Carbon pricing is an instrument that captures the external costs of greenhouse gas (GHG) emissions – the costs of emissions that the public pays for, such as damage to crops, health care costs from heat waves and droughts, and loss of property from flooding and sea level rise – and ties them to their sources through a price, usually in the form of a price on the carbon dioxide (CO2) emitted.
A price on carbon helps shift the burden for the damage from GHG emissions back to those who are responsible for it and who can avoid it.
Types of Carbon Pricing:
There are two major types of carbon pricing:
(1) Emissions Trading Systems (ETS): ETS – also referred to as a cap-and-trade system – caps the total level of GHG emissions and allows those industries with low emissions to sell their extra allowances to larger emitters. By creating supply and demand for emissions allowances, an ETS establishes a market price for GHG emissions. The cap helps ensure that the required emission reductions will take place to keep the emitters (in aggregate) within their pre-allocated carbon budget.
(2) A carbon tax directly sets a price on carbon by defining a 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.