Policy Explainer Carbon pricing
In the run up to the EU’s implementation of its carbon border adjustment mechanism (CBAM) – which will tax certain imports to the bloc from countries with no or lower carbon prices – countries such as India and Brazil have voiced anger at the potential impact of the tax on lower income countries. Recent research from an Indian thinktank found that the EU’s carbon tax could cost India 0.05% of its GDP.
The EU, however, argues that the mechanism creates a level playing field for domestically manufactured goods which are subject to a carbon tax and more rigorous environmental standards.
The UK has announced that it will introduce its own CBAM by 2027.
At its core, CBAMs come down to differences in countries’ approaches to carbon pricing. So what is carbon pricing and how does it work in the UK?
An incentive to decarbonise
Carbon pricing uses market mechanisms to pass the cost of emitting on to emitters by charging companies for their greenhouse gas emissions (GHG).
There are two main ways that governments can establish a carbon price:
- A carbon tax directly sets a price on GHG emissions by requiring companies to pay for every ton of carbon pollution emitted.
- An emissions trading system (ETS) – also known as a cap-and-trade system – places a limit on total direct GHG emissions from specific sectors and sets up a market where organisations can trade the rights to emit.
Around 40 countries have implemented a carbon pricing mechanism, but the price applied varies substantially according to countries’ varying ambitions, economic conditions, and political contexts.
How does carbon pricing work in the UK?
The UK currently uses an ETS to implement its carbon pricing, with the cap being gradually reduced in line with the UK’s 2050 net zero commitment.
At present, the UK ETS applies to energy-intensive industries, power generation, and aviation. In the coming years, it will be expanded to include domestic maritime transport and waste from the energy sector.
The government currently gives some firms, typically heavy industry, a free allocation of emissions. Companies have to buy credits on the carbon market if their emissions exceed their allocation. They can then sell any leftover credits at the end of the year.
The UK’s approach to carbon pricing currently only accounts for domestic activity. However, by 2027, the UK’s CBAM will place a carbon price on some of the most emissions intensive industrial goods imported to the UK from the aluminium, cement, ceramics, fertiliser, glass, hydrogen, iron and steel sectors.