How carbon prices are taking over the world

CO2 Markets & Reforestation

How carbon prices are taking over the world

A quarter of global emissions are now covered, and the share is rising fast

IF GLOBAL WARMING is to be limited, the world must forget about fossil fuels as fast as possible—that much almost everyone agrees upon. How to do so is the complicated part. Economists have long favoured putting a price on carbon, a mechanism that Europe introduced in 2005. Doing so allows the market to identify the cheapest unit of greenhouse gas to cut, and thus society to fight climate change at the lowest possible cost. Others, including many American politicians, worry that such schemes will provoke a backlash by raising consumer costs. Under President Joe Biden, America is instead doling out hundreds of billions of dollars to nurture green supply chains.

Yet, remarkably, the rest of the world is now beginning to look more European—with carbon prices spreading in countries both rich and poor. Take Indonesia, the world’s ninth-biggest polluter. Although it releases 620m tonnes of carbon-dioxide equivalent a year, with almost half its soaring energy consumption coming from coal, the country has green ambitions. On September 26th, at the launch of its first carbon market, Joko Widodo, the president, talked up its prospects as a hub for the carbon trade, and local banks duly snapped up credits from a geothermal-energy firm. The country also introduced a local emissions-trading scheme in February, which requires large coal-fired plants to buy permits for emissions above a threshold.

In short, even in countries better known as polluters than as green leaders, things are shifting. By the start of 2023, 23% of the world’s emissions were covered by a carbon price, according to the World Bank, up from just 5% in 2010 (see chart). The spread will only accelerate over the coming years as more countries come around to the advantages of carbon pricing, and existing schemes expand their reach. On October 1st the EU launched a groundbreaking policy under a dreary name. The “carbon border adjustment mechanism” (CBAM) will, by 2026, start to levy a carbon price on all the bloc’s imports, meaning that European companies will have a strong incentive to push suppliers around the world to go green.

The spread of carbon prices is happening in three ways. First, governments are creating new markets and levies. Indonesia is one example. If all goes to plan, its market will eventually be combined with a carbon tax. In April Japan launched a voluntary national market for carbon offsets, which will work alongside an existing regional cap-and-trade policy in place in Tokyo. Participants, accounting for 40% or so of the country’s pollution, will be required to disclose and set emissions targets. Over time the scheme will become stricter, with auctions of carbon allowances for the energy industry due to begin in 2033. Meanwhile, Vietnam is working on an emissions-trading scheme to be established in 2028, in which firms with emissions above a threshold will need to offset them by buying credits.

Second, countries with more established markets are beefing up their policies. On September 24th China’s National Climate Strategy Centre announced that its emissions-trading scheme, which is the world’s largest, will move from only focusing on the carbon intensity of coal power plants, to focusing on both their intensity and total emissions. The scheme will be linked with a dormant carbon-credit market, allowing plants to meet their obligations by purchasing credits for renewable power, planting forests or restoring mangroves. Australia, which scrapped its original carbon price in 2014, has reformed a previously toothless scheme known as the “safeguard mechanism”. Since July large industrial facilities that account for 28% of the country’s emissions have had to reduce emissions by 4.9% a year against a baseline. Those that fail must buy carbon offsets, which trade at a price of around $20 a tonne.

The final way in which carbon markets are spreading is through cross-border schemes. The EU’s programme is by far the most advanced. In CBAM’s pilot phase importers of aluminium, cement, electricity, fertiliser, hydrogen, iron and steel will need to report “embodied” emissions (those generated through production and transport). Then, from 2026, importers will have to pay a levy equivalent to the difference between the carbon cost of these embodied emissions in the EU’s scheme and any carbon price paid by the exporter in their domestic market. Free permits for sectors will also be phased out, and the housing and transport industries will be brought into the market.

Many of these schemes will take time to have an impact. Lots in Asia are flimsy, with prices set too low to produce meaningful change—well below the EU’s current price of €80-90 ($85-95), which is itself only approaching climate economists’ estimate of the social cost of carbon. For instance, half the coal plants covered by China’s emissions-trading scheme face a negative carbon price, meaning that they are in effect paid to burn the dirty fuel, since their emission intensity is below the national average, says Lauri Myllyvirta of the Centre for Research on Energy and Clean Air, a think-tank. The scheme also fails to create an incentive to shift from coal to other sources of power, he notes.

Across the world, activists criticise the ability of firms to use offsets to indulge in what they term “greenwashing”, where companies falsely present themselves as environmentally friendly. Some schemes also struggle to prove they have led to emissions reductions. In 2022 a team of academics, led by Andrew Macintosh of Australian National University, argued that reforestation used as carbon credits in Australia’s scheme either did not happen or would have happened irrespective of payments for offsets. An independent review has since recommended changes to how the scheme works.

Yet even carbon-pricing programmes that are limited will still help change behaviour, for the simple reason that they encourage the monitoring of emissions. After its launch two years ago, China’s emissions-trading scheme was dogged by fraud, with consultants alleged to have helped firms produce fake coal samples. A crackdown was announced by officials earlier this year, who are now satisfied with the quality of data. Despite the absence of a carbon price, American firms also face incentives to monitor emissions. President Biden has proposed a rule that all businesses selling to the federal government must disclose their emissions and have plans to reduce them. Many large firms have set voluntary net-zero targets as part of their marketing efforts. Apple, the world’s largest, has pledged to make its supply chain entirely carbon neutral by 2030.

And manufacturers around the world now face a still greater incentive to accurately track their carbon footprints: CBAM. The EU’s ultimate goal is to tackle “carbon leakage”. Before CBAM’s introduction, Europe’s carbon price meant that domestic industries faced an extra cost compared with those in countries with less ambitious decarbonisation plans. This gave importers an incentive to source material from abroad, even if these inputs were dirtier. To compensate for this, the EU handed out permits to industrial producers. These will now be phased out as CBAM is phased in.

During the pilot phase, CBAM simply presents an extra hurdle (what economists call a “non-tariff barrier”) for exporters to the bloc. To comply, European firms must report the embodied emissions of their imports. If such data do not exist, importers must use reference values provided by the EU. In order to nudge foreign companies to change their behaviour and prove that their emissions are lower, these are based on the emissions of the dirtiest firms in the bloc. From 2026 importers will have to pay the difference between the amount embodied emissions would be charged under the EU’s emissions-trading scheme and whatever carbon price the products pay at home.

Carbon border tariffs may themselves multiply over the coming years. In Australia the government recently announced a review into the country’s “carbon leakage”, which will examine such an option. In 2021 America and the EU paused a trade dispute, begun by President Donald Trump, by starting negotiations over a “Global Arrangement on Sustainable Steel and Aluminium”. America wants the two trading partners to establish a common external tariff on more polluting steel producers. Since America does not have a domestic carbon price, such a policy would flout the rules of the World Trade Organisation. But if the EU and America do not come to an agreement, the Trump-era tariffs and the EU’s retaliatory measures will be reinstated.

There is a domino effect to carbon pricing. Once an industry is subject to a carbon price its businesses will naturally want their competitors to face the same rules. Therefore owners of coal power plants will lobby to ensure that gas power plants operate on a level playing-field. Governments in exporting countries also have an incentive to ensure that their domestic firms pay a carbon price at home rather than a tariff abroad. If Asia’s factories are pressed to reduce their emissions anyway by schemes such as CBAM, then its governments are leaving money on the table by not levying a carbon price of their own.

The question is whether the dominoes will fall fast enough. Almost no emissions-trading schemes are aimed at emissions from residential property or cars, for instance, where consumers would really feel the pain. In choosing to introduce carbon-pricing schemes, and then to make them broader and more muscular, policymakers have most economists firmly on their side—and are proceeding much faster than is commonly realised. But future policymakers will need to make such policies even more intrusive if the effects of climate change are to be minimised. For that to happen, they will have to win over voters, too. ■

 

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