What is Carbon Pricing?

Carbon pricing is an instrument that captures the external costs of greenhouse gas (GHG) emissions—the costs of emissions that the public pays for, such as damage to crops, health care costs from heat waves and droughts, and loss of property from flooding and sea level rise—and ties them to their sources through a price, usually in the form of a price on the carbon dioxide (CO2) emitted. A price on carbon helps shift the burden for the damage from GHG emissions back to those who are responsible for it and who can avoid it. Instead of dictating who should reduce emissions where and how, 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. Placing an adequate price on GHG emissions is of fundamental relevance to internalize the external cost of climate change in the broadest possible range of economic decision making and in setting economic incentives for clean development. It can help to mobilize the financial investments required to stimulate clean technology and market innovation, fueling new, low-carbon drivers of economic growth.

There is a growing consensus among both governments and businesses on the fundamental role of carbon pricing in the transition to a decarbonized economy. For governments, carbon pricing is one of the instruments of the climate policy package needed to reduce emissions. In most cases, it is also be a source of revenue, which is particularly important in an economic environment of budgetary constraints. Businesses use internal carbon pricing to evaluate the impact of mandatory carbon prices on their operations and as a tool to identify potential climate risks and revenue opportunities. Finally, long-term investors use carbon pricing to analyze the potential impact of climate change policies on their investment portfolios, allowing them to reassess investment strategies and reallocate capital toward low-carbon or climate-resilient activities.

"Climate Countdown: Carbon Pricing"
by Kaia Rose & Eric Mann, USA

This short film was selected for the "Put a Price on Carbon Pollution Award" of the Film4Climate Global Video Competition

 

Carbon pricing can take different forms and shapes. In the State and Trends of Carbon Pricing series and on this website, carbon pricing refers to initiatives that put an explicit price on GHG emissions, i.e. a price expressed as a value per ton of carbon dioxide equivalent (tCO2e). Considering different carbon pricing approaches, an emissions trading system (ETS), on the one hand, provides certainty about the environmental impact, but the price remains flexible. A carbon tax, on the one hand, guarantees the carbon price in the economic system against an uncertain environmental outcome. Other main types of carbon pricing offset mechanisms, results-based climate finance (RBCF) and internal carbon prices set by organizations. Scaling up GHG emission reductions and lowering the cost of mitigation is crucial to decarbonize economies. Given the size and urgency imposed by the climate challenge, a full range of carbon pricing approaches will be required, alongside other supporting policies and regulations.

 
Main types of carbon pricing

An emissions trading system (ETS) is a system where emitters can trade emission units to meet their emission targets. To comply with their emission targets at least cost, regulated entities can either implement internal abatement measures or acquire emission units in the carbon market, depending on the relative costs of these options. By creating supply and demand for emissions units, an ETS establishes a market price for GHG emissions. The two main types of ETSs are cap-and-trade and baseline-and-credit:

  • Cap-and-trade systems, which apply a cap or absolute limit on the emissions within the ETS and emissions allowances are distributed, usually for free or through auctions, for the amount of emissions equivalent to the cap.
  • Baseline-and-credit systems, where baseline emissions levels are defined for individual regulated entities and credits are issued to entities that have reduced their emissions below this level. These credits can be sold to other entities exceeding their baseline emission levels.

A carbon tax directly sets a price on carbon by defining an explicit tax rate on GHG emissions or—more commonly—on the carbon content of fossil fuels, i.e. a price per tCO2e. It is different from an ETS in that the emission reduction outcome of a carbon tax is not pre-defined but the carbon price is.

An offset mechanism designates the GHG emission reductions from project- or program-based activities, which can be sold either domestically or in other countries. Offset programs issue carbon credits according to an accounting protocol and have their own registry. These credits can be used to meet compliance under an international agreement, domestic policies or corporate citizenship objectives related to GHG mitigation.

RBCF is a funding approach where payments are made after pre-defined outputs or outcomes related to managing climate change, such as emission reductions, are delivered and verified. Many RBCF programs aim to purchase verified reductions in GHG emissions while at the same time reduce poverty, improve access to clean energy and offer health and community benefits.

Internal carbon pricing is a tool an organization uses internally to guide its decision-making process in relation to climate change impacts, risks and opportunities.

For governments, the choice of carbon pricing type is based on national circumstances and political realities. In the context of mandatory carbon pricing initiatives, ETSs and carbon taxes are the most common types. Over 40 countries and 25 subnational jurisdictions (cities, states and regions), already have carbon pricing initiatives, with more planning to implement carbon pricing in the future. The most suitable initiative type depends on the specific circumstances and context of a given jurisdiction, and the instrument’s policy objectives should be aligned with the broader national economic priorities and institutional capacities. ETSs and carbon taxes are increasingly being used in complementary ways, with features of both types often combined to form hybrid approaches to carbon pricing. Some initiatives also allow the use of credits from offset mechanisms as flexibility for compliance.

Many companies use the carbon price they face in mandatory initiatives as a basis for their internal carbon price. Some companies adopt a range of carbon prices internally to take into account different prices across jurisdictions and/or to factor in future increases in mandatory carbon prices.

GHG emissions can also be implicitly priced through other policy instruments such as the removal of fossil fuel subsidies, energy taxation, support for renewable energy, and energy efficiency certificate trading. Implicit carbon pricing initiatives are not covered in the State and Trends of Carbon Pricing series and on this website.

International carbon pricing

International carbon pricing refers to carbon pricing initiatives that have the potential to cover the whole world. This includes:

Initiatives under the United Nations Framework Convention on Climate Change (UNFCCC):

Initiatives outside of the UNFCCC:

International carbon pricing took off with the introduction of the flexibility mechanisms under the Kyoto Protocol. Adopted at the third Conference of the Parties (COP) to the UNFCCC held in Kyoto, Japan, in December 1997, the Kyoto Protocol committed industrialized country signatories (so-called “Annex I” countries) to collectively reduce their GHG emissions by at least 5.2 percent below 1990 levels on average over 2008–2012. Annex I countries could fulfil their commitments through domestic actions or the use of three flexibility mechanisms IET, JI and CDM. The amendment adopted in Doha, Qatar, in December 2012 provided a basis for the three Kyoto mechanisms to continue for 2013–2020. The IET, JI and CDM were of significant relevance in the creation of cross-boundary carbon markets.

Looking ahead, carbon pricing can play a pivotal role to realizing the ambitions of the Paris Agreement and implement the Nationally Determined Contributions (NDCs). Article 6 of the Paris Agreement provides a basis for facilitating international recognition of cooperative carbon pricing approaches and identifies new concepts that may pave the way for this cooperation to be pursued. Paragraph 136 of the first COP 21 Decision (Adoption of the Paris Agreement) recognizes the important role of providing incentives for emission reduction activities, including tools such as domestic policies and carbon pricing. Many of the plans submitted to the UNFCCC recognize the important role of carbon pricing, with about 100 countries planning or considering carbon pricing mechanisms in their intended NDCs.

International Emissions Trading (IET) is an international ETS set up with the intention to allow Annex I countries to achieve emission reductions at least cost. However, individual countries made policy decisions related to other priorities, and their national context, and did not necessarily optimize their emission reduction efforts on carbon price alone. This heterogeneity of national policies meant that the IET did not achieve a least-cost outcome as originally intended. IET was also hindered by a lack of clarity about environmental outcomes, impacting its attractiveness for sovereign buyers.

The Joint Implementation (JI) and Clean Development Mechanism (CDM) are offset mechanisms under the Kyoto Protocol under which entities from Annex I Parties could participate in low-carbon projects and obtain credits in return. 

  • The CDM is the market-based mechanism that has involved the largest number of countries—both developed and developing—in efforts to reduce GHG emissions. It grew to a scale that enabled significant emission reductions and financial flows to developing countries. Developing countries can take no-regret actions and participate voluntarily in emission reductions and removal activities through the CDM. The emission reductions are then transferred to Annex I countries to meet their targets. By the end of 2014, the CDM supported investments worth approximately US$90 billion in GHG emission reduction projects in developing countries. The CDM has confirmed that offset mechanisms have the capacity to mobilize capital efficiently toward cost-effective low-carbon investments.
  • The JI has been less successful than the CDM in terms of emission reduction achievements as it faces a dual challenge of the lack of countries’ ambition and the uncertainty over the future regulatory infrastructure to issue credits. Most of the credits were issued without the supervision of the Joint Implementation Supervisory Committee, triggering some speculation on the level of rigor applied.

By 2012, the demand for Kyoto credits—Certified Emission Reductions (CERs) from CDM and Emission Reduction Units (ERUs) from JI—started to get saturated. It became clear that the Kyoto credits already issued were enough to fulfill most of the demand, including from the EU, which was the biggest source of demand historically. As no other substantial source of demand for Kyoto credits currently exists, this has led to sustained low prices for CERs and ERUs. Some carbon pricing initiatives at the national level provide the possibility of demand for CERs, such as in Korea, Mexico and South Africa, although only domestic CERs are accepted in these initiatives and the demand is limited. The upcoming Carbon Offsetting and Reduction Scheme for International Aviation (CORSIA) could represent a significant new source of demand for CERs.

The voluntary market caters to the needs of those entities that voluntarily decide to reduce their carbon footprint using offsets. By the end of 2015, the cumulative issuance on the voluntary market was 330 million credits, which is about one-eighth the volume of CDM and JI issuances. However, annual issuance levels and prices have been more stable over time than in the Kyoto credits market. The demand is mainly driven by voluntary offsetting in the private sector in jurisdictions without mandatory carbon pricing. 

Results-based Climate Finance (RBCF) is a funding approach where payments are made after pre-defined outputs or outcomes related to managing climate change, such as emission reductions, are delivered and verified. Some RBCF programs purchase compliance emission reduction units, including CERs and ERUs, helping bridge the current lack of demand for these units. Some of these programs include the World Bank’s Carbon Initiative for Development (Ci-Dev) and the Pilot Auction Facility for Methane and Climate Change Mitigation (PAF), and the German government’s Nitric Acid Climate Action Group. Elements of the existing carbon market infrastructure, such as the CDM monitoring, reporting and verification (MRV) requirements, have been incorporated into these programs. Other programs not specifically designed for compliance markets use RBCF as a direct funding mechanism and were built from the ground up. Such programs include the Performance Based Climate Finance Facility (PBC) in Latin America financed by the European Commission, KfW and CAF, and the World Bank’s Transformative Carbon Asset Facility (TCAF). These programs focus on the implementation of large scale sectoral or policy-level emission reduction programs. 

Member States of the International Civil Aviation Organization (ICAO) adopted the first global sectoral carbon pricing initiative—the Carbon Offsetting and Reduction Scheme for International Aviation (CORSIA)—on October 7, 2016. This is a global carbon offsetting initiative that aims to stabilize net emissions from international aviation at 2020 levels; any additional emissions above 2020 levels will have to be offset. According to researchers and analysts, the CORSIA has the potential to generate demand for carbon assets of around 2.5 GtCO2e between 2021 and 2035, which is comparable to the cumulative volume of Kyoto credits issued so far. Demand will be shaped by rules on the type of credits that will be eligible for airlines to purchase to comply with the CORSIA. ICAO’s Committee on Aviation Environmental Protection will recommend a set of rules for eligible credits; adoption of these rules by the ICAO Council is expected by 2018.

Article 6 of the Paris Agreement recognizes that Parties can voluntarily cooperate in the implementation of their NDCs to allow for higher ambition in mitigation and adaptation actions:

  • Articles 6.2–6.3 of the Paris Agreement cover cooperative approaches where Parties could opt to meet their NDCs by using internationally transferred mitigation outcomes (ITMOs). ITMOs aim to provide a basis for facilitating international recognition of cross-border applications of subnational, national, regional and international carbon pricing initiatives.
  • Articles 6.4 establishes a mechanism for countries to contribute to GHG emissions mitigation and sustainable development. This mechanism is under the authority and guidance of the COP serving as the meeting of the Parties to the Paris Agreement (CMA). It is open to all countries and the emission reductions can be used to meet the NDC of either the host country or another country. The mechanism is intended to incentivize mitigation activities by both public and private entities. 

The operationalization of the mechanisms under Article 6 is one of the key challenges which need to be overcome to enable carbon pricing to deliver on its potential for cost-effective decarbonization. Modalities to ensure environmental integrity and avoid double-counting, enable greater ambition and promote sustainable development are at the core of the discussions under the UNFCCC.

Regional, national and subnational carbon pricing

Over 40 countries and 25 subnational jurisdictions (cities, states, and regions) are putting a price on carbon in 2017 through an ETS or a carbon tax. This consists of 19 ETSs, mostly in subnational jurisdictions, and 27 carbon taxes primarily implemented on a national level. Over the past decade, the number of jurisdictions with carbon pricing initiatives has doubled. These jurisdictions, which include seven out of the world’s ten largest economies, are responsible for about a quarter of global GHG emissions The number of carbon pricing initiatives implemented or scheduled for implementation has quadrupled in the past decade and almost doubled over the last five years, reaching 46 in 2017. For more details on the initiatives in these jurisdictions, check out the interactive map.

On average, the emissions covered by carbon pricing initiatives implemented and scheduled for implementation is about half of the GHG emissions of jurisdictions with an ETS and/or a carbon tax. This translates to a total coverage of about 8 GtCO2e or about 15 percent of global GHG emissions. Emissions covered by carbon pricing have increased almost fourfold over the past decade. In April 2016, the High Level Panel on Carbon Pricing, a group of government leaders and international organizations, set forward a global target to double he emissions covered by carbon pricing initiatives to 25 percent by 2020 and to double this coverage again within a decade. For more details on the initiatives’ GHG emissions coverage, check out the interactive graph.

The observed carbon prices span a wide range, from less than US$1 up to US$126/tCO2e, as shown in Figure 3. About three quarters of covered emissions remain priced at less than US$10/tCO2e, thus well below the level required to effectively support at least a 2°C goal, which has been estimated by various studies to be between US$80/tCO2e to US$120/tCO2e in 2030. Higher prices will therefore be needed to increase the economic impact of carbon pricing and contribute to achieving the Paris Agreement temperature goal. To that end, the High-Level Commission on Carbon Prices was launched at the COP 22 to identify indicative corridors of carbon prices which can be used to guide the design of carbon pricing instruments and other climate policies. This is complemented by a similar initiative from the private sector—the Carbon Pricing Corridors initiative led by CDP and We Mean Business. For more details on the initiatives’ prices, check out the interactive graph.

The total value of ETSs and carbon taxes in 2017 is US$52 billion, an increase of seven percent compared to 2016. This increase is primarily due to the launch of several carbon pricing initiatives at the end of 2016 and in 2017. Part of this increase is offset by lower carbon prices and decreasing caps in some ETSs. For more details on the initiatives’ value, check out the interactive graph.

Jurisdictions implementing regional, national and subnational carbon pricing initiatives have been

exploring modalities for cooperation and knowledge sharing, which could lead to further regional carbon pricing convergence, alignment and linking. For example, California, Mexico, Ontario and Québec have signed Memorandums of Understanding (MoUs) to explore options to cooperate on carbon markets. In addition, dialogues to explore regional carbon pricing have been taking place in the context of the Pacific Alliance. Furthermore, China, Japan and Korea inaugurated an annual conference to exchange experiences on carbon pricing and explore areas for cooperation, and New Zealand started discussing potential collaboration on carbon markets with China and Korea. Such cooperative developments will support the cost-effective achievement of a 2°C or lower climate target, as demonstrated by modeling that shows that an international carbon market could deliver a 30 percent reduction in global mitigation costs by 2030 and more than 50 percent reduction by the middle of the century.

Internal carbon pricing

An increasing number of organizations are using internal carbon pricing to guide its decision-making process:

  • Corporate applications of internal carbon pricing include supporting corporate strategic investment decision making and helping companies shift to lower-carbon business models.
  • Some governments are using internal carbon pricing as a tool for in their procurement process, project appraisals and policy design in relation to climate change impacts.

Over 1,200 companiesincluding more than 100 Fortune Global 500 companies with a total annual revenue of about US$7 trillion reported to CDP in 2016 that they are currently using an internal price on carbon or plan to do so within the next two years. Of these companies, 517 reported to CDP that they are using an internal price on carbon—a more than threefold increase compared to 2014. An additional 732 companies stated that they are planning to implement an internal carbon price over the course of 2017–2018. Of the companies that have publicly disclosed that they are using an internal price on carbon or plan to do so within the next two years, 83 percent are headquartered in countries where mandatory carbon pricing is in place or scheduled for implementation at a national or subnational level. 

The reported corporate carbon prices in use are diverse, ranging from US$0.3/tCO2e to US$893/tCO2e. Some companies adopt a range of carbon prices to take into account different prices across jurisdictions and/or to factor in future increases in mandatory carbon prices. The figures below shows that for some companies, the internal carbon price adopted or the lower end of the internal carbon pricing range implemented is similar to mandatory carbon pricing levels.  In total, about half of the companies that have disclosed their internal carbon prices are using values that are higher than the mandatory prices of the jurisdictions they are headquartered in.

The broad internal carbon price range reported also indicates that some companies are moving beyond the use of internal carbon pricing as a strategic risk management tool to evaluate the potential impact of carbon pricing initiatives on their operations. These companies are also using it to explore cost savings and revenue opportunities through innovation. The United Nations Global Compact has called for businesses to adopt an internal carbon price of at least US$100/tCO2e by 2020, which will be needed to keep GHG emissions consistent with a 1.5–2°C pathway.

An increase in the adoption of internal carbon pricing is anticipated following the recommendations of the Financial Stability Board Task Force on Climate-related Financial Disclosures (TCFD) published on December 14, 2016. The TCFD considers climate-related risks to be material and advises businesses to disclose their climate-related financial risks and opportunities under existing financial disclosure obligations.85 As part of this disclosure, the TCFD recommends companies to report the internal carbon prices that are used to manage these risks and opportunities. In particular, companies with a high climate-related risk exposure are advised to communicate the internal carbon price scenarios used and explain their assumptions.

Graphs from CDP, Embedding a Carbon Price into Business Strategy, September 2016.

Governments are also using internal carbon price for decision making purposes, such as assessing the climate impact of investments on infrastructure in project appraisals. Governments generally use three different approaches to set the internal carbon price: 

  1. Estimates of the social cost of carbon: the social cost of carbon reflects the value of global damages caused by a ton of GHG emissions. This approach is subject to a high level of uncertainty as it relies on forecasts of the state of the economy, demographic changes and the cost of adaptation measures. 
  2. Estimates of the marginal abatement cost: the internal carbon price can be derived from the marginal abatement cost of meeting a national emission reduction target. Estimates of this cost are based on expectations of the cost of emission reduction technologies.
  3. The current and estimated future market values of emissions allowances: internal carbon prices can also be based on the market prices of emissions allowances. In all three cases, costs increase over time as the stock of GHGs is increasing. In the first case, costs increase as future emissions are expected to cause greater damages for each ton of GHG emitted. In the latter two cases, costs are higher as marginal abatement becomes more expensive over time.

Half of the ten Organisation for Economic Co-operation and Development (OECD) countries with the highest GHG emissions reported the use of internal carbon prices. Internal carbon prices used ranged from US$5/tCO2e to over US$400/tCO2e depending on the country, year and sector for which a decision is to be made.

How to do carbon pricing right

Carbon pricing initiatives continue to be fine-tuned, adapting to new circumstances and incorporating lessons learned. Existing carbon pricing initiatives are evolving based on past experiences and upcoming initiatives try to learn from these experiences in their design. 

Various organizations have published studies to help governments and businesses develop efficient and cost-effective instruments to put a price on the social costs of emissions, including: 

  • The World Bank Group, together with the OECD and with input from the IMF, set up the FASTER Principles. The FASTER principles are: F for fairness, A for alignment of policies and objectives, S for stability and predictability, T for transparency, E for efficiency and cost-effectiveness, and R for reliability and environmental integrity. The research draws on over a decade of experiences with carbon pricing initiatives around the world. It points to what has been learned to date: a well-designed carbon pricing initiative is a powerful and flexible tool that can cut GHG emissions, and if adequately designed and implemented, it can play a key role in enhancing innovation and smoothing the transition to a prosperous, low-carbon global economy.
  • The World Bank’s Partnership for Market Readiness (PMR)—jointly with the International Carbon Action Partnership (ICAP)—published the Emissions Trading in Practice: Handbook on Design and Implementation, a new 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 achieve this goal. It explains the rationale for an ETS, and sets out a 10-step process for designing an ETS—each step involves a series of decisions or actions that will shape major features of the policy.
  • The World Bank’s Partnership for Market Readiness (PMR) published the Carbon Tax Guide : A Handbook for Policy Makers. This guide has two main objectives. First, it serves as practical tool to help policymakers determine whether a carbon tax is the right instrument to achieve national policy goals. Second, it is a resource to support the design and implementation of a tax that is best suited to 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.
  • The European Commission published the EU ETS handbook, which provides detailed information about the EU Emissions Trading System (EU ETS), including information about how the system was designed and how it operates.
  • The UN Global Compact and World Resources Institute, together with Caring for Climate partners, published the Executive Guide to Carbon Pricing Leadership. The guide outlines what different internal carbon pricing approaches mean and features company case examples illustrating how businesses have put them into practice.
  • The European Bank for Reconstruction and Development (EBRD) and the Grantham Research Institute on Climate Change and the Environment published the Special Report on Climate Change - The Low-Carbon Transition. The report maps out the policies needed to reduce carbon emissions in central and eastern Europe and Central Asia, including carbon pricing. The report highlights the challenges and opportunities of carbon pricing in the context of the transition countries’ involvement in the global climate change mitigation efforts.
  • The Asian Development Bank published the Emissions Trading Schemes and Their Linking: Challenges and Opportunities in Asia and the Pacific report. This knowledge product summarizes some of the most significant learning experiences to date on linking of ETSs and discusses some of the solutions to alleviate challenges that have been faced. It also examines the possibilities for future linked carbon markets in Asia and the Pacific region.