Bridging the gap: using carbon pricing to finance the energy transition
A single silver bullet will not finance the energy transition. Transforming our energy system will require thousands of projects, millions of financial decisions and billions of people changing their behaviour. This necessitates a scattergun of political, financial and scientific solutions. Yet all solutions must target two fundamental necessities.
First, polluting must become more costly. In economic terms, firms must internalise the negative externalities of emitting carbon dioxide. This is carbon pricing.
Second, clean energy must become less expensive. A just transition is not simply making fossil fuels more expensive. It means making renewable energy accessible to all. Although clean electricity can often cost less than hydrocarbons, high borrowing rates in the Global South disproportionally burden capital-intensive clean energy projects, raising overall costs. Supporting infrastructure including transmission and grid capacity adds to the expense. Consequently, the true cost of renewable energy often surpasses the low headline costs of solar and wind. This is where climate finance is vital.
Progress is being made on the first of these two necessities. Carbon pricing now covers a quarter of global emissions. With the European Union’s carbon border adjustment mechanism, this is set to expand as more countries are incentivised to adopt their own carbon pricing schemes.
CBAM levels the carbon tax playing field. Although the EU has among the world’s most advanced carbon pricing systems, it also disadvantages European producers compared to foreign exporters who do not pay a carbon price. CBAM addresses this by imposing emissions duties on imports, ensuring foreign producers face the same carbon costs as EU companies.
This represents a seismic shift. Previously, countries with carbon pricing risked increased costs and diminished competitiveness. CBAM changes this by charging the ‘net’ difference between EU and local carbon taxes, creating a financial incentive for carbon pricing. Without taxing carbon, governments are simply forfeiting revenues to foreign governments such as the EU.
However, although CBAM creates an incentive for decarbonisation and carbon pricing, it also exacerbates the challenge of climate finance by imposing additional financial burdens on developing countries. Many emerging economies lack the capital needed to decarbonise, limiting their ability to respond to CBAM’s incentives. Additionally, these countries may not have the resources – or political will – to implement traditional carbon pricing to capture revenues domestically.
So, what can be done? There is no silver bullet, but carbon pricing could provide the financial ammunition needed for climate finance.
Carbon pricing creates ‘carbon tax liabilities’ on firms’ balance sheets, reflecting the cost of their emissions. Firms can settle these liabilities using ‘carbon tax assets’. In emissions trading schemes, carbon tax assets typically take the form of emissions allowances. Under CBAM, firms can purchase CBAM certificates or provide proof that they have already paid a carbon price in their home country.
To unlock the climate finance potential of CBAM, the EU could recognise emissions reductions from decarboni sation projects in developing countries as carbon tax assets. Foreign firms could purchase these assets to meet their CBAM liabilities, which, once certified, would serve as proof of having paid a carbon price. This would then reduce firms’ CBAM liabilities by the value of the carbon assets tax purchased.
This approach could generate a new stream of climate finance. Exporters to the EU would fund emissions reduction projects in developing countries to obtain carbon tax assets, which they could then use to offset their CBAM liabilities. Developing countries could recognise domestic investments in decarbonisation by their own firms as a form of carbon tax, ensuring that carbon revenues remain within the country, rather than transferred to the EU.
How to successfully get there
For this approach to succeed, robust safeguards are essential.
First, the EU and other jurisdictions must ensure that investments result in genuine emissions reductions. One approach would be to base the system on carbon assets under article 6 of the Paris Agreement. The EU could ‘gold-plate’ article 6 credits with additional requirements, ensuring that the carbon assets used for CBAM reflect real, verifiable and additional emissions reductions. This could help set global standards for carbon markets globally, as the size of the CBAM market would likely lead to its criteria becoming widely adopted.
Second, CBAM deductions should be calculated in monetary terms not tons of carbon dioxide. If a firm invests $100 million in decarbonisation, that amount should be deducted from its carbon liabilities, rather than the number of tons.
This would prevent firms from gaming the system by removing the incentive to purchase inexpensive offsets.
Third, carbon tax assets should complement, not replace, traditional carbon pricing. For developing countries, this mechanism is a stopgap to retain revenue while carbon pricing scales up. However, exporters from developed countries with lower carbon prices than those in CBAM jurisdictions could continue to generate tax assets through climate finance indefinitely.
If done right, carbon tax assets from green investments in the Global South could match CBAM liabilities, tackling both necessities of the energy transition. CBAMs offer a huge opportunity for carbon pricing, but success depends on flexible pricing systems that support – and not exacerbate – the challenge of climate finance. This may indeed not be a silver bullet, but it is a first shot at transforming two requirements for the energy transition – carbon pricing and climate finance – into a unified solution.
