Carbon markets: Accounting for thick air
If we build the carbon offset market, will they come? We might want to gain a deeper understanding of what we're trying to trade first.
Carbon markets are not a novel idea. Indeed, one might say that the idea to use markets to allocate carbon emission rights stems from an era when the slogan “market fixes this” was as ubiquitous as “blockchain fixes this” was in 2017. Turns out few things are as straightforward as they seem on first sight.
We can blame the Coase Theorem for this, or more precisely the famous (mis)interpretation of the Coase Theorem popularized by George Stigler which we might call the “Stigler truncation”. In its original inception, Ronald Coase proposed that in the absence of transaction costs, participants can frictionlessly find an optimal allocation of rights in markets with externalities — pollution being the prime example of such an externalities.
Coase’s aim was to imply, seeing that we rarely ever reach those perfect allocations in the real world, that we don’t live in a world were transaction costs are close to zero.
His Chicago colleague Stigler was so enamored with the frictionless conclusion that he all but skipped the second part when he coined the term “Coase Theorem” — hence Stigler truncation — much to Ronald Coase’s dismay.
Turns out the things we encounter on the way to establishing a perfect carbon emissions market can be bracketed under the term “transaction costs”, and we know quite a bit more about them now than we did when Coase and Stigler had their fallout.
Designing better carbon markets
Transaction costs, often termed “the costs of running the market system”, come in three different flavors: before, during, and after an exchange takes place.
“Before” captures all the costs and efforts undertaken to come to an agreement what should be exchanged. “During” captures all the logistical details of the exchange — currently in stark relief due to ongoing supply chain bottlenecks. Finally, “After” captures the complexities arising when an exchange did not conclude as expected, and the parties need to resolve their dispute.
As it turns out, all these factors come into play for carbon markets. In a carbon market, a polluting activity is exchanged — directly or indirectly — for an offsetting activity. Our hope is that these activities at least balance each other out, so that we manage to create a carbon-neutral or carbon-negative economy.
These two processes, pollution and offset, typically started in the past and conclude in the future. More to the point, their consequences might not be fully revealed until very long into the future — one or even many human lifetimes. By virtue of this fact, all carbon credits are automatically futures.
The idea of creating a market is to match these activities so they cancel each other out environmentally, and to find a price that matches the environmental cost of the polluting activity and the benefit of the offsetting activity.
Creating these markets did not go off without a hitch. “A picture emerges of international carbon markets as a hasty marriage of science of climate change and economics of emissions trading, spurred on by political pressure to reach an international climate agreement.” (Calel 2011).
Like regulatory compliance markets, voluntary carbon markets have gone through their own boom-bust cycles, but are now seeing renewed interest, especially in the wake of increasing consumer pressure on corporations to clean up their act, and the inevitable motivation for political parties to court these voters.
There is a certain aspiration in the world of online markets that the only thing needed to create a market platform is the matchmaking algorithm, and certainly buyers and sellers will gravitate towards the opportunity. This aspiration has been the graveyard of many a platform startup, and chances are that, unless they're designed properly, voluntary carbon markets will share the same fate.
Before trading, establish what is being traded
While the ultimate goal might be clean air, what customers are looking to buy on a carbon offset market is a clean conscience, while largely continuing their consumption habits. To make sure that these two things match is ultimately the task of the market operator, or the market will inevitably descend into a lemons market: honest but expensive offsetting activities will be pushed out by cheap decarbonization theater.
What is needed to prevent such a scenario is the emergence of a threefold accounting mechanism, either as a self-enforced consensus among all market participants, or as a regulatory framework. For those who do not want to wait for state regulation to take over, designing a certification process should start around three activities.
Development and application of a standard for negative certificates, ideally across borders
Secure tracking and full disclosure of the process details, to prevent double counting
Verification of this process and transformation into tradeable certificates, recording the carbon equivalent and the predicted permanence of the offsetting activity
Secure tracking of emissions and negative emission certificates beyond the certification
Only then we should start thinking about building the market itself.
Stephan Wolters, Stella Schaller, Markus Götz “Voluntary CO2 offsetting through climate protection projects” Umweltbundesamt Deutschland (2018).
Isabelle Gerretsen “How trading CO2 could save the climate” BBC Future (2021).
Raphael Calel “Climate change and carbon markets: a panoramic history” Grantham Research Institute on Climate Change and the Environment (2011).
Laura Dyer “Are voluntary carbon markets worth the hype?” Medium (2021).
Stephen Lacey “The new wave of carbon offsets: Is this time different?” Greentech Media (2020).
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