An ever-increasing number of countries are pricing carbon as a policy mechanism to address climate change. By imposing a cost on the emission of greenhouse gases, carbon pricing seeks to ensure that some of the external costs of emissions are paid for by those organisations causing them. As climate policies are strengthened to meet ever-more ambitious climate targets, carbon-pricing policies will expand in both scope and scale – meaning businesses need to prepare.
An economic signal to emitters
Market-based approaches to emissions reductions have found support amongst policymakers across Organisation for Economic Cooperation and Development (OECD) countries and other juridisctions for their adherence to prevailing discourses of economic theory and the relative ease with which they can be implemented. Rather than dictate who should reduce emissions where and how, a carbon price provides an economic signal to emitters, allowing them to decide to either change activities to lower their emissions or continue emitting and pay the associated price. As a market-based tool, it provides incentive for individuals and businesses to take steps to reduce emissions and the overall policy goal is achieved in the most flexible way for society at the lowest cost (1).
Source of revenue
For governments, carbon pricing is also a source of revenue to finance other climate-change-related mitigation and adaptation measures, such as the deployment of clean-energy technologies, or to reduce impacts to vulnerable households and businesses. Around half of all revenues raised by governments through carbon-pricing schemes is directed in such a way (2), with the remainder predominantly allocated to general government budgets.
Carbon pricing captures some of the external costs of emissions, which are otherwise paid for by the public in damages to, for example, crops, property or healthcare costs, and mandates that the producer of the emissions pays for them. A carbon price thereby shifts the burden for climate-related damages to those who are responsible for them. Government-mandated ‘compliance’ carbon pricing schemes can be broken out into two prevailing types: Emissions Trading Systems and Carbon Taxes.
Emissions Trading System
An Emissions Trading System (ETS) is a system where emitters can trade emission units on a carbon market to meet their emission targets. Under a ‘cap and trade’ principle, a government sets a cap on the total amount of emissions that a particular industry is allowed to produce. This cap is typically set to decline over time to meet emissions-reduction targets. By creating supply and demand for emissions units, an ETS establishes a market price for GHG emissions.
The EU ETS is the world’s first and largest international emissions trading system, covering around 40 per cent of the EU’s GHG emissions (3). In February 2023, the price of permits hit €100 ($107) for the first time, seen as a landmark moment and a price at which companies may be motivated to invest in expensive, low-carbon technologies. The UK, China, Canada and multiple US states also have ETS schemes in place.
A carbon tax directly sets a price on carbon by defining an explicit tax rate on GHG emissions or, more commonly, on the carbon content of fossil fuels. It is different from an ETS in that the emission-reduction outcome of a carbon tax is not pre-defined but the carbon price is. Many countries have carbon-tax instruments in place. A number of countries which participate in ETS schemes; including Norway, Sweden, France and the UK, also have carbon taxes applied to ensure certain carbon-intensive industries are priced at higher rates.
Society’s response to carbon pricing
Carbon pricing has a number of potential societal impacts, depending on how it is implemented. It imposes a cost on economic activities that may lead to social discontentment and unrest, as witnessed in France by the gilets jaunes demonstrations of 2018 onwards. There are a number of solutions to address these concerns being implemented in jurisdictions around the world. Public support for carbon pricing has been shown to be higher where the revenues raised are directed towards those affected by the policy, low-income households, or to fund decarbonisation and green infrastructure initiatives (4).
How carbon pricing impacts business
Carbon pricing can have financial impacts on a business in a number of ways. Identifying the potential levers available to a company to reduce its exposure to carbon-pricing risk, both now and in the future, requires understanding how each scope is impacted:
- Scope 1 emissions, which are those that are directly emitted by a company’s operations, incur direct taxes and carbon costs and can be financially impacted by additional operating costs.
- Scope 2 emissions, which are indirect emissions from the energy (electricity, steam, heating and cooling) purchased and used by a company, can be financially impacted by increased costs of energy prices.
- Scope 3 emissions are split into upstream and downstream. Upstream Scope 3 emissions can be financially impacted by increased raw materials costs. Downstream Scope 3 emissions, which see customers incur carbon costs, for example, at the point of sale, could suffer financial impact from loss of demand if there is a higher cost of using products.
Companies setting targets to reduce GHGs must be mindful of the risks that the business is likely to face as a result of the global transition towards a low-carbon future. The cost of carbon, in terms of the compliance carbon market, is especially sensitive to different climate futures as this pricing is assumed to be a key driving force towards decarbonisation, especially in specific sectors. This variance across different futures is explored deeply in the Network of Central Banks and Supervisors for Greening the Financial System (NGFS) set of climate future scenarios (5). Scenarios like this are useful in understanding how carbon pricing is expected to fluctuate across different climate futures.
How carbon prices may evolve
A range of economic analyses exist that consider how carbon prices may evolve in the future to incentivise emissions reductions consistent with limiting global temperature rise to a certain level. These include the International Monetary Fund (IMF), the International Energy Agency (IEA), the Inevitable Policy Response (IPR), the High-level Commission on Carbon Pricing (CPLC) and the NGFS. These analyses posit that where government climate policy is more ambitious, the global temperature increase will be less than where policy ambition is lower. To achieve the Paris Agreement goal of limiting the global temperature increase to 1.5°C, a significant increase in policy ambition will be required; conversely, continuing down a pathway where policies remain as they are at present would result in a significantly higher temperature rise of up to 3°C. Each of these economic analyses sees carbon prices reaching different levels and operating in different ways.
Making the business case
For a business, understanding the potential shifts of carbon pricing, not only in scale but also scope, is key to addressing and mitigating exposure to risk. By modelling potential, future carbon prices, it is possible to quantify the financial impact on a company and therefore provide the data to evidence a business case for emissions reductions.
The business case for reducing emissions not only mitigates risk but offers upsides. Organisations that pivot their business models to benefit from the immense change that is well underway will future-proof their business and capitalise on new consumer and technological opportunities emerging from a low-carbon economy. Ultimately, only these organisations will maintain relevance in a fast-changing and dynamic business environment.
- Download the new Risilience report: ‘The value of carbon pricing: navigating climate-policy risk to maximise business opportunity’, the latest addition to our Transition Risk Series.
- Read our blog post explaining why internal carbon pricing is good for business: ‘Carbon pricing – the market approach to climate policy’.
(1) World Bank. 2023. State and Trends of Carbon Pricing 2023. Washington, DC: World Bank. doi: 10.1596/978-1-4648-2006-9. License: Creative Commons Attribution CC BY 3.0 IGO
(2) European Commission, “EU Emissions Trading System (EU ETS) Documentation,” 2023, https://climate.ec.europa.eu/eu-action/eu-emissions-trading-system-eu-ets_en.
(3) World Bank. 2023. State and Trends of Carbon Pricing 2023. Washington, DC: World Bank. doi: 10.1596/978-1-4648-2006-9License: Creative Commons Attribution CC BY 3.0 IGO
(4) Making carbon pricing work for citizens | Nature Climate Change
(5) NGFS Climate Scenarios for central banks and supervisors, June 2021