Carbon Pricing Challenges

Fairness

A common concern with carbon taxes is that they may be regressive – burdening lower income groups by raising the price of common and essential goods. One way to mitigate this issue is through a ‘carbon fee and dividend’ which redistributes the money collected from a carbon tax to lower-income groups. Adding a dividend can make carbon taxes more politically palatable.

According to the IMF (speaking at COP28 in Dubai), explicitly pricing carbon may not be politically feasible in some countries. However, it suggests regulatory compliance as an alternative approach, in which the implementation of regulatory measures such as standards (for example, the UK’s ban on the sale of new petrol and diesel vehicles from 2035) leads to implicit prices on carbon.

The OECD’s Net Effective Carbon Rates (NECR) initiative aims to provide a comprehensive picture taking into account all the pricing mechanisms used in different jurisdictions. NECR assesses both direct carbon pricing and indirect influences from fossil fuel taxes and subsidies. The IMF has also established a taskforce to examine the different carbon prices that are implied in countries around the world by their carbon policies and regulations.

Another potential issue is that carbon pricing does not generally capture organisations’ Scope 3, or indirect, emissions. This means that certain businesses with relatively low operational emissions, but which indirectly contribute to a large volume of emissions, will not pay high carbon prices. Financial institutions, for example, may finance highly emissive projects or businesses without paying a price on those emissions. 

Competitiveness

Some worry that carbon pricing will reduce the competitiveness of businesses as a result of increased costs. However, reports from the UK Government, the Carbon Pricing Leadership Coalition, and the OECD find minimal evidence of carbon pricing negatively impacting competitiveness to date. Though there are theoretical concerns about the impact on business costs, it can also drive efficiencies and innovation.

Central to concerns around competitiveness is the idea of ‘carbon leakage’, which occurs when emissive activities move abroad in response to domestic climate policies. In essence, this means that businesses operating in a jurisdiction with a carbon price may lose out to businesses who can produce the same goods in a jurisdiction that does not have the additional cost of a carbon price. Some of these concerns about competitive advantages and carbon leakage may be mitigated by carbon border adjustments, which are covered on the next page.

Market fragmentation

Although compliance markets are well established, they largely operate within jurisdictional boundaries and are at different stages of development in different countries and regions. This leads to variations in the price of carbon and more volatility in international markets. Some economists argue that linking carbon markets will make carbon prices less volatile, increase market liquidity, and reduce the cost of carbon overall.