Carbon Pricing: Can We Put a Price on Emissions?
18 minute read
Updated on Sat May 29 2021
Climate change will result in huge costs for future generations. However, future costs are not normally included in the prices of products or services that contribute to climate change (remember negative externalities from chapter 1).
To address this, and to make emission reductions happen, some people suggest that we should put a price on our goods and services that reflect their true cost to society. This is where carbon pricing comes in.
- They can continue emitting as usual and pay up, which increases their costs
- Or, they can find a way to reduce their emissions and then don’t have to pay
The benefits of carbon pricing
There are two main ways of pricing carbon:
Let’s look at these one by one...
Charging money for every tonne of carbon emitted results in the prices of goods and services going up. Costs for energy production companies will increase due to the tax they now pay. These companies won’t want to lose profits so are likely to pass on this “extra cost” to consumers by raising electricity prices.
Energy and transport largely rely on fossil fuels, so would bear the brunt of the carbon tax. But because almost all other sectors need energy and transport too, the tax would affect the entire economy.
As well as decreasing demand for energy, a carbon tax also leads to the substitution of high carbon fuels with cleaner energy sources. This is known as the substitution effect, because individuals substitute more expensive goods for cheaper ones due to the tax.
Problems with a Carbon Tax
Although a carbon tax guarantees a price on emissions, it cannot guarantee any specific level of CO₂ reductions. This is because we don’t know whether companies will reduce their emissions, or choose to pay the tax instead.
Money can be given back to poorer households by direct payments or by cutting other taxes for them. This way, carbon taxes can actually help reduce inequalities that would otherwise be made worse by the tax. This type of carbon tax is called a revenue-neutral carbon tax.
Carbon taxes can be a relatively cheap way to reduce emissions, but their effects will depend on how they are designed. This may need adjusting for different countries, too. So, how else can we put a price on carbon?
Emission trading systems
If a company expects to produce more emissions than they have permits for, they have to purchase extra permits from other companies. Companies producing fewer emissions than their permits allow can sell their permits to other companies that emit more.
This is why the system is also known as ‘cap-and-trade’: the total emissions are capped and companies can trade the permits between each other.
Unlike the carbon tax, carbon permits do not have a fixed price; instead, they depend on the balance between supply and demand. Supply is the number of ‘carbon permits’ available for sale, while demand is the total emissions being produced. This means that the price can go up and down.
However, provided the limit is chosen well, an emissions trading system is a good way to make sure that emissions reductions will happen. Unlike the carbon tax, this is guaranteed because of the limit on the number of carbon permits available.
So, carbon pricing is one way to include the cost of CO₂ emissions in our economic system. Both carbon taxes and emission trading schemes can actually be implemented simultaneously.
However, it is not easy to implement due to the need for companies to accurately monitor and report their emissions. These reports also need checking by another organisation (so companies don’t cheat), all of which needs money and people.
As with all the policies we have looked at in this course, a carbon tax will only be part of the solution. We will still need improvements in technology, green investment and plans for emission reductions too. Nonetheless, putting a price on carbon is an efficient way to help achieve targets to reduce emissions.Next Chapter