Carbon Pricing #1: theory

06 Aug 2022

Bit of a different edition here; this is the first in a two part series on Carbon Pricing. In this edition I’ll be covering some of the theory behind different kinds of carbon pricing and in part 2 I’ll be looking at how the policy has been implemented in practice, how effective it has been, and some impact assessments as to how effective it could be at a larger scale. These aren’t really separate topics of course, experience from the real world affects theory and vice versa but it’s a useful divide to keep this article from being too much.

What is Carbon Pricing?

Carbon Pricing is a beautifully simple policy idea. The goal is to make emitting carbon dioxide more expensive, which should make those emissions go down. Most models of carbon pricing attempt to target industries where the emissions are most easily quantified, price them there, and just see what happens. All methods of Carbon Pricing attempt to give companies and investors an incentive to not emit carbon and make cleaner alternatives relatively cheaper so that more people buy them. It’s simple economics: the price goes up, so people use it less.

Carbon Tax

A carbon tax is the simplest way to price Carbon emissions. Find the sources of Carbon emissions, and put a tax on them. This means taxing coal, oil, and gas where it is dug out of the ground, where it is easiest to measure.

Estimates for what this tax should be span a pretty wide range, and this is because the values that are discussed are generally estimates of the social cost of carbon. The social cost of carbon is the damage that emitting a tonne of carbon does to people quantified as an amount of money. Unfortunately (or fortunately), there is no agreed upon conversion between human suffering and money and thus, suggested Carbon taxes range between $30-$250 /tCO2e. I’ll talk more about choosing a price in part 2 but the short version is that the price needs to be high enough to affect decisions, and not so extreme as to cause a disorderly transition (think companies laying off employees).

Another thing a carbon tax needs is time. Carbon taxes should be predictable, clear and affect companies on a timescale that let’s them make the transition we need them to.

Making bad things less profitable.

Now, if an oil company gets taxed, we think “Great! Job done! They won’t be as profitable.” but that’s not necessarily true. High emitting companies can still be providing essential services for other companies or for individuals so they can pass on those costs to consumers without a problem. We’ll deal with the problem of how people actually pay for stuff with the extra tax later but for now I’ll just spell out why carbon intensive companies will make less money.

First, products that are less carbon intensive will become cheaper relative to more carbon intensive products, so people buy them less, so those companies make less money even if they can pass on the costs, and less carbon intensive companies will make more money. With a predictable tax like a carbon tax, companies can make decisions knowing that it’s there, and how much it will cost them in the future. This means that companies have a clear financial incentive to transition to be less carbon intensive, and investors get that information too.

This clearly highlights investors’ role in the Climate Crisis; while it would be great for them to adopt a people, planet, profit triple baseline, the likelihood of this is slim because people and planet are kinda squishy, and don’t convert cleanly to numbers without some external help. That’s what Carbon Pricing is here to do!

But nobody likes expensive stuff!

Now the obvious problem with a Carbon Tax is that it’s a tax, so it makes things more expensive. During a Cost of Living crisis, this isn’t exactly going to be a popular policy on its own (and probably no one would vote for it even without the Cost of Living crisis). However, there is a solution: a Carbon Fee and Dividend (CF&D). Instead of the money going into government coffers, we can send it as a cheque directly to citizens. Since most emissions are concentrated with the wealthiest people, only the top 40% would feel higher prices, and with only a £40 /tCO2e price, the lowest 10% would have an extra ~£600 per year. (LSE 2012)

Of course people don’t have to keep making the same purchasing decisions so there’s the potential for them to save money by buying less carbon intensive products without their cheque going down!

Isn’t this awful for farmers?

Just looking at how CF&D affects people on average by wealth can be misleading; there are people who do not live around the necessary infrastructure to move to EVs and/or who just live far away from towns and cities so they tend to travel further and use more fuel. This is an important point and whenever a CF&D has actually been implemented there have been measures in place to make it more fair for people living in rural areas. Of course, no policy (like this) can be truly fair, but we can get close. The specifics of exactly how money is allocated in CF&D is not generic and is decided on a per-country basis.

What should we do with the money?

There can be a bit of a feeling of dissatisfaction when money collected by a Carbon Tax is simply given back to people, because it feels like it ought to be used to help prevent Climate Change more directly, but it is doing enough work as it is helping people who are struggling.

There is also a problem that whatever you do with the money, the whole idea is that emissions go down, so the taxes you’re getting go down so it’s important not to build too much of a reliance on these funds or to feel like they are all we need to invest in the Climate Emergency - money collected by a Carbon Tax would likely not be near as much as is needed to help electrify and increase energy efficiency across a whole country. This could be regarded as a good thing though: CF&D naturally phases itself out as it becomes unnecessary and paying it out as a dividend ensures that the government does not use it to govern their own investments in adaptation and mitigation.

Carbon Border Adjustments

Ok so this Carbon Fee & Dividend thing should work in principle, but what else does a carbon intensive company have to think about when something like this is introduced? Well first they need to make sure they’re still competitive. If their goods are more expensive when exported out of the country, no one will buy them and that’s a pretty good incentive to just leave the country where CF&D was implemented altogether. Once they’ve left the country, they can start using energy which isn’t taxed at the source, and then import their goods into the country with CF&D as if nothing has happened. This doesn’t solve the problem at all! The same amount of emissions are being released; the physical location of them doesn’t really matter to Climate Change! So what’s the solution?

Well, if we taxed goods on import and reimbursed taxes on export we could implement a CF&D without making companies in the country with CF&D less competitive. We call this a Carbon Border Adjustment (CBAM). CBAMs have snowballing effects too. If two countries implement Carbon Taxes, neither has to worry about border adjustments between the two. This encourages large economic areas with carbon taxes and makes CBAMs more feasible. There is a further incentive for more countries to adopt a Carbon Tax: imports are taxed and that tax goes to the country with the Carbon Tax, but companies would rather pay taxes to the country they’re based in, and that country would rather have more taxes, so other countries have that incentive to implement a Carbon Tax.

Cap and Trade

The other main form of Carbon Pricing is Cap and Trade (sometimes called an Emissions Trading Scheme or ETS). In an ETS governments hand out and sell a limited number of permits to emit carbon and then those permits can be traded on a secondary market.

Setting a cap on emissions.

Here’s the big argument for an ETS over CF&D: you’re actually setting a cap on emissions! After all, the atmosphere doesn’t care how much money was paid to emit carbon, just how much was emitted, so setting a cap lets governments have more control over their emissions.

Making a market! (Yeeha?)

A big part of an ETS is the secondary market where companies can buy and sell permits as they wish. Here’s the idea: companies are given or sold permits roughly relative to how much they emit, but if they need more or fewer permits they can buy and sell them on the market. Got more permits than you need? Sell them to someone else who wants them. Not got enough permits? Well you’ll have to buy them off someone with too many or bring down your emissions. This is how an ETS incentivises emissions reductions.

In reality the markets created by emissions trading schemes can be kinda whacky and have prices that are often way lower than a sensible social cost of carbon, why is that?

Credits, who gets them?

Well the reason all comes down to who gets credits, and how long they’re valid for. First of all, if the cap is too high, not much buying or selling will have to take place. Even if the targets are strict enough, another kind of problem can happen: the markets gets flooded with old or low-quality permits.

In an ETS, when should a permit expire? The obvious answer is at the end of the billing cycle, but in reality a carbon permit just expires whenever it is cashed in, plus whenever it is too old. Companies want an ETS where they can use old and low-quality permits so that they don’t have to worry about paying for expensive permits.

An old permit is just one that hasn’t been cashed in for a while since it’s creation. For example, if a company reduced their emissions in 2005, and wants to claim that reduction now, in 2022, should we let them? What about one in 2012? The question of course is: where do we draw that line? A permit is low-quality when the emissions reduction either might not have been realised yet/happened at all or where the reduction would have happened anyway. We don’t want to be giving away permits for reductions that would have happened anyway.

At the end of the day, this comes down to how the regulating authority decides if a permit or emissions reduction is valid. Sadly, validating carbon offsets is particularly difficult for reasons that I don’t have scope to get into now, but have been thoroughly explained elsewhere.

Which one?

Now to the obvious question: what should we implement? Carbon Fee and Dividend makes things more predictable for companies, but an ETS gives you control over emissions directly.

Well, an Emissions Trading Scheme lets you put a cap on emissions, so long as you can appropriately punish companies who don’t acquire enough permits. This is a big plus for an ETS, since in the end emissions are what we are trying to control. However, an ETS is more complex than CF&D and is especially vulnerable to the market being flooded with permits. Because of these complexities, an ETS is less predictable so it is harder to plan around than CF&D. An ETS lets the market deal with it in the most literal sense, which appeals to centre and centre-right politics more than policies which require more direct intervention.

CF&D, although it does not create a market in the same way an ETS does, requires much less government intervention than other green policies so it still has the appeal to centre-right politics. CF&D is, as I said above, more predictable than an ETS (and I’m going to keep reiterating this because I think it’s really important), which means that companies can plan for predictable changes to the price of carbon. Sending the signals that the price is coming and will be changing is vitally important to encouraging a transition away from fossil fuels. CF&D is progressive, which means that poorer people are better off. Often carbon pricing systems are regressive (where poorer people lose a larger portion of their income to the tax than wealthier people), so this is a significant point in CF&D’s favour.

As with all market-based solutions, the government generally lacks control as to how (and with CF&D, exactly how quickly) emissions are reduced. However, this also means that we can expect companies to find the places where emissions can be reduced most easily and efficiently and do them first. Neither policy relies on future magical technology we don’t have yet (carbon capture and storage) and both generally incentivise progress in the right direction on practically every front, even ones we aren’t aware of yet. In a final appeal to a broad political spectrum, CF&D is revenue neutral, and an ETS is at least in some part a tax, so politicians and people worrying about debt, need not be concerned by either policy.

Both of these policies work and have their merits. I happen to think CF&D is better, but either of them, if implemented strictly, would go a long way to reducing emissions. Let’s be clear though: Carbon Pricing is only part of the solution, and the systems that got us to where we are now are most likely going to need major changes. However, Carbon Pricing can have a really big impact, and that is a potential it would be greatly beneficial to see realised.


CF&D’s primary goal is to reduce carbon emissions, but it also addresses:

Alongside these more direct impacts, CF&D encourages practically every aspect of a just transition to renewables to speed up by providing a direct, predictable, financial incentive to do so. If Climate Change is a threat multiplier, you could call CF&D a solutions multiplier.

Where is this happening?

Progress on implementing CF&D is being made around the world and close to home. We’ve already seen it rolled out nationally in Canada and Austria is working on it as I write this. However, I’ll save more details for part 2, where I’ll be diving into exactly how this has been implemented around the world and what progress we are seeing. Keep your eyes peeled!

If this has interested you, please check out some of the resources below especially the Citizens’ Climate Lobby (which I am a part of).


Citizens’ Climate Lobby UK
Have a browse, there’s lots of interesting resources and articles here.

Explore this amazing model in as much detail as you’d like.

How to sound like you understand Carbon Pricing
Short for a policy document, medium read otherwise


Hank Green on fixing Climate Change
Medium video


Pricing Nature
How many times will I tell you listen to this? Enough to make you do it.

[It] is a grave error to imagine that the world is not preparing for the disrupted planet of the future. It’s just that it’s not preparing by taking mitigatory measures or by reducing emissions: instead, it is preparing for a new geopolitical struggle for dominance. - Amitav Ghosh, The Nutmeg’s Curse

Hi, thanks for reading! I’m actually a part of the Citizens’ Climate Lobby UK and can attest that the people there are nice and know an often know an awful lot more than me about Carbon Pricing. I think that Climate Income, as we brand CF&D, is a thoroughly great policy idea. CCL is a really different kind of Climate activism to what most of us are used to seeing, but we’re super focused on actually getting this policy in place ASAP. Please drop me an email or sign up online if you want some more details!

See you next edition,
Oscar Mitcham