Carbon pricing should play a key role in decarbonisation

Solutions that harness the power of markets, like cap and trade systems, will play a crucial role in helping the world to decarbonise, while ensuring minimum increases in costs to businesses and consumers. Along with regulation and new carbon taxes, these systems should be at the heart of policy discussions as the world moves toward net zero. 

One proposal to emerge from COP26 is for a global minimum price on carbon dioxide emissions. Currently only about 20% of global emissions are covered by carbon price caps, mainly in Europe and some US states. Indeed, the UK government has made clear that it sees the UK Emission Trading Scheme (ETS) as a crucial mechanism for reaching net zero by 2050. 

A typical ETS works on the ‘cap and trade’ principle, whereby a cap is set on the total amount of certain greenhouse gases that can be emitted by sectors covered by the scheme, eg aviation and energy. This limits the total amount of carbon that can be emitted and, as the cap decreases over time, should lead to a reduction in total emissions. Participants receive a certain number of free allowances, and if their emissions are below their cap they can sell their allowances at profit to firms that are exceeding their emissions limits. 

There are two reasons why a carbon tax is attractive from an economic point of view. First, it puts at least some of the societal costs of harmful emissions, such as healthcare and climate change, onto the firms responsible for producing them. Firms therefore have an economic incentive to reduce their emissions.

Second, government regulations as to how firms should reduce emissions may be poorly targeted or have unintended consequences. But a carbon price allows firms to reduce emissions in the most economically efficient way, perhaps through investment to reduce their own emissions or by buying carbon allowances from other firms. This should result in the least damage to economic growth while also reducing emissions. 

The EU, including the UK until it left at the start of 2020, has had a carbon pricing scheme for decades. It is only recently that prices have risen to a level where they now have a significant impact on firms’ decision making. Indeed, prices have risen five-fold since 2018. Since May 2021, the UK has had its own Emission Trading Scheme (ETS), which is set to cover about 155m tonnes of CO2 in 2021 – that’s almost half of the UK’s total emissions. And the government has plans to expand the number of firms covered under the scheme. 

Carbon prices will need to stay high, and possibly go higher, to incentivise firms to reach net zero emissions by 2050. In fact, some estimates suggest that the price would need to reach £200 per tonne by 2050 to encourage firms to fund solutions to remove carbon from the atmosphere as well as reducing their own emissions. 

However, the higher the cost of emitting carbon in the UK is, the more incentive there is for firms to move carbon-intensive production elsewhere, undercutting the UK’s competitiveness. This could lead to more emissions if the electricity used is produced by burning coal rather than with renewables or natural gas (as it is in the UK). This is why it is crucial that policy makers commit to establishing a global minimum price for carbon at COP26, in the same way they have committed to a global minimum rate of corporation tax. 

In the absence of a global carbon price, policy makers may instead consider carbon border taxes. These would impose a tariff on imported goods based on how much carbon was emitted during their production. The EU has already said it will introduce a carbon border adjustment mechanism (CBAM), to be phased in over three years from 1 January 2023. EU importers will need to purchase carbon certificates corresponding to the carbon price which would have been paid if goods such as steel, cement and fertiliser had been produced under intra-EU rules. The US is also reportedly considering some sort of carbon border tax.  

Although economists are generally against tariffs on trade, action is clearly needed to help speed the world towards net zero. Emission trading schemes and carbon border tariffs should play a key role in reducing carbon emissions, while minimising economic disruption.