mechanisms, imports from countries without comparable carbon prices may face a fee based on their estimated carbon content, while exports may receive a rebate. The goal is to level the playing field between domestic and foreign producers while preserving incentives to decarbonize.
These design choices illustrate that carbon pricing is not only a simple economic instrument but also involves complex questions of fairness, trade, and international cooperation.
Linking Emissions Trading Systems
As more regions adopt emissions trading systems, the possibility of linking them has gained attention. Linking means that allowances from one system can be used for compliance in another system, which effectively creates a larger carbon market.
Linking can bring several benefits. A larger market can reduce price volatility because it spreads risks and increases the number of participants. It can also increase cost effectiveness, because companies in one region can buy cheaper reductions from another region if available. In addition, linking can support international cooperation and help align climate policies.
However, linking also creates challenges. Systems must have compatible rules for MRV, enforcement, and overall ambition. If one system has a weak cap, linking it to a stronger system could dilute overall ambition or lower prices in the stronger system. Therefore, careful design and negotiation are needed before linking different schemes.
Offsets and Credits
Some carbon pricing systems allow the use of offsets, also known as carbon credits. An offset is a verified emissions reduction or removal achieved outside the main capped sectors. For example, a reforestation project that increases carbon storage in forests can generate credits if it meets certain standards. A company covered by an emissions trading system might buy these credits and use them to cover part of its emissions instead of buying allowances.
Offsets can lower the cost of compliance by providing cheaper reduction opportunities in sectors not covered by the main system. They can also channel finance to projects in developing regions or to land use and forestry activities.
However, offsets raise important integrity questions. It must be clear that the reduction or removal is real, measurable, and additional, meaning it would not have happened without the offset project. It should also be permanent and not double counted in more than one system or country. If offset quality is weak, overall emissions may not fall as much as they appear on paper.
Because of these concerns, many systems limit the share of compliance that can be met with offsets and increasingly demand high standards for verification and transparency.
Interaction with Renewable Energy Policies
Carbon pricing does not operate in isolation. It interacts with many other energy and climate policies, including those that directly support renewable energy deployment, which are discussed in other chapters of this course.
If a cap and trade system covers the power sector, renewable energy growth can reduce demand for allowances because fossil fuel plants emit less. This may lower the carbon price unless the cap is tightened. In this case, renewable policies and carbon pricing can overlap, and policy designers sometimes adjust caps in response.
A sufficiently high and predictable carbon price can, in principle, make renewables competitive without separate support. However, in practice, carbon prices in many jurisdictions have been modest or volatile, and governments often combine carbon pricing with other tools such as feed in tariffs, auctions, and regulations for grid access.
The choice is not simply a technical one. Carbon pricing spreads costs across the economy and can be politically sensitive. Targeted renewable policies can drive specific investments but may be less cost effective if they ignore cheaper abatement options in other sectors. An integrated policy mix tries to use carbon pricing to capture broad cost effective reductions while using complementary measures to overcome barriers that prices alone cannot address, such as financing constraints, information gaps, or technology development needs.
Social Acceptance and Political Considerations
Although carbon pricing is often favored by economists for its efficiency, it can be politically difficult to implement. Increases in fuel and electricity prices can be highly visible and can provoke strong reactions, particularly if people feel that the policy is unfair or that they do not see benefits.
Public acceptance depends on several factors. Clarity about how revenue is used is essential. If people receive visible rebates or tax cuts that offset higher prices, they may be more supportive. Transparent communication about the environmental goals and the health benefits of reduced pollution can also help.
Equity concerns are central. Low income households often spend a higher share of their income on energy, so a uniform carbon price can be regressive, meaning that it imposes a larger burden relative to their income. Policy design can address this by using part of the revenue to target support to vulnerable groups, for example through higher social benefits, energy efficiency programmes for low income housing, or targeted rebates.
Political debates also involve questions about the timing and level of carbon prices. Gradual phase in, predictable increases, and clear long term schedules can give households and companies time to adjust while still providing the required signal for investment decisions.
Evaluating Effectiveness
Assessing whether a carbon pricing system is effective involves several dimensions. One dimension is environmental performance, that is, whether emissions are actually falling and whether the policy is aligned with long term climate targets. In a cap and trade system, the cap trajectory provides a direct link to emissions levels. In a carbon tax, effectiveness depends on how strongly emissions respond to price changes, which can vary across sectors and over time.
Another dimension is economic efficiency. This includes whether the system delivers emissions reductions at minimum cost, whether marginal abatement costs are equalized across participants, and whether the broader economy functions well under the policy. Stable and credible pricing frameworks can support long term investment planning, especially for large capital intensive projects like renewable power plants.
Distributional impacts are also important. Analysts study who bears the cost of the policy, how different income groups, regions, and industries are affected, and whether revenue recycling measures are effective in addressing inequities.
Finally, administrative feasibility and institutional capacity matter. Good implementation requires agencies that can design, monitor, and enforce rules, and markets or tax systems that can handle the volume and complexity of transactions. Without strong institutions, even well designed carbon pricing schemes may not deliver the intended results.
Global Developments and Future Directions
Over the past two decades, carbon pricing has expanded significantly. Many countries and regions have introduced some form of carbon tax or emissions trading. The coverage varies by sector and by carbon price level, but the trend is toward broader application as part of climate strategies.
Future directions include efforts to align carbon prices more closely with the levels needed to achieve net zero targets, to harmonize different systems, and to integrate carbon markets across borders. There is also growing attention to ensuring that carbon pricing contributes to a just transition, where workers and communities dependent on high carbon industries receive support to adapt and benefit from new opportunities.
As renewable energy becomes cheaper and more mature, carbon pricing can reinforce its advantage and help drive the remaining shift away from fossil fuels, especially in sectors that are harder to decarbonize. Combined with other policies and cooperative international frameworks, carbon pricing and emissions trading will likely remain central tools in the global response to climate change.