What is carbon pricing and why is it important?

At the COP26 meeting in Glasgow, everyone was talking about carbon pricing as a way to encourage countries to reach IPCC climate targets. But what does climate pricing mean? And are we all talking about the same thing?

In conversation with sustainability experts from the leading producer of renewable diesel and sustainable aviation fuel Neste, science journalist Eva Amsen explores how different carbon pricing systems are used in different parts of the world, and how they can be defined.

What is carbon pricing?

In the broadest sense, carbon pricing is a tool that translates carbon emissions into a monetary value. But the phrase has slightly different meanings depending on the context.

“There is no single definition,” says Hugo Stenberg, Sustainability Manager at Neste in Finland. But if he had to give a top-level explanation, he would say that “carbon pricing is one of the mechanisms for policy-makers  and also for corporations to translate CO2 and other greenhouse gas (GHG) emissions into financial terms, to align decisions with climate targets.”

Part of the reason that carbon pricing is so complicated to talk about is that it can refer to different pricing mechanisms. Probably the best known mechanisms are emissions trading systems, carbon taxes, and internal carbon prices set by companies.  Although the underlying dynamics are different, they all drive the same purpose of putting a price on GHG emissions and thus supporting emission reductions.

So what do these mechanisms involve, and who is using them?

Comparing different carbon pricing systems

Emissions trading can be used as a policy tool to ensure that companies are collectively staying within a certain limit of GHG emissions - typically referred to as an emissions cap. The companies in the scope of the mechanism then need to acquire emission allowances for their GHG emissions through trading. For example, one of the best known carbon pricing mechanisms, the EU Emissions Trading System (EU ETS) is this kind of a “cap and trade” system.

“Emissions trading is effectively an auction. The allowance price depends on the availability, determined by the emissions cap, and on the demand for allowances, determined by how much GHG emissions the companies are emitting,” explains Stenberg.

Therefore, emission prices go up when demand is high, and as the emissions cap decreases every year to push towards climate targets, companies are either facing an increasing cost to comply - or invest in implementing actions to reduce their GHG emissions and to cut their need for allowances.

Another well-known carbon pricing mechanism, more aimed to reduce the emissions caused by transportation, are  so-called fuel standards. A fuel standard sets a baseline carbon intensity value for fuels sold to a specific market, defining the level of GHG emissions caused over the lifecycle of the fuel, from production to consumption. The fuel standard mechanism is designed to encourage the use and production of fuels that have a lower carbon intensity than the baseline. Such fuel standards have been successfully implemented for example in the US in California and Oregon, known there as low carbon fuel standards (LCFS).

“The mechanism effectively incentivizes producing and using low carbon fuels,” says Hélène Dieck, Sustainability Manager at Neste in the US. “Fuels that have a carbon intensity below the baseline create carbon credits, which can be sold to companies that use fuels with higher than baseline carbon intensity. The carbon price in this mechanism is then the price of these credits.

”What carbon pricing mechanisms such as the cap and trade systems and fuel standards have in common, is that they are based on emission or credit trading, and have a predefined emissions reduction target. The carbon price also varies based on the market dynamics of supply and demand.

–Therefore, the systems are to some extent prone to unexpected changes affecting the market dynamics, and sometimes forecasting the price is difficult. For example, the EU ETS allowance price has been affected by COVID-19 as well as the war in Ukraine.

“Such cases have shown that politicians need to think about how to make carbon pricing as predictable as possible,” says Stenberg. “Rapid changes in carbon pricing can create uncertainties for companies, especially when planning larger investments into climate actions.”

In addition to mechanisms where the carbon price is determined by the supply-demand balance, another method for carbon pricing is a carbon tax on a specific sector or activity. In the short term, this has the benefit of a stable fixed price for GHG emissions. The downside is that as it requires setting the carbon price separately from market dynamics, it may not be as effective in supporting actions to reduce GHG emissions. In addition with a carbon tax, the total amount of GHG emissions is not controlled in the same way as with emission trading systems.

Dieck says that “it's really important for companies to have confidence that carbon pricing mechanisms have continuity also from the technology perspective. As we know, all solutions are needed to meet global climate ambitions, and carbon pricing should treat those solutions purely based on the ability to reduce GHG emissions.”

–In addition to policy-driven carbon pricing mechanisms, many companies have implemented internal carbon pricing mechanisms to align their investment decisions and strategic planning with their climate targets.Using an internal carbon price in internal analysis can  help manage the short-term variations of the carbon price in market-driven mechanisms, and prepare for future policy developments that are more than likely to lead to increasing carbon prices.

“Global companies are often affected by various carbon pricing mechanisms, so the ways of determining and implementing an internal carbon price can differ from company to company,” says Stenberg. “At Neste for our internal carbon price we have been closely following the EU ETS price and related policy developments, and also taking into account the carbon prices in different climate scenarios modeled by for example the International Energy Agency (IEA).”

Why is carbon pricing important?

Regardless of which mechanism is used to set a carbon price and translate GHG emissions into financial terms, the ultimate goal for all these different systems is to reduce these emissions. And the good news is that they seem to be working.

According to the European Commission, the GHG emissions covered by the EU ETS have decreased by about 35 % between 2005 and 2019. The EU ETS continues to be one of the key tools for the EU to reduce GHG emissions cost-effectively and helps the EU meet its target of being climate neutral by 2050.

A 2018 study from Texas A&M University showed that since the state of California introduced their Low Carbon Fuel Standard (LCFS) system a decade earlier, CO₂ emissions in the transportation sector went down by 10%. It is making a clear difference in helping the state get closer to its climate goal of being carbon neutral by 2045.“It's really amazing how much they have reduced their overall emissions based on this LCFS program,” says Dieck.Similarly, internal carbon pricing methods are helping businesses to stay on track with their own climate targets as well as complying with regulations.

A tool for transparency

One thing that Stenberg and Dieck emphasize is that carbon pricing shouldn’t be seen as a punishment, but as a motivational tool. “It's a way for companies and for governments to make better, more informed decisions to increase the transparency of the climate impacts of different decisions, thus helping to reach climate goals,” says Dieck.

Additionally, carbon pricing regulations are also driving businesses to be transparent about their emissions – which is what consumers want to see too to help them make more sustainable choices.

“One of the ‘side effects’ of carbon pricing mechanisms is that it increases the importance of knowing either the absolute GHG emissions of your company or the carbon intensity of the products you sell, or both,” explains Stenberg.

“This requires better greenhouse gas accounting, and often also reviewing the GHG calculations with a third party - and that already creates transparency for stakeholders.”Dieck thinks the climate awareness of consumers will only increase: “Consumers expect more and more transparency about the carbon intensity of the products they buy.”

She envisions a future in which it will be easy for consumers to compare how different companies are achieving their climate goals and says: “I really hope that we can reach a point where, just as we have calories at the back of food products, we could have the same for the carbon footprint of the product.”

Credits: Dr. Eva Amsen, a science writer and communicator whose work has appeared on Forbes, Nautilus and The Scientist. Twitter