Carbon pricing, carbon tax and the global effort to decarbonize

By | 8 minute read | October 26, 2021

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Carbon pricing continues to hold a recurring spot in public political discourse around the world, with debates surrounding these climate policies increasing in the years since the Paris Agreement.

Not only did the treaty outline a global framework for nations to follow, but importantly it offered nations the opportunity to cooperate beyond geographical boundaries, by encouraging the transfer of emissions reductions across borders.

The Paris Agreement, international frameworks such as CDP and SASB, and green initiatives introduced by countries together have sent a strong signal of the international willingness to turn the tide with climate change.

The most widely adopted of these initiatives spanning almost all industrialized countries today is government-mandated carbon pricing, a model which some organizations have also adopted internally within their sustainability plans as an additional lever to achieve their pledges.

At the vanguard of corporate sustainability strategy is the sustainability manager, and staying informed on international and private sector initiatives is now more important than ever as companies experience a growing urgency to create and deliver on outcomes.

In this article, we explore traditional forms of external carbon pricing models in some international markets, and look at internal carbon pricing as a company-led initiative in the private sector’s push to decarbonize.

What is external carbon pricing and how does it work?

In an effort to reduce greenhouse gas (GHG) emissions from producers and financially incentivize them to emit less, governments (“external”) place a fee on emissions in the form of carbon pricing. This “polluter pays” principle removes the burden from the public in bearing the responsibility of paying for the results of climate change (such as property and livestock loss), and shifts it to the producer of the emissions.

The producer can then determine whether they continue to pay the hefty premiums associated with GHG emissions or reduce emissions to avoid the additional cost. Given the financial weight that carbon pricing models bear on already resource-intensive industries, the ‘”polluter pays” principle also has a rippling influence throughout corporate strategy, as it provides a solid case for directing investments into more efficient and greener technologies as opposed to those with higher emissions.

Common positions against carbon pricing models

The way carbon pricing is applied can lead to common challenges such as:

  • Major producers may pass on the cost of the carbon tax directly to the end consumer, leading to increases in the cost of living.
  • Companies may continue to pay carbon tax with little to no change in corporate behavior (although this has led to significant revenue for the government, which has allowed them to subsidize cleaner forms of energy).
  • Governments may struggle to set an adequate pricing level that incentivizes behavior change without impacting profitability (however, as we later explore in the case of Sweden, the model has proved successful).
  • Producers may have an uneven influence on public discourse around carbon pricing.

Despite these challenges, carbon pricing continues to be a viable market-based solution to reducing GHG emissions. As of 2021, over 60 carbon pricing initiatives have been implemented around the world, and in 2020 more than 2,000 companies reported using an internal price on carbon as another mechanism to support decarbonization pledges.

Carbon taxes and cap-and-trade systems

Carbon pricing is the broad model which covers two approaches: a carbon tax and a cap-and-trade system. Both systems share the goal of reducing carbon emissions—through different means.

What is a carbon tax?

Under a carbon tax, the government establishes a price that producers pay for each unit of carbon pollution they emit. This system is intended to encourage businesses and the wider industry to fuel-switch, reduce their emissions or explore innovative technologies to avoid the tax imposed.

What is a cap-and-trade system?

Also referred to as emissions trading, a cap-and-trade system limits the amount of emissions that a producer can release. The government places this limit and reduces the limit over time to reach an emissions reduction target.

Under the cap-and-trade system, producers who exceed the limit are taxed, while the producers who reduce their emissions output can trade (emissions trading) and sell the credits they didn’t use. The European Union’s Emissions Trading System (EU ETS), which is the world’s largest carbon market, is an exemplary model of this, having reduced CO2 emissions by 1 billion tons between 2008 and 2016.

Corporate use of internal carbon pricing

With markets moving toward a low-carbon economy and mandatory external carbon pricing initiatives expected to grow, companies are increasingly reporting the current or planned adoption of internal carbon pricing in corporate strategy.

By placing an internal fee on GHG emissions, companies can not only make strategic decisions on investment and business operations, but also gain a competitive advantage over others that prepares them for future regulatory requirements.

Microsoft, for example, has implemented internal carbon pricing to fund green projects, research and employee climate education. Novartis has adopted an internal carbon price of USD 100/tCO2e to assess the financial impact of emissions from significant investments, as has ASDA (Walmart affiliate) to guide their investment decisions.

Types of internal carbon pricing

Much like external carbon pricing models, there are also various approaches under internal carbon pricing. These typically include one of three types:

Internal carbon fee

Comparable to a carbon tax set by governments, an internal carbon fee places a value on each ton of carbon emissions, creating revenue to fund the company’s decarbonization efforts.

Shadow pricing

Placing a hypothetical price on activities and investments that produce carbon emissions, shadow pricing helps with long-term business planning and forecasting by prioritizing less carbon-intensive activities while also preparing the business for future external carbon pricing.

Implicit pricing

Calculated retroactively after a company has reached its emissions reduction targets, implicit pricing is based on how much a company has spent to reduce its GHG emissions and adhere to government regulations where applicable.

Internal carbon pricing is yet another lever companies can use in their decarbonization strategy to reach targets, differentiate themselves from others in the market and ease the transition toward a low-carbon economy. Sustainability managers should refer to the jointly developed How-to Guide to Corporate Internal Carbon Pricing for guidance on engagement, design, implementation and evaluation of internal carbon pricing.

Carbon pricing policies around the world

Canada

Earlier this year, we reported on Canada’s ambitious action plan for tackling climate change. The country’s carbon pricing model is built around a federal carbon pricing system and is now written into law. For the past couple of years, carbon pricing has been applied within every jurisdiction in Canada and has ensured that if a jurisdiction does not appropriately price pollution, the federal system is enacted in that region.

This federal system is comprised of two parts: a regulatory fuel charge and a performance-based charge (OBPS: Output-Based Pricing System). The latter is a cap-and-trade system designed for industries, which applies a financial incentive for producers to reduce their emissions and prevents facilities from relocating to other regions to avoid paying the charges.

United States

The United States has also placed climate action at the center of federal policies, following four years of stifled progress under the previous administration. The US has experienced years of gridlock on climate discussions and policy, and as a result does not have a nationwide carbon pricing policy. The new administration is being heralded as a significant game-changer in the nation’s efforts to implement federally-backed green initiatives to combat its emissions output, and there are jurisdictions that have already led the way in modeling this change.

Washington State’s governor signed a historic climate policy bill in May 2021 that packages a number of innovative and progressive initiatives for the state, including legislation to reduce GHG emissions from the transportation sector and to enforce a limit on the state’s emissions.

Still in its early days, the bill provides a blueprint for state-backed ambitious climate policy and joins California, Oregon and other states that have led on climate action in the absence of a federally-backed plan.

Australia

Not immune from the public and political discourse on climate change, Australia has also been locked in discussions in recent years on the state of a federally backed climate policy.

In 2011, a bill was introduced to price carbon emissions from the country’s largest carbon emitters, which covered a broad range of industries. Three years later, the carbon pricing mechanism was repealed following a change in government and was replaced with a different, voluntary mechanism whereby both organizations and individuals can participate in emissions reduction initiatives such as carbon sequestration.

Sweden

Touted as having the highest carbon pricing in the world at USD 137/tCO2, Sweden’s system comprises a carbon tax and an energy tax. This “decoupling” system has so far demonstrated that carbon pricing and economic growth can exist harmoniously, with the Swedish economy growing by 60% and carbon emissions decreasing by 25% since the system’s introduction in 1991.

China

Based on a cap-and-trade system, China’s ETS officially began trading online in July 2021, following several pilot schemes in its main cities as early as 2013. For the time being, the model applies to coal and gas-fired energy plants, with an expansion into the construction and oil industries set to be introduced in the next few years.

China’s ETS scheme is based on reducing the intensity of emissions generation, as opposed to absolute emissions as seen in other countries including Canada and the EU.

Progress demands a dual approach to decarbonization

The evidence suggests that carbon pricing is an important lever in the fight against climate change, and it must be urgently expanded globally to deliver the swiftest outcomes on climate action.

The most effective schemes are the comprehensive, mandated programs set up at a federal level. However, the private sector also has a responsibility to initiate internal programs where government mandate is limited or nonexistent to keep momentum advancing toward a net zero future.