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What is the difference between carbon taxes and emissions trading schemes?

Carbon Markets: Definitions

Carbon taxes and emissions trading schemes (ETS) are two distinct carbon pricing strategies aimed at internalizing the costs of carbon emissions. In short: putting a price on carbon emissions.

What is the difference between carbon taxes and emissions trading schemes?
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Carbon taxes and emissions trading schemes (ETS) are two distinct carbon pricing strategies aimed at internalizing the costs of carbon emissions. In short: putting a price on carbon emissions.

A carbon tax is a government-imposed fee on fossil fuels and emissions-generating activities. It incentivizes businesses to reduce their carbon footprint by attaching a financial cost to emissions, but fixes no boundaries on the total amount of CO2 emitted by the economy. 

On the other hand, cap-and-trade mechanisms also put a price on carbon, but also impose a strict limit on emissions by controlling the overall carbon budget available for industries. Currently, such schemes cover more CO2 emissions globally than carbon taxes, with approximately the same number of individual ETS and carbon taxes.

  • What are different carbon pricing strategies?
  • ETS and carbon taxes in numbers 
  • Why are ETS systems more effective than carbon taxes? 

What are different carbon pricing strategies?

Why put a price on carbon?

A negative externality is an unintended consequence of an economic activity that imposes costs on unrelated third parties who did not choose to incur those costs. When industries emit carbon as part of their activities, it constitutes a negative externality as they impact the environment without bearing the associated costs. In turn, this impacts society as a whole in the form of health degradation, lower agricultural yields, extreme weather events, loss of infrastructure, migration, etc. So, governments must ensure that polluters internalize these costs by implementing economic measures linked to carbon emissions.

What is a carbon tax?

A carbon tax is a government-imposed fee on the carbon content of fossil fuels and other activities that produce greenhouse gas emissions. It aims to incentivize individuals and businesses to reduce their carbon footprint by placing a financial cost corresponding to every unit of CO2 released. There are no limits on the volumes of carbon that can be emitted - all that matters is that the individual actors pay for their emissions. A tax is simple to understand and to implement, but doesn’t necessarily incentivize a change in behavior. It’s a brute force approach. 

What is carbon pricing through an ETS?

A carbon pricing mechanism is a policy tool used to internalize the cost of carbon in a different way - it aims to use the free market dynamics while imposing a strict limit on emissions. There is no logic of “one can pollute infinitely as long as they have the financial means to match their emissions” since the legislature controls the overall carbon budget available for the whole industry. 

ETS and carbon taxes in numbers 

Emissions trading schemes cover more CO2 emissions than carbon taxes

Currently, there are 38 carbon tax mechanisms and 37 Emissions Trading Systems (ETS) operating globally. Together, these initiatives cover approximately 11.66 billion tonnes of global greenhouse gas emissions, which accounts for approximately 23% of all worldwide CO2 emissions. Carbon taxes encompass 5% of global emissions, while ETS covers 18% of the world's emissions.

ETS systems and covered emissions

What are the prices of ETS and carbon taxes? 

Globally, the aggregated price of carbon across carbon taxes and emissions trading schemes (ETS) stands at $32. Among all tax and ETS mechanisms, the EU ETS had the fourth highest in carbon price in 2023. Over the years, both carbon ETS and taxes have experienced an upward trend, with averages hovering around $20 since 2005. Even despite having recently faced several months of losses, the EU ETS is currently priced trading at around €60 EUR after staying at a level around 80 throughout all of 2023.

Average 2023 price of carbon taxes and ETS around the world

Why are ETS systems more effective than carbon taxes? 

What are the objectives of ETS and carbon taxes? 

There is ongoing debate over whether a carbon tax or a cap-and-trade system offers the most effective approach to pricing greenhouse gas pollution. Both systems have different environmental and economic impacts. The economic theory states that the two systems can even be complementary, for example the David Suzuki Foundation advocates for a broad application of carbon pricing in the Canadian economy, achievable through a possible hybrid model with a carbon tax and a cap-and-trade system.

What is the advantage of a carbon tax? 

A carbon tax is easy and fast to implement. It is straightforward and can be understood by a lot of economic representatives and actors. It does not mobilize a lot of administrative frameworks and resources - its introduction can be a matter of months. Also, every individual country can decide itself on the levels and scopes of its carbon taxes. A carbon tax is predictable and companies can know in advance their exact cost of carbon that they will need to face. 

ETS offer environmental certainty 

Emissions trading schemes offer greater certainty regarding the quantity of emissions reductions achieved. Cap-and-trade systems are among the most powerful policy tools that governments possess to fight climate change. Unlike with carbon taxes, the CO2 emissions are capped - there is no threat of a privilege for the most wealthy. The price discovery is complex and driven by many factors from the real economy, but the amounts of carbon released in the economy over a certain period of time are very predictable. 

An alignment between price levels and emissions with Cap-and-Trade

Taxes are fixed and inflexible. They require ongoing reassessment to ensure their alignment with the economic and environmental reality. Although they are relatively easier to implement compared to Emissions Trading Systems, they entail substantial post-implementation efforts. ON the other hand, in ETS, emissions caps are set to align with CO2 mitigation goals, resulting in prices that naturally adjust to real-world emissions. This self-alignment happens through the free market market forces, reducing the need for additional regulatory interventions after the implementation of the scheme.

Key Takeaways

  • Carbon taxes and emissions trading schemes (ETS) internalize the costs of carbon emissions.
  • ETS cover more CO2 globally than carbon taxes.
  • There are 38 carbon tax mechanisms and 37 ETS, covering approximately 11.66 billion tonnes of greenhouse gas emissions.
  • The average price of carbon across taxes and ETS stands at $32 globally, with the EU ETS trading at around €60 EUR.
  • Emissions trading schemes offer greater certainty regarding emissions reductions as caps align with CO2 mitigation goals.
  • Taxes require ongoing reassessment to correspond to the environmental and economic reality.

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