Types of carbon pricing
Markets to trade carbon
Carbon price calculation
Understanding the price
Effects of regulation
What is coming next?
How can we help?
A price on carbon shifts the burden for the costs associated with climate change on those who are responsible for it. This blog explores the fundamentals of carbon pricing and how different carbon pricing mechanisms can push companies to reduce their emissions to achieve supply chain decarbonization.
What is carbon pricing?
As defined by the World Bank, carbon pricing is a tool that captures the external costs of greenhouse gas (GHG) emissions and ties them to their sources through a price, usually in the form of a price on carbon dioxide (CO2) emitted. A key aspect of carbon pricing is the principle that the “polluter pays.” By putting a price on carbon, society can hold emitters responsible for the costs of adding GHG emissions to the atmosphere. Examples of some of these external costs to society include polluted air, warming temperatures, rising health care costs,and damage to crops from heat waves and droughts, and loss of property from flooding and rising sea levels.
What are the main types of carbon pricing?
A range of approaches to carbon pricing has enabled governments, institutions, and businesses to choose the method best suited to the broader policy context.
- An emission trading system (ETS) allows emitters to trade emission units to meet certain GHG emission targets. To comply with their emission targets at minimal cost, regulated entities can either implement internal abatement measures or buy emission units in the carbon market. An ETS establishes a market price for GHG emissions, this can be through cap-and-trade or baseline-and-credit.
- A carbon tax directly sets a price on carbon by defining an explicit tax rate on GHG emissions or on the carbon content of fossil fuels. For example, a price per tonne of CO2 equivalent (CO2e). Carbon tax tool provides certainty about price because the price per tonne of CO2e is fixed; but the extent of emissions reduction is less certain.
- A crediting mechanism (also known as an offset mechanism) designates GHG emission reductions from project or program-based activities, which can be sold either internationally or domestically. Entities seeking to lower their emissions can buy the credits as a way to offset their actual emissions. This approach requires a formally recognized third-party verifier to sign off on the emission reduction before it is credited.
- Internal carbon pricing is a tool an organization uses internally to guide its decision-making process in relation to climate change impacts, risks, and opportunities. This approach stimulates investment in low-carbon technologies and prepares institutions to operate under future carbon restricting policies and regulations. Internal carbon pricing can be divided into two types:
- Shadow price on carbon use is when a hypothetical cost of carbon is determined for a companies’ activities. This price is calculated and allocated with the goal of managing risk and identifying opportunities in operations, projects, and supply chains to lower emissions.
- Internal carbon fee is when companies charge internal business units for emissions. The fees that are paid are then directed back into greener projects, for example investments in renewable energy technology.
What markets exist today to trade carbon?
Carbon prices can be categorized into either compliance carbon markets (CCMs) or voluntary carbon markets (VCMs), which are significantly different from each other in terms of regulations, impact, and market size.
In CCMs, or involuntary carbon markets, governments set a limit on how many tonnes of emissions certain sectors can release. This is mainly in oil, transportation, energy or waste management sectors. Instead of a fixed price for each tonne of carbon emitted, emitters are required by law to purchase special allowances or permits at a government auction or trading market to cover all of their reported emissions. For example, if a company goes over the prescribed emissions limit, it must buy or use saved credits to stay under the emissions cap. If a company stays under that cap, it can save or sell those credits.
In VCMs, individuals, companies or governments can buy carbon credits on a voluntary basis to offset carbon emissions that come from industrial production, delivery vehicles or travel, with the aim of achieving carbon compensation or neutralization. A carbon credit can be described as a permit that represents one tonne of CO2e removed from the atmosphere or avoided. Carbon credits in unregulated VCMs can be created through projects that reduce, avoid, destroy or capture emissions, for example, forestry practices.
According to research by the World Bank, as of May 2022, there were 68 direct carbon pricing instruments operating (36 carbon taxes and 32 ETSs) in operation globally and this number is predicted to grow. The largest carbon compliance markets are in the European Union, where the EU ETS covers emissions from factories, power plants and other installations in 30 countries, resulting in coverage of around 40% of the EU’s GHG emissions. Other national initiatives include ETSs in China, Australia, Mexico, and Canada. On the voluntary side, a recent report from the World Bank showed that annual voluntary carbon market value exceeded 1 billion USD for the first time this year, driven by corporate commitments. The Taskforce on Scaling Voluntary Carbon Markets (TSVCM), estimates that the market for carbon credits could be approximately 50 billion USD as soon as 2030 (S&P Global, 2021).
How are carbon prices calculated?
The price of carbon varies widely. Assigning prices to carbon is not straightforward due to the wide variety of carbon trading mechanisms in the market and the number of factors influencing the price.
In compliance markets, pricing is calculated based on local economies and systems as credits are sold and traded in the same way as stocks. With carbon taxes, a government sets controlled prices that are not subject to changes in the marketplace. In voluntary markets, the nature of the underlying project is one of the main factors affecting the price of the credit. Carbon credits can be grouped into avoidance or removal projects. Removal credits tend to trade at a premium to avoidance credits, because of the higher level of investment required by the underlying project and also due to the high demand for this type of credit. The price of carbon is also influenced by the volume of credits traded at a time, the geography of the project, its age, and the delivery time (S&P Global, 2021).
Determining the ‘correct’ price on carbon has proven a challenge. A critique of existing carbon pricing systems has been that their price is too low to effectively reduce emissions. Research has shown that carbon pricing covers 23% of global GHG emissions (World Bank, 2022). However Joseph Stiglitz and Nicholas Stern (who lead the High-Level Commission on Carbon Prices) found that most pricing initiatives remain below $40-80 USD/tCO2e, an estimated range that needs to stay consistent to achieve the global temperature goal of the 2015 Paris Agreement.
Why is it important to understand the price?
Reports from the Intergovernmental Panel on Climate Change (IPCC) warn of dangerous effects of global warming on agriculture, water resources, ecosystems, and human health if countries do not take action. If adequately designed and implemented, carbon pricing tools can play a key role in the transition to a low-carbon global economy.
Despite this urgent need, according to the World Bank, only 4% of emissions in carbon pricing initiatives around the globe are being priced at a level consistent with what the current ‘optimal’ price would be. Understanding the wide range of pricing and nuances amongst different mechanisms provides insight into how carbon prices differ and are clearly underpriced within both VCMs and CCMs. It is important to understand carbon pricing and the difference between the types of carbon pricing so standards are further refined to help reach ‘optimal’ market prices and so these tools are used correctly and with integrity in the private sector.
Furthermore, internal carbon pricing structures can enable ESG integrated business planning and help align incentives for balancing both carbon metrics and financial metrics in the supply chain planning sphere. Increasingly, the private sector is finding innovative ways to use internal carbon pricing as a powerful tool to identify greater opportunities for GHG mitigation, reduce climate-related financial risks and work towards achieving net-zero emissions targets (CDP, 2019). By assigning a shadow price to monetize the GHG emissions associated with a decision, companies can see how much emissions are costing their business and this can become an immediate incentive to lower emissions or continue to pay an increasing price for them.
How can regulation affect business?
Carbon pricing is already here, and effective regulations around paying a price for polluting are becoming more prevalent. For example, carbon taxes are increasingly being implemented to directly price the CO2 emissions that businesses emit to drive towards a low carbon economy. Furthermore, a report released this year from the World Bank, shows that cross-border approaches to carbon pricing are increasingly gaining traction. For example, the EU moved closer to adopting its Carbon Border Adjustment Mechanism (CBAM), and Canada and the UK are exploring options for similar mechanisms (World Bank, 2022), some countries have welcomed the idea of adopting international climate groups, including the proposed US-EU Carbon-Based Sectoral Arrangement on Steel and Aluminum Trade. The International Monetary Fund (IMF) and World Trade Organization (WTO) are also advocating for an international carbon pricing floor (minimums through fixed prices). These approaches illustrate the momentum to prevent carbon leakage (a situation where a company moves their production from a country with strict climate policies to a country that is more lenient, leading to an increase in total GHG emissions) and encourage mitigation beyond national borders. There is a general consensus that these approaches to carbon pricing will have significant implications and restrictions for businesses trading and sourcing materials internationally.
Carbon pricing offers opportunities for both companies and governments. However, governments have the challenges of implementing carbon price mechanisms and harmonizing their interaction, preventing double-counting and maximizing their mitigation effect.
As awareness and support increases around carbon pricing policies, analyses show that carbon pricing could lead to significant costs for businesses. As a result of regulation (e.g., carbon taxes or caps on their emissions), businesses either are or will increasingly have to discontinue high-emitting activities, reduce emissions or continue business as usual and pay an increasing price for their emissions. They will need to design more carbon-efficient production to continue to be competitive. Businesses will also need to proactively prepare and position themselves to be agile when confronted with this changing regulatory landscape. For example, starting with the measurement and accounting of carbon emissions can enable companies to pivot more effectively in response to tightening restrictions.
What is coming next?
While there are few barriers to entry, the lack of transparency in transactions and insufficient understanding of carbon pricing mechanisms have prevented many potentially interested players from participating in voluntary carbon markets and internal carbon pricing. However, significant increases in corporate climate commitments, with initiatives such as the SBTi encouraging the private sector to set science based emission reduction targets has driven investment from the private sector and pushed regulators to scale and standardize operations.
Carbon pricing initiatives continue to be fine-tuned, adapting to new circumstances, and incorporating lessons learned. Existing carbon pricing initiatives are evolving based on learnings from past experiences and upcoming initiatives are improving in design. Recent movements that have aimed to bring together carbon pricing measures such as revisions of Article 6 of the Paris Agreement at COP 26 in 2021 present a promising future for international carbon markets, especially for ‘hard to abate’ emissions. The adoption of rules under Article 6 alongside emerging governance frameworks that seek to promote integrity and clarity in an increasingly complex and diverse market suggests that carbon markets will soon be able to attract new entrants and increase in size.
Existing political challenges in adopting and expanding carbon pricing have also been affected as global oil and gas prices have risen, putting pressure on individual household budgets. In the next phases of policy development, ensuring carbon pricing is fair will be crucial in building and maintaining public support. The long-term outlook and contribution of carbon pricing mechanisms toward the net-zero transition remains constructive, where carbon pricing has vast potential of being a key driver for businesses to start their journey towards decarbonization.
How can we help?
It is clear that regulatory, customer, and investor requirements are rapidly increasing relative to the urgent need to address climate change within supply chains. International governments are working towards improving the durability of current carbon pricing mechanisms and this will have a significant impact on pushing supply chain decarbonization forward. If companies want to remain relevant, they need to engage in sustainable supply chain planning.
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- Adler, K., Brooks, C. (2021). IHS Markit: COP26: Article 6 rulebook updated, but remains work in progress.
- CDP (2022). Carbon Pricing Connect. https://www.cdp.net/en/climate/carbon-pricing/carbon-pricing-connect
- EDF.org (2022). How Cap-and-Trade Works.
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- IPCC (2022): Climate Change 2022: Impacts, Adaptation, and Vulnerability. Contribution of Working Group II to the Sixth Assessment Report of the Intergovernmental Panel on Climate Change. Cambridge University Press. In Press. https://www.ipcc.ch/report/sixth-assessment-report-working-group-ii/
- Nordeng, A. (2022). Refinitiv: Carbon trading: Exponential Growth on Record High.
- South Pole (2022). The voluntary carbon market: eight things to know for the year ahead.
- SBTi (2021) From Ambition to Impact Report: How Companies are reducing Emissions at Scale https://sciencebasedtargets.org/resources/files/SBTiProgressReport2020.pdf
- United Nations (2015) The Paris Agreement. https://unfccc.int/files/essential_background/convention/application/pdf/english_paris_agreement.pdf#page=9
- World Economic Forum (2021) Net-Zero Challenge: The supply chain opportunity
- World Bank (2022). Carbon Pricing Dashboard. Washington, DC: World Bank.
- World Bank (2021). Carbon Prices now apply to a fifth of greenhouse gasses. Washington, DC: World Bank.
- World Bank (2022). Countries on the cost of Carbon Markets. Washington, DC: World Bank.
- World Bank. (2022). State and Trends of Carbon Pricing 2022. Washington, DC: World Bank.
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o9 SolutionsThe Digital Brain Platform
o9 Solutions is a leading AI-powered platform for integrated business planning and decision-making for the enterprise. Whether it is driving demand, aligning demand and supply, or optimizing commercial initiatives, any planning process can be made faster and smarter with o9’s AI-powered digital solutions. o9 brings together technology innovations—such as graph-based enterprise modeling, big data analytics, advanced algorithms for scenario planning, collaborative portals, easy-to-use interfaces and cloud-based delivery—into one platform.