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Climate policy tools: Carbon markets

December 3, 2015

I will be doing a series on carbon policy tools starting with a set on carbon markets and how they could be useful to implement the Paris Agreement. I’ll start with a basic intro to carbon markets before getting into the nitty gritty of how they could work as part of the UNFCCC.

K Rudd

Panel from the COP21 High-Level Event on Carbon-Pricing 

 

Why put a price on carbon?

We have already passed the point where our climate is changing, but we have a small buffer of how much more carbon we can emit before temperature increases become dangerous*. Whenever we emit carbon, we are using up a bit more of our buffer. So when we talk about putting a price on carbon, what we are actually talking about is putting a price on the amount of our buffer used (an economist would call this internalizing an externality by putting a price on the damage caused). This is important as it is the exact opposite of how we are used to setting prices and will become critical as we explore carbon pricing further.

At the level of an individual firm, a price on carbon provides an incentive to reduce emissions because it drives up the price of their products. This makes their product more expensive than that of their carbon efficient competitors, so consumers are likely to buy from their competitors instead.

At a national level, a price on carbon is even more effective if it occurs in a context that allows carbon emissions to be traded (a carbon market). If firms can trade carbon permits (a permit to use up some of our buffer, basically a unit of carbon with a price on it), they can raise revenues by selling their permits as they become more efficient. Firms that needed to emit carbon for their processes would have to purchase permits, noting that this cost would be reflected in the price of their product. By providing a clear price signals to reduce emissions, carbon markets have the potential to help national economies find the most efficient way to reduce their carbon output.

A range of countries have already begun experimenting with carbon pricing to reduce their emissions. They include China, Mexico, Chile, South Korea and the European Union. Collectively these carbon pricing schemes will cover 50% of global GDP by next year. Additionally, more than 1,000 companies are currently, or will be in the next 2 years, imposing a price on carbon internally in preparation for governments introducing carbon pricing more broadly.

In my next post I’ll go over some of the important lessons we’ve learnt about carbon pricing and carbon markets from these national schemes.

If you are interested in more detail on carbon markets, check out the work of the Carbon Pricing Leadership Coalition http://www.worldbank.org/en/programs/pricing-carbon

*This should be the level countries agree to limit temperature increases to in the Paris Agreement

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