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What is carbon pricing?
An introduction to carbon pricing, its core objectives, and how it operates within both mandatory and voluntary carbon markets. It also outlines key market features and summarises the primary safeguards in place to ensure credibility and transparency across carbon trading mechanisms.
What is the purpose of carbon pricing?
Carbon pricing uses market forces to influence behaviour and reduce greenhouse gas (GHG) emissions by internalising the cost of negative externalities associated with carbon-intensive activities. It shifts the burden of responsibility for emissions onto those who are accountable and capable of reducing them, while sending a strong price signal that incentivises low-carbon choices. Depending on the mechanism, carbon pricing can generate tax revenue to fund climate mitigation and adaptation, or direct financing toward emissions-reduction projects. It also has the potential to encourage market and technological innovation. According to the World Bank, 53 national jurisdictions currently use carbon pricing mechanisms, and recent studies such as Hildebrandt et al. (2024), suggest that these schemes can lead to immediate and substantial reductions in emissions.
Types of carbon pricing
An emissions trading scheme (ETS) or "cap‐and‐trade" system – sets a limit on the total level of GHG emissions, and requires entities to purchase "allowances", or permits to emit. GHG emission allowances are usually issued by a government body and can be traded. Low emitters can sell their emissions allowances to high emitters. Each year, entities within the scope of the ETS have to surrender emissions allowances equivalent to their emissions to the regulator. The effect on GHG emissions is pre‐determined: the overall cap on emissions allowances issued is reduced over time to reduce emissions. But while the emissions level is set by the Regulator, the price of carbon is set by the market.
Carbon tax – a direct tax on carbon, often on the carbon content of fossil fuels or on GHG emissions. The effect on GHG emissions isn’t pre‐determined, only the price of carbon.
Voluntary carbon markets – voluntary trading of carbon credits, usually so participants can offset GHG emissions, in order to meet voluntary climate commitments.
Other ways carbon is priced include removing subsidies for GHG‐emitting activity, paying for carbon reductions, subsidies for activities that are expected to reduce GHG emissions, and taxes on carbon intensive products eg fuel taxes.
Mandatory and voluntary carbon markets
- The market operates through voluntary carbon standards and codes of conduct, not regulation.
- Companies trade certificates/credits and legal title to the emissions reduction contractually, not through law.
- The certificate doesn't necessarily entitle its holder, in law, to claim emissions reductions. Participants transfer contractually both the certificate and the underlying mitigation claim.
- Usage is entirely voluntary. Buyers usually engage with the voluntary carbon markets to purchase offsets.
- Voluntary emissions reduction credits usually originate from implementing activities that reduce or sequester (remove) GHG emissions. Activities can be project or programme based.
- Issuing and transferring credits is overseen by a voluntary registry or tracking system of the relevant carbon standard subject to the terms of the registry.
- Some standards have guidance as to how the credits should be used eg the claims that should (and shouldn’t) be made.
- Certificates/credits can only be transferred in the specific registry of the chosen carbon standard, and they’re subject to the registry’s terms of use (some exceptions apply).
- Pricing is determined by market participants per transaction, based on market value and relevant risks associated with the project or programme or the level of quality or integrity they represent.
- This market is regulated. It has a specific legal framework that varies by jurisdiction.
- Jurisdictions can define the legal nature of the allowances as:
- a property right (so they can be used as a financial instrument);
- an administrative authorisation to emit;
- a sui generis administrative right (a personal right under common law); or
- a combination of both a property and administrative right.
- The law and contracts regulate the allowances and how they’re transferred.
- Participation is required by law.
- Allowances that are allocated or purchased through competitive auctions can be secondarily traded and transferred within a registry.
- Allowances must be surrendered to the relevant regulator to fulfil compliance obligations regarding emissions.
- The volume and allocation of allowances, and how they can be transferred and surrendered is regulated.
- Monitoring, reporting, and verification requirements regarding GHG emissions of entities are regulated.
- Allowances can usually be transferred between different registries but require a central log that records the transfer of allowances in a cap‐and‐trade system.
- Regulation sets out which types of allowances can be used for different compliance obligations.
- Typically, allowances are sold through competitive auctions, usually with a minimum price.
- Emissions trading systems commonly have cost containment mechanisms that can calibrate the price of allowances if prices are too high.
- Prices can be adjusted according to appetite for emissions reduction.
Overview of carbon market safeguards
- Indigenous rights and the rights of local communities – consultation, prior informed consent, benefit sharing.
- Other environmental and social factors – "not at any cost" doctrine ie considering biodiversity and environmental justice concerns, alongside GHG reduction/removal.
- Integrity – avoiding double‐counting. Interaction with Nationally Determined Contributions.
- Monitoring, reporting, and verification – ensuring credits issued represent carbon genuinely reduced/removed, accurately calculated.
- Claimsneed to be appropriate and factual, avoiding greenwashing.
- Pricing – if the price is too low, it’s unlikely to achieve the desired emissions reductions and suggests emissions reduction outcomes could be more ambitious. If price is too high, it could be unworkable, negatively affect other considerations, or lead to non‐compliance.
- The overall cap needs a central log to ensure allowances issued and surrendered don’t exceed the cap.
- Integrity – allowance surrenders need to be verified and double‐counting avoided.
- Monitor, report, and verify to accurately assess entities' GHG emissions.
