In many countries carbon pricing has become a key part of the journey to decarbonisation. Currently, the World Bank reports that there are 64 carbon pricing initiatives around the world which have either been implemented or are scheduled for implementation.  Recently there have also been calls for a worldwide coalition for carbon pricing. 

At their core, carbon pricing mechanisms ensure that “polluters pay” by setting a price on CO2 or equivalent (CO2-eq) emissions. However, there is a diversity of approaches to setting a carbon price; the most popular alternatives are carbon taxes and “emissions trading systems” (ETS).

  • Carbon tax. A carbon tax fixes the carbon price (e.g., requiring emitters to pay per tonne of CO2-eq emitted). As emitting becomes expensive, there will be an incentive to reduce emissions. If the cost of reducing emissions becomes lower than paying the tax, then emitters will profit from reducing emissions and investing in clean projects. As the tax increases, aggregate emissions will decrease. However, as there is no overall limit on emissions, the exact amount of emissions reductions is uncertain.
  • ETS. A “cap and trade” ETS fixes the quantity of overall emissions (the cap) and allows emitters to bid for emissions permits which can then be traded with one another. In a basic regime, the permit price (being the carbon price) will then be set by the market. It should be determined by the cost of the marginal abatement needed to reach the cap (i.e., as emitters approach the cap, abatement costs rise and so emitters should be willing to pay more for a permit). By setting an emissions cap (which is usually set to reduce each year), the amount of emissions reductions can be measured with accuracy. However, as abatement costs are not fully known before setting the emissions cap, the actual carbon price is uncertain.

Often these pricing regimes are not used in isolation and are paired either with one another or with supporting mechanisms. As such, to determine the true “carbon price”, a holistic view of a country’s tax (and reliefs) system must be considered to reach what the OECD have termed an “Effective Carbon Rate”.

In 2002, the UK established Europe’s first ETS which served as a prototype for the EU-ETS; London has remained at the forefront of emissions trading ever since. Currently, the UK supplements the market price set on the EU-ETS with a domestic carbon price support. In effect, the regime uses a carbon tax (known as the Carbon Price Floor) to establish a minimum price that emitters pay irrespective of the ETS permit price. As the OECD have noted, this “guarantees a minimum return on clean investment” which incentivises risk averse emitters to invest in green carbon alternatives.

Although the UK Government has signalled its commitment to maintaining a carbon price after Brexit, it remains unclear exactly how the price will be implemented. The preferred approach of the Government (and a large proportion of stakeholders) is a UK-ETS which is linked to the EU-ETS. However, as time runs out to cut a deal, the likelihood of linking the two systems is reducing.  This could risk leaving an un-linked ETS which may result in unwelcome price instability and carbon leakage. As such, the Government is also considering the implementation of a standalone carbon tax; its consultation paper closed for comments at the end of September and the Government response is expected soon.  As ever, the details remain unclear.