Carbon pricing has become an increasingly popular policy tool around the world as countries and jurisdictions seek to reduce their greenhouse gas emissions and combat climate change. The use of carbon pricing frameworks can be divided into two categories: indirect and direct.
Indirect carbon pricing involves instruments that change the price of products associated with carbon emissions in ways that are not directly proportional to those emissions. Direct carbon pricing involves carbon pricing instruments that apply a price incentive directly proportional to the greenhouse gas emissions generated by a given product or activity, primarily through a carbon tax or an emissions trading system (ETS).
An emissions trading system involves placing a limit or cap on the total volume of greenhouse gas emissions in one or more sectors of the economy. Rather than setting a fixed price on carbon, the price is determined by the supply and demand of emission allowances or credits. Governments then auction or distribute tradable emission allowances to entities covered by the cap, where each allowance represents the right to emit a certain volume of emissions. The total volume of allowances equals the emissions cap.
There are two types of ETS: 1) cap-and-trade systems, which apply a cap or absolute limit on the emissions within the ETS and emissions allowances are distributed for the amount of emissions equivalent to the cap, and 2) baseline-and-credit systems, where baseline emissions levels are defined for individual regulated entities and credits are issued to entities that have reduced their emissions below this level. These credits can be sold to other entities exceeding their baseline emission levels.
Carbon crediting mechanisms refer to a system where tradable credits are generated through voluntarily implemented emission reduction or removal activities. Carbon crediting mechanisms operate differently to carbon taxes and ETSs. Rather than requiring businesses to pay for emitting, businesses and other organizations can generate carbon credits (and hence revenue) by demonstrating that emissions have been reduced or sequestered relative to a counterfactual baseline. Internal carbon pricing is an additional tool organization can use internally to guide its decision-making process in relation to climate change impacts, risks, and opportunities.
The growth of carbon pricing schemes is shown by the fact that 2021 was the first time that carbon pricing revenues from ETS surpassed carbon tax revenue. China hosts the world’s largest carbon market by emissions, whereas the EU has the largest carbon market by traded value. As of April 2022, there are over 60 carbon pricing instruments operating globally. A new carbon tax in Uruguay commenced in January 2022, and three new ETSs also commenced in the past year in subnational jurisdictions in North America—Oregon, New Brunswick, and Ontario.
This year’s estimate indicates that carbon pricing instruments are approaching coverage of one quarter of all emissions. Carbon pricing frameworks have become an increasingly popular tool to reduce greenhouse gas emissions around the world. Understanding the various types of carbon pricing instruments can help individuals and organizations to make informed decisions about their own emissions and contribute to the global effort to combat climate change