27 Apr 2022

Carbon pricing explained

What do NEDs need to know about carbon pricing? Explore carbon pricing mechanisms, trends and how businesses can respond.

Carbon pricing checklist: What NEDs need to know

Understanding carbon pricing

  • Understand the basic rationale for putting a price on carbon and the different types of policy that can do this.
  • Understand national and international carbon pricing trends including new mechanisms, and carbon price increases.

Business implications

  • Assess the likely business impacts of regulatory compliance carbon pricing.
  • Consider how pricing mechanisms abroad or potential carbon border adjustments may influence value chains.

How businesses can take action

  • Ensure that your business is ready for changes to carbon pricing policies and builds them into medium to long-term planning and transition risk analysis.
  • Check whether your business has set an internal or ‘shadow’ carbon price to manage transition risk and whether it is in line with recommendations. If an internal carbon price has not been set, encourage your business to explore this as part of its transition strategy.
  • Determine whether your business could levy an internal carbon fee.

Carbon pricing basics

Many business activities give rise to greenhouse gas emissions. Although the science is clear on the negative impacts of post-industrial emissions, the external cost has not been factored into the price of goods and services. In other words, climate change is a ‘negative externality’ – a cost borne by society but not reflected in market prices. One way of addressing negative externalities is by intervening to put a price on the harms caused by that externality, in this case giving market actors a financial incentive to reduce their emissions. This is the basic rationale for putting a price on carbon.

Carbon pricing usually involves assigning a price per tonne of carbon dioxide or equivalent greenhouse gas (tCO2e) and making emitters pay this price. By making emitting costly, carbon pricing makes low-carbon and negative carbon alternatives more attractive, accelerating the shift towards a net-zero economy. When compared to command-and-control measures such as regulation, carbon pricing policies can have the benefit of ensuring that emissions reductions are economically efficient – firms that can make these reductions most easily will be compelled to shift to low-carbon alternatives most quickly. As a market mechanism, carbon pricing has the benefit of facilitating a market-driven shift to net zero rather than directly controlling business behaviour. There is strong consensus amongst economists that carbon pricing will reduce emissions – while not sufficient to tackle climate change on its own, many consider it the single most effective policy lever for reaching climate targets.

Deciding on the price of carbon to apply is important. One approach is the ‘social cost of carbon’, though there is not a clear consensus as to what this price should be. Another approach is for the government to project the impact of different carbon prices on total emissions and choose a price that is compatible with climate targets. To ensure that emissive practices become progressively less viable, the price of carbon should increase over time either through predetermined increases in the case of taxes, or through reducing the supply of allowances in compliance emissions trading systems. The High-Level Commission on Carbon Prices recommended prices of at least $50-$100 per tCO2e by 2030 to limit global warming to 2C. Of course, compliance carbon prices may actually exceed this level. The Bank of England has warned businesses that carbon prices over $100 may be needed to reach net zero at the required speed, and BP assumes prices of $250 per tonne in developed countries and $175 per tonne in emerging economies by 2050. Although there is strong agreement that carbon pricing is an effective policy lever for fighting climate change, there is often significant political opposition to such policies. For example, after being introduced in 2011, carbon pricing received political backlash in Australia and was subsequently repealed in 2014.

Some worry that carbon pricing will reduce the competitiveness of businesses. However reports from the UK Government, the Carbon Pricing Leadership Coalition, and the OECD find minimal evidence of carbon pricing negatively impacting competitiveness to date. Though there are theoretical concerns about the impact on business costs, it can drive efficiencies and innovation. Some of these concerns about competitive advantages may be mitigated by carbon border adjustments, which are discussed below.

Carbon pricing mechanisms

There are multiple ways of pricing carbon – the two main mechanisms being carbon taxes and compliance emissions trading (or ‘cap and trade’). While different pricing mechanisms should theoretically have the same impact assuming prices are the same, each mechanism operates differently which means there are some practical differences. These mechanisms are not mutually exclusive – some jurisdictions use both carbon taxes and emissions trading to price carbon in different parts of their economy.

Carbon tax Compliance emissions trading

Carbon taxes are levied on greenhouse gas emissions and generally paid by emitters. They are usually set as a price per tonne of carbon dioxide or equivalent greenhouse gas. Implicit carbon taxes are levied on specific goods that produce greenhouse gas emissions, such as fuel.

A common concern with carbon taxes is that they may be regressive – burdening lower income groups by raising the price of common and essential goods. One way to mitigate this issue is through a ‘carbon fee and dividend’ which redistributes the money collected from a carbon tax to lower-income groups. Adding a dividend can make carbon taxes more politically palatable.

Carbon taxes have the advantage of giving certainty of price, can be applied to a wider range of enterprise sizes and sectors, and can be simpler to administer than other mechanisms. However, like other taxes, they are often politically unpopular.

Compliance emissions trading systems are a popular way to limit emissions from the hard-to-abate sectors and determine a market price of carbon. Instead of fixing the price from the outset, governments or groups of governments decide on a limit to the total volume of emissions from their jurisdictions per year. They then issue or auction off ‘allowances’ in accordance with this limit.

Businesses must retire allowances based on the volume of greenhouse gases they emit, and can buy or sell allowances. The market price of one allowance is the price of carbon in a compliance emissions trading system.

In a well-functioning compliance emissions trading system, the environmental impact is more certain. Additionally, emissions trading can be more politically palatable than carbon taxes. However, implementation can be difficult when dealing with market fluctuations, and risks of theft and fraud.


Case study: Canada’s Carbon Pricing System and Federal Fuel Charge Case study: The UK’s Emissions Trading Scheme
In 2019, Canada implemented a federal framework for pricing carbon. The government set a national benchmark carbon price which provinces can meet through either taxes or emissions trading. If a province does not meet this threshold, the government applies a federal tax on emissive fuels. Separately, large emitters also join the Output-Based Pricing System, a form of emissions trading.

Canada’s carbon pricing system is revenue neutral and most families earn back more than they pay through a rebate system. The price is currently set at 50 CAD/tCO2e, and is set to rise to 170 CAD by 2030. The system saw opposition, including an unsuccessful legal challenge, from provinces with large fossil fuel production and manufacturing sectors.

Upon leaving the European Union, the UK also left the EU’s Emissions Trading System and created its own, covering energy-intensive industries, aviation and power generation. The government capped emissions in line with its net zero ambitions – prices have increased since implementation, reaching almost £90 per tCO2e, and have tended to be higher than in the EU ETS.

The government will review the scheme in 2023 and 2028, and plans to consult on new net-zero consistent yearly caps on emissions. It has also indicated the possibility of capturing a greater range of activities and industries in the ETS. The scheme has generally been well-received, though certain energy-intensive industries have requested that the government step in to lower prices.


Pricing emissions from abroad – carbon border adjustments

Carbon border adjustments operate similarly to a carbon tax but impact goods coming from other countries – they are tariffs levied on imports based on their embodied carbon and whether there is a compliance pricing regime in their country of origin. Carbon border adjustments are a way of covering a broader range of activities than domestic measures. In particular, they aim to avoid ‘carbon leakage’, which occurs when emissive activities move abroad in response to domestic climate policies. Carbon border adjustments are a relatively new mechanism, but several governments and coalitions have shown interest in implementing them. Like other tariffs, however, carbon border adjustment mechanisms may cause diplomatic tension, and may be used to disguise protectionism.

Case Study

The EU’s Carbon Border Adjustment Mechanism

In July 2021, the European Commission proposed a ‘Carbon Border Adjustment Mechanism’ (CBAM) as part of its European Green Deal. The mechanism would force EU importers to pay the carbon price that would have been paid had their imports been produced in the EU. The proposal is to initially apply to goods with high risks of carbon leakage, but eventually cover a larger section of the economy. While some countries have indicated that they may adopt a similar mechanism, critics suggest that the CBAM may cause trade disputes or burden developing countries.

Read the Cambridge Institute for Sustainability Leadership’s in-depth analysis here

Offsetting and voluntary carbon markets

Carbon offsetting involves paying for emissions reductions or removals elsewhere, usually in order to account for emissions caused by the purchaser. Voluntary carbon markets primarily involve private actors purchasing and selling credits, but Article 6 of the Paris Agreement laid the groundwork for an international framework for these markets. The main way in which carbon offsetting interacts with compliance carbon pricing mechanisms is through emissions trading. Some trading systems allow firms to meet their obligations to a degree through purchasing and retiring voluntary carbon credits rather than allowances. However, there has been a shift away from allowing some types of voluntary carbon credits. Emissions data or projections from certain credits may not be accurate and sometimes reductions may not even occur for credits that represent avoided emissions. These risks are particularly salient in the case of nature-based offsets. Businesses should consider these potential issues with offsetting regardless of the relevant trading system’s rules. Offsetting should always complement, not replace, action to directly reduce emissions.


Carbon offsetting explained

Read more about opportunities and challenges associated with offsetting in our explainer on the topic


Carbon offsetting explained

How businesses can respond to carbon pricing

Businesses are directly and indirectly impacted by carbon pricing. Businesses in energy-intensive sectors are often covered by emissions trading systems, and many businesses purchase fuel and other products covered by specific carbon pricing measures. Carbon pricing can also impact supply chains both in the UK and abroad, raising the cost of emissive goods and services. This factor may become more pronounced when carbon border adjustments are implemented.

On the whole, since carbon pricing generally aims to cut emissions across the entire economy, most businesses will need to adjust to higher prices for goods and services that cause greenhouse gas emissions and prioritise those with smaller footprints. This means that the level of compliance carbon prices should be a key consideration for businesses looking at transition risk regardless of whether they are directly covered by a carbon pricing mechanism. Businesses should consider potential changes, including increasing carbon prices and broadening sectoral or geographical scopes. Although the prospect of paying higher prices means that carbon pricing can be a risk to businesses, it may also drive cost reductions, resilience and create opportunities. Businesses that are prepared for changes to carbon pricing may gain a competitive advantage, and it is even possible to purchase emissions trading allowances as an investment asset. Read EY’s short article on the opportunities and challenges that carbon prices pose to businesses.

One of the best ways to prepare for climate policy measures is to set an internal carbon price (sometimes called a ‘shadow carbon price’). This involves factoring in a price of carbon to business decisions separate from any compliance obligation. For example, a business might apply an internal carbon price when building new offices. Gas heating and high-carbon materials may appear to be cheaper, but factoring in an internal carbon price could identify lower-carbon alternatives as the better option. Internal carbon prices generally apply to emissions falling within Scopes 1 and 2. For more detailed information on internal carbon pricing, see Ecofys’ guidance, Harvard Business Review’s article .

Deciding on an internal carbon price is important – businesses could look to the High-Level Commission on Carbon Pricing’s recommendations ($40-$80 rising to $50-$100) when setting their own price. Not only has this price range been estimated to effectively reduce emissions, but following these guidelines will make businesses resilient to changes in compliance carbon pricing, which may follow the same recommendations.

Internal carbon prices help businesses by reducing emissions in a similar way to compliance carbon pricing mechanisms, and bring the benefit of helping businesses manage transition risks. Using the previous example, shifting to renewable sources of heating may help manage the risk of gas prices increasing due to government restrictions or energy security issues. Businesses with an adequate internal carbon price should not face the same disruption from policy changes. By encouraging a shift towards sustainable alternatives across a business’ operations, an internal carbon price can also minimise the impact of other climate policies including industrial standards and technical regulations, giving businesses a competitive advantage over others who are less prepared, and helping to future proof business operations.

Businesses can also go a step further and actually impose an internal carbon fee. This strategy involves using the internal carbon price to calculate an amount that is paid into a central fund. Such funds have typically been put towards sustainability projects.

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