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Role of Carbon Pricing in Reducing Greenhouse Gas Emissions

Climate change will have terrible costs for society. But right now, the price of fossil fuels—the main cause of climate change—doesn’t reflect these costs. Carbon pricing is a way to change that.
Carbon emissions in the air at sunset

Global warming is the greatest threat facing humans today—possibly the greatest ever. Already, it’s causing heat waves, wildfires, intense storms, flooding, and drought. All these effects will only grow worse over time.

To get climate change under control, we need to rein in emissions of the carbon-based greenhouse gases responsible for warming. Scientists say we must cut greenhouse gas emissions nearly in half by 2030 and to zero by 2050. And that means ending our use of fossil fuels, the main source of greenhouse gas emissions.

But that’s easier said than done. In many places, fossil fuels are still the cheapest energy source. It’s not reasonable to expect people to stop burning them when it’s in their economic interest to do so. That’s why many experts say we need to change the equation. Make fossil fuels more expensive, and their users will shift away naturally. This idea is called carbon pricing.

Understanding carbon pricing

The idea behind carbon pricing can be summed up as, “Make polluters pay.” Fossil fuel use is the main driver of climate change. But right now, the people suffering most from climate change aren’t the heaviest fossil fuel users. Instead, the damage largely affects poor people and poor countries that use the least fossil fuel—an environmental injustice. By putting a higher price on fossil fuels, we can shift the cost where it belongs.

Social costs of carbon pollution

Greenhouse gas emissions impose huge burdens on society. These “social costs” include:

  • Increased health care costs for treating heat-related illnesses and tropical diseases.
  • Crop loss due to changes in rainfall.
  • Property damage from increased flooding.
  • Damage to ecosystems.
  • Loss of life.

In 2021, a panel formed by the U.S. government added up all these costs in dollar terms. It concluded that each metric ton of carbon dioxide (CO2) emitted in 2025 would ultimately cost society $56. Other greenhouse gases, like methane and nitrous oxide, have far higher costs.

Currently, the dollar cost of fossil fuel doesn’t reflect these social costs. Users of coal, oil, and natural gas aren’t paying the price for the damage they do to society. And because these fuels remain cheap, polluters have no incentive to stop using them.

Changing incentives

Carbon pricing makes the social cost of fossil fuels part of their dollar cost. Governments raise the price of these fuels, encouraging consumers and businesses to use less of them. This promotes all the behaviors that reduce fossil fuel use—conservation, efficiency, and clean energy use—instead of just one.

Lower emissions aren’t the only benefit of carbon pricing. It also reduces other types of pollution associated with fossil fuel use, saving lives and lowering health care costs. Carbon pricing also encourages companies to innovate, developing new technologies to cut fossil fuel use. Consumers benefit as solutions like electric vehicles become cheaper. And while carbon pricing does destroy fossil fuel jobs, it creates new jobs in fields related to clean energy.

There are two basic approaches to carbon pricing: carbon taxes and cap-and-trade systems. Both make greenhouse gas emissions more expensive, but through different mechanisms.

Carbon pricing diagram

Carbon taxes: Pricing carbon directly

The simplest way to put a price on carbon emissions is to tax fossil fuels. This has an immediate, direct impact on their cost.

How carbon taxes work

A carbon tax is a tax on fossil fuels based on the amount of carbon emissions they produce. Since not all greenhouse gases are equally harmful, emissions are usually priced in tons of “CO2 equivalent.” Most carbon taxes are collected “upstream,” when fossil fuels are produced, rather than “downstream,” when they’re sold to consumers. Upstream taxes are simpler because they don’t need to be collected in as many places.

Of course, when you tax fossil fuel producers, they generally respond by raising their prices. This drives up energy costs for consumers, such as gas prices and electricity bills. Consumers, in turn, typically respond by cutting their fossil fuel use, driving down emissions.

Figuring out how much to tax emissions can be tricky. The higher the carbon tax, the more it will reduce emissions. However, if you impose a large tax all at once, it causes a huge spike in energy prices. That sharply drives up prices for other goods shipped with fossil fuels—which is pretty much all goods, period. This kind of sudden price shock can cause a lot of damage to the economy. That’s why most carbon taxes have started out fairly low, then rise steadily over time.

Benefits and challenges of carbon taxes

One big advantage of carbon taxes is their simplicity. There’s no need for complex regulations about what people or companies can and can’t do. The government simply raises the price and consumers choose how to respond. There’s also no need for a large, new bureaucracy. Since governments already have systems in place to tax companies, they can collect the carbon tax the same way.

Also, carbon taxes generate valuable revenue. The government may spend this money on other programs to mitigate climate change and help people adapt to it. It can also fund programs to help fossil fuel workers hurt by the energy transition, such as job retraining. Or it can provide tax relief for families facing higher energy bills.

Carbon taxes have a direct impact on energy prices, and therefore on emissions. This is both a benefit and a downside. Higher energy costs are unpopular with voters, especially because they drive up prices for everything else. Also, higher energy prices are regressive. That means they put a heavier burden on low-income families, who typically spend more of their income on energy. In other words, they hit hardest against those who can least afford it.

Carbon fee and dividend systems

One way around these problems is a fee-and-dividend system. This is like a carbon tax, but the money collected doesn’t go to the government. Instead, it’s returned to the people as a “carbon dividend.” They can use this money to offset higher energy costs.

If people get back what they spend on carbon fees, what incentive do they have to cut fossil fuel use? The answer lies in how the money is distributed. The carbon dividend is equal for all households. No matter what you do, the amount you receive is the same—but the amount you pay is not. Consumers who use less fossil fuel pay less in added energy costs than they collect in dividends, coming out ahead.

Carbon dividends can make carbon taxes progressive—better for low- and middle-income people—instead of regressive. Lower-income households spend a larger percentage of their income on energy, but their total energy use is lower. That means they generally get more from carbon dividends than they spend on higher energy bills. A fee-and-dividend system actually puts money in their pockets.

Several provinces in Canada use a system like this. In 2021, most Canadians in these provinces collected more from the carbon dividend than they paid. A 2023 bill called the Energy Innovation and Carbon Dividend Act would establish a similar system in the U.S.

Cap-and-trade systems: Setting emission caps

The other way to price carbon is cap and trade, also known as a carbon-trading or emissions-trading system (ETS). These systems also increase the price of fossil fuels, but less directly. Essentially, they turn the right to pollute into a commodity that can be bought and sold.

How cap-and-trade works

As the name implies, a cap-and-trade system has two parts. The first part, the cap, is a limit the government sets on the total greenhouse gas emissions. The government divides up this total into smaller amounts called emissions allowances and allots them to businesses. Businesses may receive allowances based on their size or may have to bid for them in an auction. Each business can only emit up to its allowance.

What if a business can’t meet this target? That’s where the trading part comes in. Businesses can buy and sell their allowances on a carbon market. Businesses with emissions below their limit sell their excess emissions credits to other businesses that need more. This gives companies a financial incentive to cut emissions so they can sell their credits.

The U.S. successfully used a cap-and-trade system in the 1990s to reduce emissions of the pollutant sulfur dioxide (SO2). However, carbon trading would require a much bigger and more complex system. Carbon emissions aren’t limited to smokestack pollution; they’re much more pervasive throughout the economy. And carbon is much harder to capture and filter out than SO2.

Nonetheless, some individual U.S. states, including California, have their own carbon cap-and-trade systems. Several eastern states take part in the Regional Greenhouse Gas Initiative (RGGI), a cap-and-trade system specifically for power plants. There’s also a large international ETS in the European Union (EU) and an even larger one in China.

Benefits and challenges of cap-and-trade

One benefit of cap and trade is flexibility. Companies and sectors that can cut their emissions easily can trade their credits to others that can’t do it as easily. Another advantage is that the cap sets a firm upper limit on emissions.

An ETS can be effective in reducing emissions. The EU’s system has helped cut emissions from power plants and factories 37% since 2005. However, cap and trade has several big downsides:

  • Added bureaucracy. The government has to set the cap, determine how to divide it up, and create a market for trading allowances. After that, it must keep tabs on each company to make sure it’s not emitting more than allowed. Because of this, a cap-and-trade system takes much longer to set up than a carbon tax.
  • Market manipulation. There are many ways to manipulate the carbon market. Investors can buy and sell allowances to drive their price up or down. Companies can also fudge their emissions numbers to increase their carbon allowance. They may even try to increase emissions before the carbon market opens to maximize their allowance.
  • Price volatility. Even without deliberate market manipulation, the cost of carbon varies widely over time. This makes energy prices less stable. It’s harder to calculate the costs of decisions involving energy, from installing solar panels to designing a new transportation system.
  • Limited effectiveness. Under an ETS, businesses that reduce their own emissions don’t reduce total emissions. They just sell their excess allowances to other companies, allowing them to pollute more. While total emissions will never rise above the level of the cap (barring cheating), they’ll never fall below it either.

Effectiveness in reducing emissions

Carbon pricing helps the climate in two ways. First, it reduces emissions directly. Second, it accelerates the transition to a clean energy economy.

Emission reduction targets

Carbon pricing can help nations meet their targets for reducing emissions. A 2020 study by the World Economic Forum (WEF) analyzed long-term emissions from over 140 countries. It found that on average, emissions fell in countries with a climate price and rose in those without one. The WEF calculated that carbon pricing reduced total emissions by an average of 2 percentage points. The higher a country’s carbon price was, the more it reduced emissions.

Several countries offer examples of how carbon pricing helps cut emissions. Since Sweden introduced its carbon tax in 1991, its total emissions have fallen 33% without slowing economic growth. In Canada, a carbon tax helped reduce emissions 8.4% from 2005 through 2021. And U.S. states participating in the RGGI have cut power plant emissions more than 50% since 2008.

Role in transitioning to clean energy

Besides cutting emissions today, carbon pricing sends a signal to investors that prices will rise still more tomorrow. This creates big incentives to invest in alternatives. In RGGI states, for instance, renewable electricity production has risen 73% since 2008.

This isn’t an isolated occurrence. A 2023 paper shows that carbon pricing leads to more patent applications for clean energy technology. Another paper, from 2021, says “carbon pricing has had a small but positive and significant effect on low-carbon innovation.”

Wind turbines in a large green field.

Carbon pricing as a tool for climate action

Carbon pricing isn’t a magic wand. It’s a useful tool for nations to achieve their climate goals, but it can’t do it all on its own. It’s not politically possible—maybe even not physically possible—to increase fossil fuel prices fast enough.

Even carbon-pricing advocates, such as the Carbon Tax Center, say carbon pricing needs to work alongside other climate policies. These can include:

  • Energy efficiency standards for vehicles, buildings, and appliances.
  • Subsidizing clean energy and ending existing subsidies for fossil fuels.
  • Subsidies for companies to develop and consumers to purchase energy-efficient equipment.
  • Clean air regulations that limit pollution from burning fossil fuels.

Nonetheless, many experts consider carbon pricing an essential piece of the climate puzzle. The World Bank says it’s “critical to scaling up climate action.” Currently, 39 countries use some form of carbon pricing system, and these systems regulate nearly a quarter of global emissions.

You can see both the power and the limits of carbon pricing directly with the EN-Roads Climate Solutions Simulator. This tool allows you to adjust different policy levers and see what impact they have on global temperatures. Dragging the “carbon price” lever all the way to the right lowers the global temperature increase from 3.4°C to 2.3°C. That’s more than any other individual policy change, but it’s still not enough. You can’t reduce warming below 2°C without adding other policies, such as building electrification and reducing deforestation.

What individuals can do

A nationwide carbon tax will only become a reality if our leaders can see the people support it. You can show your support by:

  • Promoting carbon pricing legislation. Contact your legislators and encourage them to support carbon pricing policies, such as the Energy Innovation Act. Consider joining Citizens Climate Lobby (CCL), an international group that advocates for carbon pricing.
  • Educating others. Spread the word about carbon pricing and its benefits. Explain it to your friends and talk it up on social media. CCL can help you find appropriate videos and posts to like and share.
  • Reducing your personal carbon footprint. You don’t have to wait for action from Congress to start lowering your own carbon footprint. Save energy at home to reduce both your emissions and your electric bill. Change your diet by eating less meat and other high-emissions foods. And promote clean energy by switching to community solar for your home or business.
Sun shining on community solar panels

How carbon pricing can change the world

Like all environmental policies, carbon pricing has a cost. It will increase energy prices—though there are ways to reduce the burden on low-income individuals. But failing to address climate change will have an even bigger cost—in health care, property damage, and human lives. By pricing carbon, we can make polluters pay for these social costs.

Putting a price on carbon isn’t a complete solution to climate change, but it’s an essential part of the solution. By learning about and promoting carbon pricing policies, you can do your part to make this powerful idea a reality.

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