Carbon Pricing

Carbon pricing makes emitters face a monetary cost for releasing greenhouse gases. It internalises a negative externality by bringing climate-related costs, otherwise imposed on society, into the private decisions of producers and consumers. The price is generally expressed per tonne of carbon dioxide equivalent, allowing different greenhouse gases to be compared.

Why unpriced emissions cause market failure

Greenhouse-gas emissions contribute to climate change, but emitters do not ordinarily bear the full damage their emissions impose on others. Consequently, the marginal social cost of an emitting activity exceeds its marginal private cost.

• When market prices exclude this damage, carbon-intensive activities can be undertaken beyond the socially efficient level.
• Internalisation changes the incentives behind these activities; it does not necessarily eliminate all emissions.

How a carbon price changes decisions

A carbon price adds an emissions-related cost to production and consumption. This encourages firms to improve efficiency, switch fuels or adopt cleaner technologies, while higher prices for carbon-intensive products can encourage consumers to substitute towards lower-emission alternatives.

• An emitter has an incentive to reduce emissions whenever its marginal abatement cost is below the carbon price.
• In the textbook ideal, a Pigouvian tax equals the marginal external damage at the socially efficient level of the activity.
• A common emissions price encourages reductions where they are cheapest, helping achieve a given reduction at lower aggregate cost.

Carbon taxes and emissions trading

The two principal approaches create the price signal differently, but both make emissions costly at the margin.

• A carbon tax sets a charge on covered emissions or the carbon content of fuels; the resulting emissions quantity depends on how firms and consumers respond.
• A cap-and-trade system limits aggregate covered emissions and requires emitters to surrender tradable allowances; allowance trading establishes the carbon price.
• A tax provides greater certainty about the emissions price, whereas a binding cap provides greater certainty about the covered emissions quantity.

Conditions for effective internalisation

The extent of internalisation depends on the price level, coverage and implementation. Reliable measurement, reporting and verification and effective enforcement are necessary to make the price meaningful.

• A price below marginal external damage internalises only part of the external cost.
• Carbon leakage can arise if production shifts to jurisdictions with weaker emissions constraints, reducing the global environmental benefit.
• Revenue can support vulnerable households or cleaner investment, addressing distributional concerns while preserving the incentive to reduce emissions.