What is carbon price and why do we need one?

Carbon price is a cost applied to carbon emissions, in order to encourage emitters to reduce the amount of greenhouse gas they emit into the atmosphere. Economists and policy makers broadly agree that introducing a carbon price is the most effective way for countries to reduce their emissions.

Climate change is considered a market failure by economists, because it imposes huge costs and risks on future generations who will suffer the consequences of climate change, without these costs and risks normally being reflected in market prices. To overcome this market failure, they argue that we need to internalise the costs of future environmental damage by putting a price on the thing that causes it – namely carbon emissions.

A carbon price not only has the effect of encouraging lower-carbon behaviour (eg. using a bike rather than driving a car), but also raises money that can be used in part to finance a clean-up of “dirty” activities (eg. investment in research into fuel cells to help cars pollute less).

There are two main ways to establish a carbon price.

One: Carbon Tax

First, a government can levy a carbon tax on the distribution, sale or use of fossil fuels, based on their carbon content. This has the effect of increasing the cost of those fuels and the goods or services created with them, encouraging business and people to switch to greener production and consumption.

Two: Cap and Trade

The second approach is a quota system called cap-and-trade. In this model, the total allowable emissions in a country or region are set in advance (“capped”). Permits to pollute are created for the allowable emissions budget and either allocated or auctioned to companies. The companies can trade permits between one another, introducing a market for pollution that should ensure that the carbon savings are made as cheaply as possible.

To serve its purpose, the carbon price set by a tax or cap-and-trade scheme must be sufficiently high to encourage polluters to change behaviour and reduce pollution in accordance with national targets. For example, the UK has a target to reduce carbon emissions by 80% by 2050, compared with 1990 levels, with various intermediate targets along the way. The government’s independent advisers, the Committee on Climate Change, estimates that a carbon price of £30 per ton of carbon dioxide in 2020 and £70 per tonne in 2030 would be required to meet these goals.

As of 2020, both the above mechanisms have been tried out in many countries, with varying success. Neither of these has however brought down, on their own or together, the CO2 emissions worldwide to a level that will lower temperatures to the desired targets.