Carbon pricing is a policy tool to lower emissions of carbon dioxide (CO2) and other greenhouse gases. Emissions are produced when fossil fuels are burned to do things like make electricity, fuel vehicles, make materials and products, and heat and cool homes. These emissions are the main cause of climate change, resulting in flooding, sea-level rise, drought, heatwaves, and other costs to society.
Currently, the public bears the costs of these impacts. The goal of carbon pricing is to shift the responsibility for these costs to those who produce the emissions. When producers and consumers have to pay for each ton of CO2 they emit, they have an economic incentive to shift away from fossil fuels, improve their energy efficiency, and invest in low-carbon technology.
How to Set a Carbon Price
In theory, a carbon price should be equal to the “social cost of carbon.” For example, if one ton of CO2 emissions costs the public $100, it should cost $100 to emit that ton of CO2. However, that price is very hard to determine, so often carbon prices are instead set at levels that policymakers think will help them meet certain emission or temperature targets.
There are two main approaches to carbon pricing: a carbon tax and a cap-and-trade system.
The two types of carbon pricing
A carbon tax directly sets a price per ton of emissions. The resulting fall in emissions then depends on how much emitters change their behavior in response to the tax.
A cap-and-trade system (or emissions trading system) sets the total amount of emissions that can be released. Then the government issues a limited number of emissions permits, either by giving them away freely to emitters, or through an auction. For each ton of emissions released, the emitter must have a permit. Permits can be traded, so emitters who can’t cost-effectively lower their emissions must buy extra permits from emitters who can. The resulting carbon price then depends on the supply and demand for permits.
Both approaches give emitters strong incentives to invest in reducing their emissions, either to lower their tax bills, or to lower the cost of buying permits. Both approaches can also raise revenue for the government, through taxes or through the auction in a cap-and-trade system. That revenue can be given back to taxpayers, especially low-income taxpayers, to help them pay for energy and other goods, which usually become more expensive as a result of the carbon price. The revenue can be used for other purposes as well, such as investing in low-carbon technologies or infrastructure or training workers for green jobs.
Advantages of Carbon Pricing
Many economists and policymakers consider carbon pricing one of the best available tools to combat climate change. That’s because carbon pricing can touch every part of the economy, from electricity to manufacturing to transportation, and because it rewards any behavior that reduces greenhouse gas emissions. Rather than regulating exactly where and how emissions should be reduced, carbon pricing gives markets the flexibility to find the cheapest ways to lower emissions. Several states, countries and regions around the world already use carbon pricing, including the European Union, China, California, and a group of states in the Northeast United States called the Regional Greenhouse Gas Initiative.
Updated January 11, 2022.
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