What is Carbon Pricing? A Short Guide and the EU ETS

, by Kelly Schwarz

What is Carbon Pricing? A Short Guide and the EU ETS

As the name suggests, carbon pricing means that emitters, such as businesses or industries, must pay a price for their greenhouse gas emissions (GHG). It is a measure to address climate change and is based on the ‘polluter pays principle’, meaning those causing environmental damage should pay for its impact. Carbon pricing instruments intend to create financial incentives for environmentally friendly development. It may assist in mobilising the necessary financial resources to promote market innovation and clean technology to further a low-carbon economic growth.

The two primary carbon pricing instruments are carbon taxes and tradeable permits, also called cap-and-trade. There are also other carbon pricing instruments, such as carbon offsetting, carbon crediting mechanisms and internal pricing instruments of companies.

Here is an overview of the carbon pricing tools, along with their definitions and examples.

Carbon Pricing Instrument Definition Example/ Examples
Carbon tax The government decides on a specific level of which pollution reduction needs to be achieved and sets a tax on the level to reach it. Many EU Member States implemented carbon taxes: In Sweden, for example, all fossil fuels are subject to a carbon tax based on their carbon content.
Cap-and-trade Cap-and-trade instruments set a limit for emissions and assigns carbon credits for emissions generated within the limits. If a company doesn’t use all of its emissions credits, it can trade the extra credits to other businesses that would otherwise go over the limit. European Emissions Trading System
Carbon offsetting Offsetting carbon emissions means that a polluting company invests in a program, such as a reforestation program, to make up for the GHG emissions that the company has emitted. The funds must be used to support programs that prevent or reduce carbon emissions by the same amount that the company has released into the atmosphere. Clean Development Mechanism
Internal carbon pricing Companies set their own price for the carbon emissions they generate. Microsofts internal carbon fee on emissions from, for example, their business vehicles and electricity purchases.

Here are some definitions of the key terminology to comprehend carbon pricing before delving further into the two main carbon pricing instruments.

Carbon caps = It defines a maximum amount of carbon to be emitted.

Carbon market = In some cases, carbon pricing instruments also produce carbon markets. Carbon markets are trading platforms where carbon credits are sold and purchased. An example is cap-and-trade policy instruments such as the European Emissions Trading System. Carbon taxes do normally not create markets.

Emissions permits or allowances = It is the right to emit a specific amount of a pollutant, for example, one ton of CO2.

Carbon taxes

Strengths
- A carbon tax lets a polluter decide how (much) to reduce pollution. Those who can (cheaply) reduce pollution will do so and pay less tax. Others will pay higher tax.
- It provides a constant incentive for industry actors to reduce pollution to pay lower taxes.
- It can be a revenue source for governments, which can be used to finance climate mitigation and adaptation measures.

Weaknesses
- To determine the appropriate tax rate, market conditions must be known, which may not be the case.
- A tax may have to be constantly adjusted in reaction to shifting (market) conditions, which is troublesome, expensive, and uncertain.
- Carbon taxes are oftentimes regressive, meaning it affects lower-income households more as they tend to spend more money on emissions-intensive goods and services than higher-income households. For example, a carbon tax on vehicle fuel affects low-income groups more.

Cap-and-trade

Strengths
- There is a financial incentive for companies to continuously improve environmental performance.
- It provides the possibility for companies to cut pollution where it is most cost-effective.
- It can also be a revenue source for governments, which can be used to finance climate mitigation and adaptation measures.

Weaknesses
- Reliable baseline data on emissions needed to set caps and allocate emission allowances.
- Fair and acceptable procedure to allocate emission allowances is difficult.
- For the scheme to operate properly, it needs a reliable monitoring and enforcement scheme.

The primary Carbon Pricing Instrument in the EU: The European Emissions Trading System

One of the most popular carbon pricing instruments in the EU is the European Emissions Trading System (EU ETS). It is a cap-and-trade instrument and sets an overall limit (the cap) on how much of a particular GHG can be emitted by certain sectors. Polluting entities in the pertinent sectors are given emissions rights (allowances) up to this cap. Those who can reduce their emissions at a minimal cost will emit less than their authorised cap and are able to sell any extra allowances. Those that exceed their allocated emission cap may purchase emission permits on the market.

The EU ETS was launched in 2005 and covers the electricity and heat sector, aviation and energy-intensive industries such as cement, steel and oil. The EU ETS covered roughly 10,400 industrial facilities, power plants, and about 350 airlines in 2021. It was recently agreed to also include the shipping sector.

The EU ETS is seen as a cornerstone of an economic instrument to fight the climate crisis. More than 1 billion tonnes of CO2 have been observed to have been reduced between 2008 and 2016, which equates to a 3.8% decrease in overall EU emissions compared to a scenario without the EU ETS.

However, there are several problems with it that limit its environmental effectiveness, for example:
- The price is too low to set a good incentive to reduce emissions.
- Some sectors such as airlines and the cement sector receive free allowances which lead to no incentives for them to reduce their emissions. Moreover, it is unfair to other sectors.

It also still allows business-as-usual practices and sees climate change as more of a market failure without addressing the core issues with our consumption and production practices. This leads us to talk about the overall problems of carbon pricing instruments in the next section.

Discussion on Carbon Pricing

When properly implemented, carbon pricing can have a variety of positive side effects: they raise revenues for governments, preserve the environment, and encourage investment in clean technologies.

However, a carbon pricing instrument needs to be well-designed in order to be really effective with a high enough carbon price to stimulate sustainable business practices. This is often not the case, which leads us to talk about the overall systematic problems of carbon pricing as an instrument to fix the climate crisis:
- It focuses on optimising technology and practices and energy efficiency rather than a very much-needed systematic transformation of our economy.
- There are limits to improvement in high-energy intensive industries
- The issue of localised pollution: It allows localised pollution as long as overall pollution reduction levels are met, so for local hotspots the environment does not improve and it affects the health of the local population. This is also criticised within the EU ETS.
- And lastly and most importantly: Carbon pricing defines climate change as a market failure rather than a systematic problem. The usage of fossil fuels got ingrained in interrelated sociotechnical systems of technology, legislation, economic models, and lifestyles. These systems have a growing dependence on the burning of fossil fuels and the subsequent production of GHG emissions. For instance, cities are designed for fossil-fuel vehicles. The provision of energy and the development of fossil fuel-based resources have become deeply ingrained into political and economic concerns.

In a world of economic prevalence and efficiency, the problem with carbon pricing instruments is too much emphasis on technology as a solution and the over-optimistic view of the market. By implementing, for example, less-resource-intensive technologies, it does not specifically address the high mass consumption that is so embedded in our society. Overall, carbon pricing should not be used as a main policy instrument but as a policy mix including regulations and measures to achieve a systematic transformation rather than just a ’greening’ of the current economic model.

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