Conversations last week at the United Nations Climate Change Conference, known as COP26, made clear that increases in carbon prices and in the adoption of carbon pricing programs are critical to reduce carbon emissions to keep the global temperature increase under 2 degrees Celsius.
Though long touted by economists as the solution to reduce carbon emissions and tackle climate change, carbon pricing has for years been mostly abstract, a textbook concept bearing theoretical merit with little possibility of application.
Discussions at COP26, however, indicate the textbook solution might soon become a reality for more than a few countries and industries.
Why carbon pricing?
Carbon emissions are an externality, which arises when an economic activity affects those who are not part of the market mechanism. During production of most goods, companies emit carbon, which leads to social costs that are not captured in the market price. Since no one in the transaction bears the cost, more carbon than the efficient level is emitted.
Governments can intervene by imposing fees on companies for their level of carbon emissions. Such carbon price programs reflect the true cost of production, which involves not just capital and labor but also emissions that contribute to climate change.
To date, over 40 countries have adopted some type of carbon pricing program, either using a cap-and-trade system or a carbon tax, covering 22% of the world’s total emissions.
In a cap-and-trade system, a total emissions allowance—a “cap”—is set, and firms can trade their carbon units with each other, allowing the market to determine a price on carbon. The cap is gradually lowered over time to ensure emissions are reduced.
In a carbon tax system, firms pay a tax on their carbon emissions, with the tax gradually increasing over time to encourage firms to lower emissions.
Canada passed the Greenhouse Gas Pollution Pricing Act to set carbon prices at CA$20/ton in 2019, set to increase to $170/ton by 2030, one of the most ambitious carbon pricing schemes in the world.
The European Union has had a cap-and-trade program in place since 2005, the longest-running large scale carbon market program.
In the United States, eleven Northeastern states formed the Regional Greenhouse Gas Initiative cap-and-trade program, and California’s cap-and-trade program is one of the largest multi-sectional emission trading systems in the world.
Additionally, there have also been tax credit initiatives incentivizing carbon capture and storing, designed to further reduce emissions.
An urgent shift
To date, most carbon pricing programs have been modest, either setting the cap quite high or the tax quite low to the point where aggressive emission reduction is not required and vastly below the socially optimal level.
According to the Network for Greening the Financial System, if countries take immediate action, carbon prices would have to increase to about US$100 per ton by 2040 and US$200 per ton by 2050. This is vastly greater than the current carbon prices across different programs, whose median hovers near US$20.
However, we might be witnessing a shift, given that carbon pricing has been front and center in COP26 conversations. World leaders and scientists alike have referred to COP26 as the last chance to tackle climate catastrophe, and emission reduction is likely impossible without carbon pricing.
Prominent figures have championed a global carbon price at the conference, including Canadian prime minister Justin Trudeau and Mark Carney, United Nations special envoy for climate action and finance.
In June 2021, the International Monetary Fund proposed an international carbon price floor among large emitters, according to which advanced economies would pay at least US$75 per ton of CO2 by 2030, $50 for emerging economies and $25 for developing economies.
Furthermore, hundreds of large companies, including Amazon, Alaska Airlines and Proctor & Gamble have pledged to reduce their carbon emissions. Going a step further, Microsoft announced a bold plan to become carbon negative by 2030.
What happens when more countries adopt carbon pricing?
Whether a global carbon price is adopted or a number of major countries implement their own carbon pricing programs, the impact on global trade flows will almost certainly be profound.
When there is divergence in carbon policy, production will move from countries with high carbon prices to those with low or no carbon prices. However, countries may also impose carbon prices on imports, which will shift trade patterns and reallocate competitive advantages.
Countries that are carbon-intensive such as Russia, China and India will lose their current competitive advantage of having cheap energy, and thus cheap production. Canada, whose economy is heavily dependent on fossil fuel, will also feel the brunt.
Countries with high energy efficiency in production and those leading in the digital economy, such as Singapore and Scandinavian countries, will count themselves among the winners.
Because carbon emissions affect the entire supply chain, no industry will remain untouched by the vast transformations on the horizon. Businesses throughout the supply chain will have to work together to reduce emissions efficiently and effectively, while ensuring that the needs of all stakeholders are accounted for.
Cost of goods will increase with carbon prices affecting fossil fuels used in production and transportation. For consumers, the era of free next-day delivery and of seemingly infinite cheap plastic consumer goods may soon be over, depending on which actions countries take.
Carbon-intensive industries, including fossil fuel, manufacturing and agriculture, will see their cost of production increase substantially.
Meanwhile, industries whose scaling up do not require proportionate increases in carbon, such as software technology and financial services, will benefit as they harness the future of a low-carbon economy.
Carbon pricing might finally catch on globally as countries increasingly pledge to reach net zero, and we expect the spread of carbon pricing programs across the globe will fundamentally alter trade flows.
As carbon pricing programs become more prevalent and prices more expensive, businesses will need to work on reducing their emissions drastically. With carbon pricing expanding across sectors, more reporting and disclosure requirements for businesses will also come.
At the same time, businesses with carbon abatement, capture, and offset technologies will enjoy ample business opportunities in emerging carbon markets.