The underlying idea of carbon pricing is based on the economic principle of negative externalities. It means when production or consumption imposes an external cost on third party or society and compensation is not paid, it causes negative externality. In the carbon market, carbon emissions pose social cost by degrading the environment. This social cost is monetised in terms of the carbon price.

Carbon pricing mechanism works by quantifying the external cost posed by carbon emissions. The external cost basically includes damage borne by the public in the form of damaged crop, health care, flooding and sea-level rise. These damages are now being tied to their cause in the form of a carbon price.

A carbon price can be imposed through a carbon tax or emissions trading systems (ETS) (also known as cap-and-trade scheme). Some other indirect ways include fuels taxes, removal of fossil fuel subsidies and inclusion of the social cost of carbon.

Through carbon pricing, the damage cost can be shifted back to the responsible industries. It also encourages the polluters to reduce the emission and find other green sources to reduce carbon emissions. Carbon pricing sets an economic signal for polluters whether to continue their emissions and incur the economic cost or reduce emissions and use green technology.

A carbon price can serve in two ways. It encourages the businesses and individuals to switch towards lower carbon-intensive production and consumption as it creates a price incentive to reduce carbon emissions (i.e. employees can use cycle rather other transport- cycle to work incentive). On the other hand, revenue generated from carbon pricing (tax or auctioned allowances), can be further invested in improving environment and financing R&D projects. The revenue raised from it can be used in subsidising the low-carbon technologies.