Carbon markets: the difficult balancing act of pricing emissions

As the world grapples with the need to reduce greenhouse gas emissions, carbon markets have emerged as a key policy tool in the fight against climate change. However, the effectiveness of their mechanisms in driving meaningful action has become a subject of scrutiny.

Recent data and expert analyses reveal a complex landscape where ambition often outpaces reality, and the impact of pricing schemes falls short of what's needed to align markets more closely with global climate goals.

"More governments are introducing a price on carbon in the hope of forcing polluters to decarbonise," says Emma Coker, Head of European Carbon at BloombergNEF, a strategic research provider covering global commodity markets and the transition to a low-carbon economy.

The grim reality is that “just 8% of carbon markets and taxes in operation have reached the price level needed to be on track for net-zero emissions by 2050," she adds, citing comparisons of carbon market effectiveness by Victoria Cuming, Global Head of Policy at BloombergNEF.

How can policymakers and industry leaders remove at least some of the obstacles on the road to effective carbon pricing?

"Globally, the average price across carbon taxes and markets today is $35 per metric of CO2, only $1 more than in 2023. Many languish well below the mean," Coker says, referencing Cuming's analysis. This does not measure up to the $80 per ton that the United Nations' Intergovernmental Panel on Climate Change deems necessary to limit global warming to 1.5°C above pre-industrial levels.

Despite these challenges, carbon markets continue to evolve and expand. The European Union's Emissions Trading System (EU ETS), often considered a benchmark for carbon pricing mechanisms, has shown promising developments. "The price is currently around €70 ($76.4) per metric ton, having been up at €100/t earlier this year (compared to spending most years < €20/t previously). With such prices, we can expect far more decarbonisation activity to be driven by the ETS in the coming years," says Ben McWilliams, Affiliate Fellow at Bruegel, an independent research institute.

McWilliams highlights the EU ETS's role in driving change: "So far, price signals from the ETS have been important for shifting electricity generation away from coal-fired toward gas-fired (with lower carbon emissions) and energy efficiency improvements." However, he also points out limitations, noting that "prices have not been sufficient to incentivise decarbonisation elsewhere,” for example, by switching steel production away from coal.

The introduction of new policies, such as in the European Union the Carbon Border Adjustment Mechanism (CBAM), is reshaping the carbon market ecosystem.

"Questions remain over how the levy will be brought in and what emissions and sectors will be covered. As it stands, the carbon tariff will be less onerous for products whose indirect emissions matter more, such as aluminum," BNEF’s Coker notes.

The CBAM's ripple effects are already being felt globally, with other regions considering similar measures or accelerating the development of their own carbon markets to avoid potential tariffs.

While compliance carbon markets play a crucial role in funding the energy transition, their impact is often underestimated. Coker points out that major European and US compliance carbon schemes raised "almost $57 billion in 2022 and over $64 billion in 2023. This is equivalent to around 30% of all investment in low-carbon energy supply for non-EMDE markets in 2022."

However, experts agree that carbon pricing alone is not a silver bullet. McWilliams emphasises that "carbon prices play a fundamental role in shifting the allocation of resources across an economy, but societal and political realities mean that cannot work in isolation."

He identifies two key issues with relying solely on carbon prices: the potential for large redistributional consequences and the creation of vested interests lobbying against their introduction, as well as the need for government involvement beyond private sector initiatives.

The future of carbon markets looks both promising and challenging. The EU's bold move to introduce a second ETS covering households and road transport from 2027 marks a new era in climate policy. "While the carbon price will provide guidance, it cannot alone be trusted to deliver required emissions reductions as this would place too high a burden on (especially lower-income) households and likely drive a political backlash," McWilliams notes.

Looking ahead, the integration of carbon markets with other climate policies will be crucial. As Coker states, "compliance carbon markets, together with other policies such as the US Inflation Reduction Act, can help to quickly scale up clean technologies like carbon capture utilisation and storage (CCUS), hydrogen, and biofuels. Achieving net-zero emissions will require multiple policies."

The recent setback at COP28, where progress on international carbon offset trading stalled, highlights the ongoing challenges in global climate negotiations. However, as carbon markets mature and policymakers refine their approaches, there's potential for these mechanisms to play an increasingly vital role in driving meaningful climate action.

Coker of BloombergNEF offers a forward-looking perspective."Compliance carbon markets can play an important role in providing funding for the energy transition, but the scale is often underestimated,” she said. “Shrinking emissions caps in European compliance carbon markets will ratchet up the pressure to decarbonise -- as further greener options are harder to come by, regulators could allow carbon offsets to be used to help close the gap to climate goals."