Carbon Pricing – 7 questions on an emerging global economic dynamic

First in our new series: Putting a price on carbon

On March 22, top executives from major oil companies expressed their support for the Biden administration’s carbon pricing plan. The embrace of carbon pricing by “Big Oil” – its longtime most-fervent opponent – is probably the clearest sign of it moving to near-universal support. This weekly series of blog posts will take a closer look at this emerging global economic dynamic. Follow us on this journey!

1. What is carbon pricing?

Carbon pricing is a market-based approach to lower carbon emissions. It starts from the observation that climate change is – economically speaking – the result of a market failure. Emitting carbon or using carbon-intensive goods produces significant costs to the environment and eventually to society itself.

These costs, however, are either not sufficiently or not at all borne by the market participants who reap the benefits or profits from these emissions. For instance, consumers who drive a car or companies that produce its fuel bear a not insignificant part of the cost.

2. How does carbon pricing work?

By putting a price on carbon, governments introduce a “polluter pays” principle that shifts the costs to those responsible for them. Producers and consumers then have an incentive to re-adjust their behavior and use more carbon-efficient technologies or less carbon-intensive products.

In addition, governments generate revenue from higher carbon prices which they can spend on the environment. This approach is more efficient and less intrusive to individual choices than banning certain carbon-intensive products altogether.

3. What forms does carbon pricing take?

Carbon pricing comes in two basic options: carbon taxes with carbon cap-and-trade systems or emissions trading systems (ETS). The tax solution establishes a direct price for emitting carbon. The price is supposed to correspond to the so-far uncovered costs to the environment.

The ETS solution, on the other hand, sets a ceiling on permitted emissions. States give out emission certificates whose number and size correspond to the overall emissions ceiling. Emitters can buy and trade these certificates based on their needs. As a result, the price is not predetermined but is a result of supply and demand.

4. Which countries have already introduced carbon pricing?

As of late March 2021, a total of 64 countries have implemented or plan to implement carbon pricing schemes. The first countries to set up national carbon pricing schemes were Poland and Finland in the early 1990s, with Sweden and Norway following soon afterward.

In 2005, the EU emissions trading system entered into force. Only in 2007 did the idea spread beyond Europe when the Canadian province of Alberta set up a carbon pricing scheme. About 22 percent of global carbon emissions are now covered by the different measures [Carbon Pricing Dashboard | Up-to-date overview of carbon pricing initiatives (worldbank.org)].

5. What are the intended effects of carbon pricing?

The overarching idea of carbon pricing is to preserve the environment and slow down climate change. Carbon pricing makes carbon-intensive production and consumption more costly. In the short run, this translates into lower demand for carbon-intensive products; as a result, carbon emissions go down.

In the long run, carbon producers have additional incentives to invest in carbon-free or low-emission technologies. Ideally, this means that growing economic activity and environmental protection can co-exist.

6. What are the (unintended) side-effects of carbon pricing?

By re-balancing the market to adequately reflect production and consumption costs, carbon pricing also re-balances profits and losses. Consumers and producers who cannot – or only at high costs – avoid carbon-intensive products are hit hardest and might need compensation.

If carbon prices differ between states, they change the competitiveness of domestic vis-à-vis foreign firms. They might even induce firms to relocate their production to countries with lower carbon prices – a process known as carbon leakage – thus counteracting the original goal of lower emissions.

7. What’s next on carbon pricing?

With rising carbon prices, the European Union has come to fear for its firms’ competitiveness and for an increase in carbon leakage. As a result, the European Commission is expected to unveil a proposal for a carbon border adjustment mechanism (CBAM) in June. It would tax imported carbon-intensive goods whose price does not reflect the environmental costs associated with their production.

In the run-up to this introduction, we will run a weekly blog post series on the economics of carbon pricing – based on a forthcoming book by Thieß Petersen – and top it off with two studies, which take stock of national carbon pricing policies and possible carbon border adjustment schemes.