Both tax and trading can be used to create an explicit price for carbon; and regulation can create an implicit price.
For all these instruments, credibility, flexibility and predictability are vital to effective policy design.
A lack of credible policy may undermine the effectiveness of carbon pricing, as well as creating uncertainties for firms considering large, long-term investments.
To establish the credibility of carbon pricing globally will take time. During the transition period, governments should consider how to deal with investments in long-lived assets which risk locking economies into a high-carbon trajectory.
To reap the benefits of emissions trading, deep and liquid markets and well designed rules are important. Broadening the scope of schemes will tend to lower costs and reduce volatility. Increasing the use of auctioning is likely to have benefits for efficiency, distribution and potentially the public finances.
Decisions made now on the third phase of the EU Emissions Trading Scheme pose an opportunity for the scheme to influence, and be the nucleus of, future global carbon markets.
The establishment of common incentives across different sectors is important for efficiency. The overall structure of incentives, however, will reflect other market failures and complexities within the sectors concerned, as well as the climate change externality.
The characteristics of different sectors will influence the design and choice of policy tool. Transaction costs of a trading scheme, for instance, will tend to be higher in sectors where there are many emission sources.