Carbon pricing: the social and environmental cost of carbon emissions finally charged

What is carbon pricing? 

Carbon pricing is a method identified by economists to reduce carbon emissions, thus trying to solve the problem of global warming, to which most of the corporations around the world contribute. The system is based on giving a price to carbon emissions, meaning that companies which emit carbon dioxide, CO2, are charged a price for their emissions. The charge is called carbon price and it is the price to emit one tonne of carbon dioxide in the atmosphere. The price is proportional to the damage caused to the environment by the carbon emission, which however is not easy to determine. The measure tries to respond to the negative externality of carbon emission, negative externality meaning a negative consequence which is not priced by the market. This method is a market mechanism that allow states all around the world to efficiently try to solve the problem of the greenhouse effect. 


How is it implemented?

Carbon pricing can be implemented in different ways. One way is to implement carbon policies, such as taxes or caps. Another way is to set carbon commitments, such as emission reduction commitments or price commitments.
Carbon policies can be price-based (carbon taxes) or quantity-based (cap-and-trade).
A carbon tax is a price-based policy since the regulator sets the price directly and markets determine the optimal quantity of carbon to emit. In principle all sources of carbon should be taxed at the same rate but in practice it is difficult to determine precisely the rate to apply to each fossil fuel source. A carbon tax can be implemented locally, nationally or by the EU parliament. It cannot be implemented on a global scale because there is no authority with such power. However, all countries could commit to a harmonized set of national carbon taxes.
The second possibility is the emission trading system or cap and trade policy. First, the government emit a chosen number of permits to emit a predefined number of tons of carbon emissions. Then there are two ways in which the process can work. The government can give the permits to stakeholders in some politically or administratively determined way. The alternative is to set an auction and place the permits to the highest bidder. After this phase, the permits can be traded privately. A company needs a permit to emit carbon otherwise it faces a penalty that generally costs more than buying a permit. The level of carbon emissions is therefore limited to the permits issued by the government.

If the level is low there will be a low offer for a high demand and the price will be high. If the level is low, there will be a high offer for a low demand and the price will be lower. Two or more countries can link their cap and trade markets by accepting carbon permits from each other. The effect is to create a single price for more countries and to increase efficiency. 
The IMF’s Fact Sheet states that “Cap-and-trade systems are another option, but generally they should be designed to look like taxes through revenue-raising and price stability provisions." Such designs are called hybrid designs. The stability provisions referred to are typically floor and ceiling prices. When permits are auctioned there is a floor price, under which the permits cannot be sold, and a ceiling price, at which a permit can be always sold for an immediate use, even if sales have already reached the cap. To the extent price is controlled by these limits, it is a tax and if the floor is set equal to the cap it works properly as a tax.
The revenues earned with these policies cannot be redistributed to corporations. There are different uses proposed for revenues. They can be returned to the public on a per capita basis, used instead of another tax (tax swap), used for energy research, invested in energy efficiency and renewable energy projects to lower emissions.
Carbon commitments too can be either price-based or quantity-based. 
Emission reduction commitments are quantity-based commitments. They are different from caps because a country can emit more provided it buys permits from another country that already satisfied its commitment. Also, commitments can be also met with non-price policies and can therefore not lead to a carbon price. These kinds of commitments are present in the Kyoto protocol, that helped to reduce carbon emissions. A new quantity commitment approach is for all countries to commit to the same global emission target. 
A lot of personalities have also proposed price-based commitments as a way to achieve an efficient uniform carbon price and to overcome all negotiating problems.


Characteristics of carbon pricing

Carbon pricing has many economic properties regardless of the way it is implemented.
First of all, it is considered the most efficient way to reduce carbon emissions, meaning that it reduces emissions for the lowest possible cost, in terms of direct cost of the measures implemented and indirect cost of reduced production of goods that need a carbon emission in their production process.
Second, carbon prices interact in different ways with non-price policies such as renewable energy subsidies. Third, there is also a cost pass-through process, under which the right person, i.e. the carbon emitter, is taxed. The government may tax or cap an oil refinery based on all the carbon it buys in the form of oil, but the refinery does not emit all of that carbon and instead it makes gasoline and sells that to gas stations and ultimately to drivers, who emit the carbon. In this case the refinery passes on the cost of its carbon permits or carbon tax, and the gas stations pay those costs. But then the gas stations pass on their cost to the drivers. So, drivers actually bear the cost of carbon pricing, and that is as it should be, because driving is the real reason for the emissions. Ultimately, drivers will choose alternatives to drivers if the cost is too high or will chose to drive if it is convenient, and in the second case they will have paid for the social cost of emitting carbon, whereas in the first case carbon won’t be emitted.

Carbon pricing is therefore a necessary part of a larger package of policies which can reduce carbon emissions. It is important the carbon emissions are priced in the correct way. If this objective is achieved, either the social and environmental cost of emitting carbon is paid back, or an alternative is chosen, without emitting carbon at all. 

Written by Giulia Galli


Sources: World Bank Group, Carbon Pricing Dashboard, Carbon Pricing Leadership