The role of carbon pricing in achieving carbon neutrality

The role of carbon pricing in achieving carbon neutrality
Sep 8, 2021
8 MIN. READ

How can carbon pricing help governments and the private sector make a cost-effective low-carbon transition?

What is carbon pricing?

In both developed and developing countries, it is well known that carbon emissions come with a cost to the environment and to society, that cost is known as carbon pricing. In a new comprehensive report, the United Nations’ IPCC (Intergovernmental Panel on Climate Change) re-emphasized the impacts carbon emissions have on our environment, such as extreme weather patterns like and their effects like droughts, floods, heatwaves, hurricanes or typhoons, and rising sea levels. It also included the impact on society, from our internal human ecosystems to the greater health of our cities, infrastructure, and agricultural land.

Policymakers have grappled with the best way to mitigate the impacts of carbon emissions since the United Nations first adopted its Framework Convention on Climate Change in 1992 when countries collectively acknowledged the need to reduce emissions to limit the costs of climate change.

As with any challenge, governments typically have several options to choose from when addressing a problem. Carbon pricing is no different. Governments can directly regulate the operators of the heaviest source of emissions, such as power plants that generate electricity from coal. Or, they can regulate broader stakeholders upstream or downstream from the source of emissions, such as petroleum fuel producers or large electric consumers. Another way governments can address carbon pricing is to invest in and encourage private sector investment in low- and zero-carbon technology that can displace fossil fuels.

Alternatively, polluters may be fined for the emissions they create. That is known as the “polluter pays” principle and leads to an explicit “price on carbon” that the polluter pays for the external costs of carbon emissions.

Why do governments and business leaders support carbon pricing?

The core advantage of a price on carbon for governments and industries is it reduces the need for governments to use bureaucratic means to fairly and efficiently identify and regulate each source of carbon emissions across the economy. Instead, a price on carbon provides a price signal to industries and consumers that reflects the cost of carbon pollution in their consumption and investment decisions. The relative costs of products and services will therefore, change according to their carbon intensity.

What are the paths governments can take to price carbon?

Governments have generally taken one of two approaches to pricing carbon: a carbon tax or an emissions trading system. The government can levy a carbon tax on each ton of carbon regulated at a fixed price. Or it can provide an emissions trading system (ETS), an overall cap on regulated emissions that reduces annually and has subsequent allowances for each individual company or installation. Companies can trade their allowances, giving rise to a carbon price, as long as they meet their annual compliance obligation by surrendering the allowance equal to their emissions.

The former approach has the advantage of providing price certainty for regulated enterprises, though it cannot guarantee emissions reduction levels. The latter approach provides greater certainty in relation to emissions reduction but leads to a variable price and involves more substantial transaction costs. An ETS should realize cheaper abatement earlier, leading to overall lower costs. With the impacts of increasingly severe climate change every year, however, any carbon pricing system needs to go hand-in-hand with enough ambition to reach the goals of the Paris Agreement.

What is the current price of carbon, and what carbon price is needed to achieve decarbonization?

For as long as carbon pricing has been planned, an appropriate price for carbon has been debated in academic literature. Increasingly in the public policy space, and there is substantial variance across different carbon markets globally as to the correct answer.

The European Union Emissions Trading System, the longest-running ETS, saw some volatility in the price of EU Emission Allowances (EUAs) in its first two phases (2005-2012), then a prolonged period of prices under EUR 10/tonne CO2e until 2018. Since that time, the price has risen steadily to a high of over EUR 50/tonne in May 2021. The period of relatively low prices was due in large part to lower than expected emissions EU-wide from the global financial crisis that reduced demand for allowances.

Since then, the rising price was from key reforms to the system, namely the introduction of a Market Stability Reserve (MSR) from 2019 which saw a large number of surplus allowances withheld from the market and increased ambition for emission reduction in the fourth phase of the system.

In the linked California-Québec carbon market, allowance prices dipped over the last year due to reduced economic activity from COVID-19, with the price staying around the auction floor price of USD 16.68. Though auctions were undersubscribed in May and August 2020, stronger demand returned by November.

The allowance price in the EU ETS and New Zealand quickly recovered, and prices in both systems reached record highs in early 2021. In the Republic of Korea, prices fell from May onward before moving up again in late summer; the Regional Greenhouse Gas Initiative (RGGI) also remained relatively stable. This provides a stark contrast to the 2007–2008 financial crisis and subsequent economic downturn, which led to sustained price depressions across multiple systems.

A majority of carbon prices still remain far below the USD 40–80/tCO2e range needed in 2020 to meet the 2°C temperature goal of the Paris Agreement, according to the World Bank’s High-Level Commission on Carbon Prices. Only 3.76% of global emissions are covered by a carbon price at and above this range (see figure below). Carbon prices over the next decade need to be even higher if they are to reach the 1.5°C target.

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Since 2013, eight different carbon prices have emerged in regions across China where ETS was piloted. At the time of writing, prices in these markets ranged from CNY 9 in Fujian to CNY 87.5 in Beijing.

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China’s national ETS started trading in July. On the opening day, trading started at CNY 48/tonne, and as of 5 August, prices were trading between CNY 53-59/tonne.

Is carbon pricing really making an impact on the reduction of greenhouse gas emissions?

The EU ETS is a successful tool in reducing emissions cost-effectively. Between 2005 and 2019, installations covered by the ETS reduced emissions by about 35%. The introduction of the Market Stability Reserve in 2019 resulted in higher and more robust carbon prices, which helped ensure a year-over-year total emissions reduction of 9%, with a 14.9% reduction in electricity and heat production and a 1.9% reduction in the industry. In September 2020, under the European Green Deal, the Commission presented an impact-assessed plan to increase the EU’s net greenhouse gas emissions reductions target to at least 55% by 2030. And in July 2021, the Commission presented legislative proposals to implement the new target, including revising and expanding the scope of the EU ETS.

In late 2020, the California Air Resources Board (CARB) released the final 2018 greenhouse gas emissions inventory. While overall 2018 emissions were slightly higher (0.8 MMT CO2e) than in 2017, the state was still 6 MMT CO2e below the 2020 goal of returning to 1990 emission levels. Since peak emissions in 2004, California’s emissions have dropped over 65 MMT CO2e, or just over 13%. But CARB itself acknowledges that the state must do much more to reach the 2045 carbon neutrality goal. An encouraging piece of news from the 2018 emissions inventory is that emissions from the transportation sector have declined 1.5 MMT CO2e since 2017. This is an important step as transportation emissions make up approximately 40% of California’s emissions, and this sector has historically been hard to decarbonize.

Will carbon pricing continue to expand in jurisdiction coverage and impact on the global actions to fight climate change?

PwC’s 2020 survey of carbon markets participants reported many stakeholders expect the expansion of carbon pricing regimes to other countries to slow. This is a difficult metric to measure, while the only major additional carbon pricing mechanism expected to start operation in 2021 will be China’s national emissions trading system, it will lead to a major leap in global emissions covered, by as much as 25%. However, the world’s next largest emitters, India and Russia, are not expected to introduce carbon pricing in the short to medium term.

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What impact will carbon neutrality targets have on carbon pricing?

In late 2020 and early 2021, as countries revise their Paris Agreement commitments, key economies, including the EU, U.S., China, Japan, Korea, and the U.K. announced a number of new commitments to achieving carbon neutrality. Of these countries, the EU, China, and Korea already have carbon pricing in place at the national level and are expected to expand its coverage: in China by adding major emitters other than the power sector, and in the EU by Germany covering entities that fall below the entry threshold for the EU ETS.

In the U.S., a national carbon pricing system seems unlikely due to the difficult politics of climate policy, however moderate expansion to the existing regional carbon pricing mechanisms is taking place. Virginia became the 11th state to participate in the Regional Greenhouse Gas Initiative (RGGI) in January 2021, and the Governor of Pennsylvania is working to make his state the 12th on the RGGI list. On the other hand, Texas is the state that produces the most CO2 emissions and is unlikely to pursue carbon pricing in the near future; its state Republican Party is deeply opposed to the idea.

In Japan, the government’s commitment to carbon neutrality gained momentum around the discussion of national carbon pricing and built on the experience of the cap-and-trade program in Tokyo for commercial buildings and factories.

As the Paris Agreement is implemented and expands, ambition to grow a carbon pricing mechanism will emerge. If the temperature goals laid down in the agreement are to be met, it will be inevitable, and should lead to greater and more extensive use of carbon pricing in jurisdictions that already have it as well as in those that have yet to introduce one. Interest is increasing in the tool, especially in emerging economies in South America and Southeast Asia, as it not only provides a way for governments to meet emission reduction targets while limiting economic impacts, but it also helps companies shift their operations in the direction of a low-carbon future, which will be crucial for future success.

Meet the author
  1. Huw Slater, Lead Specialist, Climate

    Huw specializes in carbon pricing, low-carbon development, and power sector reform. View bio