Carbon Pricing Explained: Emerging Pricing Trends And Approaches
Carbon pricing is integral to our climate change policies and is already starting to make a difference. However, carbon pricing is not adopted worldwide and some pricing schemes are ineffective. To meet our climate changes goals, carbon pricing will need to become mainstream in the coming years. However, on the first day of trading after COP26, European carbon prices — which help put a cost on polluting for EU utilities and industry — have jumped almost 5% to an all-time record above €66 a tonne.
Let’s understand what is carbon pricing and, eventually, how to avoid the financial risks associated with the volatility which characterizes the carbon markets.
What is carbon pricing?
Carbon pricing is a policy mechanism that aims to capture the costs of Greenhouse Gas (GHG) emissions. In our societies, GHG emissions indirectly lead to increases in healthcare costs, damage to crops, damage to infrastructure, and other costs. Carbon pricing attempts to pay for these costs 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.
Emissions can be priced explicitly, for example through a carbon tax, an emissions trading system (ETS), or a crediting mechanism. A carbon price can also be implicit, such as through the removal of fossil fuel subsidies, or through differential energy pricing/taxation.
Common carbon pricing approaches
An Emissions Trading System (ETS) — also known as a ‘Cap and Trade’ system — limits (or caps) the GHG emissions from particular sectors of the economy. Industries are given a ‘right to emit’ within the limit — provided that they have been allocated or purchased emission allowances.
The main premise of an ETS is that the limit is gradually reduced over time. This reduces supply in the market and would increase the carbon price — assuming demand remained the same. With higher carbon prices, industries and companies should be incentivised to invest in energy efficiency or switch to low/zero-carbon fuels in their processes.
The European Union Emission Trading System (EU ETS) was the first and is the most well-known ETS. Total emissions capped in the EU ETS is currently ~ 1.5 Gigatonnes CO2e. This cap will reduce linearly by 2.2 percent each year until 2030. In 2020, The 2020 EU ETS auctions brought in €19 Billion for the member states. This figure should be much higher for 2021, with recent price increases.
A Carbon Tax puts a direct price on GHG emissions. Using a carbon tax to price emissions is much more straightforward than an ETS mechanism. However, an ETS has much more certainty on the extent of emissions reduction. When emissions are priced with a carbon tax, it’s difficult to estimate how industries will respond, and how much emissions will be reduced.
Carbon taxes are widely used globally. In terms of emissions coverage, Japan, Canada, and South Africa are some of the larger carbon tax markets. By tax intake, France leads the market with approximately $10 Billion generated at a carbon tax rate of €45/tCO2.
Some countries and regions use a mix of both to price carbon across different sectors or fuels. The World Bank’s carbon pricing map highlights which mechanisms are used globally.
Carbon pricing trends
Trend 1 — The share of emissions covered by carbon pricing is increasing each year
Global action on climate change is increasing. This can clearly be seen in the growth of carbon pricing schemes over the past decade. Since 2010, the number of carbon pricing schemes in operation globally has increased each year from 19 to 64 in 2021. This development means over 20 percent of GHG emissions are now being priced compared to just over 5 percent in 2010.
The most significant recent addition to these mechanisms is the China ETS. The scheme officially started trading in mid-July 2021 and immediately became the world’s biggest carbon market, by emissions coverage. Around 4.5 Gigatonnes of CO2 emissions are covered in the initial stage, which covers the power generation sector. Other sectors will be gradually added to the scheme.
This is a significant development and sets up the potential expansion of ETS mechanisms globally…
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