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  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.

Carbon pricing can take different forms and shapes. In general, both the State and Trends of Carbon Pricing series and the Carbon Pricing Dashboard focus on direct carbon pricing instruments – that is, those that apply a price incentive directly proportional to the greenhouse gas emissions generated by a given product or activity (primarily carbon taxes, ETSs, and carbon crediting mechanisms). However, some jurisdictions, including Argentina, Mexico, and Uruguay, have introduced carbon taxes with varying tax rates (per metric ton CO2) across fuels. While these policies are called “carbon taxes” and have been historically included within the State and Trends Reports, they are closer to the definition for indirect carbon pricing, due to non-uniform carbon prices across fuels.

"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.

A crediting mechanism designates the GHG emission reductions from project- or program-based activities, which can be sold either domestically or in other countries.  Crediting Mechanisms 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. 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 indirectly priced through other policy instruments such as the removal of fossil fuel subsidies and energy taxation. Indirect carbon pricing initiatives are not currently covered in the State and Trends of Carbon Pricing series and on this website.

International carbon pricing

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 International Emissions Trading, 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.

The voluntary market caters to the needs of those entities that voluntarily decide to reduce their carbon footprint using offsets. In 2021, the total traded value of the voluntary carbon market was around US$ 1.4 billion. This significant increase in value from previous years reflects both rising prices and rising demand from corporate buyers leading to higher transacted volumes.

 

Results-based Climate Finance (RBCF) is a form of climate finance where funds are disbursed by the provider of climate finance to the recipient upon achievement of a pre-agreed set of climate-related results. These results are typically defined at the output or outcome level, which means that RBCF can support the development of specific low-emission technologies or the underlying climate outcomes, such as emission reductions. Various RBCF initiatives build on existing carbon market mechanisms and prepare for new instruments. 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.

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. 
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.
  • Financial institutions have also begun using internal carbon pricing to assess their project portfolio.
     

Additional detail on internal carbon pricing is collected and reported by CDP.

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.

Financial institutions increasingly use internal carbon pricing as a tool to evaluate their investments by including the cost of carbon in economic analyses of new projects. Reasons include to better understand and measure their carbon footprint, and to systematically integrate the negative externality of CO2 emissions into project appraisal as part of commitments to support low-carbon solutions through their lending portfolio.

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 second edition of Emissions Trading in Practice: Handbook on Design and Implementation, a guide for policymakers that distills best practices and key lessons from more than a decade of practical experience with emissions trading worldwide. This revised 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 World Bank’s Partnership for Market Readiness (PMR) published a Guide to Developing Domestic Carbon Crediting Mechanisms.  The guide is intended to assist national and subnational policymakers considering whether and how to establish a carbon crediting mechanism in their jurisdiction. It provides insights into the decision points for designing a crediting mechanism and how to tailor the mechanism to achieve domestic policy objectives. The guide is divided into 10 chapters representing the key elements that must be considered when setting up a domestic crediting mechanism.
  • The World Bank’s Partnership for Market Readiness (PMR) published A Guide to Greenhouse Gas Benchmarking for Climate Policy Instruments. The guide is intended to provide policymakers with structured guidance on the development of benchmarks and draws on over a decade of global experiences in benchmark development, covering practices in 16 jurisdictions that are already using or are in the process of developing a benchmarking approach.
  • 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.
  • Ecofys, The Generation Foundation and CDP have developed a guide on best practice approaches to internal carbon pricing in businesses to support further adoption of internal carbon pricing. Using a new four-dimensional framework, the guide explains how a best-practice internal carbon pricing approach can be established to optimize decarbonization in a company’s value chain.