Carbon Pricing 101 (original) (raw)

How does carbon pricing work?

There are broadly two ways to put a price on carbon:

Under a cap-and-trade program, laws or regulations would limit or ‘cap’ carbon emissions from particular sectors of the economy (or the whole economy) and issue allowances (or permits to emit carbon) to match the cap. For example, if the cap was 10,000 tons of carbon, there would be 10,000 one-ton allowances. A declining emissions cap would help reduce emissions over time.

Every source of emissions subject to the cap (for example, power plants or refineries) would be required to hold allowances equal to the emissions they produce. Power plant operators could acquire allowances through an auction (where they bid for the allowances they need) or allocation (where they are given a set number of allowances for free).

Once these entities have allowances, they would be able to trade or sell allowances freely among themselves or other eligible market participants. Because the allowances are limited and therefore valuable, those subject to the cap will try to cut their emissions as a way to reduce the number of allowances they have to purchase. The resulting interaction between the demand and supply of allowances in the market determines the price of an allowance (also known as the carbon price).

With a carbon tax, laws or regulations are enacted that establish a fee per ton of carbon emissions from a sector or the whole economy. Owners of emissions sources subject to the tax would be required to pay taxes equivalent to the per-ton fee times their total emissions. Those who can cut emissions cost-effectively would reduce their tax payments. Those subject to the tax would have an incentive to lower their emissions, by transitioning to cleaner energy and using energy more efficiently. A rising carbon tax would help ensure a decline in emissions over time.

Hybrid approaches include programs that limit carbon emissions but set bounds on how much the price can vary (to prevent prices from dropping too low or rising too high). Another hybrid approach adjusts the tax to ensure specific emission reduction goals are met. A third hybrid approach could be when a jurisdiction implements a carbon cap-and trade program for some sectors and applies a carbon tax on others. Carbon pricing programs can also work in a complementary manner with other renewable energy and energy efficiency policies, such as renewable electricity standards, energy efficiency standards, and vehicle fuel economy rules.

Gasoline taxes, severance taxes for coal mining and natural gas or oil drilling, or policies that incorporate a social cost of carbon are examples of other ways of indirectly factoring a price on carbon into consumer or business decisions.

From an economic perspective, both carbon tax and a cap-and-trade systems function in equivalent ways: one sets a price on emissions which then determines the level of emissions, the other sets the level of emissions, which determines a price for those emissions. The level of the tax or cap and its rate of increase (for a tax) or decline (for a cap) over time drives the degree to which emissions are cut. Designed well, both of these approaches can deliver on the main aim of a robust carbon pricing program, which is to help cut emissions cost-effectively in line with climate and energy goals. However, there may be important policy or political reasons to prefer one or the other in a particular context, such as voter preferences or limits on regulatory or legislative authority.