Setting the Right Price: Determining an Effective Carbon Price

8 Jul 2024
Setting the Right Price: Determining an Effective Carbon Price

Developing the floor price of carbon is key to effectively developing carbon markets. This is the price of carbon that drives low-carbon investment. The International Monetary Fund (IMF) in 2021 proposed an International Carbon Price Floor of $50/mtCO2e for a middle-income country and $25/mtCO2e for low-income countries. 

Countries, companies and other institutions in recent years have increased their commitment to net zero. This commitment has led to the development of a market-based strategy to reduce greenhouse gas emissions. Carbon pricing provides a financial incentive for GHG emitters to reduce emissions. By limiting the quota of carbon an organisation or company can emit, governments establish a commodity, the right to emit carbon. Companies that fall short of targets and emit can buy carbon credits to offset the additional carbon emitted. 

Developing the floor price of carbon is key to effectively developing carbon markets. This is the price of carbon that drives low-carbon investment. The International Monetary Fund (IMF) in 2021 proposed an International Carbon Price Floor of $50/mtCO2e for a middle-income country and $25/mtCO2e for low-income countries. To implement this price floor, several or even combinations of different mechanisms can be used. 

Some of the mechanisms currently used include: 

  1. Emissions trading system (ETS) where entities emitting CO2 (or other GHG) can trade emission units to meet their emission targets. To comply with emission targets companies can acquire carbon credits in the carbon market. This type of demand and supply-based compliance market establishes a market price for carbon emissions. 
  2. Carbon tax which sets a fixed price for the carbon by levying an exact tax rate on the emissions or the carbon content of fossil fuels, i.e. a price per mtCO2e. 
  3. A crediting mechanism which assigns the GHG emission reduced or eliminated due to a specific project or program activities and can be sold either locally or internationally. Crediting Mechanisms issue carbon credits based on an accounting protocol and have their registry. Voluntary carbon markets fall under this type of carbon pricing. 
  4. The result-based climate financing approach provides payments when the agreed outcome indicators relating to climate action, such as emission reductions are delivered and verified. Many RBCF programs strive to both buy verified emissions reductions and provide some social benefits like improved clean energy access and reduced poverty. 

Countries looking to adopt specific carbon pricing mechanisms must understand the nuances of their emissions, as well as the challenges they may face in monitoring and validating GHG emissions. 

Crediting Mechanisms like voluntary carbon markets (VCMs) represent one of the best options for developing countries in Sub-saharan Africa. They are increasingly being adopted by many stakeholders to meet their net-zero targets. VCMs grew at a compound annual growth rate of over 31% from 2016 to 2021. They offer significant benefits over the other pricing mechanisms. 

VCMs have enabled companies, governments and individuals to buy carbon credits to offset their greenhouse gas (GHG) emissions voluntarily. The carbon credits are generated by projects and activities such as renewable energy projects and reforestation efforts that eliminate or reduce emissions. They have some benefits over the other pricing mechanisms, especially for developing nations in Africa. 

For instance, establishing or joining an ETS requires a country to have robust regulatory frameworks and monitoring systems, which can be challenging for African nations with limited resources. An ETS could also affect the development of key industries as it places an emissions compliance burden on companies. Companies that may be reliant on backup fossil fuel generators to meet their energy needs, due to poor grid supply may be forced to buy carbon credits to meet compliance requirements, which could affect their operations, and have larger negative economic effects.  Also, VCMs are more flexible, allowing for the integration of a broader range of projects and methodologies that might not adhere to the guidelines of an ETS. 

Compared to carbon taxes, the visibility of the VCM funds is transparent as VCMs directly support specific projects, allowing carbon credit purchasers to validate and report on the climate and in many cases social impacts of their contributions. As VCMs are market-driven, it leads to a much more efficient allocation of resources. VCMs also have a global reach, engaging stakeholders and projects from regions or sectors not covered by an ETS. These diverse stakeholders ensure the inclusion of a variety of projects with multiple benefits. There is, however, one drawback of VCMs is that the carbon prices can fluctuate, making it less predictable for project developers when modelling project finances. 

Carbon pricing has become an important tool in the global decarbonization efforts. VCMs represent a good starting point for countries in Africa, but they must also address issues like transparency, the need for additional capacity, as well as strengthen its monitoring, reporting, validation and verification capacity.  As a country develops its regulatory capacity and framework, it can adopt a much more robust mechanism like  ETS which can provide a stable long-term framework for emissions reduction.
 

*Image credit: Veeterzy, licensed under CCBY 2.0

 

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