As stated by the International Energy Agency (IEA), carbon pricing is a valuable instrument in the policy toolkit to promote clean energy transitions. By internalising the societal cost of greenhouse gas emissions, carbon pricing can stimulate investments in low-carbon technological innovations, foster multilateral co-operation and create synergies between energy and climate policies; emissions trading systems offer one possible design for carbon pricing schemes.
Moreover, where emissions are capped, trading systems create certainty about the allowed emissions trajectory, while allowing carbon prices to fluctuate. Emissions trading systems create incentives to reduce emissions where these are most cost-effective.
Furthermore, sub-national, national and supranational jurisdictions have shown increasing interest in emissions trading systems as a policy instrument to achieve climate change mitigation goals.
Direct carbon pricing mechanisms
According to the IEA, emissions trading systems are market-based instruments that create incentives to reduce emissions where these are most cost- effective, allowing the market to find the cheapest way to meet the overall target.
It is important to mention that policy makers can set a cap for an emissions trading system that would determine the maximum amount of greenhouse gases that can be emitted in the sectors covered by the trading system. The cap can be set in different ways, such as an absolute emissions reduction target (also called a “mass-based” cap) or a relative emissions reduction target (often called a “rate-based” or “intensity-based” cap.
Defining the role of an emissions trading system
A fundamental concept for policy makers in designing an emissions trading system is its role; the role concerns what the system is designed for and expected to do.
An emissions trading system could be intended to either drive emissions reductions as its principal role, or provide a backstop for other policies; however, in practice, the system may function somewhat differently than intended.
The system could end up functioning as a means to raise revenue for investing in further emissions reductions projects, or in sectors other than those covered by the system. Defining the role offers a chance for policy makers to consider the expected outcomes of the system, such as changing business practices and shifting investment decisions.
In an ideal world, a carbon price would play the central, if not singular, role in driving cost-effective emissions reductions. However, in the real world the role of the carbon price is limited by three main factors:
- Jurisdictions face constraints in implementing carbon prices at a level that would send a strong signal throughout the economy, including challenges associated with increasing final energy prices;
- Jurisdictions have multiple objectives that overlap and co-exist with emissions reductions within the energy transitions agenda, such as economic development (including growth of low-carbon sectors), energy access, air quality improvement, energy security and energy affordability. As a result of various constraints and objectives, governments develop packages of policies, of which carbon pricing may be only one (though important) element;
- In the real world, market failures make it difficult for a carbon price signal to get through and play the role it is meant to play.
Also, in many jurisdictions, the role and function of the emissions trading system have also evolved. The function of a system can change as its design elements alter, such as changes in the cap stringency, carbon price levels, sectoral and gases coverage, and allowance allocation method.
Carbon pricing in the public policy and private sector landscape
As stated by the IEA, carbon pricing instruments are often implemented within complex energy and climate policy landscapes that serve many policy objectives. If well designed and implemented, carbon pricing can bring environmental and social benefits and help governments and enterprises to find cost-effective emissions reduction methods.
A price on carbon can affect operation costs, encourage stakeholders to lower emissions and spur technological innovation. In addition to reducing emissions, carbon pricing instruments can facilitate the achievement of complementary energy and environmental goals, such as conserving energy and reducing air pollution; for example, the emissions trading system pilot in Beijing and the carbon tax in Chile are also significantly reducing local air pollution.
Moreover, the implementation of emissions trading systems in certain jurisdictions may also have supported the application of internal carbon pricing for corporate investment decisions. The private sector is increasingly using carbon pricing as an indicator to quantify the financial implications relating to energy transition risks, as part of their climate risk management strategies.
It is important to note that, in particular, the Task Force on Climate-related Financial Disclosures (TCFD) recommends that organisations provide their internal carbon prices as part of the metrics used to assess climate-related risks and opportunities, in line with their strategy and risk management processes.
Nevertheless, private companies, organisations and investors are also using internal carbon pricing more and more as a planning tool to help identify revenue opportunities and risks, as an incentive to reduce costs through energy efficiency, and as guidance for capital investment decisions.
The level, distribution, variation and trends of internal carbon prices could become key drivers for companies to change development plans, investment philosophies and climate governance.
Carbon pricing initiatives from around the world
As of April 2020, there were 61 carbon pricing initiatives around the world already implemented or planned for implementation, including 31 ETS and 30 carbon tax initiatives.
Carbon prices vary widely from scheme to scheme, from less than USD 1 per tonne of CO2 equivalent (tCO2-eq) to USD 127/tCO2-eq (Sweden Carbon Tax). Carbon prices have increased in some regions in recent years, but only 5% of current carbon prices around the world are at levels consistent with emissions pathways that fulfill the Paris Agreement targets and less than 4% are at levels consistent with the emissions pathways of the IEA Sustainable Development Scenario.
Jurisdictions in Asia and the Americas are now the driving forces for the development of new carbon pricing initiatives; 8 new operational initiatives have been launched in the Americas in the past 3 years: carbon taxes or hybrid systems for Alberta, Chile, Colombia, Argentina and Canada at the federal level, and emissions trading systems in Mexico, Massachusetts and Washington State.
In Asia, carbon pricing initiatives have been implemented or are scheduled for implementation in China, Indonesia, Japan, Kazakhstan, Korea, Philippines, Thailand, Singapore and Vietnam, alongside various subnational jurisdictions.
Implementing a carbon price initiative in these regions requires innovation in policy design because their economies are growing and restructuring rapidly, creating significant challenges for determining the emissions cap and price stabilisation (in the case of an emissions trading system), or the optimal price level (for a carbon tax).
Emissions trading systems (ETS) and hybrid ETS operational or scheduled for implementation, 2020, by emissions covered (GHG emissions covered [MtCO2e])
Furthermore, as of April 2020, there were 23 emissions trading systems covering around 9% of global emissions:
- 1 supranational system: the European Union Emissions Trading System (EU ETS);
- 5 national systems: in Kazakhstan, Korea, Mexico, New Zealand and Switzerland;
- 10 systems at regional, provincial or state level: in Alberta, California, Fujian, Guangdong, Hubei, Massachusetts, Nova Scotia, Quebec, the Regional Greenhouse Gas Initiative (RGGI) in the United States and the federal Output- Based Pricing System (OBPS) applied to certain provinces and territories in Canada;
- 7 systems at city level: in Beijing, Chongqing, Saitama, Shanghai, Shenzhen, Tianjin and Tokyo.
In 2021, both China and Germany launched the China National ETS and the National Emissions Trading System (nEHS), respectively.
Managing emissions trading system interactions with wider energy transitions policies
As suggested by the IEA, jurisdictions should carefully assess interaction issues between emissions trading system design and other energy-related domestic companion policies, which may include air pollution control, renewable energy, energy conservation, economic restructuring and power sector reform.
A top-down approach for setting the emissions trading system cap could help better align the system with national mitigation objectives, such as nationally determined contributions to the Paris Agreement or other long-term strategies.