Carbon Pricing

ETS, also known as a cap-and-trade system—sets a limit (“cap”) on total direct GHG emissions from specific sectors and sets up a market where the rights to emit (in the form of carbon permits or allowances) are traded. This approach allows polluters to meet emissions reductions targets flexibly and at the lowest cost. It provides certainty about emissions reductions, but not the price for emitting, which fluctuates with the market.

A Carbon Tax puts a direct price on GHG emissions and requires economic actors to pay for every ton of carbon pollution emitted. It thus creates a financial incentive to lower emissions by switching to more efficient processes or cleaner fuels (i.e., less pollution means lower taxes). This approach provides a lot of certainty about price because the price per ton of pollution is fixed; but it offers less certainty about the extent of emissions reduction.

Under crediting mechanism, emissions reductions that occur as a result of a project, by a business or government, or policy are assigned credits, which can then be bought or sold. Entities seeking to lower their emissions can buy the credits as a way to offset their actual emissions. This approach requires a formally recognized third-party verifier to sign off on the emission reduction before it is credited.

Under a RBCF framework, entities receive funds when they meet pre-defined climate-related goals, such as emissions reductions. Like crediting mechanisms, this approach requires the involvement of independent verifiers (in this case, to confirm that a goal has been met). By linking financing to specific results, RBCF facilitates carbon pricing and the creation of carbon markets, helps polluters meet climate goals, and stimulates private sector investment.

Under internal carbon pricing, governments, firms, and other entities assign their own internal price to carbon use and factor this into their investment decisions. Used as part of a broader decarbonization efforts, this approach encourages investment in low-carbon technologies and prepares institutions to operate under future climate policies and regulations. Internal carbon pricing generally takes two forms: 
- The first assigns a shadow price to carbon use—that is, determines its hypothetical cost. Entities calculate this price for their activities with the goal of managing climate risks and identifying opportunities in operations, projects, and supply chains to lower emissions and avoid locking their investments in long-lived high-carbon capital and infrastructure. For example, the World Bank Group has announced plans to apply a shadow carbon price to relevant investment projects using a price consistent with the recommendations of the High-Level Commission on Carbon Prices.
 

- The second form is an internal carbon fee that companies voluntarily charge their business units for their emissions. Funds generated from this fee are channeled back into cleaner technologies and greener activities that support low-carbon transition.