[First published by Environmental Finance]

By Prajwal Baral

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Carbon pricing has a critical role to play in combating climate change but scaling it up will take time, says Prajwal Baral.

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Carbon pricing has become a hotly discussed topic among political, business, and academic experts who believe it will accomplish the critical goal of net-zero carbon emissions.

In the real world, however, carbon pricing has not achieved anything approaching wide use. Less than a quarter of global carbon emissions is currently covered by existing carbon pricing initiatives – even as a continued rise in global emissions puts the planet in peril.

Meanwhile, other efforts are in play. More than 120 countries, accounting for more than 60% of global greenhouse gas emissions, have announced net zero carbon emissions targets by up to 2060.

But that's not enough. The existing policies of governments still point us to a rise of 3°C in global temperature, when we will reach what many call a planetary tipping point.

Does this mean we stop the pursuit of putting a price on carbon? Absolutely not. It must still play a critical role in our collective ambition towards a zero-carbon economy because polluters must be made liable to pay. However, we must be practical about its limitations and focus on complementary tools where needed.

I see four critical areas that policy makers and the private sector should be familiar with if they want carbon pricing to work and scale up.

Support government and explore alternative tools

First, we need to support "starter countries" — governments that are early on in the process of understanding carbon pricing — while at the same time encourage them to apply alternative tools in the interim.

It is admittedly challenging to increase the coverage of carbon pricing from less than a quarter of global GHG emissions to 100% within the limited time frame we have for transitioning to a net zero carbon global economy.

Designing and implementing technical infrastructure and crafting and adopting required legislation for a carbon pricing system takes years. On top of that, the bulk of future carbon emissions is in developing and emerging economies that have weak institutional, legislative, and regulatory structures in addition to weak capacity to track, audit and monitor such emissions.

In these jurisdictions, the international community should extend technical and financial support to the governments in first identifying the role of carbon pricing and then designing necessary infrastructure. While the groundwork for carbon pricing is being laid, the governments should consider alternate institutional, regulatory, or legislative tools to start bending their emissions curve. Some alternatives include immediate removal of fossil fuel subsidies, low carbon fuel standard for transportation fuels, gradual phase out of coal-fired power plants and non-electric vehicles, tax incentives for clean technologies, roll out of incentive-based standards for clean electricity and green buildings, mileage standards for automobiles, and aggressive public investment in green assets.

Do not get carried away by price levels

Second, it is important to understand that the "price" of carbon, while important, is not a deal breaker.

It is unrealistic for countries to aim for a carbon pricing level that is too high. The European Union Emissions Trading System (EU ETS), which started in 2005 and is the oldest carbon market, was at less than $10/tCO2e at the time of adoption of Paris Climate Agreement (2015) and is currently at $48. If a starter country directly aims for a price at that range, it could face political and industry opposition.

Instead, countries should start at a price level that is commensurate with their national circumstances and gradually build regulatory policies that support and incentivize the upward movement of price.

Do not be a copycat

Third, a carbon pricing instrument used in one part of the world might not work in others. It might also be not the best instrument for addressing climate change.

There are primarily two types of carbon pricing instruments – carbon tax and emissions trading system (ETS). The choice should be guided by comprehensive technical studies complemented by national consultation with participation from both government and private sector.

Generally, countries with limited technical and institutional infrastructure for carbon pricing find it easier to start with sector specific carbon tax because it can be built on existing tax infrastructure and implemented faster. In current times of low oil price, a carbon tax is particularly easier to implement in energy intensive sectors as energy prices are low everywhere. The countries should start with a pilot phase and gradually move to full implementation.

In some countries and sometimes in certain sectors, alternative instruments work better than carbon pricing. For example, in sectors such as agriculture and heavy industry with no point sources of carbon emission, performance standards (e.g., energy efficiency standards) work better.

Honour customs and trade rules

Fourth, the global economy is founded on a set of internationally agreed upon trade and customs rules. Any carbon pricing instruments that are at odds with these rules will likely be questioned.

This can happen when, for example, countries implement carbon pricing at different times, which can immediately lead to a much bigger problem. The industries in jurisdictions with carbon pricing could start either replacing domestic production with imports from jurisdictions without carbon pricing or entirely relocate to such jurisdictions. In technical language, it is called "carbon leakage".

Carbon leakage could be avoided by imposing extra tariff on carbon positive products to reduce trade distortions and limit competitiveness effects. This is called "border carbon adjustment (BCA)". However, introducing BCAs on thousands of products with different carbon content will require complicated trade negotiations, which could take many years. If not done right, this could also ignite a full-blown trade war among countries. Understandably so, no country has implemented a BCA mechanism yet.

Since a BCA based on the actual carbon footprint of individual products is both technically and politically complicated, countries should start with benchmark data i.e., use emissions data of sectors used in existing carbon pricing instruments in the country as a reference. More important than that is for countries to see the alignment of their BCAs with custom and trade agreements they have with their trading partners. A compliance at the level of the World Trade Organization (WTO) could be a more sustainable solution in the long run.

A combination approach

Irrespective of the level of price or the choice of pricing instrument, carbon pricing in isolation will most likely not be fully effective. It must go hand in hand with complementary climate policies that, among others, incentivise and remove market barriers for the research, development, demonstration and deployment of low carbon technologies, processes, and business models. However, by keeping the four areas in mind, countries could test carbon pricing as one element in their overall climate mitigation goal.

Prajwal Baral is a public policy specialist and managing partner of Hornfels Group, a technology investment consultancy.