Carbon pricing is an instrument that captures the external costs of greenhouse gas (GHG) emissions—the costs of emissions that the public pays for, such as damage to crops, health care costs from heat waves and droughts, and loss of property from flooding and sea level rise—and ties them to their sources through a price, usually in the form of a price on the carbon dioxide (CO2) emitted. A price on carbon helps shift the burden for the damage from GHG emissions back to those who are responsible for it and who can avoid it.
Instead of dictating who should reduce emissions where and how, a carbon price provides an economic signal to emitters, and allows them to decide to either transform their activities and lower their emissions, or continue emitting and paying for their emissions. In this way, the overall environmental goal is achieved in the most flexible and least-cost way to society. Placing an adequate price on GHG emissions is of fundamental relevance to internalize the external cost of climate change in the broadest possible range of economic decision making and in setting economic incentives for clean development. It can help to mobilize the financial investments required to stimulate clean technology and market innovation, fueling new, low-carbon drivers of economic growth.
There is a growing consensus among both governments and businesses on the fundamental role of carbon pricing in the transition to a decarbonized economy. For governments, carbon pricing is one of the instruments of the climate policy package needed to reduce emissions. In most cases, it is also be a source of revenue, which is particularly important in an economic environment of budgetary constraints. Businesses use internal carbon pricing to evaluate the impact of mandatory carbon prices on their operations and as a tool to identify potential climate risks and revenue opportunities. Finally, long-term investors use carbon pricing to analyze the potential impact of climate change policies on their investment portfolios, allowing them to reassess investment strategies and reallocate capital toward low-carbon or climate-resilient activities.