Key messages
- Carbon pricing has not yet delivered substantial emissions reductions.
- To be effective, carbon prices need to increase rapidly in the near term, be sector-specific and be part of larger policy packages.
- To be publicly accepted, carbon pricing schemes need to consider equity and justice.
Insight explained
Carbon pricing policies are implemented in a steadily growing share of markets. In 2020 they covered 22% of global emissions, but only 3.76% of these are priced above 40 USD/tonne CO2eq. The High Level Commission on Carbon Pricing recommended that CO2 be priced between 40-80 USD/tonne by 2020 to be consistent with the Paris Goals.17 The limited global coverage and generally low price levels mean that carbon prices have only had a small impact on emission trajectories.
Several economic and political obstacles have been identified as causes. Carbon pricing creates short-term costs to consumers, but is perceived to only deliver future benefits. This often creates opposition, from both firms and consumers, reducing political acceptability. The result is often that prices are set too low to create substantial climate benefits, which may also fail to adequately consider climate risks and risk overrunning our collective carbon budget. Instead, some research suggests that, in the near term, carbon prices should be raised sufficiently to achieve rapid and substantial emissions reductions and then decrease over time.
A universal carbon price has been discussed but the difficulties in finalizing the rules for Article 6 of the Paris Agreement, which creates new global mechanisms for carbon trading, are evidence of the political challenges of this approach. Sector-based carbon prices and border tax adjustments could help overcome some resistance. However, border tax adjustment policies will raise new political and economic challenges for trade, particularly for some low- and middle-income countries, and there are important equity implications.
There are also intrinsic limitations to carbon pricing as a mechanism. Carbon pricing can be regressive and impact poor households more than the rich, even if the former use less energy. This can be balanced through redistribution schemes, making sure that revenues from carbon taxes benefit low-income groups. Another limitation to the effectiveness of carbon pricing is that a large share of the world’s emissions comes from maintenance and use of large-scale infrastructures, with lock-in effects and long lead times, leading to low price elasticity. In addition, carbon pricing has been found to mainly drive efficiency improvements and fuel switching but have limited effect on decarbonization. Therefore, carbon pricing should only be seen as one tool among many for green transitions.
Highlights
- 137 – current highest national carbon price globally (Sweden) (USD/tonne)18
- 61 – countries with carbon pricing.18
- Less than 850 – companies adopting internal carbon prices.18
- 22% – amount of global emissions covered by a carbon price.18
Important carbon-pricing schemes
EU ETS: The European Union ETS covers approximately 40% of EU emissions.19 It plans to implement a “carbon border adjustment mechanism” which will levy a fee on imports from jurisdictions without a carbon price.20
China ETS: The world’s largest emitter, China, launched an ETS in 2021 which covers 40% of national emissions focussed primarily on the power sector.21
CORSIA: The 2015 aviation emissions agreement (CORSIA) will create a new demand for carbon offsets – between 142 and 174 Mt CO2 in 2025.22
Article 6 of the Paris Agreement: Two new market mechanisms will be created through the Paris Agreement. Article 6.2 creates a framework for countries to trade emissions reductions activities (i.e. “internationally traded mitigation outcomes”), while Article 6.4 allows countries to purchase emissions reductions compared to an emissions baseline through a “sustainable development mechanism,” similar to the Kyoto-based Clean Development Mechanism. The rules for both mechanisms are still being negotiated.
Background
In order to apply the “polluter pays” principle and internalize the negative externalities of climate change, academics and policy makers have long championed carbon pricing. Carbon pricing may take the form of carbon taxes, which levy a price per tonne of carbon emitted, or an emissions trading scheme (ETS), where carbon allowances are traded. Economists view carbon pricing as efficient, since companies have flexibility in deciding how to meet the reduction requirements set by governments.
Implications & Recommendations
At a global level, decision makers need to:
- apply carbon prices to a larger share of global emissions and the prices must be high enough to stimulate significant decarbonization;
- acknowledge the diversity of economic and political circumstances, rather than seeking a global carbon price. Sector-based carbon pricing can address potential competition challenges.
- control the use of carbon offsets carefully and reduce fossil fuel subsidies quickly, for carbon pricing to be effective.
These implications are also very relevant at a national level.
At a national level, governments should:
- use or refund revenues from carbon taxes in a transparent and fair manner, including to lower other taxes, fund public goods and climate investment, to avoid regressive effects and to increase acceptance;
- use carbon pricing only as one policy in “bundles” of climate policy instruments to drive transformative decarbonization.
