Carbon Markets

by Joe Perullo

Lately, the phrase Carbon Markets is what comes to me when I hear the word “controversial.”  Much of the literature I have read on them mentions how the markets are “a horrible distraction from real emission mitigation strategies” and how they “redefine the problem to fit the assumptions of neoliberal economics.”  I wouldn’t say I disagree with these statements, but at the moment I can’t brush the idea of carbon markets aside without a better understanding of their ability to evolve from where they are now into effective mitigation mechanisms… or maybe I can.

How do Carbon Markets work?

Say a country wants to reduce its carbon emissions by 80% by 2050.  First, it would need to put a cap on emissions, where a company that would emit over the legal amount would be punished (most likely through a fine or tax increase).  This cap would become tighter and tighter: 10% fewer emissions this year, 30% next, etc.  Initially, the national government would auction off (or sometimes give away!) a set amount of permits to emit.  Companies that would have trouble reducing the required amount of emissions can bid for these allowances.  Companies that can emit lower than the cap (through improvements in energy efficiency, say) can turn that gap between how much they emit and how much they are allowed to emit into permits called carbon credits.  These credits can be sold to companies that can’t reduce their emissions as effectively.  One carbon credit is worth a ton of carbon, so a company that “must” produce one ton of carbon over the legal limit can buy a credit to make up for it. This is cap and trade, and isn’t limited to companies within the same country.

Also, the tightening of the cap will make the carbon credits more and more valuable (and expensive), giving more incentive for companies to reduce their emissions.

Offsets

If a company chooses, instead of making itself use less carbon, it can invest in carbon reduction actions in another country.  This grants the company carbon credits equal to the amount it reduces abroad.  Economically this is flawed, since the offset credits appear out of thin air, saturating the market: when companies receive these offset credits, this increases the amount of credits that are out there—inflating and devaluing them.  Since they are all still equal to one ton of carbon, this effectively allows more carbon to be emitted and counters the efforts of the tightening cap.

What are the Carbon Markets?

There are several different carbon markets out there, but only two are mechanisms under the Kyoto Protocol, known as “flexibility mechanisms,” and they are both offsets. They are the Clean Development Mechanism (CDM) and Joint Implementation (JI). Simply, the CDM is the mechanism used for offsetting where the flow of investment moves from developed countries to developing countries, and JI is offsetting from developed countries to other developed countries. JI makes up only 1% of the physical volume of global carbon trading and .5% of the financial value (of $30B), so much more attention is given to the CDM, which makes up 29% and 17%, respectively.

The CDM is defined in Article 12 of the Protocol, and has two intentions: (1) to assist non-industrialized countries in sustainable development and (2) to assist industrialized countries in achieving compliance with their quantified emission limitation and reduction commitments. Under the guidance of the COP, the CDM is supervised by the CDM Executive Board (CDM EB)—a highly flawed and horribly understaffed operation.  Since developed countries can use the CDM to ease their emission commitments and developing countries can use it to get money to flow from north to south, the CDM ED is under great pressure to approve foreign mitigation investments, even if they do very little to help the country or reduce global emissions. On top of that there is a risk of fraud where projects earn more carbon credits than they deserve.

Furthermore, although the CDM awards emission reductions, it does not penalize emission increases.  This can create perverse incentives for firms to raise their emissions in the short-term, with the aim of getting credits for reducing emissions in the long-term.

The most “economic” way to mitigate?

No mechanism that stalls real mitigation action is economically, or for that matter socially and environmentally, sustainable in the long run.

To the neoclassical economist with a heart for environmentalists, carbon markets are a gift from god (perhaps with the exception of offsets); it truly does provide the least amount of economic harm.  Under the principle of comparative advantage, companies who are better at reducing their emissions will be doing nearly all the reductions, since they can earn more selling credits and investing than buying credits and not.  Those that aren’t so good at reducing their emissions will reduce as little as possible, since it is cheaper for them to buy credits.  In this dichotomy both types of businesses can work under the cap with the least amount of harm to their profits.

Despite the attractiveness of carbon markets on paper, they are in no way a solution to the problem of climate change.  The fact is that they only work if there is a truly enforced cap on emissions.  The only emissions cap that exists under the UNFCCC is the Kyoto Protocol, but countries have not respected its authority—emitting more than what it allows—and if (or perhaps when…) a second commitment period of the protocol is not agreed upon, there will no longer be a legally binding cap for the UN member states.  Countries could of course set their own national caps, but the market would inevitably be far less effective, since investors may be scared in the volatility of their own governments to keep the legal cap in place.  Also, it is possible that the markets would only work if a vast majority of economies had a cap. A rebound effect could occur where the countries that do emit less subsidize the ones that don’t:  Since some countries aren’t using as many resources, there are more out there to use. A higher supply and lower demand makes these resources cheaper, allowing countries without caps to use more. This results in a net reduction in emissions of 0… in theory of course.

Furthermore, the market approach is without a doubt a distraction from employing real mitigation policies.  The climate is not something we can let the markets take care of.  Only a purely profit-seeking entity or a neoliberal economist would say otherwise. But do we need to trash the idea entirely? Is it not possible to effectively have both real mitigation policies eased with carbon markets?  If we don’t have carbon markets, we must then be sure that we can create the political will for real carbon enforcement.  This is a gamble no doubt, but if we rely on markets to pick up the work, how will we confidently have reduced global emissions?  Right now I am on the fence.  I know carbon markets themselves are not the answer, but I am cynical of the ability for all member countries of the UN to reach agreement, especially when the U.S., who’s own national politics are stagnant and unprogressive, has such leverage over the negotiations.

I hope the next few weeks in Durban will help me jump off that fence. Perhaps it is wrong to say that carbon markets are our last hope.  All too often do we forget how unpredictable politics really are.  As a professor of mine once said referring to national caps: “If Australia can do it so can we.” Still in need of a better understanding of the whole process, I can only hope this is the case…

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