What is a Carbon Tax?
An explanation of carbon taxes and carbon pricing mechanisms — how they work, how the UK Emissions Trading Scheme operates, and what SMEs need to understand about carbon cost exposure.
Key Takeaways
- A carbon tax puts a direct price on greenhouse gas emissions to incentivise reduction.
- The UK uses an Emissions Trading Scheme (UK ETS) rather than a direct carbon tax for large industrial emitters.
- SMEs are rarely in the UK ETS directly but face indirect carbon costs through energy prices and supply chain pricing.
How carbon pricing works
A carbon tax is a charge levied on the emission of greenhouse gases, designed to reflect the environmental cost of those emissions in market prices and thereby incentivise reduction. There are two main policy mechanisms: a carbon tax sets a fixed price per tonne of CO2 emitted (simple and predictable, but the volume reduction is uncertain); and an emissions trading scheme (ETS) sets a cap on total emissions, issues permits up to that cap, and allows companies to buy and sell permits (the price fluctuates with supply and demand, but the total emission volume is controlled). Both mechanisms create a financial incentive to reduce emissions.
The UK Emissions Trading Scheme
The UK operates an Emissions Trading Scheme (UK ETS), launched in 2021 as a replacement for participation in the EU ETS following Brexit. The UK ETS applies to energy-intensive industries (power generation, steel, cement, aviation and others) above certain capacity thresholds. Covered businesses must surrender UK ETS allowances for each tonne of CO2 they emit. The price of UK ETS allowances fluctuates — it peaked above £75/tonne in 2022 before falling back. Most SMEs are not directly in the UK ETS, but energy suppliers and industrial customers pass carbon costs through to energy prices, so all businesses feel the indirect effect through their electricity and gas bills.
Carbon border adjustment and future exposure
The EU's Carbon Border Adjustment Mechanism (CBAM), which began phasing in from 2024, will impose a carbon price on certain goods imported into the EU — initially steel, aluminium, cement, fertilisers and electricity. UK exporters of these goods to the EU will face CBAM costs if they cannot demonstrate that their production emissions have already been priced through the UK ETS or equivalent. The UK government is consulting on its own CBAM. For SMEs, the key message is that carbon pricing is expanding in scope and cost — reducing your emissions reduces your exposure to carbon costs whether you are currently in a regulated scheme or not.