Carbon credit markets: How they work and understanding externality

The idea is to penalize higher greenhouse gas emissions, reward less emissions, and pay for environmental / clean energy projects. There are different solutions and different types of carbon credits markets.

Climate change is already a part of our daily lives. It is an undeniable phenomenon, as it causes weather-related anomalies that did not happen as frequently before, such as stronger cyclones and hurricanes, more frequent fires, desertification of different areas, among other impacts. Humanity has emitted 20 billion tons of carbon dioxide in the 1990s, and today we produce between 35 and 40 billion. It is said that this number is actually underestimated and, in reality, is closer to 50 billion tons per year. If this is the real number of our global greenhouse gas emissions, only 11 billion of these 50 are compensated through the purchase of carbon credits. Therefore, there is a potential market, or a gap to be filled via offsetting/buying carbon credits, of around 40 billion tons annually — or $1 trillion in the current average price of global carbon credits.

What is a carbon credit? And what is an “externality”?

Carbon credits put a cost on greenhouse gas emissions. The idea of the carbon credit market is to penalize those who have more emissions, reward those who have less emissions, and fund environmental / clean energy projects.

Greenhouse Gas Emissions are considered to be an “externality” from an economic perspective. An externality is a side effect, a market failure, which is not included in the classical economic system. Most neoliberal and classical economists, such as Adam Smith and John Stuart Mill, in the 18th and 19th centuries, considered that Nature was something external to the society, and that humans were always superior beings who dominated nature and exploited its endless resources. In mainstream economics, nature has always been considered an entity apart from the economic system.

Therefore, any effect on nature is considered (even today, oddly enough) as an externality by classical or liberal economics. For this reason, there is also a more recent argument made by new revisionist economists and philosophers (Kate Raworth, Daniel Wahl) that we must begin to understand nature as an integral part of the economic system and its resources as scarce, so that we have a complete view of how our society and our planet function (just as labor, our time, and our money are considered by mainstream economics to be scarce resources).

Externalities can be positive or negative. An example of positive externality is the Silicon Valley, where there is a concentration of several technical and engineering colleges. As they are located close to one another, the generation of high-level technical jobs, higher economic development, and constant technological innovation are a positive externality. People who live in the Silicon Valley region, or who moved there in the 1950s and 1960s, did not pay for this positive side effect. These people receive these benefits as a premium for which they pay nothing.

The same concept described above, with the opposite impact, applies to greenhouse gas emissions. This is a negative externality, and Petrobrás’ behavior is a good example of how it works.

Petrobrás emits 60 million tons of CO2 per year. It makes no difference to Petrobrás if they emit two billion or even two trillion tons of CO2—the company will not change its activity at all, as Brazil is not a regulated market. Petrobrás is not forced to pay for the cost of their emissions, but this clearly has a cost for humanity globally: it becomes more difficult to breathe, we die earlier, we are afflicted with a series of diseases, among other numerous negative effects on us.

How does one “internalize” this “externality” then? How is it that a company that produces greenhouse gas emissions is forced to consider this social cost as its own, therefore aligning its interests to those of the rest of humanity, which requires a more responsible attitude from companies, so that they reduce their emissions and do not harm the planet? Well, the solution is to put a price on greenhouse gas emissions, and to force companies to pay for it. It is from that scenario that the carbon credit market and trading system emerged.

(The classic example of externality in economics classes: “the tragedy of the commons”):

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The carbon credit trading system and market was conceived at Eco 92, in Rio de Janeiro, also known as the first “Conference of the Parties” — a global climate conference for all countries. At that time, all countries in the world came together to discuss climate change and the environment. In 1997 the Kyoto Treaty was negotiated and signed, and a regulated market was implemented in 2005.

The first regulated carbon market was global and organized by the UN, called CDM — Clean Development Mechanism. After signing the Kyoto Treaty, almost all countries in the world were regulated, with the notable exception of the United States, the biggest greenhouse gas emitter in the world. Even Brazil was regulated in a system called “cap and trade”, which works as follows: to create greenhouse gas emissions limits (“cap”) and to force companies with higher emissions to buy from companies with  lower emissions (“trade”). The regulator set targets for countries on a decreasing “ladder”. As an example, let’s say that the emission of a country was one billion tons in the year, considering the year 1990 as the basis for the calculation. In the following year, the target would be 950. In the next year, 900, and so on until reaching zero.

The Kyoto Treaty also led signatory countries to set industry targets. The airline industry, for instance, has had its own goals from their outset. Let us illustratively set a target of 2 million tons per year. In the case of Europe, if Alitalia generated 3 million greenhouse gas emissions (i.e. 1 million above the annual target of 2), the company would be forced by the European regulator to buy one million CO2 certificates, or “allowances” (or “permits” to generate greenhouse gas emissions), in organized carbon exchanges in Europe. In other words, if Alitalia exceeds the target emissions per limit, there would be a  financial cost due to its extra emissions. Since the “allowance” currently costs$25, Alitalia would have a financial cost of $25 million, due to the greenhouse gas emissions of 1 million tons over the target set by Europe.

In contrast, if another European company like Lufthansa emitted 1 million less than the target in the same year, the company would have a financial benefit by certifying the issuance of one million “allowances” that can be sold in the market. Lufthansa would therefore be rewarded $25 million for its greater efficiency. In other words, the system creates an incentive for the companies to reduce their emissions (because they have a higher cost for pollution above the target and it hurts their finances) and companies that emit less have an incentive to continue researching and maintaining their best environmental practices. This is how current regulated markets work, such as the ETS (Emission Trading System) in Europe and the ETS in Chinese provinces. Brazil’s CBIO, the regulated market for ethanol carbon credits, is an example of “cap and trade” and could potentially become the embryo of a broader regulated market in Brazil.

CAP & TRADE: ETS (emission trading system) — EU, CBIO

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Two other carbon instruments that exist are: (1) Carbon Taxes, and (2) voluntary credits.

The first, Carbon Taxes, are used in countries with a greater presence of the State in the economy and a greater culture of social democracy, such as Scandinavian countries and France. Experts believe (and I agree) that the “carbon tax” is less efficient than the “cap and trade” market system, because the carbon price can get set too high or too low, as it is arbitrarily determined by the government or regulator. It can end up burdening the industries in an unnecessarily high manner and causing an excessively harmful economic impact. There is also a risk that the price will be set at a very low level, and that it will not lead to an incentive high enough for companies to reduce their greenhouse gas emissions.

Carbon Tax (Scandinavia, France)

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We must remember that the distribution of these resources across the economy may also end up being arbitrary and political. The government can decide to spend this tax revenue on health, education, part of it can disappear via corruption — in short, this money can be distributed inefficiently, and it may not end up being used in developing new technologies or encouraging new ways of cleaner production, as in the case of “cap and trade” systems.

In the next article, we will discuss the certification and operation of voluntary carbon credits, which are quite complex, and their different types (there are several). See you next time!

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