Most economists consider human-made greenhouse gas (GHG) emissions an unintended negative externality of production and consumption. A negative externality occurs when the effects of producing or consuming goods and services impose costs on a third party which are not reflected in the prices charged for said goods and services. In the context of GHG emissions, this negative externality is calculated using the “social cost of carbon,” which is the future damage to society (adjusted to present value) of one additional tonne of carbon emitted to the atmosphere today.

Governments have a wide variety of policy alternatives to address the negative externality of emissions depending on the degree and depth of the policy intervention. They can either mandate individuals and firms to change their behaviour through command- and-control regulations, grant subsidies and tax credits to foster cleaner energy sources, or use market-based mechanisms to correct the misalignment of incentives. It is widely acknowledged that carbon pricing, one of these market tools, is the most costeffective policy to reduce emissions, as it relies on price signals and trade to provide flexibility to economic agents as to where and how emissions mitigation occurs.

Generally, there are two main types of carbon pricing mechanisms: carbon taxes and emissions trading systems (ETS). With a carbon tax, governments set the tax rate, generally according to the social cost of carbon, and allow the market to figure out the optimal amount of emissions. In an ETS, governments create a carbon-permits market by capping the aggregate amount of emissions and allowing trade between emitters to determine the price.

However, certain conditions must be met for carbon pricing to deliver cost-effective emissions reductions. Carbon pricing revenues should be recycled back into the economy in the form of tax reductions to mitigate the gross efficiency costs of introducing a carbon tax or an ETS into an already distorted taxation environment. Also, carbon pricing revenue should not be used to subsidize specific energy sources as it would defeat the purpose of providing flexibility to individuals and firms. Second, the introduction of carbon pricing tools must be accompanied by the repeal of non-pricing emission control regulations such as emissions caps, mandated fuel standards, technology-based standards, subsidies to electric vehicles, and renewable power mandates. Layering regulations on top of emission-related taxes will have distortionary effects causing disproportionate

damage to the economy.