Solving the carbon crisis will take more than financial engineering


What are carbon markets? Regulators are increasingly asking companies to start paying for the damage caused by their carbon pollution.

CONDON, OREGON, UNITED STATES OF AMERICA, September 14, 2022 / — Carbon emissions are an established threat to the health, safety and economic viability of communities around the world. 68% of all greenhouse gas emissions come from carbon-rich fossil fuels. Since gaseous emissions respect no political or even geographic boundaries and travel freely through the atmosphere where they exacerbate the ongoing threat of a runaway greenhouse effect and associated climate volatility, it is a problem that requires broad cooperation.

There is a concept in economics that directly addresses this issue called externality. Also called external costs, externalities are consequences that are borne not by the person or group responsible for them, but by uninvolved third parties. Pollution is one of the most widespread and harmful externalities.

Let’s take the example of a trucking company: they have to pay for their fleet, the drivers and the fuel they need, but they are generally not required to pay anything to compensate for the damage caused by emissions. of its vehicles to local communities or to take responsibility for its contribution to anthropogenic climate change. These negative costs and impacts are passed on to others.

When left unchecked, externalities represent moral hazard, a situation where there is no incentive to do the right thing because the consequences are so disconnected from the main actors and therefore offer no real deterrent. . In such a case, not only is there no reason to avoid causing externalities, but taking advantage of them can be considered a wise and economical decision.

The carbon atom that broke the camel’s back
Taken even further, such situations inevitably lead to a problem particularly relevant to ecological systems called the tragedy of the commons. Commons refer to resources and land shared by large groups. British economist William Forster Lloyd first coined the phrase in the 19th century to describe a problem where many people acting independently inadvertently destroy a resource they share because each assumes their own small actions are harmless. Isolated acts may actually be relatively harmless, but taken together they can wreak havoc.

For example, if a single person regularly dumps polluting waste into a river, it will likely be diluted to a safe level over time. But if everyone in the community follows suit, the river will eventually turn toxic, destroying its usefulness.

The nature of free markets is such that every actor is assumed to be rational. Not rational in the way psychologists would define it, but it does mean it is taken for granted that, all things being equal, they will make decisions that closely follow their own self-interest. So, since externalities save companies money, they are not likely to care about them unless forced to – and this is precisely the impetus behind the development of carbon taxes. and carbon markets.

Making polluters finally pay their fair share
Carbon taxes are levies imposed by regulators on the hidden costs of carbon emissions. The intention is to make the use of polluting technologies more expensive so that companies seek alternatives and innovation is accelerated in sustainable solutions.

The main disadvantage of simple carbon taxes is that they are not well aligned with real market conditions and updating them can be a slow process to accurately reflect the current cost/benefit relationship between pollution and profitability. To correct this imbalance, nations and groups of geopolitical partners across the planet have instituted a different framework called emissions trading.

Also known as cap and trade or carbon pricing, emissions trading refers to the creation of a carbon emissions market (or, more briefly, a carbon market). These markets are numerous and operate according to different principles. Some are more aggressive in their targets than others, but generally they all reduce the competitiveness of fossil fuels against renewable energy sources by setting an upper limit on the total emissions of all participants bound by the agreement. Therefore, the price of pollution naturally floats with actual market activity; when emissions increase, the price of offsetting the released carbon also increases.

In practical terms, the process works like this: if a company exceeds its allowed carbon emissions, it is required to buy offsets from another company that has not fully used its own. In this way, the total emissions of the group remain within the limits, the polluting company is penalized for having exceeded its individual limit and the non-polluting company is rewarded.

This system encourages companies to seek cost-effective carbon reduction strategies. In some trading systems, a regulator distributes emission allowances for free, in others they are auctioned off to the highest bidder, but in both cases, once established, natural market forces will raise or lower the price dynamically. Recent models attempting to determine the social cost of carbon estimate that each ton of CO2 emitted causes $3,000 in damage.

Solving the carbon crisis will take more than financial engineering
Despite their benefits, carbon markets are far from a panacea and alone cannot address the carbon crisis facing the planet. Most current frameworks only cover certain types of emissions. For example, the European Union’s carbon market focuses mainly on heavy industries, which means that smaller sectors of its economy may continue to pollute.

The United States currently does not have a national emissions trading framework. However, several states, including California and Washington, have adopted their own cap and trade programs. There is also a cooperative carbon market called the Regional Greenhouse Gas Initiative (RGGI) which several New England states have joined.

Carbon trading is also susceptible to manipulation. In an alarming example, companies in China have been caught intentionally producing unnecessary greenhouse gases for the sole purpose of destroying them to obtain carbon permits under a United Nations scheme. These permits were then sold to polluters in the United States, effectively rewarding the polluters. Fortunately, international regulators are aggressively prosecuting rule breakers.

Either way, carbon markets are just one more tool in the battle to fix our planet’s ecosystems. Read more

Fred Parent
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