Toward a global carbon pricing system

This vicious cycle of uneven carbon pricing regimes and carbon leakage prevents global coordination and negatively affects the development of carbon markets globally. Currently, only 1% of global emissions are priced above the level recommended by the High-Level Commission on Carbon Prices and Competitiveness, a panel backed by the World Bank comprising a voluntary group of dozens of governments, private sector organizations, non-profits, and academia, that sought to limit the global temperature increase to below 2ºC.

In recent years, concerns over the loss of economic competitiveness from carbon leakage led to the rise of border carbon adjustments (BCA) measures, a policy tool where a government charges a fee on imported goods based on the amount of GHG emissions and carbon taxes produced during their manufacturing process. Entered into force on 1 October 2023, the European Union’s Carbon Border Adjustment Mechanism (CBAM) is the first BCA to be implemented globally. Australia, Canada, Japan, the UK, the US, and Taiwan are at various stages of considering their own BCAs. In particular, the UK has announced that it will implement its own CBAM starting in 2027. In response, developing countries such as India, Indonesia, Türkiye, Morocco, Ukraine, and Uruguay have implemented, adjusted, or considered implementing explicit carbon pricing to offset compliance costs and capture domestically the revenue that would otherwise flow to the EU.

However, solely relying on BCA measures as a backdoor toward a global carbon market faces challenges. The BCA’s strict focus on explicit carbon prices overlooks the opportunity to advance the global energy transition that addresses implicit carbon prices that indirectly incentivize consumers and producers toward more sustainable practices. Examples of such indirect incentives include infrastructure that promote energy efficiency. Developing countries have criticized the EU’s CBAM as punitive and conflicting with the "common but differentiated responsibilities" principle of the Paris Agreement. For many developed countries, adopting BCA-driven climate policies can prove challenging as they are likely to increase the cost of living and therefore stoke political resistance.

As developing countries consider establishing their own explicit carbon pricing schemes, they may want to consider coordinating the development of regional carbon markets as a pragmatic and realistic interim step. While this does not immediately eliminate the risk of carbon leakage, it helps these economies to better adapt the transition to the context of developing countries’ economic, political, and institutional processes and perspectives. Moreover, as the EU faces strong pressures to grant CBAM exemptions, there is room for negotiating a temporary reduction in developed countries’ border adjustments in exchange for other credible climate commitments from regional blocs. Lessons from the Montreal Protocol on Substances That Deplete the Ozone Layer suggest that the regional approach can effectively help achieve global coordination through a stepwise approach.

For developing countries, the adoption of regional carbon markets starts with the recognition of their economic exposure to current and future BCAs. In negotiating for a more gradual carbon adjustment level, developing countries may find concessions such as the removal of fuel subsidies particularly attractive in terms of environmental, economic, and social impacts. In developing their own regional markets, countries will need to avoid a "spaghetti bowl" of overlapping and inconsistent rules and processes that undermine market efficiency and scalability. The Association of Southeast Asian Nations (ASEAN) Community, which has already formalized the ASEAN Common Carbon Framework, presents a viable prospect both as a key regional carbon market and as a potential model for other regions around the world.

Meanwhile, public-private cooperation can be strengthened by leveraging the recent breakthrough in Article 6 agreement to encourage the integration of international carbon markets. After a decade of impasse, governments finally reached an agreement at the United Nations Climate Change Conference (COP 29) in Baku, Azerbaijan on the rules of how countries can create, trade and register emission reductions and removals as carbon credits. With the reassurance that environmental integrity will be prioritized through technical reviews, this strengthens the foundational framework on which international carbon credit markets can be developed.

Indeed, despite setbacks due to integrity concerns and their relatively small market size globally, carbon credits remain an important part of climate mitigation strategies. To this end, BCA-implementing governments could consider integrating voluntary carbon credits into their compliance systems to leverage the strengths of voluntary carbon markets and private sectors. Private sector associations may also play a critical role in setting a high bar for carbon credits use. The Carbon Offsetting and Reduction Scheme for International Aviation (CORSIA) program, for example, is a notable example of how the International Civil Aviation Organization (ICAO) requires only the use of "conditionally adjusted" credits for industry compliance purpose to overcome the integrity deficit problem of the carbon credit market.

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This report is part of the Hinrich-IMD Sustainable Trade Index 2024.

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