1.9 - Carbon economy, monetization of externalities*

Version 3


    Why a carbon economy?


    Since the beginning of the Industrial Revolution, the development of the world’s economy has rested on free use of the atmosphere capacity to store greenhouse gases. Economic actors considered it an infinite reservoir, capable of absorbing all emissions, which has lead to emissions accumulating in such proportions, that today the stability of our climate is under threat.


    Setting a carbon price stems from the idea that one can influence the choices made by economic agents towards carbon-free solutions by making it more expensive to use goods and services which are the source of relatively high emissions.
    Three types of price instruments can be implemented to introduce a carbon price into the economy: taxes, emissions trading and project-based mechanisms. These different instruments can be combined as far as possible so as not to neglect any potential source of emission cuts.


    Carbon taxation


    A carbon tax is sets a price for CO2 emissions. Its rate, which is expressed in euros per metric ton of CO2 emitted, sets the price. A carbon tax adjusts the relative price of assets or energy sources according to their carbon content. When the fiscal instrument is used, it is the public authority that sets the carbon price, and the effects on emissions will depend on the reactions of the sector players.


    Emissions trading schemes or cap-and-trade


    In a greenhouse gas emissions allowance trading scheme, more commonly known as carbon trading, the public authority fixes a emission quantity reduction objective and the market then sets the price.

    The global emissions cap guarantees that the environmental objective is met. The authorities set the total volume of emissions authorized by distributing or selling a limited number of allowances (1 allowance = the right to emit 1 metric ton of CO2); in this case we refer to regulation by quantities (as opposed to regulation by prices via a tax). The allowances are shared between participants, who can trade these rights among themselves. Emission trading attaches a price to the release of greenhouse gases and enables the environmental objective to be reached at a lower cost.


    The project-based mechanisms of the Kyoto Protocol


    The Clean Development Mechanism (CDM) and the Joint Implementation (JI) are the second main pillar of worldwide carbon finance.

    Following the strict rules laid down and monitored by the UNFCCC (United Nations Framework Convention on Climate Change) Secretariat, these two tools fund emission-cutting projects through carbon credits. The mechanism works as follows: to be eligible, a project must demonstrate that it engenders an "additional" reduction in emissions compared to a reference scenario, defined as the most probable scenario if the project did not exist. Once the project has been approved and implemented, the project owners receive the number of carbon credits corresponding to emissions cuts compared to the reference scenario.


    * Monetization of externalities


    This involves evaluating the damage to an asset or deterioration in provision of a service caused by an activity.
    This can be determined by damage costing (e.g. impacts on health and hospitalization costs, drinking water pollution and installation of a water treatment system), or by evaluating a "willingness to pay" or the maximum amount that a person is prepared to pay for an asset or a service (the same house in a quiet district will cost more than one standing alongside a highway).