What is carbon pricing?

Reducing emissions through carbon pricing

Carbon pricing is an approach that captures the external costs of greenhouse gas (GHG) emissions through a price on the carbon dioxide equivalent (CO2e) emitted. It is gaining momentum as one of the means to bring down emissions and drive investments into cleaner options. In Indonesia, carbon pricing and its mechanisms were first introduced through Presidential Regulation No. 98/2021 concerning The Economic Value of Carbon.

There are two main types of mandatory carbon pricing instruments:  (1) Emissions Trading Scheme (ETS) and (2) Carbon tax. Voluntary carbon pricing is typically implemented through domestic or international crediting mechanisms and independent standards.

1. ETS caps the total level of GHG emissions that countries or businesses can emit and allows them to buy or sell units of GHG emissions to meet their emission level limits. An ETS works in the following manner:

• The government sets a maximum level of emissions (referred to as the cap) in one or more economic sectors. It creates permits or allowances for each unit of GHG emissions.
• The regulated entities are required to surrender one allowance for every unit of GHG emission they are accountable for. They may initially obtain permits freely, buy permits from the government, or trade with other entities, depending on the requirements of the ETS.
• Entities whose GHG emissions exceed the cap limits are obliged to buy permits in the market, while those that cut their emissions level to below the cap may sell their unused permits to other entities or save them for future use.
• The cap on allowances creates supply and demand in the market, resulting in a market price for allowances and subsequently incentives to reduce emissions.

The cap on emission allowances declines over time, which translates into a lower allowance supply and a higher allowance price. This creates a stronger incentive for entities to consider their emission reduction strategy ahead of time. In 2021, a trial run of an ETS was specifically initiated for coal-fired power plants in Indonesia. There were 84 coal-fired power plants involved, including PLN and IPPs, concerning a total capacity of 27.5 GW of electricity.

2. A carbon tax directly sets a carbon price by defining a GHG emission tax rate. Unlike ETS, the government pre-determines the carbon price (i.e. the tax) instead of the upper limit of emissions (cap). A carbon taxation regime works in the following manner:

• The government sets a price that emitters must pay for each unit of GHG emission (typically one tonne of CO₂e).
• The carbon tax is charged on the total GHG emissions of an emitter to encourage emission reduction initiatives.

Indonesia is in the process of implementing a carbon tax, the principles of which are regulated through Law No. 7/2021 concerning the Harmonization of Tax Regulations. The enforcement was originally planned for 1 April 2022 and was announced to be moved to 1 July 2022, however there has been yet any confirmed implementation date until the publication of this article.

A combination of both approaches (or a hybrid approach), such as a carbon tax that is charged only on the excess over emissions cap in carbon markets or a carbon taxation regime that accepts emission allowances to lower tax liabilities, could be imposed to internalize the price of carbon.

Globally, as of April 2022, 68 carbon pricing instruments are being implemented across jurisdictions with three more scheduled for implementation. Carbon pricing can take different forms in different jurisdictions. An ETS provides certainty on the environmental impact of price fluctuations, while a carbon tax provides a fixed price with undetermined environmental outcomes.