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Understanding carbon pricing options

Updated: Jun 29, 2023

Setting a price on carbon is a powerful mechanism to fight climate change. Consequently, countries, companies, and communities have opened their agendas to implement it. However, carbon pricing cannot be understood as a single and homogeneous tool. It is a set of instruments, each of which can work in specific situations. Knowing this diversity and functionality is the secret to successfully implementing a carbon price system and changing carbon intensive behaviors.

People began to put a price on carbon dioxide emissions in the 1990s, creating notable variants. First, Nordic countries embarked on carbon taxes, and in 1997 the Clean Development Mechanism of the Kyoto protocol established compensation as the basic concept of the market. Carbon price schemes have been evolving from national to international level. Taxes and ETS are implemented through public policies at national or sub-national level (e.g., states). Meanwhile, in the European Union (EU), ETS and Carbon Border Adjustment Mechanism proposal cross national borders as importers will buy carbon certificates corresponding to the carbon price that would have been paid had the goods been produced under the EU's carbon pricing rules. This phenomenon is now encouraging comparable carbon price systems in countries that export goods and services to Europe.

Today, we can still divide carbon price schemes generally into taxes and Emissions Trading Systems (ETSs) and private carbon markets. The first two are created from public entities to fix a price for each ton of CO2-equivalent emitted. When a government establishes a carbon tax, all emitters included in the scope of the tax have to pay the tax. In an ETS, each emitter has a cap under which they can emit without payment, encouraging entities to maintain the production method under this level. If they exceed their cap, they can buy carbon credits, which generally finance carbon mitigation from another source. Generally, taxes make industries, mainly in the fossil fuel use sector, pay more, discouraging carbon-intensive actions and generating more public funds than an ETS.

Taxes and offsets conceptually interact in an ETS. In the carbon price version of an ETS, the government sets a limit or a cap on the level of emissions. Emissions allowances are imposed on companies or sectors -- direct emission sources – that must redeem allowances for every emitted ton of CO2, with the possibility to buy additional allowances or sell unused ones. In the 2000s, emissions trading provided other economic signals designed to reduce emissions through establishing a cap and the possibility of negotiating results when the cap was surpassed. This cap-and-trade system has been broadly implemented in the Asia-Pacific region, Europe, and parts of the USA.

In private carbon markets, mitigation outcomes (carbon credits) are also generated by projects that demonstrate that they have emitted less or absorbed carbon. The credits, measured in tons of carbon dioxide equivalent, can then be purchased by companies or governments in order to offset emissions that they were unable to reduce through technological or logistic changes. In carbon markets, unlike for a tax or an ETS, the price is set by the rules of supply and demand, not by the government.

Another innovation is the interconnected carbon tax and voluntary private programs proposed for some Latin American countries (2018-2022). Some countries allow the non-incurrence of the tax through the purchase of offsets from voluntary private certifications programs, creating another tool, a national trade market without caps over companies or sectors, compared with ETS versions. This version decreases the effectiveness of the tax because offsets are cheaper than tax payments, but it can help redistribute revenue to rural sectors where taxes generally do not work due to the lack of governance in the rural sector in developing countries.

Carbon markets have opened the door to the consideration of carbon savings due to reductions in the use of fossil fuels or logistic/technological changes, but also from wild ecosystems and some forest plantations/reforestation with low-emission systems that remove carbon. In addition to trapping more carbon, including nature-based solutions in the market can help rural communities preserve ecological resources. Carbon markets also allow for the monetization of carbon removal technologies.

Voluntary private markets are agile systems. The formalized market established by the UNFCCC under as Article 6 of the Paris Agreement, includes the role of the States in approving transactions, which adds quality assurance, but tends to slow the process down. Carbon credits can be measured under the UNFCCC rules or under private standards. Depending on which practices are chosen, projects can offer credits to a country or company that has this option in their policy.

Voluntary markets can also be sector specific. The Carbon Offsetting and Reduction Scheme for International Aviation (CORSIA) was adopted in 2016. It uses credits from the UNFCCC registry and private voluntary certification programs to allow airlines to offset aviation emissions.

Carbon markets offer opportunities for both companies and governments. Going forward, private companies either are or will be subject to carbon taxes or caps on their emissions. They need to design more carbon-efficient production to continue being competitive and choose how to offset their remaining emissions. Or perhaps a company will have the capacity to create mitigation results in an industry or the rural sector. At that point, they can generate carbon credits for the private voluntary market or following the current rules of Article 6 of the Paris Agreement. Governments have a challenge of implementing the carbon price versions and harmonizing their interaction, preventing double-counting and maximizing their mitigation effect.


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