Economic Instruments: Carbon Pricing
Economic(market-based) instruments work by encouraging certain behaviors and practices through economic incentives. They provide the most efficient solution to reducing emissions. Before examining the modalities of market-based instruments, we need to look at a very important concept called an externality.
An externality is a side effect of an activity that affects other people who weren’t involved in it. An externality can be negative or positive. If a factory pollutes the air, people living nearby suffer from the pollution even though they had no say in the factory’s actions. This is a negative externality. If someone plants a garden, neighbors may enjoy the view and fresh air without doing any of the work. This is a positive externality.
Pollution as an economic externality
All environmental pollution, including emissions of greenhouse gases (GHGs), imposes costs on people who did not create the pollution. This is an example of a negative economic externality. It is a consequence or side effect of an action that is not experienced by the individual or entity from which it originates, and that is not reflected in prices.
The damages and associated costs to society that GHGs cause through climate change (e.g., increased extreme weather events, rising sea levels, and loss of biodiversity) are not paid for by the entities that emit those gases, so those costs are not reflected in the market prices of goods and services.
Because polluters do not have to account for the costs associated with the damages that greenhouse gases create, society produces and consumes too many pollution-creating products (like fossil fuels) resulting in additional GHG emissions being put into the atmosphere.
Market-based policies aim to correct this form of market failure1. They do this by constructing systems that cause the “external” costs associated with pollution to be incorporated in the polluting entity’s decision-making. When firms explicitly see and must pay for the societal cost of pollution, they are able to determine how best to meet an environmental objective. Moreover, when prices of products reflect their full environmental costs, consumers also are better able to make informed purchasing decisions.
Command and Control instruments (CCIs) which operate by setting standards may seem effective in delivering a particular emission-reduction objective, but the disadvantage is that they limit the freedom for polluters to choose the method of complying with the regulation. Even if there is some freedom, the imposition of a target on an individual firm provides no incentive for the firm to reduce emissions below the target. Technology-based standards, which are the most widespread form of regulation, are the most expensive form of control. Economic instruments set out to minimise compliance costs by maximising flexibility of response. They set a price (typically in the form of a tax) or a quantity and then leave the producers to decide how they will respond.
For some types of pollutants, it matters that emissions at any particular point or region do not exceed health-related thresholds. For those types of pollutants, command and control regulation is often the appropriate policy response. Because GHGs are not harmful on a localized basis (they are globally mixed in the atmosphere and do damage on a global scale), market-based policies that provide greater compliance flexibility can achieve environmental objectives at lower overall costs.
Carbon pricing is a method to reduce greenhouse gas emissions by assigning a cost to emitting carbon dioxide (CO₂) and other greenhouse gases. The idea is that, by putting a price on carbon, businesses and individuals are financially motivated to reduce their emissions and switch to cleaner alternatives. The two main types of carbon pricing are carbon tax and emissions trading scheme (cap-and-trade system)
3.1 Carbon tax
The most basic form of a market-based policy is a tax that sets a price on each unit of pollution. By introducing a tax on pollution, the entity producing the pollution incurs an additional cost based on the amount of pollution emitted. Because of this, the entity has an incentive to reduce the pollution produced by changing its processes or adopting new technology. In this way, the tax provides a continuous incentive for innovation; the more emissions can be reduced, the less tax a company would pay. Ideally, the cost of the tax would be set equal to the cost to society2 that the pollution creates.
This idea was first developed by Arthur Pigou in 1920, through what is now called the Pigouvian tax3. He introduced the idea of externalities and that external issues could be corrected by introducing a charge. This forms the basis of carbon tax. If someone is creating a negative externality, such as pollution, they are engaging in too much of the activity that generated the externality, and should pay.
A carbon tax directly sets a price on carbon (hence why it is ‘price-based’) by defining a tax rate on greenhouse gas emissions or on the carbon content of fossil fuels. For example, a government may charge companies €50 per ton of CO₂. This tax directly increases the cost of fossil fuels, encouraging companies and consumers to use less or switch to cleaner energy sources.
Carbon taxes in Europe
Finland was the world’s first country to introduce a carbon tax, in 1990. Since then, 23 European countries have implemented carbon taxes, ranging from less than €1 per metric ton of carbon emissions in Ukraine to more than €100 in Sweden, Liechtenstein, and Switzerland4.
Switzerland and Liechtenstein currently levy the highest carbon tax rate at €122.87 per ton of carbon emissions, followed by Sweden (€118.35) and Norway (€99.01). The lowest carbon tax rates can be found in Poland (€0.09) and Ukraine (€0.72).
Implementing a carbon tax system offers several benefits. First, It raises important revenue for governments, that can be spent on mitigating the effects of pollution and climate change. In Ireland for example, carbon tax revenues are used to finance green initiatives and other climate-related policies such as home retrofits and addressing energy poverty5. It makes the biggest polluters pay their cost of carbon emissions and encourages firms to look for alternative sources of energy, for example solar power, which are cleaner, promoting a cleaner and more sustainable economy6.
One of the major drawbacks of a carbon tax system is that it could discourage investment and economic growth, as firms may decide to shift production to countries without carbon taxes. Additionally, accurately measuring carbon dioxide emissions and, consequently, determining the appropriate tax can be challenging. There is also a risk that companies might attempt to bypass regulations, secretly polluting and avoiding tax payments in the process.
3.2 Emissions trading scheme (cap-and-trade system)
The cap-and-trade system is ‘quantity based’. Instead of setting a price on each unit of pollution, the regulatory authority determines a total quantity of pollution (a “cap”) that will be allowed. Companies buy and sell emission allowances 7 based on their needs, while others are offered for free (grandfathering) according to actual historical emissions. The limited number of these allowances creates scarcity. The requirement that regulated businesses hold enough allowances to cover their emissions ensures the cap is met and creates demand for the allowances.
If it is less costly for a company to reduce emissions than to buy allowances, the company will reduce its own emissions. If a company can reduce emissions below its requirements, so it has excess allowances, those allowances can then be banked for future use or sold in an open market to a firm that finds it more difficult (costly) to reduce emissions.
Because there is a scarcity of allowances and businesses can trade them, the allowances are valuable and lead to a price on greenhouse gas emissions. This price provides a continuous incentive to reduce emissions and innovate since firms can save money if they reduce their emissions and avoid buying allowances. Some firms may actually be able to raise revenue by selling their excess allowances.
So whereas a tax sets a price (the tax) and leaves the polluter to adjust the quantity (the level of emissions), a tradable permit system sets a quantity (a quota of emission permits), and the price (the price of the permit) adjusts according to the resulting supply and demand for permits.
The EU emissions trading scheme
The EU emissions trading scheme (ETS) was launched in 2005 and was the world’s first carbon market and among the largest ones globally. It operates in all EU countries plus Iceland, Liechtenstein and Norway. It requires polluters to pay for their greenhouse gas (GHG) emissions. Since 2013, the EU ETS has raised over EUR 175 billion8.
The EU ETS covers carbon dioxide (CO2) from i) electricity and heat generation, ii) energy-intensive industry sectors, including oil refineries, steel works, and production of iron, aluminium, metals, cement, lime, glass, ceramics, pulp, paper, cardboard, acids and bulk organic chemicals, iii)aviation within the European Economic Area and departing flights to Switzerland and the United Kingdom and iv) maritime transport, specifically 50% of emissions from voyages starting or ending outside of the EU and 100% of emissions from voyages between two EU ports and when ships are within EU ports. It also covers nitrous oxide (N2O) from production of nitric, adipic and glyoxylic acids and glyoxal, and perfluorocarbons (PFCs) from the production of aluminium.
The EU ETS cap is expressed in emission allowances with one allowance giving right to emit one tonne of CO2 eq (i.e., carbon dioxide equivalent). This cap is reduced annually in line with the EU’s climate target, ensuring that overall EU emissions decrease over time. By 2023, the EU ETS had helped bring down emissions from European power and industry plants by approximately 47%, compared to 2005 levels. Allowances are sold in auctions and may be traded. As the cap decreases, so does the supply of allowances to the EU carbon market.
Under the system, companies must monitor and report their emissions on a yearly basis and surrender enough allowances to fully account for their annual emissions. If these requirements are not met, heavy fines are imposed.
While allowances are predominantly sold in auctions, companies receive some allowances for free. They may also trade allowances among themselves as needed. If an installation or operator reduces emissions, the company can either sell the spare allowances and/or keep them to use in the future.
The EU ETS revenue primarily flows to national budgets and member states must use it to support investments in renewable energy, energy efficiency improvements and low-carbon technologies that help reduce emissions. Furthermore, a share of the EU ETS revenue supports low-carbon innovation and the EU’s energy transition.
The choice between carbon taxes and ETS
Both ETS and carbon taxes follow the ‘polluter pays’ principle. They impose an explicit price on carbon, encouraging producers and consumers to internalize part of the social cost of GHG emissions. This helps to make low-carbon alternatives more attractive, changing consumption patterns and supporting low-carbon investments. They are also both cost effective. A carbon price does not tell people what actions they must take to reduce emissions. Rather, individuals and companies decide how best to respond to the price. This means that across the economy, both an ETS and a carbon tax can achieve more reductions for the same cost than other climate policies. Moreover, they can generate revenue. Like other taxes, a carbon tax will raise public revenues, even as it discourages polluting behavior. An ETS that auctions allowances can also generate revenues. Carbon pricing revenues can be used, for example, to invest in climate and energy measures, finance tax reforms, pay down public debt, support social programs, or to compensate households9.
One of their major differences is that by setting a cap, an ETS determines the total amount of emissions permitted and thereby assures the mitigation outcome of the policy, while the carbon price is determined by market dynamics. As a result, the carbon price in an ETS fluctuates depending on the demand and supply of allowances. The price may be higher when the economy is booming and lower during a downturn. In contrast, a carbon tax provides price certainty but the resulting mitigation outcome cannot be set. Moreover, a carbon tax can be easier to implement as it uses the established channels of the tax system and does not require new infrastructure for trading allowances. However, an ETS provides more flexibility: for example, provisions such as offsetting, banking, and limited borrowing give covered entities options for when and where to reduce emissions. Finally, there is the potential to extend ETS across borders by linking with other systems, which is not possible with a carbon tax.
With the exception of Switzerland, Ukraine, and the United Kingdom, all European countries that levy a carbon tax are also part of the EU ETS.
Footnotes
A market failure happens when the free market, on its own, doesn’t allocate resources efficiently, leading to a loss of overall economic value. This means that the market fails to produce the best possible outcome for society. It occurs when individual or business decisions don’t lead to a socially beneficial result. For instance, if companies pollute because they don’t bear the full costs of cleaning up, they produce more pollution than is good for society. This is a classic case of market failure due to a negative externality.↩︎
Assessing the cost to society from pollution is often difficult. While some damages caused by pollution are relatively easy to estimate in monetary terms, others are much more challenging to quantify. For example, if pollution causes a reduction in the fish population for a commercial fishery, we can estimate the damages based on the lost value of the fish at market prices. If, however, wetlands are destroyed or a species becomes extinct, it is not clear how society should assign a specific economic value to that loss.↩︎
tradable certificates that allow a certain amount of emissions↩︎