The Carbon Market and How it Can Work

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Carbon pricing is an instrument that captures the external cost of GHG emissions – the cost of emissions that the public is paying that damages to crops, health care costs, and property damages due to heatwaves, droughts, sea-level rise, and flooding. 

A price on carbon transfers the burden of damages from GHG emissions to those who are emitting and can avoid it in the first place. Hence, when countries apply a correct carbon price, it can encourage huge carbon-emitting companies and manufacturers towards low and zero-carbon options required to limit climate change.

In reality, not all governments have the political will to implement a carbon tax, let alone the correct one.

According to the World Bank, only 45 countries and 34 subnational jurisdictions have adopted some form of carbon pricing that ranges from taxes to emissions-trading systems.

However, these schemes are nearly not enough to curb emissions but only cover about one-fifth of global GHG emissions. Such a ‘piecemeal’ approach to carbon pricing can have negative consequences.

According to The Economist’s article “How piecemeal carbon pricing affects cross-border lending,” one such consequence is that banks in countries with carbon taxes tend to reduce lending to coal, oil, and gas companies domestically but would also increase lending abroad, especially in countries with no or lax carbon tax policies. Such banks or lending institutions’ practices are labelled as ‘dirty loans’.

Notwithstanding, studies show that domestic carbon pricing is worth pursuing. It can still reduce net fossil-fuel lending by the banks domestically. It should also be supplemented by policies and measures that discourage leakage, and by pushing for greater transparency, countries could boost the impact of carbon-pricing schemes.

The video, “Do carbon markets work?” explains what carbon tax is and how it has evolved from the cap and trade first applied in the United States in 1990 to reduce sulphur dioxide emitted from their power stations, returning to the ground as acid rain. The cap-and-trade system forced polluters to pay for their emissions. As a result, acid rain fell by 20%. In 1997 the Kyoto Protocol, the international climate change treaty, suggested the cap-and-trade system to carbon, leading to some nations adopting it.

Vijay Vaitheeswaran, Global Energy & climate innovation editor of The Economist, says that the ‘genius’ of the cap-and-trade system is that the cap gives an incentive to emitters to get cleaner. At the same time, the trading mechanism pushes them to decarbonise – the more emissions they cut, the lesser carbon permits they have to buy and the more excess they have to sell to other emitters. In theory, the cap-and-trade system should reduce CO2 emissions, but in reality, the reason is simple, carbon prices are just too low to motivate emitters to decarbonise.

For decarbonisation to happen, the carbon price should be at $50 – $100 per ton by 2030; however, most carbon prices remain far below this figure. Additionally, the fines for exceeding emissions need to rise as well.

Then there’s a host of other problems related to regulating carbon markets, says Vaitheeswaran, which includes an issue of measuring carbon from indirect vs direct emissions, cheating, and leakage in some countries. Punishment for violators is lax.

While some countries are serious about their carbon pricing, others are not, which leads to carbon leakage. This “carbon leakage” occurs when high-emitting companies relocate from a country with a stricter environmental rule to countries that are the opposite.

Creating more stringent rules around carbon taxing is not seen yet in many parts of the world. So far, only countries that consist of the European Union are the only ones showing seriousness about regulating the carbon markets, according to Vaitheeswaran.

How to make carbon tax work to reduce carbon, the importance of regulations, and the role of a border tax and is explained in the video below:

The “Effective Carbon Rates 2021 report” by the OECD looks at how the 44 OECD and G20 countries, responsible for 80% of the world’s emissions, are using carbon pricing to shift their energy use towards low and zero-carbon options.

Are these countries using carbon pricing to its full potential? The report takes a comprehensive view of carbon prices, including fuel excise taxes, carbon taxes and tradable emissions permit prices – taking all these components together constitutes an effective carbon rate.

To achieve the Paris Agreement to limit warming to 1.5°C requires decarbonisation by mid-century. Against this background, the effective carbon rates for 2021 employs three carbon price benchmark values for carbon costs:

  • EUR30 per tonne of CO2, a historic low-end price benchmark of carbon costs in the early and mid-2010. IN 2021, this price is consistent with a slow decarbonisation scenario by 2060.
  • EUR60 per tonne of CO2, a low-end 2030 and mid-range 2020 benchmark. And in 2030 is also consistent with a slow decarbonisation scenario by 2060.
  • EUR120 per tonne of CO2 is a central estimate of the carbon price needed in 2030 to decarbonise by mid-century assuming carbon pricing plays a major role in the overall decarbonisation effort. EUR 120 is also more in line with recent estimates of overall social carbon costs.

The report provides examples of how increasing carbon pricing could reduce emissions. It estimates that an increase in the effective carbon rate by EUR1 per CO2 tonne will lead to an average reduction of 0.73%, and a carbon tax of EUR10 per CO2 tonne in the energy sector can lead to a 7.3% emissions reduction.

When the United Kingdom increased its effective carbon rates in the electricity sector from EUR7 per tonne of CO2to more than EUR36 between 2012 and 2018, emissions in the electricity sector, the nation’s emission fell by 73%, pointing that higher effective carbon rates produce a strong response from utilities.

The report also explains the concept of Carbon Pricing Score (CPS), which measures how close the 44 countries, as a whole and individually, to the goal of pricing all energy-related carbon emissions at current and future carbon price benchmarks.

“The report highlights the structure of effective carbon rates across countries and sectors in 2018 and discusses change compared to 2012 and 2015. It also provides an outlook on recent trends in emissions trading in China and the European Union.”

Read the report by clicking the link on the list of references at the bottom of this post.


How piecemeal carbon pricing affects cross-border lending. (2021, December 4). The Economist. Retrieved from  

What is Carbon Pricing. (2022). The World Bank. Retrieved from

How do carbon markets work? (2021, October 2). The Economist. [Video]. Retrieved from

OECD (2021), Effective Carbon Rates 2021: Pricing Carbon Emissions through Taxes and Emissions Trading, OECD Publishing, Paris,

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