By imposing a fee on CO₂ emissions, carbon taxes create strong economic incentives for businesses to adopt low-carbon technologies, thereby reducing their emissions. This strategy not only encourages direct decarbonisation but also addresses the limitations associated with carbon credits, ensuring that financial incentives align with environmental goals.

In 2023, global carbon pricing revenues reached a record $104bn, reflecting the growing adoption of such measures worldwide. However, to effectively drive the energy transition, it is crucial to set carbon tax rates at levels that significantly impact business decisions, compelling a shift towards sustainable practices.

A carbon tax directly targets the financial foundation of emissions-intensive industries by increasing the cost of emitting CO₂. Businesses are charged a fee for each tonne of CO₂ they emit, effectively making pollution more expensive. Companies relying on carbon-intensive processes will find that this additional cost erodes profit margins and are therefore compelled to innovate or adapt to avoid additional cost.

To escape the financial burden of carbon taxes, companies have a clear incentive to transition to low-carbon or carbon-neutral technologies. These include renewable energy solutions such as wind and solar power, energy-efficient machinery and advanced carbon capture and storage systems. By adopting these technologies, businesses can dramatically cut their CO₂ emissions to reduce their tax liabilities. This shift would not only help companies save money but also contribute to a broader societal transition toward sustainable energy and practices.

Why do carbon credits have a bad reputation?
Critics often argue that carbon credits are ineffective, claiming that they merely allow companies to continue emitting CO₂ while offsetting those emissions through purchased credits. Even as a global carbon markets framework is being formulated post-COP29, the effectiveness of carbon credits as a tool for genuine emission reductions remains a topic of debate.

Critics argue that this enables major polluters to avoid making substantial changes to their operations, relying instead on purchased credits to offset emissions. Concerns have been raised about the potential for greenwashing and the adequacy of oversight to prevent double counting of emission cuts. While this criticism may hold in poorly regulated markets, it overlooks the critical role of a robust carbon tax in ensuring that the balance favours decarbonisation.

A higher carbon tax creates a powerful incentive for businesses to adopt cleaner technologies rather than rely solely on offsets. Carbon credits are not merely a way to maintain the status quo – they represent measurable reductions in emissions. By tying carbon credits to stringent certification standards and increasing the cost of emissions through taxation, governments can ensure that the balance leads to a net reduction in CO₂ and a significant push toward the energy transition.

As one of the few countries in the Asia-Pacific region with an operational carbon tax, Singapore has set an example by incrementally increasing its tax rate, which is expected to reach S$50–80/t US($37–59) by 2030. It was raised from S$5 to S$25 last year. This approach aims to drive emissions reductions domestically while fostering a robust carbon trading ecosystem. Singapore’s carbon markets also enable companies to trade offsets and credits, ensuring that businesses unable to fully decarbonise can still contribute to global emission reductions.

By aligning its carbon tax with international trading standards, Singapore maximises the impact of both mechanisms, promoting transparency, accountability, and innovation in emissions reduction strategies.

A higher carbon tax creates a powerful incentive for businesses to adopt cleaner technologies rather than rely solely on offsets.

How do carbon credits change markets?
The ripple effects of a higher carbon tax extend beyond individual companies. As carbon-intensive practices become increasingly uncompetitive, entire industries are nudged towards cleaner energy sources and sustainable practices. Over time, this could lead to a market-wide transformation, spurring innovation in green technologies and driving down the cost of sustainable solutions. Industries that once relied on fossil fuels are gradually replaced by those aligned with a low-carbon future.

Consider a manufacturing company emitting 10,000 t/y of CO₂. With a carbon tax of $100/t, its tax liability would be $1mn/y. To reduce this burden, the company might take the following steps:

• Invest in renewable energy: install solar panels or wind turbines to cut emissions by 4,000 tonnes.
• Upgrade to energy-efficient equipment: new machinery reduces emissions by an additional 2,000 tonnes.
• Purchase carbon credits: the remaining 4,000 tonnes of emissions are offset by buying carbon credits at $50/t, costing $200,000.

By reducing emissions and using carbon credits, the company’s tax liability drops from $1mn to $200,000. This significant cost saving demonstrates how higher carbon taxes can drive businesses toward greener solutions.

A higher carbon tax is more than just a financial penalty; it is a catalyst for change. By making CO₂ emissions increasingly expensive, it pushes businesses to adopt clean technologies, drives innovation and fosters a thriving carbon market. Combined with stringent standards for carbon credits and the leadership of hubs like Singapore, this approach ensures that financial incentives favour decarbonisation rather than perpetuating emissions.

The views and opinions expressed in this article are strictly those of the author only and are not necessarily given or endorsed by or on behalf of the Energy Institute.

• Further reading: ‘(Carbon) credits where credit is due’. Are offsets a licence to pollute – or an effective economic incentive to cut carbon? Finance journalist Jennifer Johnson looks at the need for unambiguous certification schemes.
• With more options on the table for carbon pricing than ever, sustainability consultant Michelle Meineke asks if this choice will confuse or propel decarbonisation efforts later on.