What is Carbon Pricing?

Carbon pricing assigns a cost to carbon emissions, effectively integrating the environmental and social costs associated with carbon pollution into the market. This market-driven approach compels emitters to internalize these external costs.

For example, cruise lines would not only pay for the fuel to operate but also for the environmental damage caused by their emissions. This financial pressure encourages companies to improve efficiency and invest in cleaner alternatives, such as sail-assisted vessels.

Moreover, as businesses typically pass these costs onto consumers, the increased prices for high-emission activities can steer consumers toward more environmentally friendly choices.

The Two Approaches to Carbon Pricing

Governments can implement carbon pricing through two main methods: a direct carbon tax or a cap-and-trade system.

A carbon tax is straightforward, imposing a fee on fossil fuel combustion to internalize pollution costs.

In contrast, cap-and-trade is more complex. A regulatory body sets a limit on emissions for specific sectors (e.g., aviation), and companies receive carbon credits that allow them to emit a certain amount. If a company exceeds its allocation, it can either pay fines or purchase unused credits from others.

Some markets permit companies to buy carbon offsets, which fund projects that reduce emissions elsewhere, essentially balancing out their own emissions.

Vijay V. Vaitheeswaran, Global Energy and Climate Innovation Editor at The Economist, notes, “The genius of cap-and-trade systems when executed correctly lies in their dual approach of incentives and penalties.” However, I maintain that a carbon tax is a superior strategy.

Why a Carbon Tax is Beneficial

Currently, rather than instituting an effective carbon tax, we are inadvertently subsidizing carbon emissions. For every dollar spent by the oil and gas sector, only 4 cents is allocated to clean energy and carbon capture.

Shockingly, the top 20 fossil fuel corporations account for 35% of global carbon and methane emissions since 1965, yet fossil fuel subsidies nearly doubled in 2021, overshadowing clean energy investments.

Despite the known environmental impact of the meat and dairy industries, they continue to receive substantial farming subsidies globally.

Redirecting these subsidies into a carbon tax could generate significant funding for initiatives aimed at mitigating climate change, such as renewable energy projects and habitat restoration.

Kristalina Georgieva, head of the IMF, emphasizes, “When you place a price on carbon, decarbonization accelerates.” She points to the European emission trading scheme, which has successfully reduced emissions by 37% since its inception in 2005.

Will Carbon Pricing Burden the Poor?

A valid concern arises: Could carbon pricing exacerbate living costs, disproportionately affecting low-income families?

Indeed, attaching a carbon price will likely increase costs for essentials like electricity and transportation, impacting those with lower incomes who spend a larger share of their earnings on these necessities. Unlike wealthier households, low-income families renting homes may find it difficult to transition to greener technologies.

However, a well-designed carbon pricing policy should not solely focus on raising prices. A revenue-neutral approach could allow a portion of the tax revenue to support affected families through social safety nets, while the rest funds infrastructure improvements.

This concept is not novel; the 2019 Energy Innovation and Carbon Dividend Act in the U.S. proposed a carbon tax with the revenue returned to citizens as monthly payments.

Canada has implemented a similar model, redistributing carbon tax revenue to assist households in offsetting increased costs. Moreover, carbon taxes can be tailored for specific sectors, ensuring higher emissions lead to higher taxes.

For instance, air travel could face steeper taxes than other transport forms, encouraging eco-friendly alternatives like trains, and ensuring frequent fliers contribute more.

Carbon Pricing: A Long-Term Financial Strategy

Human behavior often centers around self-interest. Until companies perceive threats to profits or governments recognize direct economic benefits, encouraging widespread environmental responsibility will be challenging.

While carbon pricing may raise immediate costs, it can stimulate innovation and yield long-term savings. Researchers at University College London estimate that delaying decarbonization could cost the shipping industry an additional $100 billion annually.

Additionally, firms that anticipate higher carbon prices may accelerate their pursuit of innovations, fostering competition to enhance efficiency and reduce emissions.

Furthermore, a rise in carbon prices can correlate with an uptick in low-carbon technology patents, indicating that carbon pricing can effectively motivate innovation.

Funds collected from carbon taxes can also be allocated to research and enhance public infrastructure, promoting decarbonization and leading to significant public health savings.

By reducing pollutants, we can expect fewer respiratory and cardiovascular issues, decreasing healthcare costs associated with pollution-related illnesses.

Challenges with Cap-and-Trade Systems

Though both carbon taxes and cap-and-trade systems impose costs on pollution, cap-and-trade is more susceptible to exploitation, making it a less reliable method.

A WWF study in 2022 revealed that the EU has granted nearly €100 billion in free carbon permits to major polluting industries without any environmental stipulations.

While a strong cap-and-trade system should enforce strict permit allocation and penalties, the complexity of accurately measuring emissions can lead to loopholes. For instance, Volkswagen's emissions scandal highlights how companies might circumvent regulations.

Carbon leakage is another issue; firms may relocate to regions with lenient emissions regulations. In a tax-based system, imported goods can be taxed to reflect local carbon costs, mitigating this risk.

While a carbon tax system is not without flaws, it offers greater transparency than the intricate calculations and opaque processes of cap-and-trade. A transparent tax system enables authorities to focus on minimizing evasions.

Moreover, carbon taxes can be tailored to target specific high-emission industries, while cap-and-trade allows for trading among companies, which can perpetuate emissions in vulnerable communities.

Carbon Offsets: A Major Concern

Some carbon pricing models permit offsets to lessen tax burdens, but the offset market lacks clarity and can be problematic.

Matthew J. Kotchen, a professor at Yale, notes, “There’s no regulation about offsets in particular that measures their quality or permanence.”

Offsets often do not provide immediate emissions reductions; projects like tree planting require time to mature. Thus, emissions continue to contribute to climate change before the offset projects can take effect.

Additionally, quantifying avoided emissions is challenging, complicating the use of offsets. Funding renewable energy projects does not guarantee a direct reduction in equivalent emissions.

Lastly, the durability of offset projects is questionable. According to The Guardian, many rainforest carbon offset programs are ineffective, with significant overestimations of their protective capabilities.

While some offset initiatives may be beneficial, relying on the opaque offset market poses substantial risks.

In conclusion, while carbon pricing alone will not solve climate change, it is a crucial step forward. Implementing a significant carbon tax can impose a financial burden that encourages emissions reductions across various sectors.

Industries with high emissions will be pressured to improve efficiency, and collected revenue can bolster community support and enhance local production capabilities.

Effective carbon pricing has the potential to reduce emissions by 4 to 15%. It is essential to make pollution costly.