What Is Carbon Pricing and Why Is It Important?

by Eva Amsen (Neste) Carbon pricing is a tool increasingly used to translate greenhouse gas emissions into a financial cost, and can be used by governments and businesses to help reduce emissions and meet climate goals. There are different pricing mechanisms in place such as emissions trading systems, carbon taxes and internal carbon pricing. They are all related, but each has its own logic to determine the carbon price.

Emissions trading can be used as a policy tool to ensure that companies are collectively staying within a certain limit of GHG emissions - typically referred to as an emissions cap. The companies in the scope of the mechanism then need to acquire emission allowances for their GHG emissions through trading. For example, one of the best known carbon pricing mechanisms, the EU Emissions Trading System (EU ETS) is this kind of a “cap and trade” system.

“Emissions trading is effectively an auction. The allowance price depends on the availability, determined by the emissions cap, and on the demand for allowances, determined by how much GHG emissions the companies are emitting,” explains Stenberg (Hugo Stenberg, Sustainability Manager at Neste in Finland).

Therefore, emission prices go up when demand is high, and as the emissions cap decreases every year to push towards climate targets, companies are either facing an increasing cost to comply - or invest in implementing actions to reduce their GHG emissions and to cut their need for allowances.

Another well-known carbon pricing mechanism, more aimed to reduce the emissions caused by transportation, are so-called fuel standards. A fuel standard sets a baseline carbon intensity value for fuels sold to a specific market, defining the level of GHG emissions caused over the lifecycle of the fuel, from production to consumption. The fuel standard mechanism is designed to encourage the use and production of fuels that have a lower carbon intensity than the baseline. Such fuel standards have been successfully implemented for example in the US in California and Oregon, known there as low carbon fuel standards (LCFS).

In addition to mechanisms where the carbon price is determined by the supply-demand balance, another method for carbon pricing is a carbon tax on a specific sector or activity. In the short term, this has the benefit of a stable fixed price for GHG emissions. The downside is that as it requires setting the carbon price separately from market dynamics, it may not be as effective in supporting actions to reduce GHG emissions. In addition with a carbon tax, the total amount of GHG emissions is not controlled in the same way as with emission trading systems.

Using an internal carbon price in internal analysis can help manage the short-term variations of the carbon price in market-driven mechanisms, and prepare for future policy developments that are more than likely to lead to increasing carbon prices.

A 2018 study from Texas A&M University showed that since the state of California introduced their Low Carbon Fuel Standard (LCFS) system a decade earlier, CO₂ emissions in the transportation sector went down by 10%.

Additionally, carbon pricing regulations are also driving businesses to be transparent about their emissions – which is what consumers want to see too to help them make more sustainable choices.

“One of the ‘side effects’ of carbon pricing mechanisms is that it increases the importance of knowing either the absolute GHG emissions of your company or the carbon intensity of the products you sell, or both,” explains Stenberg. READ MORE