Climate Laws link

Legislation outlines the overall goals regarding how governments intend to change behaviour and can be used to embed net zero targets and strategies in law, thus making compliance mandatory. Several countries have already enacted legislation that enshrines their stated net zero targets in law, and many others have begun preparations to do the same (Net Zero Tracker, n.d.).

Market-based instruments: putting a price on carbon

One of the main policy levers available to governments is fiscal and market measures, also known as market-based instruments. These instruments include subsidies, tariffs and tax incentives, as well as carbon trading and pricing schemes intended to correct so-called market failures.

Market failures may arise, for example, when the true cost associated with GHG emissions is not reflected in market prices. This relates to the concept of negative externalities, which can be defined as the indirect costs that arise from the production or consumption of a specific good or service, without those costs being passed on to the producer or consumer. Negative externalities often impact the environment, society or parts of the economy in a detrimental manner, for example when pollution from a manufacturing process affects the health of the local community, brings down property values or destroys the value of natural resources (Kenton, 2020).

Carbon pricing initiatives are market-based instruments that aim to correct negative externalities and put a price on carbon emissions. The aim of carbon pricing is to provide a financial incentive to reduce emissions, by making producers and consumers pay for the actual cost of carbon-intensive goods or services. Carbon pricing also aims to increase innovation and competition for alternative, lower-emission products (World Bank, 2021).

While there is widespread acceptance among governments, businesses and economists that carbon pricing has an essential role in reducing emissions, it can be difficult to get the pricing right (LSE, 2018). The price of carbon cannot be so high that business and the public reject it, and not so low that it becomes ineffective for reducing emissions. Globally, the price of carbon varies greatly, from less than US$1 per tonne in some regions, to US$139 per tonne in Sweden (Houlder & Livsey, 2021).

Moreover, carbon pricing initiatives on their own are unlikely to result in the emissions reductions required to meet the targets set out in the Paris Agreement. They are the most effective when combined with other climate-related policies and regulations, or with other carbon-pricing mechanisms.

Compliance-based carbon pricing

Compliance-based carbon pricing mechanisms include carbon taxes and emission trading schemes. Carbon taxes are set by governments and consist of a predetermined, fixed price on carbon that is paid by the producers or consumers of high-emission goods or services. Taxes have no cap on emission levels, but the intention is to provide a powerful price signal that incentivises emission reductions and increases consumption of low carbon alternatives.

Emission trading schemes (ETS) regulate the level of emissions permitted by those included in the scheme while allowing the price of carbon to be determined by the market. Producers of high-emission products must acquire permits for their emissions through one of the following two systems:

  1. In cap-and-trade systems, a maximum level of permitted emissions is set by the government, and either auctioned or allocated to companies covered by the scheme. Depending on how much they emit, these companies can then buy and sell their emissions allowances, with the price fluctuating depending on the market.
  2. In baseline-and credit systems, companies covered by the scheme are provided with a baseline level of permitted emissions. Those that manage to reduce their emissions below their baseline are given carbon credits which they can sell to others within the same scheme (World Bank, 2021).

The EU Emissions Trading System was the world’s first international ETS when it launched in 2005. Since then, it has undergone several revisions to improve its effectiveness and resilience, and more sectors have been included.

National, regional or subnational ETSs exist in over 60 jurisdictions and are also being piloted or considered in many other locations. In 2021, China created the world’s largest carbon market by launching its national ETS, covering over 2,000 companies in the power and electricity sector. Despite the upsurge, in that year only one fifth of global GHG emissions were covered by compliance-based carbon pricing instruments (World Bank, 2021).

For governments, compliance-based schemes have the advantage of raising revenue which can then be reinvested into innovative technologies or earmarked for mitigating any negative impacts experienced by lower-income households or smaller businesses (Roser, 2021). For businesses, one of the benefits is the stability and clarity that comes from having transparent rules and more complete market information, thus helping companies plan for the future (Klenert et al, 2018).

Explore further:

The Carbon Pricing Dashboard from the World Bank reveals where regional, national and subnational carbon pricing initiatives are in operation or being planned.

Voluntary carbon markets and offsetting

Countries and businesses can also participate in voluntary trading schemes where carbon credits are generated through independent standard-setting organisations (eg Verra or Gold Standard), either as a complement to existing ETSs or in markets where no ETS exist. Countries wanting to ‘offset’ emissions that are difficult to eliminate can purchase carbon credits from other countries that have managed to cut their emissions below their stated national targets (NDCs). Businesses might purchase carbon offsets as part of their net zero strategy to compensate for residual emissions by reducing the equivalent amount of GHG elsewhere in the world – for example, through the planting of trees in degraded land areas.

In a well-structured scheme, carbon credits are generated and verified based on the demonstration of additionality. In other words, credits are only issued for projects that result in emission reductions beyond what would have happened without carbon credit funding. For example, if one country purchases carbon credits for installing solar water heating systems in another country, the additionality criterion is only fulfilled if the crediting mechanism is what enabled the host country to go ahead with the project (Kizzier, Levin & Rambharos, 2019).

Voluntary carbon markets have the potential to generate benefits for all stakeholders and provide private financing for important emissions reduction projects. However, offsetting schemes have been plagued by the complexities around defining, verifying and measuring carbon offsets, and a lack of consistent standards and rules for international trading in carbon credits. Controversy has also arisen from the perception that offsetting schemes are used by some businesses as a tactic for balancing their carbon accounting, rather than significantly reducing emissions from their own operations, energy consumption and supply chains. For this reason, non-governmental organisations (NGOs) and consumer groups are increasingly critical of offsetting where it is often perceived as a form of greenwashing.

Definition of greenwashing:

Greenwashing occurs when a business or organisation knowingly or unknowingly presents a false impression of how environmentally friendly their products, practices or operations are (Kenton, 2022).

Voluntary schemes will no doubt continue to play a part in the international carbon markets. However, with an increased level of scrutiny, most schemes are likely to partially align with the United Nations Framework Convention on Climate Change (UNFCCC) centralised system set out in the Article 6 framework.

Explore further:

The Article 6 framework was finally agreed at COP26 after many years of negotiation. It sets out the structure for international trading in carbon credits through a centralised UNFCCC system of emissions trading in both the public and private sectors, and a separate bilateral system designed for countries only.

The Article 6 framework has implications for voluntary carbon markets, the intricacies of carbon offsets and the greenwashing dilemma.