In July 2023, Earth recorded its hottest day in over 125,000 years (NOAA, 2023), a stark reminder of the accelerating pace of global warming. At the heart of this crisis is carbon dioxide, the gas most responsible for trapping heat under our atmosphere. To mitigate carbon dioxide emissions, an increasing number of nations worldwide have begun implementing carbon pricing, also known as a carbon tax. 

Carbon pricing is a tool that captures the external costs of greenhouse gas (GHG) emissions—the costs of emissions that the public bears, such as crop damage, health care costs from heat waves and droughts, and property loss from flooding and sea level rise—and ties them to their sources through a price (World Bank, 2022). A carbon price serves to redistribute the weight of damage caused by GHG emissions back to those who are responsible and can prevent it.

Instead of mandating who should decrease emissions where and how, a carbon price sends an economic signal to emitters, allowing them to choose whether to alter their activities and reduce emissions or to continue emitting and pay for their emissions (Europe, Tax Foundation, 2023). In this approach, the overall environmental goal is achieved in the most flexible and cost-effective manner for society.

Cutting carbon emissions

To date, 46 countries have implemented pricing mechanisms for emissions through carbon taxes or emissions trading schemes (ETS), while others are considering this approach (International Monetary Fund, 2022). This carbon pricing will motivate consumers and companies not only to reduce carbon emissions and energy consumption but also to improve energy efficiency and utilize more renewable energy sources. Sweden is among the first countries to implement a tax like this one (Sweden, Government, 2023). 

Currently, Sweden has the world's highest carbon tax rate, at USD$126 per metric tonne of CO2. The tariff largely applies to fossil fuels used for heating and motor fuels. The country also boasts one of the highest levels of energy consumption in the world while producing one of the lowest levels of carbon emissions among wealthy countries. Sweden has been able to cut national carbon emissions while maintaining steady GDP growth since imposing its carbon tax roughly 30 years ago (Europe, Tax Foundation, 2023).

Diagram 1: The impact of carbon tax on the negative externality of production

 

A negative externality is when a cost is imposed on a third party as an indirect result of another party's actions (Kenton, 2024). In this case, burning fossil fuels imposes costs, such as health issues and environmental degradation, which are not reflected in the market price. The marginal private cost (MPC) represents the producer's cost without considering these externalities, whereas the marginal social cost (MSC) includes them. The MPC of production, exclusive of these external costs, is what the price of power P1 reflects in a market devoid of government interference. The consumption level produced is Q1, which is higher than the socially efficient level, Q3. As a result, society’s costs are greater than private costs, as indicated by the deadweight loss (DWL), which is the area between the demand curve and the MSC. Governments can implement a carbon tax that internalizes these external costs, thereby alleviating this inefficiency. 

Carbon taxes can shift the supply curve from MPC to MPC + tax, aligning market outcomes closer to the socially optimal quantity. Sweden provides a compelling case study. As one of the first countries to introduce a carbon tax—now the highest globally at $126 per metric tonne—Sweden has managed to reduce emissions while maintaining steady GDP growth (Government of Sweden, 2023). The nation has successfully balanced environmental regulation and economic development over the last 30 years, reducing carbon emissions while maintaining high energy consumption and economic growth (UNFCCC, 2024).

Limitations of carbon taxing

Despite such success, many businesses globally continue traditional operations. In aviation, where demand is inelastic, major airlines like United and American are projected to consume over 95 billion gallons of jet fuel in 2023. These companies often pass increased costs onto consumers, resulting in minimal reductions in fuel use (Wiskich, 2024).

The limitations of carbon taxes extend beyond aviation. In ground transport, the growing adoption of EVs hasn't slowed gasoline-powered vehicle production.

Automakers like Ford and GM continue to produce over 8 million gas-fueled cars annually, while companies like ExxonMobil and Chevron extract over 3.7 million barrels of oil equivalent daily (OPEC, 2022). This pattern underscores the limited behavioral impact of carbon taxes in sectors with inelastic demand.

Carbon leakage

Global inconsistency in carbon pricing introduces a problem known as carbon leakage—when emissions shift to regions with looser regulations. According to the World Bank, only 24% of global emissions are covered by carbon pricing instruments (World Bank, 2024), indicating a disjointed approach to climate policy. Empirical research shows that carbon leakage rates can be as high as 25%, meaning that a 100-ton decrease in emissions at home could lead to a 25-ton increase overseas (Misch, 2021). Industries with high exposure to global trade, such as cement and aluminum, suffer severe losses in competitiveness (Branger, 2014). This fragmented global approach burdens firms with administrative costs and erodes competitiveness. Although border carbon adjustments (BCAs) offer a solution, they carry risks of trade disputes and financial retaliation (World Trade Report, 2022). The effectiveness of carbon pricing is ultimately threatened by the possibility of corporations moving production to nations with lower or no carbon costs.

Given these limitations, carbon taxation alone may not sufficiently drive global decarbonization. A promising alternative is subsidizing clean production and innovation. The U.S. Inflation Reduction Act exemplifies this strategy, directing large investments toward renewable energy projects (US EPA, 2024). These subsidies support emissions-reducing technologies and stimulate research breakthroughs. Simulation studies suggest that clean production subsidies can yield 96% of the utility gains of ideal carbon tax schemes, while clean research subsidies offer 91% (Carattini et al., 2018). Countries like Germany have leveraged such policies to lead advancements in solar and wind power.

While carbon taxes are a key instrument in the climate policy toolkit, their limitations in the face of inelastic demand and global regulatory fragmentation suggest that complementary measures are essential. Subsidies for clean energy and research offer substantial emissions reductions while encouraging innovation and preserving economic competitiveness.

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(The author is a grade 12 student of The Shri Ram School, Haryana, India. Views expressed are personal. He can be contacted at vasudeva.vivaan@gmail.com)