Can a universal carbon price be fair for everyone?

An emissions trading scheme (ETS) ⏤ or cap-and-trade system ⏤ allows industries with low GHG emissions to sell their extra allowances to those with larger ones, creating a market price for emissions. A carbon tax sets a carbon price through a levy on GHG emissions or fossil fuels.⁵

For example, France has a carbon tax of US$48.5/ton CO₂e, while Poland's is less than US$0.1/ton CO₂e. Similarly, the price of emissions allowances traded on the EU ETS in March 2023 was US$96.3/ton CO₂e, compared to US$8.15/ton CO₂e in China.⁶

In addition to geographical fragmentation, ETS schemes also operate at different levels of government, from supranational (e.g., the EU) to national (e.g., Canada, the United Kingdom) and from province and state level (e.g., Oregon, Hubei) to city level (e.g., Beijing, Tokyo).

Despite current flaws, the growing number of carbon pricing systems worldwide shows that it has become a core component of government policies. The introduction of large-scale schemes ⏤ such as China's national ETS, which covers 12% of global CO₂ emissions ⏤ offers hope for real progress.⁷

Also, the corporate world has been applying carbon pricing internally for decades. More than 2,000 companies, representing over US$27 trillion in market capitalization, apply internal carbon pricing or plan to do so, with low carbon investment being a key driver, according to the Carbon Disclosure Project (CDP).⁸ Improving energy efficiency and behavior change are also crucial factors.⁹ “Equitable carbon pricing fosters both innovation and emissions reduction. Integrating carbon price scenarios into long-term business plans will be crucial to adapt to future developments,” reflects Amy Brachio, EY Global Vice Chair – Sustainability. “Companies that proactively prepare can gain a competitive advantage through decarbonization, driving the wider value sustainability can create and protect through their business model and strategy.”

Coordinating individual emissions reduction efforts is crucial, and it’s starting to happen. The Organization for Economic Co-operation and Development (OECD) formed the Inclusive Forum on Carbon Mitigation Approaches (IFCMA) in October 2022 to achieve carbon reduction targets through better data and knowledge sharing.¹⁰

Carbon markets must be restructured to reduce global emissions and achieve decarbonization NDC targets. Any successful pricing scheme will need to be both fair and effective to address economic and social concerns while meeting targets. The ideal approach will price carbon as a commodity reflecting the cost of its negative externalities, and be applied globally. Accurate CO₂ accounting will be crucial.

There are two types of CO₂ accounting. Production-based accounting levies taxes on the industrial sector responsible for CO₂ emissions within domestic borders but may lead to carbon leakages and production shifts between countries. Consumption-based accounting taxes CO₂ embedded in goods regardless of where emissions are generated, eliminating carbon leakages and allowing for trading and pricing of CO₂ as a commodity across borders.

If CO₂ emissions measured via a consumption-based approach exceed those measured via a production-based approach, it indicates that the region’s imported products embed more CO₂ emissions than the region’s exported products.

For example, if emissions are measured under a consumption-based approach, the share of CO₂ emissions is 18% to 19% higher in the US and the EU than in a production-based approach. In comparison, CO₂ emissions are 15% to 17% lower in consumption-based measurements than in production-based measurements in India and China, respectively.

Coordinating individual emissions reduction efforts is crucial, and it’s starting to happen. The Organization for Economic Co-operation and Development (OECD) formed the Inclusive Forum on Carbon Mitigation Approaches (IFCMA) in October 2022 to achieve carbon reduction targets through better data and knowledge sharing.¹⁰

Carbon markets must be restructured to reduce global emissions and achieve decarbonization NDC targets. Any successful pricing scheme will need to be both fair and effective to address economic and social concerns while meeting targets. The ideal approach will price carbon as a commodity reflecting the cost of its negative externalities, and be applied globally. Accurate CO₂ accounting will be crucial.

There are two types of CO₂ accounting. Production-based accounting levies taxes on the industrial sector responsible for CO₂ emissions within domestic borders but may lead to carbon leakages and production shifts between countries. Consumption-based accounting taxes CO₂ embedded in goods regardless of where emissions are generated, eliminating carbon leakages and allowing for trading and pricing of CO₂ as a commodity across borders.

If CO₂ emissions measured via a consumption-based approach exceed those measured via a production-based approach, it indicates that the region’s imported products embed more CO₂ emissions than the region’s exported products.

For example, if emissions are measured under a consumption-based approach, the share of CO₂ emissions is 18% to 19% higher in the US and the EU than in a production-based approach. In comparison, CO₂ emissions are 15% to 17% lower in consumption-based measurements than in production-based measurements in India and China, respectively.

The case for pricing carbon as a commodity in the long term

Our research model analyzed trade patterns and carbon intensity in goods production to map CO₂ emissions by origin and region, which is crucial for assessing pricing mechanisms. We focused on emissions embedded in each region’s demand, recognizing that regions may be net carbon exporters (producers) or importers (consumers) based on their economic and industrial structure.

Regions with lower emission intensity (the US, the EU and the UK, and Southeast Asia) are net carbon importers. The regions that pollute the most to produce goods (China, India, rest of world and Middle East) are those that export most of these goods worldwide. A positive impact on global emissions could be achieved by decarbonizing supply chains in carbon-exporting regions — notably by engaging carbon producers to create a decarbonized supply chain.

Adopting consumption-based accounting, which considers CO₂ a commodity embedded in goods, is a way to reduce emissions in carbon-exporting regions. Our analysis suggests this approach could facilitate a smoother price transition for domestic products compared to production-based accounting. Using consumption-based accounting would act as a disincentive to importing or consuming products with high CO₂ content, resulting in a more equitable distribution of costs between importing and exporting regions. It could also mitigate against carbon leakages.

The global application of consumption-based accounting and pricing will require a phased approach due to the substantial undertaking in establishing an efficient and equitable global carbon pricing framework that accommodates diverse government and societal contexts.¹¹ These challenges are also rooted in historical emissions imbalances, whereby some countries benefited from fossil fuel usage while others grapple with the consequences of climate impacts. Addressing this equity concern implies sizable financial transfers, which potentially hinder political negotiations, particularly in achieving parity under a universal carbon price.

George Atalla, EY Global Government & Public Sector Leader, says, “More than two decades of carbon pricing schemes have demonstrated both their potential and pitfalls. For carbon pricing to be truly transformational and deliver a just transition, governments should adopt a coordinated approach that ensures different national approaches — be they taxes or trading systems — work in concert together and without loopholes.”

The prevailing trend highlights a dynamic landscape of diverse policy frameworks. As the international community discusses the possibility of a global pricing scheme, it presents an opportunity for governments to adopt a blended approach encompassing:

• Pricing domestic CO₂ emissions on a production-based scheme, using a carbon price levied on its productive sectors proportional to direct CO₂ emissions. This framework reflects currently adopted carbon pricing policies such as ETS.
• Applying additional prices on imported products according to a consumption-based scheme to avoid carbon leakage and the shift of production to countries without environmental regulation.

The EU’s proposed Carbon Border Adjustment Mechanism (CBAM) is based on these principles.¹² Combining the two approaches tries to mitigate some weaknesses (e.g., carbon leakages) of standard production-based schemes by assigning a markup to carbon embedded in imported goods. This mechanism aims to impose a CO₂ penalty on imported products from regions with less restrictive environmental policies.

Benefits of pricing carbon as a commodity in shaping the energy transition

In particular, our research analyzed the global power sector, responsible for 43% of global emissions, to test the impacts of different carbon prices and implementation modes on CO₂ emissions and tax revenues. Scenarios are based on proposed carbon price floors by the International Monetary Fund and price trends from the International Energy Agency (IEA) or projected from regional policies.

We modeled three carbon price floor scenarios: 

1. The first scenario is called the universal price floor. In this scenario, all regions implement the same carbon tax of €190 per ton of carbon. This is the highest price reached in the IEA’s Announced Pledges Scenario introduced in 2021. 
2. The second is the global gradual floor. In this scenario, all regions implement a specific carbon price level that gradually increases over time. Here, the 2020 to 2030 regional carbon prices match the carbon taxation levels the International Monetary Fund reported. While the 2030 to 2040 prices align with IEA estimates, 2050 prices are at the same level as the universal price floor of €190 per ton of carbon.
3. The third scenario is the large emitters floor. In this scenario, price floors are aligned to the stated policies in each region or country. In EU27+UK, USA and Australia, the carbon price starts at €70 per ton of carbon, gradually shifting towards €190 per ton of carbon in 2050. In China, it gradually shifts from €8 per ton of carbon to €30 per ton of carbon in 2050.

Our research shows that higher global carbon prices and a wider application of pricing mechanisms can accelerate the transition to green energy by 2050. This could result in CO₂ emission reductions of 17% to 68% within the power sector, generating government tax revenues ranging from €15.4t to €80.5t. These scenarios are promising and demonstrate the importance of international collaboration and cooperation to shape sustainable and fair policy frameworks.

While our economic study showcases the potential for carbon pricing as a powerful tool for governments, each government needs to craft its tailor-made strategy, adapting it to its specific context. Several key considerations may enhance the efficacy of their efforts.

As governments consider how best to incorporate carbon pricing into their national decarbonization policies and strategies, they must juggle the economic impacts of such schemes, as well as the political and societal. “The big question in terms of carbon pricing — whether it’s in the form of a direct tax or a cap-and-trade system — is what to do with the money you raise?” says Andrew Philips, EY Global Government & Infrastructure Tax Leader.  “That’s really important from a social impact perspective because putting a price on carbon will likely impact all parts of society — but some more than others.”

Carbon pricing can be a contentious topic, and negotiations around implementing carbon reduction policies can become a drawn-out process unless governments have clear objectives.

How should governments start shaping effective carbon regulation? Consider these seven key factors:

1. Know what type of pricing is best for your economy and society

A comprehensive carbon price signals every business to price carbon as effectively they would any other business input and to reduce emissions, eliminating the need for thousands of micro-interventions. Governments without carbon pricing must rely on incentives, which pose budgetary challenges.

The first step is choosing your country's best carbon pricing form. If it’s a direct tax, which industries will be taxed first? If it’s an ETS, which industry sectors and gases are covered, and how do you expand coverage over time? And how do you adjust taxation on imported products?

Design issues include the initial tax rate and how will it rise, assigning the statutory burden, CO₂ cap, allowance distribution, existing regulations and ⏤ perhaps most important, from a political perspective ⏤ revenue allocation.

2. Offsetting as an alternate route to carbon pricing

The landscape of carbon emissions regulation is poised to embrace diverse tactics. Offsets, characterized by their ability to counterbalance GHG or enhance carbon storage elsewhere, present a pathway for companies to achieve emission reduction targets. This approach can establish a shared cost framework without a formal carbon pricing mechanism. However, it is essential to exercise caution and conduct extensive evaluations within the carbon credits market to ensure accurate carbon accounting.

Governments can foster decarbonization by setting a significant offset price while simultaneously addressing potential carbon leakage. By allowing offsets to be traded across nations, countries with lower emission intensities can engage in carbon abatement initiatives, such as technology projects or carbon storage, in nations with higher emission intensities. This strategic move is particularly beneficial where older industrial facilities and lower restoration costs exist. Thus, implementing offsets requires a thoughtful balance between incentivizing decarbonization and managing potential carbon leakage, shaping a nuanced approach to emissions control.

3. Have a clearly articulated plan to distribute the revenue raised

Governments can use carbon pricing revenue to lower taxes, invest in clean energy and technology infrastructure, provide relief for low-income households most impacted by increased food and energy prices, tackle social issues related (or unrelated) to climate change, or even finance decarbonization investments for individual companies. The decisions will have a significant social impact, making it crucial for governments to choose their strategy wisely.

4. Demonstrate transparency to build credibility and support for the pricing system

Transparency will maintain credibility for a connected regional and national carbon pricing system framework. Governments must accurately measure carbon outputs and the effectiveness of offsetting to minimize carbon leakage, reduce double accounting and combat carbon fraud and greenwashing.

Technology and better data analytics improve transparency. Space technologies, including satellite data, monitor tropical forests involved in carbon offsetting projects, while distributed ledger technology can track carbon emissions and footprints in global supply chains. AI and data analytics can offer insights into carbon risks and mitigation in operations and suppliers. The information’s value will continue to grow and help shape a global carbon price. “Soon, we will see a variety of carbon pricing systems coexisting as separate markets, says Gianluca di Pasquale, EY Global Green Economies & Infrastructure Leader and Future Cities Co-Leader. “To achieve a unified approach, harnessing the potential of blockchain integrated with IoT is crucial. The main challenge is establishing an ecosystem that promotes trust, transparency, and interoperability."

5. Bolster reporting to drive adoption

Improved carbon data and demands for more robust sustainability reporting will increase the credibility and value of carbon pricing. Governments worldwide regulate non-financial reporting, and the EU’s new Corporate Sustainability Reporting Directive requires most companies to report how climate change impacts not just their business but also the planet and society. In the US, the Securities and Exchange Commission (SEC) has proposed rule changes requiring companies to report climate-related risks likely to have a material impact on their business and financial condition.

6. Build a working and governing culture that understands the importance of decarbonization

The shift toward a net zero economy requires a new generation of professionals who prioritize the climate emergency, biodiversity, and the preservation of the planet in their decision-making. This cultural shift demands a new breed of green jobs and a mindset change across the workforce. Moreover, profitable businesses will increasingly mean green businesses, as the hard-nosed economics of climate change and carbon pricing shape the future economy. The gray economy will slowly dwindle as entrenched industries make way for green alternatives.

7.  Leverage carbon pricing for global climate resilience and innovation

Governments can harness the revenue generated from carbon pricing as a significant source for international redistribution by contributing to a pool of funds to support vulnerable nations' climate resilience and facilitate the transition to low-carbon economies. This collaborative approach demonstrates developed nations' commitment to global climate action and establishes a framework for mutual benefit. Even countries with lower carbon intensity can reap the rewards, as they can export their advanced green technologies and solutions, engage in joint projects and ventures with developing countries, enhance supply chain resilience, and foster improved global trade relations. Examples such as technology transfers are crucial for enabling less-developed nations to adopt clean and efficient technologies, accelerating their transition, and facilitating the exchange of expertise, knowledge and solutions.