What is carbon pricing?

Carbon pricing is “government policy that puts a price on carbon emissions” in the form of a tax or a market-based mechanism such as cap and trade1 with the intent of incentivizing emitters to reduce their greenhouse gas (GHG) emissions.2 In the process, it attempts to correct a market failure: lack of economic incentives for businesses and consumers to reduce GHG emissions because they are an externality, a side-effect of use of fossil fuels that results in many impacts/costs borne by those not producing and using them, such as future generations and those in developing countries.2 These costs are called “negative externalities” because the production and use of carbon-based fuels has costs that are not entirely reflected in the prices of the fuels.3 In 2006, the Stern Review on the Economics of Climate Change concluded that climate change is “the greatest and widest-ranging market failure ever seen.”4

Carbon pricing incorporates some of the costs of potential climate change-related damages by putting a price on the product that has been shown or expected to cause climate change i.e. carbon-based fuels.2 As a result of the externalities being to some extent assimilated into the production and use of carbon-based fuels, it is expected to encourage lower-carbon behaviour and generate revenue that can be used to fund development and use of low carbon technology, or to reduce the cost borne by individuals/households and/or corporations by providing dividends or reducing personal and/or corporate taxes.1,2 Thus, the costs of mitigating climate change effects are spread across generations.2

There are two main mechanisms of carbon pricing: carbon tax and cap and trade. For more information on these mechanisms and their variations, see Carbon Pricing Options page.

Carbon pricing is widely acknowledged by economists to be the most cost efficient way of reducing our greenhouse gas emissions. In the “Effective Carbon Prices” study, the Organisation for Economic Co-operation and Development (OECD) concluded that carbon pricing i.e. carbon taxes and cap and trade are the most cost-effective ways of reducing greenhouse gas emissions.5 Similar conclusions have been drawn by the International Monetary Fund and the World Bank.6

References:

1.    Environmental and Energy Study Institute. Fact Sheet: Carbon Pricing around the World | Environmental and Energy Study Institute. (Environmental and Energy Study Institute, 2012). at http://www.eesi.org/fact-sheet-carbon-pricing-around-world-17-oct-2012

2.   Institute, G. R. & Clark, D. What is a carbon price and why do we need one? The Guardian (2012). at http://www.theguardian.com/environment/2012/jul/16/carbon-price-tax-cap

3.   Bowen, A. The case for carbon pricing: policy brief. (Grantham Research Institute on Climate Change and the Environment at the London School of Economics and Political Science and The Centre for Climate Change Economics and Policy, 2011). at http://www.lse.ac.uk/GranthamInstitute/publications/Policy/docs/PB_case-carbon-pricing_Bowen.pdf

4.   Stern, N. Stern Review on the Economics of Climate Change. (HM Treasury, 2006). at http://webarchive.nationalarchives.gov.uk/+/http:/www.hm-treasury.gov.uk...

5.    Organisation for Economic Co-operation and Development. Effective Carbon Prices. (Organisation for Economic Co-operation and Development, 2013). at http://www.oecd-ilibrary.org/content/book/9789264196964-en

6.   Milman, O. Carbon pricing most cost-effective way to reduce carbon emissions, says OECD. The Guardian (2013). at http://www.theguardian.com/environment/2013/nov/05/carbon-pricing-best-w...