Education
Carbon Pricing 101
A plain-English guide to the two main ways governments put a price on carbon emissions.
🪙
Carbon Tax
Fixed price, variable quantity
📊
Emissions Trading (ETS)
Fixed quantity, variable price
Both instruments aim to make pollution costly — they just differ in what they fix.
🪙A price on carbon emissions
Carbon Tax
A carbon tax is a fee charged on the carbon content of fossil fuels — oil, coal, and natural gas. It is the most direct way to put a price on greenhouse gas emissions.
How it works
1
Government sets a price
The government establishes a fixed price per tonne of CO₂ emitted — for example, $50 per tonne.
2
Emitters pay the tax
Businesses, fuel suppliers, or consumers pay the tax when they burn fossil fuels. Higher emissions = higher tax.
3
Behavior changes
As fossil fuels become more expensive, households and businesses shift to cleaner alternatives — EVs, heat pumps, renewables.
4
Revenue is recycled
Tax revenue can be returned to households as rebates, invested in clean energy, or used to cut other taxes.
Advantages
- Simple to understand and administer
- Provides price certainty for long-term investment
- Revenue can fund rebates or green investment
- Technology-neutral — rewards any solution that cuts emissions
Challenges
- Quantity of emissions reduction is uncertain
- Politically challenging to set rates high enough
- Risk of carbon leakage to non-taxing countries
- Can be regressive without rebate design
Real-world examples
Sweden
$137/tCO₂ · since 1991
Canada
$50/tCO₂ · since 2019
Singapore
$25/tCO₂ · since 2019
📊Cap-and-trade emissions markets
Carbon Trading (ETS)
An Emissions Trading System (ETS) — also called cap-and-trade — limits total emissions by issuing a fixed number of permits. Companies can buy and sell these permits, creating a carbon price through the market.
How it works
1
Government sets the cap
A total emissions limit (the 'cap') is set for covered sectors. The cap is lowered over time to drive reductions.
2
Allowances distributed
Emission allowances (1 allowance = 1 tonne CO₂) are either auctioned or given free to regulated companies.
3
Companies trade
Companies that reduce emissions below their allowances can sell surplus permits. Those who emit more must buy extra.
4
Compliance & surrender
At year-end, each company must surrender enough allowances to cover its actual emissions or face penalties.
Advantages
- Guarantees a fixed total emissions level
- Market finds the most cost-efficient reductions
- Auction revenue can fund climate programs
- Can be linked across jurisdictions for liquidity
Challenges
- Carbon price is volatile and uncertain
- Complex to design and administer
- Risk of over-allocation weakening price
- Free allowances can create windfall profits
Real-world examples
EU ETS
40% of EU emissions · since 2005
China ETS
Power sector · since 2021
California C&T
85% of state emissions · since 2013
Key Concepts
Carbon Leakage
When companies move production to jurisdictions with weaker carbon rules to avoid the cost. Addressed by free allowances or border carbon adjustments.
Price Floor / Ceiling
Some ETS systems set a minimum (floor) or maximum (ceiling) carbon price to reduce volatility and provide investment certainty.
Offset Credits
Certified emissions reductions from projects (e.g. reforestation) that can substitute for allowances or reduce a carbon tax liability.
tCO₂e
Tonnes of CO₂ equivalent — the standard unit for measuring greenhouse gas emissions, converting gases like methane into CO₂ terms using their warming potential.
Cap Tightening
In ETS systems, the total cap is reduced each year (the 'linear reduction factor'), ensuring total emissions fall over time toward climate targets.
Border Carbon Adjustment
A tariff on imported goods that prices their embedded carbon, preventing carbon leakage and leveling the playing field. The EU CBAM is the leading example.