Carbon pricing (or CO₂ pricing) is a method for governments to mitigate climate change, in which a monetary cost is applied to greenhouse gas emissions. This is done to encourage polluters to reduce fossil fuel combustion, the main driver of climate change. A carbon price usually takes the form of a carbon tax, or an emissions trading scheme (ETS) that requires firms to purchase allowances to emit.^[1] The method is widely agreed to be an efficient policy for reducing greenhouse gas emissions. Carbon pricing seeks to address the economic problem that emissions of CO₂ and other greenhouse gases are a negative externality – a detrimental product that is not charged for by any market.

21.7% of global GHG emissions are covered by carbon pricing in 2021, a major increase due to the introduction of the Chinese national carbon trading scheme.^[2][3] Regions with carbon pricing include most European countries and Canada. On the other hand, top emitters like India, Russia, the Gulf states and many US states have not introduced carbon pricing.^[4] Australia had a carbon pricing scheme from 2012 to 2014. In 2020, carbon pricing generated $53B in revenue.^[5]

According to the Intergovernmental Panel on Climate Change, a price level of $135–$5500 in 2030 and $245–$13,000 per metric ton CO₂ in 2050 would be needed to drive carbon emissions to stay below the 1.5°C limit.^[6] Latest models of the social cost of carbon calculate a damage of more than $300 per ton of CO₂ as a result of economy feedbacks and falling global GDP growth rates, while policy recommendations range from about $50 to $200.^[7]: 2 Many carbon pricing schemes including the ETS in China remain below $10 per ton of CO₂.^[3] One exception is the European Union Emissions Trading System (EU-ETS) which exceeded €100 ($108) per ton of CO₂ in February 2023.^[8]

A carbon tax is generally favoured on economic grounds for its simplicity and stability, while cap-and-trade theoretically offers the possibility to limit allowances to the remaining carbon budget. Current implementations are only designed to meet certain reduction targets.

Carbon pricing is considered by many economists to be the most economically efficient way to reduce emissions,^[9][10] taking into account the costs of both efficiency measures and the inconvenience of lesser fossil fuels. By pricing the externalities of carbon emissions, efficiency comes about by eliminating the market failure of the unpriced external costs of carbon emissions at its source.^[11] It is regarded as more efficient than renewable energy subsidies given to individual firms,^{[citation needed]} because the difficulties of determining the value of emissions to each firm makes command and control regulation less likely to be efficient.^[12]

In a carbon tax model, a tax is imposed on carbon emissions produced by a firm. In a cap-and-trade design, the government establishes an emissions cap and allocates to firms emission allowances, which can thereafter be privately traded. Emitters without the required allowances face a penalty more than the price of permits. Assuming all else is equal, the market for permits will automatically adjust the carbon price to a level that ensures that the cap is met.^[13][14] The EU ETS uses this method. In practice, it has resulted in a fairly strong carbon price from 2005 to 2009, but that was later undermined by an oversupply and the Great Recession. Recent policy changes have led to a steep increase of the carbon price since 2018, exceeding 100€ ($118) per ton of CO₂ in February 2023.^[8]

Evaluations of 21 carbon pricing schemes, show that at least 17 of these have caused reductions in greenhouse gas emissions. The achieved emissions reductions range between 5% and 21% for the studied schemes.^[15]

The exact monetary damage of the social cost caused by a tonne of CO₂ depends on climate and economic feedback effects and remains to some degree uncertain. Latest calculations show an increasing trend:

Cap-and-trade systems can include price stability provisions with floor and ceiling limits.^[18] Such designs are often referred to as hybrid designs.^[12]: 47 To the extent the price is controlled by these limits, it can be considered a tax.

Carbon emissions trading works by setting a quantitative limit on the emissions produced by emitters. As a result, the price automatically adjusts to this target. This is the main advantage compared to a fixed carbon tax. A carbon tax is considered easier to enforce on a broad-base scale than cap-and-trade programs. The simplicity and immediacy of a carbon tax has been proven effective in British Columbia, Canada – enacted and implemented in five months.^[19] A hybrid cap-and-trade program puts a limit on price increases and, in some cases, sets a floor price as well. The upper limit is set by adding more allowances to the market at a set price while the floor price is maintained by not allowing sales into the market at a price below the floor.^[20] The Regional Greenhouse Gas Initiative, for example, sets an upper limit on allowance prices through its cost containment provision.

However, industries may successfully lobby to exempt themselves from a carbon tax. It is therefore argued that with emissions trading, polluters have an incentive to cut emissions, but if they are exempted from a carbon tax, they have no incentive to cut emissions.^[21] On the other hand, freely distributing emission permits could potentially lead to corrupt behaviour.^[22]

Most cap and trade programs have a descending cap, usually a fixed percentage every year, which gives certainty to the market and guarantees that emissions will decline over time. With a tax, there can be estimates of reduction in carbon emissions, which may not be sufficient to change the course of climate change. A declining cap gives allowance for firm reduction targets and a system for measuring when targets are met. It also allows for flexibility, unlike rigid taxes.^[19] Providing emission permits (also called allowances) under emissions trading is preferred in situations where a more accurate target level of emissions certainty is needed.^[23]

Standard proposals for using carbon revenues include

• a return to the public on a per-capita basis^[24] This can compensate the risk of rising energy prices reaching high levels as long as cheap wind and solar power is not available yet. Rich people who tend to have a larger carbon footprint would pay more while poorer people can even benefit from such a regulation.
• subsidies accelerating the transition to renewable energy
• research, public transport, car sharing and other policies that promote carbon neutrality
• subsidies for negative emissions: Depending on the technology, such as PyCCS or BECCS, the cost for generating negative emissions is about $150–165 per ton of CO₂.^[25] The removal past emissions – 1,700 Gt in total^[26] – can theoretically be addressed by auctioning allowances starting with a price that exceeds the removal costs of the proposed emissions.

About one third of the systems stays below $10/tCO₂, the majority is below $40. One exception is the steep incline in the EU-ETS reaching $60 in September 2021. Sweden and Switzerland are the only countries with more than $100/tCO₂.

Unexpected spikes in natural gas prices and commodities such as oil and coal in 2021 caused a debate whether a carbon price increase should be postponed to avoid additional social burden. On the other hand, a redistribution on a per-capita-basis would even release poorer households which tend to consume less energy compared to wealthier parts of the population. The higher the high carbon price the greater the relief. Looking at individual situations though, the compensation would not apply to commuters in rural areas or people living in houses with poor insulation. They neither have liquidity to invest into solutions using less fossil fuels and would be dependent on credits or subsidies. On the other hand, a carbon price still helps to provide an incentive to use more effective fossil fuel technologies such as CCGT gas turbines in contrast to high-emission coal.^[28]

In the relevant countries with ETS and taxes, about 40% to 80% of emissions are covered.^[29] The schemes differ much in detail. They include or exclude fuels, transport, heating, agriculture or other greenhouse gases apart from CO₂ like methane or fluorinated gases.^[30] In many EU member states like France or Germany, there is a coexistence of two systems: The EU-ETS covers power generation and large industry emissions while national ETS or taxes put a different price on petrol, natural gas and oil for private consumption.

The final consumer price for fuels and electric energy depends on individual tax regulations and conditions in each country. Though carbon pricing is playing an increasing role, energy taxes, VAT, utility expenses and other components are still the main cause for completely different price levels between countries.

The table gives examples for a carbon price of $100 or 100 units of any other currency accordingly. Food calculation is all based on CO₂ equivalents including the high impact of methane emissions.

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Many economic properties of carbon pricing hold regardless of whether carbon is priced with a cap or a tax. However, there are a few important differences. Cap-based prices are more volatile and so they are riskier for investors, consumers and for governments that auction permits. Also, caps tend to short-out the effect of non-price policies such as renewables subsidies, while carbon taxes do not.

Carbon leakage is the effect that regulation of emissions in one country/sector has on the emissions in other countries/sectors that are not subject to the same regulation.^[43] There is no consensus over the magnitude of long-term carbon leakage.^[44]

The leakage rate is defined as the increase in CO₂ emissions outside the countries taking domestic mitigation action, divided by the reduction in emissions of countries taking domestic mitigation action. Accordingly, a leakage rate greater than 100% means that actions to reduce emissions within countries had the effect of increasing emissions in other countries to a greater extent, i.e., domestic mitigation action had actually led to an increase in global emissions.

Estimates of leakage rates for action under the Kyoto Protocol ranged from 5% to 20% as a result of a loss in price competitiveness, but these leakage rates were considered very uncertain.^[43] For energy-intensive industries, the beneficial effects of Annex I actions through technological development were considered possibly substantial. However, this beneficial effect had not been reliably quantified. On the empirical evidence they assessed, Barker et al. (2007) concluded that the competitive losses of then-current mitigation actions, e.g., the EU-ETS, were not significant.

Under the EU ETS rules Carbon Leakage Exposure Factor is used to determine the volumes of free allocation of emission permits to industrial installations.

A general perception among developing countries is that discussion of climate change in trade negotiations could lead to green protectionism by high-income countries^[45] Eco-tariffs on imports ("virtual carbon") consistent with a carbon price of $50 per ton of CO₂ could be significant for developing countries. In 2010, World Bank commented that introducing border tariffs could lead to a proliferation of trade measures where the competitive playing field is viewed as being uneven. Tariffs could also be a burden on low-income countries that have contributed very little to the problem of climate change.

Cap-and-trade and carbon taxes interact differently with non-price policies such as renewable energy subsidies. The IPCC explains this as follows:

A carbon tax can have an additive environmental effect to policies such as subsidies for the supply of RE. By contrast, if a cap-and-trade system has a binding cap (sufficiently stringent to affect emission-related decisions), then other policies such as RE subsidies have no further impact on reducing emissions within the time period that the cap applies [emphasis added].^[46]: 29

According to a 2020 study carbon prices have not harmed economic growth in wealthy industrialized democracies.^[47]

In order for such a business model to become attractive, the subsidies would therefore have to exceed this value. Here, a technology openness could be the best choice, as a reduction in costs due to technical progress can be expected. Already today, these costs of generating negative emissions are below the costs^{[clarification needed]} of CO₂ of $220 per ton,^[48] which means that a state-subsidized business model for creating negative emissions already makes economic sense today.^{[citation needed]} In sum, while a carbon price has the potential to reduce future emissions, a carbon subsidy has the potential to reduce past emissions.^{[clarification needed]}

In late 2013, William Nordhaus, president of the American Economic Association, published The Climate Casino,^[49] which culminates in a description of an international "carbon price regime". Such a regime would require national commitments to a carbon price, but not to a specific policy. Carbon taxes, caps, and hybrid schemes could all be used to satisfy such a commitment. At the same time Martin Weitzman, a leading climate economist at Harvard, published a theoretical study arguing that such a regime would make it far easier to reach an international agreement, while a focus on national targets would continue to make it nearly impossible.^[50] Nordhaus also makes this argument, but less formally.

Similar views have previously been discussed by Joseph Stiglitz^[51] and have previously appeared in a number of papers.^[52] The price-commitment view appears to have gained major support from independent positions taken by the World Bank and the International Monetary Fund (IMF).^[53]

The "Economists' Statement on Climate Change"^[54] was signed by over 2500 economists including nine Nobel Laureates in 1997. This statement summarizes the economic case for carbon pricing as follows:

The most efficient approach to slowing climate change is through market-based policies. In order for the world to achieve its climatic objectives at minimum cost, a cooperative approach among nations is required – such as an international emissions trading agreement. The United States and other nations can most efficiently implement their climate policies through market mechanisms, such as carbon taxes or the auction of emissions permits.

This statement argues that carbon pricing is a "market mechanism" in contrast to renewable subsidies or direct regulation of individual sources of carbon emissions and hence is the way that the "United States and other nations can most efficiently implement their climate policies."

Carbon offsets for individuals^[55] and businesses^[56] may also be purchased through carbon offset retailers^[57] like Carbonfund.org Foundation.

A new quantity commitment approach, suggested by Mutsuyoshi Nishimura, is for all countries to commit to the same global emission target.^[58] The "assembly of governments" would issue permits in the amount of the global target and all upstream fossil-fuel providers would be forced to buy these permits.

In 2019 the UN Secretary General asked governments to tax carbon.^[59]

The economics of carbon pricing is much the same for taxes and cap-and-trade. Both prices are efficient;^[a] they have the same social cost and the same effect on profits if permits are auctioned. However, some economists argue that caps prevent non-price policies, such as renewable energy subsidies, from reducing carbon emissions, while carbon taxes do not. Others argue that an enforced cap is the only way to guarantee that carbon emissions will actually be reduced; a carbon tax will not prevent those who can afford to do so from continuing to generate emissions.

Besides cap and trade, emission trading can refer to project-based programs, also referred to as a credit or offset programs. Such programs can sell credits for emission reductions provided by approved projects. Generally there is an additionality^[60] requirement that states that they must reduce emissions more than is required by pre-existing regulation. An example of such a program is the Clean Development Mechanism under the Kyoto Protocol. These credits can be traded to other facilities where they can be used for compliance with a cap-and-trade program.^[61] Unfortunately the concept of additionality is difficult to define and monitor, with the result that some companies purposefully increased emissions in order to get paid to eliminate them.^[62]

Cap-and-trade programs often allow "banking" of permits. This means that permits can be saved and can be used in the future.^{[citation needed]} This allows an entity to over-comply in early periods in anticipation of higher carbon prices in subsequent years.^[63] This helps to stabilize the price of permits.^[13]

• IPCC (2018). Masson-Delmotte, V.; Zhai, P.; Pörtner, H.-O.; Roberts, D.; et al. (eds.). Global Warming of 1.5°C. An IPCC Special Report on the impacts of global warming of 1.5°C above pre-industrial levels and related global greenhouse gas emission pathways, in the context of strengthening the global response to the threat of climate change, sustainable development, and efforts to eradicate poverty (PDF). Intergovernmental Panel on Climate Change. Global Warming of 1.5 °C —.
  • de Coninck, H.; Revi, A.; Babiker, M.; Bertoldi, P.; et al. (2018). "Chapter 4: Strengthening and Implementing the Global Response" (PDF). IPCC SR15 2018. pp. 313–443.

• Kikstra, Jarmo S; Waidelich, Paul; Rising, James; Yumashev, Dmitry; Hope, Chris; Brierley, Chris M (September 6, 2021). "The social cost of carbon dioxide under climate-economy feedbacks and temperature variability". Environmental Research Letters. 16 (9): 094037. Bibcode:2021ERL....16i4037K. doi:10.1088/1748-9326/ac1d0b. S2CID 237427400.

• Bank, World (2021). State and Trends of Carbon Pricing 2021. The World Bank. doi:10.1596/978-1-4648-1728-1. ISBN 978-1-4648-1728-1. S2CID 242987579.

• "Technical Update of the Social Cost of Carbon for Regulatory Impact Analysis Under Executive Order 12866" (PDF). Interagency Working Group on Social Cost of Greenhouse Gases (US govt.). 2016. Retrieved September 12, 2021.

• "Measuring Emissions: A Guide for Organisations" (PDF). Ministry for the environment, New Zealand. 2020.
• Quaschning, Volker. "Specific Carbon Dioxide Emissions of Various Fuels". Retrieved September 23, 2021.
• "Meat Eater's Guide" (PDF). Environmental Working Group. 2011.
• Noleppa, Steffen (2012). "Klimawandel auf dem Teller" (PDF) (in German). WWF Germany. Archived from the original (PDF) on November 1, 2020.

• Our Climate Put A Price On It campaign
• CDM Rulebook — Defines Kyoto commitments
• UN Climate Change Framework — Lists national commitments for 2020
• Pricing Carbon Initiative — US focused effort for carbon-pricing commitments