Carbon pricing; what, why, how?

Putting a price on carbon is one way to reduce emissions. It incentivises organisations and consumers to reduce carbon emissions or face increased costs. There has been a carbon pricing mechanism in place in the UK since 2002, in various forms but mainly through the EU Emissions Trading Scheme (ETS) from 2005 and a UK only ETS since 2021.

Carbon prices can be levied through taxes, in which a price is set by Government, or via trading schemes which rely on the market to price carbon. Border adjustments to account for emissions in imports can be applied to both systems to try reduce carbon leakage.

Many economists see carbon pricing as an efficient route to cutting emissions, but there remain significant logistical and political difficulties in implementing carbon prices and in ensuring that they are an effective driver of emissions reduction.

What is a carbon price?

A carbon price is a charge on carbon emissions, usually levied on the carbon content of goods or services. By applying a cost that increases over time, carbon prices incentivise cleaner means of producing things, or reduce demand for high carbon goods and services by increasing prices.

The aim of a carbon price is to drive carbon emissions reductions by ensuring that polluters pay for their emissions. Carbon prices can be applied economy-wide or targeted towards specific sectors, as is currently the case for the power sector in the UK.

Carbon pricing in some form has been implemented in over 40 countries to date, including the EU, New Zealand, India, Mexico and China. Overall, it is thought that about 15% of global greenhouse gas emissions are covered by carbon pricing schemes.

In the UK, an emissions trading scheme has been present since 2002, which widened to the EU emissions trading scheme in 2005. The EU ETS covers manufacturing, aviation and power. These sectors will also take part in the UK Emissions Trading Scheme after Brexit, and the power sector in the UK has been subjected to an additional carbon price since 2013.

The positives and negatives of carbon pricing have been discussed for decades, with the Climate Change Committee recently referring to them as ‘an important part of the policy toolkit’ as they can ‘support the public finances while strengthening incentives to reduce emissions’ on the pathway to net zero.

Pricing carbon: taxes or trading

Carbon taxes

Carbon prices can be levied through fixed rate taxes on goods and services. This is known as a ‘carbon tax’ and includes taxes such as the Carbon Price Support (CPS).

Proponents of a carbon tax say that it is a simple method of reducing emissions by applying a cost to carbon as it provides greater price certainty and administrative simplicity. Carbon taxes can be tailored to suit different sectors, with different prices, and can (in theory) provide longer term clarity on carbon costs than a market driven carbon price.

However, opponents argue that it is difficult to set and maintain a price at a level to drive decarbonisation cost-effectively. For a tax to be effective it needs to be set at an impactful level, with a set trajectory in the future. This also means it can be rendered ineffective during financial downturns.

The inability for governments to decide policies in perpetuity also adds uncertainty. Carbon taxes can be amended or removed quickly, and therefore do not provide investors with the same levels of confidence in comparison to other governmental measures.

Carbon trading

Carbon trading does not set a fixed price for carbon, instead it lets the market decide how much emitting carbon should cost. By issuing a limited number of permits for emissions, the number of which is reduced over time, trading schemes aim to avoid the inherent uncertainty associated with a Government-controlled carbon tax.

One example of carbon trading is the EU ETS. Here, carbon emissions can be bought and sold via auctions, in which allowances are procured to cover emissions from power stations, industry and other sectors. If a company invests in cleaner production processes, it will procure fewer allowances.

Trading schemes also need to balance certainty and flexibility, ensuring that market downturns do not render them ineffective, as was the case for the EU ETS in the years after the 2008 crash. Years of negotiations resulted in the formation of a ‘stability reserve’ that would mop up surplus credits, supporting prices to a level at which they became effective.

Since 2020 ETS permit prices have soared, topping €40 per tonne of carbon in early 2021. In the UK-only ETS, after Brexit, carbon prices will start at £22 per tonne but are likely to rise when the auctions get underway in mid-2021.

Different types of carbon price
There are several options for a future carbon price in the UK. A carbon trading scheme could remain – with either the UK ETS linking to the EU ETS, or remaining as a standalone scheme, or a flat rate carbon tax could be applied. Source: The Future of Carbon Pricing in the UK (Vivid Economics).

In time, the UK ETS could be linked to the EU system, which could provide access to a larger market with increased liquidity. Larger markets also limit volatility, giving more certainty to market participants. A linked ETS could also reduce competitiveness between organisations in the European Economic Area, as the carbon prices would be the same in the UK and in the EU, and an increased certainty about the policies in place could lower costs for businesses.

However, a UK-only ETS has advantages too, including being able to tie the ETS more closely to the UK’s net zero policy and counteract any slumps or sharp rises in the carbon price, by Government intervention. This is known as counter-cyclical policy.

Border Carbon Adjustments (BCA)

For both carbon taxes and trading systems, border adjustments can be applied to prevent imports – not subject to the same level of carbon pricing – from undercutting domestic goods and services. This is known as carbon leakage.

Border adjustments work by applying the same domestic carbon price to imported goods and services, to ensure that domestic trade is not placed at a disadvantage. The EU and US are believed to be considering introducing BCAs.

Border adjustments are highly complex and complicated, in theory accounting for the total supply chain emissions of all imports. They bring significant logistical burden, and have been described as undesirable by leading figures, including US climate envoy John Kerry.

Proponents, however, point to BCAs as a way of using carbon pricing as a tool to cut carbon and preventing cheaper and dirtier products from overseas undercutting domestic industries.

Political considerations

Essentially, carbon prices are a means of implementing the ‘polluter pays’ principle, internalising the cost of carbon. Depending on the elasticity of different parts of the economy, they can either be used to raise revenue or to cut carbon.

Raising carbon prices on petrol, an inelastic product, would raise tax take. It would also lead to undesirable consequences – higher costs of living, for example – as an immediate substitute is not available.

Demand for domestic air travel, on the other hand, responds rapidly to price; it is an elastic product. The ready availability of train or road transport means increases in the cost of internal-UK air tickets will see demand fall.

Politicians will look to balance these two factors in implementing new carbon prices. The issue of ‘lost revenue’ for Treasury as cars, vans and lorries use less petrol and diesel has been highlighted as an issue. In theory, all carbon taxes should ultimately lead to changes in behaviour that sees the amount of revenue they raise fall to zero.

In addition, it has been suggested that carbon taxes could be regressive, for example a group of experts from the London School of Economics state that ‘without mitigation measures, a carbon tax on energy fuels is regressive, hitting low-income households disproportionately’ as costs to producers are passed on to the consumer eventually through increased costs for goods and services.

Canada carbon price
Devolved administrations in different areas of Canada have either implemented their own carbon pricing system, have chose the federal back up option, or the back up option has been applied. Source: CleanTechnica.

Carbon pricing around the world

In Canada, a carbon tax scheme is applied to both industries that emit carbon, at $30 per tonne of carbon in 2020 (rising to $50 per tonne in 2023), and consumers. The price paid for carbon per household depends on the area, for example ranging from $439 in Ontario to $720 in Saskatchewan. However, the money collected from households is given back to them through tax returns and the majority (70%) actually receive more back than they paid for carbon. This increases the acceptability of the scheme to households however it is still not universally popular – the premier in Ontario has previously described it as ‘the worst tax ever’.

Similarly, in Australia carbon tax has been a politically divisive issue. In 2012 a carbon tax was introduced at around €15 per tonne of carbon but repealed just two years later when an opposition party won the election. The party campaigned on an ‘axe the tax’ message as, among other issues with the scheme, it was thought the tax increased electricity costs by around 10%.

Future of carbon pricing in the UK

The UK ETS will launch in May 2021 and when trading begins the price of carbon in the UK ETS will become clear. A flat carbon price on consumers (including sectors such as food) has been ruled out in the near-term, although this is likely to be an ongoing discussion for reaching net zero by 2050.

UK environmental taxes
Environmental taxes currently operating in the UK. Some are not related to carbon, e.g. the Landfill Tax. Source: NAO.

The Treasury’s Net Zero review, expected in 2021 or early 2022, is expected to discuss setting a longer-term carbon price in the UK to try to reach net zero in the most cost-effective way. A carbon price could also be a politically attractive option to increase revenue for the coronavirus recovery without compromising on Conservative Manifesto commitments to not increase income tax, VAT or national insurance.