A carbon price is a cost applied to carbon pollution to encourage polluters to reduce the amount of greenhouse gases they emit into the atmosphere. Economists widely agree that introducing a carbon price is the single most effective way for countries to reduce their emissions.

Climate change is considered a market failure by economists, because it imposes huge costs and risks on future generations who will suffer the consequences of climate change, without these costs and risks normally being reflected in current market prices. To overcome this market failure, they argue, we need to ‘internalise’ the costs of future environmental damage by putting a price on the thing that causes it – namely greenhouse gas emissions.

carbon price (PDF) not only has the effect of encouraging lower-carbon behaviour (e.g. using a bike rather than driving a car), but also raises money that can be used in part to finance a clean-up of ‘dirty’ activities (e.g. investment in research into fuel cells to help cars pollute less). With a carbon price in place, the costs of stopping climate change are distributed across generations rather than being borne overwhelmingly by future generations.

Approaches to establishing a carbon price

There are two main ways to establish a carbon price. First, a government can levy a carbon tax on the distribution, sale or use of fossil fuels, based on their carbon content. This has the effect of increasing the cost of those fuels and the goods or services created with them, encouraging businesses and individuals to switch to less carbon-intensive production and consumption.

The second approach is a quota system called cap-and-trade. In this model, the total allowable emissions in a country or region are set in advance (‘capped’). Permits to pollute are created for the allowable emissions budget and are either allocated or auctioned to companies. The companies can trade permits between one another, introducing a market for pollution that should ensure that the carbon savings are made as cheaply as possible.

Typically, the government will decide how to use the revenue raised from carbon pricing (either tax revenue or revenue from auctioned allowances). Since the purpose of a carbon price is to create a price incentive to reduce carbon-intensive behaviours, governments do not necessarily need the actual revenue raised from the carbon price (unless they explicitly impose a carbon price as a revenue-raising measure, as was the case in Iceland and Ireland during the recession that started in 2008). Therefore governments can ensure that the overall government budget does not increase from imposing a carbon price by ‘giving back’ the revenue to taxpayers. One option, the so-called fee-and-dividend model, has the tax revenues distributed in their entirety directly back to the population. Another option is to reduce the taxes collected from other sources (for example, income and health).

Governments can also decide to use the revenue to address citizens’ concerns about carbon pricing. A synthesis of different empirical studies suggests that when people do not trust that a carbon price will be sufficient to reduce emissions, they prefer using the carbon price revenue to subsidise low-carbon technologies and research. If they are concerned about the impact of carbon pricing on low-income households, governments can use carbon pricing revenues to reduce the burden on low-income households.

How effective is pricing carbon for reducing emissions? Example of the UK

To serve its purpose, the carbon price set by a tax or cap-and-trade scheme must be sufficiently high to encourage polluters to change behaviour and reduce pollution in accordance with national targets. For example, the UK has a target to reduce carbon emissions to net-zero by 2050, with various intermediate targets along the way.

Currently, many large UK companies pay a price for the carbon they emit through the EU’s emissions trading scheme (EU ETS). The carbon prices from the EU ETS collapsed during the economic recession, so that the price signal given to installations to reduce emissions was not strong enough. For the UK power sector, the government introduced the Carbon Price Support (CPS) to supplement the European carbon price, requiring UK power generators to pay a minimum carbon price, which is referred to as the Carbon Price Floor (CPF). The Carbon Price Floor was introduced in 2013 at a rate of £16 (€18.05) per tonne of carbon dioxide-equivalent (tCO2e), and was set to increase to £30 (€33.85) by 2020. However, the government more recently decided to cap the Carbon Price Floor at £18.08 (€20.40) till 2021.

The price freeze and the low trading price of allowances within the EU emissions trading system have meant that in the UK the carbon price has remained lower than expected and is inconsistent with meeting the Paris Agreement and the UK’s own targets. To be more effective, it has been argued that the CPS rate could be modified to become an economy-wide carbon tax.

The case for a uniform carbon price

Ideally, there should be a uniform carbon price (PDF) across the world, reflecting the rationale that a tonne of carbon dioxide-equivalent does the same amount of damage over time wherever it is emitted. Uniform pricing would also remove the risk that polluting businesses flee to so-called ‘pollution havens’ – locations where a lack of environmental regulation enables businesses to continue to pollute unrestrained. The Report of the High-Level Commission on Carbon Prices (2017) estimated that the appropriate carbon price across the world will need to be US$40–80/tCO2e by 2020, and US$50–100/tCO2e by 2030, to be consistent with meeting the goals of the Paris Agreement.

At the moment, carbon pricing is far from uniform but a growing number of countries and regions have, or plan to have, carbon pricing schemes in place, whether through cap-and-trade or carbon taxes. These include the European Union, Australia, South Korea, South Africa, parts of China and California.

This FAQ was last updated in November 2019 to reflect the UK’s new net-zero target. The original FAQ was written by Alex Bowen and reproduced from the following article: What is a carbon price and why do we need one? © The Guardian, 2012, used under a Creative Commons No Derivative Works licence

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