Carbon pricing (orCO₂ pricing) is a method for governments tomitigate climate change, in which a monetary cost is applied togreenhouse gas emissions. This is done to encourage polluters to reducefossil fuel combustion, the main driver ofclimate change. A carbon price usually takes the form of acarbon tax, or anemissions trading scheme (ETS) that requires firms to purchase allowances to emit.^[1] The method is widely agreed to be an efficient policy for reducing greenhouse gas emissions. Carbon pricing seeks to address the economic problem that emissions ofCO₂ and othergreenhouse gases are anegative externality – a detrimental product that is not charged for by any market.

21.7% of global GHG emissions are covered by carbon pricing in 2021, a major increase due to the introduction of theChinese national carbon trading scheme.^[2][3] Regions with carbon pricing include most European countries andCanada. On the other hand, top emitters likeIndia,Russia, theGulf states and many US states have not introduced carbon pricing.^[4]Australia had acarbon pricing scheme from 2012 to 2014. In 2020, carbon pricing generated $53B in revenue.^[5]

According to theIntergovernmental Panel on Climate Change, a price level of $135–$5500 in 2030 and $245–$13,000 per metric ton CO₂ in 2050 would be needed to drive carbon emissions to stay belowthe 1.5°C limit.^[6] Latest models of thesocial cost of carbon calculate a damage of more than $300 per ton of CO₂ as a result of economy feedbacks and falling globalGDP growth rates, while policy recommendations range from about $50 to $200.^[7]: 2 Many carbon pricing schemes including the ETS in China remain below $10 per ton of CO₂.^[3] One exception is theEuropean Union Emissions Trading System (EU-ETS) which exceeded €100 ($108) per ton of CO₂ in February 2023.^[8]

A carbon tax is generally favoured on economic grounds for its simplicity and stability, while cap-and-trade theoretically offers the possibility to limit allowances to the remainingcarbon budget. Current implementations are only designed to meet certain reduction targets.

Carbon pricing is considered by many economists to be the mosteconomically efficient way to reduce emissions,^[9][10] taking into account the costs of both efficiency measures and the inconvenience of lesser fossil fuels. By pricing the externalities of carbon emissions, efficiency comes about by eliminating themarket failure of the unpriced external costs of carbon emissions at its source.^[11] It is regarded as more efficient than renewable energy subsidies given to individual firms,^{[citation needed]} because the difficulties of determining the value of emissions to each firm makescommand and control regulation less likely to be efficient.^[12]

In acarbon tax model, a tax is imposed on carbon emissions produced by a firm. In acap-and-trade design, the government establishes an emissions cap and allocates to firms emission allowances, which can thereafter be privately traded. Emitters without the required allowances face a penalty more than the price of permits.Assuming all else is equal, the market for permits will automatically adjust the carbon price to a level that ensures that the cap is met.^[13][14] TheEU ETS uses this method. In practice, it has resulted in a fairly strong carbon price from 2005 to 2009, but that was later undermined by an oversupply and theGreat Recession. Recent policy changes have led to a steep increase of the carbon price since 2018, exceeding 100€ ($118) per ton of CO₂ in February 2023.^[8]

Evaluations of 21 carbon pricing schemes, show that at least 17 of these have caused reductions in greenhouse gas emissions. The achieved emissions reductions range between 5% and 21% for the studied schemes.^[15]

The exact monetary damage of thesocial cost caused by a tonne of CO₂ depends on climate and economic feedback effects and remains to some degree uncertain. Latest calculations show an increasing trend:

Cap-and-trade systems can includeprice stability provisions with floor and ceiling limits.^[18] Such designs are often referred to as hybrid designs.^[12]: 47 To the extent the price is controlled by these limits, it can be considered a tax.

Carbon emissions trading works by setting a quantitative limit on the emissions produced by emitters. As a result, the price automatically adjusts to this target. This is the main advantage compared to a fixedcarbon tax. A carbon tax is considered easier to enforce on a broad-base scale than cap-and-trade programs. The simplicity and immediacy of a carbon tax has been proven effective in British Columbia, Canada – enacted and implemented in five months.^[19] A hybrid cap-and-trade program puts a limit on price increases and, in some cases, sets a floor price as well. The upper limit is set by adding more allowances to the market at a set price while the floor price is maintained by not allowing sales into the market at a price below the floor.^[20] TheRegional Greenhouse Gas Initiative, for example, sets an upper limit on allowance prices through its cost containment provision.

However, industries may successfully lobby to exempt themselves from a carbon tax. It is therefore argued that with emissions trading, polluters have an incentive to cut emissions, but if they are exempted from a carbon tax, they have no incentive to cut emissions.^[21] On the other hand, freely distributing emission permits could potentially lead to corrupt behaviour.^[22]

Most cap and trade programs have a descending cap, usually a fixed percentage every year, which gives certainty to the market and guarantees that emissions will decline over time. With a tax, there can be estimates of reduction in carbon emissions, which may not be sufficient to change the course of climate change. A declining cap gives allowance for firm reduction targets and a system for measuring when targets are met. It also allows for flexibility, unlike rigid taxes.^[19] Providing emission permits (also called allowances) under emissions trading is preferred in situations where a more accurate target level of emissions certainty is needed.^[23]

Standard proposals for using carbon revenues include

• areturn to the public on a per-capita basis^[24] This can compensate the risk of rising energy prices reaching high levels as long as cheap wind and solar power is not available yet. Rich people who tend to have a larger carbon footprint would pay more while poorer people can even benefit from such a regulation.
• subsidies accelerating the transition to renewable energy
• research, public transport, car sharing and other policies that promotecarbon neutrality
• subsidies for negative emissions: Depending on the technology, such asPyCCS orBECCS, the cost for generating negative emissions is about $150–165 per ton of CO₂.^[25] The removal past emissions – 1,700 Gt in total^[26] – can theoretically be addressed by auctioning allowances starting with a price that exceeds the removal costs of the proposed emissions.

About one third of the systems stays below $10/tCO₂, the majority is below $40. One exception is the steep incline in the EU-ETS reaching $60 in September 2021. Sweden and Switzerland are the only countries with more than $100/tCO₂.

Unexpected spikes in natural gas prices and commodities such as oil and coal in 2021 caused a debate whether a carbon price increase should be postponed to avoid additional social burden. On the other hand, a redistribution on a per-capita-basis would even release poorer households which tend to consume less energy compared to wealthier parts of the population. The higher the high carbon price the greater the relief. Looking at individual situations though, the compensation would not apply to commuters in rural areas or people living in houses with poor insulation. They neither have liquidity to invest into solutions using lessfossil fuels and would be dependent on credits or subsidies. On the other hand, a carbon price still helps to provide an incentive to use more effective fossil fuel technologies such asCCGT gas turbines in contrast to high-emission coal.^[28]

In the relevant countries with ETS and taxes, about 40% to 80% of emissions are covered.^[29] The schemes differ much in detail. They include or exclude fuels, transport, heating, agriculture or other greenhouse gases apart from CO₂ likemethane orfluorinated gases.^[30] In many EU member states like France or Germany, there is a coexistence of two systems: The EU-ETS covers power generation and large industry emissions while national ETS or taxes put a different price on petrol, natural gas and oil for private consumption.

The final consumer price for fuels and electric energy depends on individual tax regulations and conditions in each country. Though carbon pricing is playing an increasing role,energy taxes,VAT, utility expenses and other components are still the main cause for completely different price levels between countries.

The table gives examplesfor a carbon price of $100 or 100 units of any other currency accordingly. Food calculation is all based on CO₂ equivalents including the high impact ofmethane emissions.

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Many economic properties of carbon pricing hold regardless of whether carbon is priced with a cap or a tax. However, there are a few important differences. Cap-based prices are more volatile and so they are riskier for investors, consumers and for governments that auction permits. Also, caps tend to short-out the effect of non-price policies such as renewables subsidies, while carbon taxes do not.^[39]

Carbon leakage is the effect that regulation of emissions in one country/sector has on the emissions in other countries/sectors that are not subject to the same regulation.^[40] There is no consensus over the magnitude of long-term carbon leakage.^[41]

The leakage rate is defined as the increase in CO₂ emissions outside the countries taking domestic mitigation action, divided by the reduction in emissions of countries taking domestic mitigation action. Accordingly, a leakage rate greater than 100% means that actions to reduce emissions within countries had the effect of increasing emissions in other countries to a greater extent, i.e., domestic mitigation action had actually led to an increase in global emissions.

Estimates of leakage rates for action under the Kyoto Protocol ranged from 5% to 20% as a result of a loss in price competitiveness, but these leakage rates were considered very uncertain.^[40] For energy-intensive industries, the beneficial effects of Annex I actions through technological development were considered possibly substantial. However, this beneficial effect had not been reliably quantified. On the empirical evidence they assessed, Barkeret al. (2007) concluded that the competitive losses of then-current mitigation actions, e.g., the EU-ETS, were not significant.

Under the EU ETS rulesCarbon Leakage Exposure Factor is used to determine the volumes of free allocation of emission permits to industrial installations.

A general perception among developing countries is that discussion of climate change in trade negotiations could lead to greenprotectionism by high-income countries^[42]Eco-tariffs on imports ("virtual carbon") consistent with a carbon price of $50 per ton of CO₂ could be significant for developing countries. In 2010, World Bank commented that introducing border tariffs could lead to a proliferation of trade measures where the competitive playing field is viewed as being uneven. Tariffs could also be a burden on low-income countries that have contributed very little to the problem of climate change.

Cap-and-trade and carbon taxes interact differently with non-price policies such asrenewable energy subsidies. TheIPCC explains this as follows:

A carbon tax can have an additive environmental effect to policies such as subsidies for the supply ofRE. By contrast, if a cap-and-trade system has a binding cap (sufficiently stringent to affect emission-related decisions), then other policies such asRE subsidies have no further impact on reducing emissions within the time period that the cap applies [emphasis added].^[43]: 29

According to a 2020 study carbon prices have not harmed economic growth in wealthy industrialized democracies.^[44]

In order for such a business model to become attractive, the subsidies would therefore have to exceed this value. Here, a technology openness could be the best choice, as a reduction in costs due to technical progress can be expected. Already today, these costs of generating negative emissions are below the costs^{[clarification needed]} of CO₂ of $220 per ton,^[45] which means that a state-subsidized business model for creating negative emissions already makes economic sense today.^{[citation needed]} In sum, while a carbon price has the potential to reduce future emissions, a carbon subsidy has the potential to reduce past emissions.^{[clarification needed]}

In late 2013,William Nordhaus, president of theAmerican Economic Association, publishedThe Climate Casino,^[46] which culminates in a description of an international "carbon price regime". Such a regime would require national commitments to a carbon price, butnot to a specific policy. Carbon taxes, caps, and hybrid schemes could all be used to satisfy such a commitment. At the same timeMartin Weitzman, a leading climate economist at Harvard, published a theoretical study arguing that such a regime would make it far easier to reach an international agreement, while a focus on national targets would continue to make it nearly impossible.^[47] Nordhaus also makes this argument, but less formally.

Similar views have previously been discussed byJoseph Stiglitz^[48] and have previously appeared in a number of papers.^[49] The price-commitment view appears to have gained major support from independent positions taken by theWorld Bank and theInternational Monetary Fund (IMF).^[50]

The "Economists' Statement on Climate Change"^[51] was signed by over 2500 economists including nine Nobel Laureates in 1997. This statement summarizes the economic case for carbon pricing as follows:

The most efficient approach to slowing climate change is through market-based policies. In order for the world to achieve its climatic objectives at minimum cost, a cooperative approach among nations is required – such as an international emissions trading agreement. The United States and other nations can most efficiently implement their climate policies through market mechanisms, such as carbon taxes or the auction of emissions permits.

This statement argues that carbon pricing is a "market mechanism" in contrast to renewable subsidies or direct regulation of individual sources of carbon emissions and hence is the way that the "United States and other nations can most efficiently implement their climate policies."

Carbon offsets for individuals^[52] and businesses^[53] may also be purchased through carbon offset retailers^[54] likeCarbonfund.org Foundation.

A new quantity commitment approach, suggested by Mutsuyoshi Nishimura, is for all countries to commit to the sameglobal emission target.^[55] The "assembly of governments" would issue permits in the amount of the global target and all upstream fossil-fuel providers would be forced to buy these permits.

In 2019 theUN Secretary General asked governments to tax carbon.^[56]

Theeconomics of carbon pricing is much the same for taxes and cap-and-trade. Both prices are efficient;^[a] they have the same social cost and the same effect on profits if permits are auctioned. However, some economists argue thatcaps prevent non-price policies, such as renewableenergy subsidies, from reducingcarbon emissions, while carbon taxes do not. Others argue that an enforced cap is the only way to guarantee that carbon emissions will actually be reduced; a carbon tax will not prevent those who can afford to do so from continuing to generate emissions.

Besides cap and trade, emission trading can refer to project-based programs, also referred to as a credit or offset programs. Such programs can sell credits for emission reductions provided by approved projects. Generally there is an additionality^[57] requirement that states that they must reduce emissions more than is required by pre-existing regulation. An example of such a program is theClean Development Mechanism under the Kyoto Protocol. These credits can be traded to other facilities where they can be used for compliance with a cap-and-trade program.^[58] Unfortunately the concept of additionality is difficult to define and monitor, with the result that some companies purposefully increased emissions in order to get paid to eliminate them.^[59]

Cap-and-trade programs often allow "banking" of permits. This means that permits can be saved and can be used in the future.^{[citation needed]} This allows an entity to over-comply in early periods in anticipation of higher carbon prices in subsequent years.^[60] This helps to stabilize the price of permits.^[13]

• Pigou, A.C. (1920).The Economics of Welfare. London: Macmillan.

• Stavins, Robert N. (2019).Carbon Taxes versus Cap and Trade: Theory and Practice (Discussion Paper). Harvard Environmental Economics Program. Harvard University.

• IPCC (2014). "Chapter 15: Adaptation Needs and Options". In Edenhofer, O.; Pichs-Madruga, R.; Sokona, Y. (eds.).Climate Change 2014: Mitigation of Climate Change. Contribution of Working Group III to the Fifth Assessment Report of the Intergovernmental Panel on Climate Change. Cambridge, United Kingdom and New York, NY, USA: Cambridge University Press.

• Aldy, Joseph E.; Stavins, Robert N. (2012).The Promise and Problems of Pricing Carbon: Theory and Experience. University of Chicago Press.ISBN 978-0226011981.

• Klenert, David; Mattauch, Linus; Combet, Emmanuel; Edenhofer, Ottmar; Hepburn, Cameron; Rafaty, Ryan; Stern, Nicholas (2018). "Making carbon pricing work for citizens".Nature Climate Change.8 (8):669–677.doi:10.1038/s41558-018-0201-2.

• Cramton, Peter; MacKay, David J.C.; Ockenfels, Axel; Stoft, Steven (2017).Global Carbon Pricing: The Path to Climate Cooperation. MIT Press.ISBN 978-0262036658.

• Our Climate Put A Price On It campaign
• CDM Rulebook — Defines Kyoto commitments
• UN Climate Change Framework — Lists national commitments for 2020
• Pricing Carbon Initiative — US focused effort for carbon-pricing commitments

• Carbon finance
• Fossil fuels
• Subsidies
• Environmental tax

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