Question

Topic :Carbon trading.

1. What are carbon permits, credits and offsets?
2. How did the EU-ETS carbon price evolve during 2013-2020? Why is carbonprice volatility a problem?
3. What are TAC? What are MAC?
4. Explain the grandfathering principle used to allocate permits.
5. Why is there reason for trade when the MAC’s of different firms or countries are different?
6. Give two reasons why a carbon emission permit is not a well-defined commodity (as, for instance, a train ticket).
7. Explain why it is impossible to express all global warming costs in monetary terms. (Answer: what is the social rate of discount? What is the money value of ecosystem damage? Etc.)
8. Explain why the carbon market is not a perfectly competitive market?
9. What is the problem with carbon offsets according to Spash?
10.Carbon pricing should be comprehensive. What does this mean?
11.Explain how carbon pricing may stimulate undesirable behaviour?
12.How do environmental motivations get crowded out? Explain in detail.

Answer 1

1.

A carbon credit is a tradable permit or certificate that provides the holder of the credit the right to emit one ton of carbon dioxide or an equivalent of another greenhouse gas – it’s essentially an offset for producers of such gases. The main goal for the creation of carbon credits is the reduction of emissions of carbon dioxide and other greenhouse gases from industrial activities to reduce the effects of global warming.

Carbon credits are market mechanisms for the minimization of greenhouse gases emission. Governments or regulatory authorities set the caps on greenhouse gas emissions. For some companies, the immediate reduction of the emission is not economically viable. Therefore, they can purchase carbon credits to comply with the emission cap. Companies that achieve the carbon offsets (reducing the emissions of greenhouse gases) are usually rewarded with additional carbon credits. The sale of credit surpluses may be used to subsidize future projects for the reduction of emissions.

The introduction of such credits was ratified in the Kyoto Protocol. The Paris Agreement validates the application of carbon credits and sets the provisions for the further facilitation of the carbon credits markets.

Types of Carbon Credits

There are two types of credits:

• Voluntary emissions reduction (VER):  A carbon offset that is exchanged in the over-the-counter or voluntary market for credits.
• Certified emissions reduction (CER): Emission units (or credits) created through a regulatory framework with the purpose of offsetting a project’s emissions. The main difference between the two is that there is a third party certifying body that regulates the CER as opposed to the VER.

Trading Credits

Carbon credits can be traded on both private and public markets. Current rules of trading allow the international transfer of credits.

The prices of credits are primarily driven by the levels of supply and demand in the markets. Due to the differences in the supply and demand in different countries, the prices of the credits fluctuate.

Although carbon credits are beneficial to society, it is not easy for an average investor to start using them as investment vehicles. The certified emissions reductions (CERs) are the only product that can be used as investments in the credits. However, CERs are sold by special carbon funds established by large financial institutions. The carbon funds provide small investors with the opportunity to enter the market.

There are special exchanges that specialize in the trading of the credits, including the European Climate Exchange, the NASDAQ OMX Commodities Europe exchange, and the European Energy Exchange.

2.

The scheme has been divided into a number of "trading periods". The first ETS trading period lasted three years, from January 2005 to December 2007. The second trading period ran from January 2008 until December 2012, coinciding with the first commitment period of the Kyoto Protocol. The third trading period began in January 2013 and will span until December 2020. Compared to 2005, when the EU ETS was first implemented, the proposed caps for 2020 represents a 21% reduction of greenhouse gases. This target has been reached six years early as emissions in the ETS fell to 1812 million tonnes in 2014.

The EU ETS has seen a number of significant changes, with the first trading period described as a 'learning by doing' phase.^[9] Phase III sees a turn to auctioning more permits rather than allocating freely (in 2013, over 40% of the allowances were auctioned^[10]); harmonisation of rules for the remaining allocations; and the inclusion of other greenhouse gases, such as nitrous oxide and perfluorocarbons.^[5] In 2012, the EU ETS was also extended to the airline industry, though this only applies within the EEA.^[11][12][13] The price of EU ETS carbon credits has been lower than intended, with a large surplus of allowances, in part because of the impact of the recent economic crisis on demand.^[14] In 2012, the Commission said it would delay the auctioning of some allowances.^[14] Currently^[when?] legislation is under way which would introduce a Market Stability Reserve to the EU ETS that adjusts the annual supply of CO₂ permits based on the CO₂ permits in circulation.^[15] European Parliament recently backed former MEP Ian Duncan’s proposals to revise the EU’s Emissions Trading Scheme (ETS) to cut emissions across Europe. The new scheme will impose a cap on carbon emissions for 31 countries.

For Phase III (2013–2020), the European Commission has proposed a number of changes, including (CCC, 2008, p. 149):^[51]

• the setting of an overall EU cap, with allowances then allocated to EU members;
• tighter limits on the use of offsets;
• limiting banking of allowances between Phases II and III;
• a move from allowances to auctioning;
• and the inclusion of more sectors and gases.

Also, millions of allowances set aside in the New Entrants Reserve (NER) to fund the deployment of innovative renewable energy technologies and carbon capture and storage through the NER 300 programme,one of the world's largest funding programmes for innovative low-carbon energy demonstration projects.^[64] The programme is conceived as a catalyst for the demonstration of environmentally safe carbon capture and storage (CCS) and innovative renewable energy (RES) technologies on a commercial scale within the European Union.^[65]

Ahead of its accession to the EU, Croatia joined the ETS at the start of Phase III on 1 January 2013.^[66][67] This took the number of countries in the EU ETS to 31.

On 4 January 2013, European Union allowances for 2013 traded on London's ICE Futures Europe exchange for between 6.22 euros and 6.40 euros.^[68]

The number of excess allowances carried over ("banked") from Phase II to Phase III was 1.7 billion.^[69]

Price volatility

The price of emissions permits tripled in the first six months of Phase I, collapsed by half in a one-week period in 2006, and declined to zero over the next twelve months. Such movements and the implied volatility raised questions about the viability of the Phase I system to provide stable incentives to emitters.^[97]

In future phases, measures such as banking of allowances, auctioning and price floors were considered to mitigate volatility.^[103] However, it's important to note that considerable volatility is expected of this type of market, and the volatility seen is quite in line with that of energy commodities generally. Nonetheless, producers and consumers in those markets respond rationally and effectively to price signals.^[97]

Newbery (2009) commented that Phase I of the EU ETS was not delivering the stable carbon price necessary for long-term, low-carbon investment decisions.^[19] He suggested that efforts should be made to stabilize carbon price, e.g., by having a price ceiling and a price floor. This led to the reforms outlined above in Phase II and III.

Both The New York Times and The Wall Street Journal were at it this week, flogging stories about how falling carbon prices are threatening clean technology. I’ve written before about how easy it is to get distracted by carbon prices, which, under cap-and-trade, are more of a symptom of a broader issue, not a cause.

The Journal piece is fairly defensible. The Times piece is fairly hopeless:

Another blow to the sector is the tumbling price of permits for emitting carbon dioxide, the main greenhouse gas. In countries where emitters must buy these permits, like those in the European Union, low prices mean emitters have fewer incentives to make their production process more efficient or move to less greenhouse gas intensive fuels.

No. Decreased consumption due to a massive recession, coupled with price declines for natural gas and other factors, is removing incentives to invest in efficiency or renewable energy. The sagging carbon price reflects that fact. It doesn’t cause it.

A substantive point lurks beneath the Times article: Carbon price volatility is one of the bad features of a poorly designed cap-and-trade system. Even if the specific price of carbon isn’t really the point, lots of bouncing around doesn’t do the environment or the economy a ton of good.

Fortunately, provisions for “banking” permits — meaning that they can be carried over from one year to the next — can do a lot to smooth out price volatility while maintaining the integrity of a cap. RGGI allows banking, the California AB 32 scoping plan includes banking, and even the USCAP plan calls for banking. Long story short, any national system in the U.S. will likely include provisions for banking allowances, which hopefully will dampen some of the price volatility Europe is currently experiencing.

One thing I should have been more clear about: the European carbon market (known as ETS, for European Trading Scheme) didn’t allow banking between Phase I and Phase II of its implementation, but does allow banking between the current Phase II and Phase III. So if the ETS does allow for banking, why is the market crashing? Because the recession is really deep. Observers are forecasting a 20 – 30% drop in industrial output. Firms aren’t worried overly much about banking allowances if they’re not sure they’re even going to survive. Banking can help dampen volatility, but it can’t make it go away entirely.

As others have noted, auctioned allowances with a price floor are another mechanism for damping volatility. Although certainly a desirable feature in a cap-and-trade system, I’m not sure price floors would matter too much more than banking — by their nature, price floors tend to be pretty low.

Finally, none of this changes the original point: carbon prices are symptomatic of the same trends depressing clean tech investment. They aren’t the cause of the problem.

3.

A Marginal Abatement Cost Curve (MAC curve or MACC) is a succinct and straightforward tool for presenting carbon emissions abatement options relative to a baseline (typically a business-as-usual pathway). A MAC curve permits an easy to read visualization of various mitigation options or measures organized by a single, understandable metric: economic cost of emissions abatement.

MAC curves are broken into discrete ‘blocks’. Each block represents an individual or set of similar carbon abatement measures. An example, based on the widely cited 2007 McKinsey & Company study and reproduced for the King County Strategic Climate Action Plan, is shown above combining various measures from different sectors. For each block (or measure), the width indicates the amount of potential carbon emissions abatement (tCO2) while the height estimates the marginal cost of the carbon emissions abatement ($/tCO2). Typically the blocks are ordered such that the lowest cost options, which may represent net cost savings (negative $/tCO2), are shown first on the left with subsequent higher cost options proceeding to the right.

The first carbon-focused MAC curves date to the early 1990s, while similar curves for energy savings and other air pollutants first appeared in the early 1980s (Ekins et al.). The most well-known and widely used MAC curves have been compiled by McKinsey and Company starting in 2007 at the country leve

THE USEFULNESS OF MAC CURVES

MAC curves are useful for framing carbon emissions abatement options, providing a tidy and accessible tool that orders measures on a simple economic metric ($/tCO2). This allows measures from various sectors (e.g. transportation and power) to be compared on equivalent terms, serving as an initial lens of where abatement opportunities are potentially the largest and most cost effective. Therefore, MAC curves can be powerful for robust initial framing and identification of options to further evaluate. In this sense, MAC curves provide a great conversation starter from which deeper discussion and analysis can evolve with consideration of additional important dimensions and suitable policy options for unlocking the potential in each block.

ICAO has released the list of members appointed to the Technical Advisory Body (TAB) that will assess emissions units programmes for eligibility under the UN agency’s Carbon Offsetting and Reduction Scheme for International Aviation (CORSIA). The TAB, which will provide recommendations on eligibility to ICAO’s governing 36-State Council for decision, is made up of 19 members that the Council has agreed meet the required technical expertise and balanced geographical representation. Around 40 candidates had been nominated for membership by 34 countries. Among the members are two former chairmen of the UNFCCC’s CDM Executive Board and others with experience of carbon markets and UN negotiations. An early task of the TAB will be to discuss and provide recommendations on the vintage of eligible units.

The two former chairmen of the CDM Executive Board are Peer Stiansen of Norway and José Domingos Miguez of Brazil. The CDM Executive Board supervises the Kyoto Protocol’s clean development mechanism and the registration of projects and issuance of CDM CERs (Certified Emission Reductions).

Both Stiansen and Miguez have also represented their countries in UN climate change negotiations, as have Ulrika Raab (Sweden), Dimitar Nikov (France), Molly Peters-Stanley (United States) and Rajani Ranjan Rashmi (India). Others on the TAB are climate change or carbon market specialists from governments, research and academia.

Members are expected to serve a minimum of three years in accordance with each CORSIA compliance cycle and a Chairperson and Vice-Chairperson will be appointed who will hold their posts on a renewable one-year basis. It is possible that up to four new members could be added over time to the body if felt necessary by the Council.

Early consideration of the emissions unit vintage issue by the TAB is likely although this may require analysis and input from ICAO’s environmental technical committee CAEP. It is understood the Council may hold an informal briefing on the implications of introducing a possible vintage and a timeframe during the preliminary Committee phase of the next 217th Session in late April or early May. Council members are divided on whether an early decision should be made or whether to wait while further assessments of offset programmes are undertaken.

4.The terms ‘grandfather clause’ and ‘grandfathering’ describe elements of a policy program in which existing participants in an activity are protected from the impact of regulations, restrictions or charges applied to new entrants. In this paper, the role of grandfathering in the design of a carbon emissions trading scheme in Australia is assessed. It is argued that adjustment assistance policies such as those adopted in conjunction with previous microeconomic reform programs are preferable to policies based on the free issue of emissions permits

The term ‘grandfather clause’ arose in the Southern United States after the Civil War and Reconstruction eras, when resurgent white elites sought to exclude blacks (and sometimes poor whites) from voting, by restricting the franchise to men whose grandfathers had been entitled to vote before the War. Such clauses were eventually ruled unconstitutional (BlackPast.org 2008). Despite these unsavory origins, the terms ‘grandfather clause’ and ‘grandfathering’ have come to be used as a neutral description of any element of a policy program in which existing participants in an activity are protected from the impact of regulations, restrictions or charges applied to new entrants. Grandfathering has been particularly common in the development of policies to control pollution in the United States, where the Clean Air Act Extension of 1970 drew a sharp distinction between new and existing sources of pollution.

Two main forms of grandfathering have been used, depending in part on the form of regulation applied to pollution. Where point sources of pollution are required to adopt particular control technologies, or to limit the volume of emissions, existing sources may be exempted from the requirement, or subjected to less stringent restrictions than new sources. Where an aggregate limit is applied to pollution or some other environmentally damaging activity, existing sources may be granted permits, while new entrants may be required to buy permits, or to undertake offsetting activity.

International experience of grandfathering in emissions trading schemes The first emissions trading schemes were mandated by the 1990 amendments to the US Clean Air Act (first passed in 1963) and covered the emission of sulphur dioxide (SO2) (US Environmental Protection Authority 2008). Title IV of the Act set a goal of reducing annual SO2 emissions by 10 million tons below 1980 levels. To achieve these reductions, the law required a tightening of the restrictions placed on power plants that relied on fossil fuels. Phase I began in 1995 and affected 263 units at 110 mostly coal-burning electric utility plants located in 21 eastern and Midwestern states. An additional 182 units joined Phase I of the program as substituting or compensating units. Emissions data indicate that, under Phase I, SO2 emissions at these units were reduced by almost 40 percent below their required level. Phase II started in 2000. Annual emissions limits imposed on these large, higher emitting plants were tightened. In addition, restrictions were imposed on smaller, cleaner plants fired by coal, oil, and gas. The program now covers all new generating units and existing units with an output capacity of greater than 25 megawatts.

The US SO2 emissions permit trading system evolved from more limited forms of offsets, which in turn evolved from a fixed regulation. The starting point implied 100 per cent grandfathering, since companies did not have to pay anything to emit their regulated quantity. To establish an auction market, the US Environmental Protection Authority withdrew around 3 per cent of allowable emissions permits, and sold these at auction.

Under the cost-based regulatory system that prevailed when the SO2 emissions trading scheme was introduced, electricity prices were adjusted in line with costs, so that they would be unlikely to change as a result of the issue of free permits. However, with deregulation, market prices would be expected to incorporate the opportunity cost of permits, whether they were issued freely or bought in the market. Thus, the allocation of free permits represented an effective transfer from consumers to generators. However, because the permit program evolved gradually from a system of regulatory controls, with allocation of permits to generators being the default choice, this issue did not raise significant concern. The European experience with CO2 emissions trading is more directly relevant to the choices faced in Australia. In the first trading period, from 2005 to 2007, emissions permits were required for the power and heat generation industry and in selected energy-intensive industrial sectors. As in the US SO2 emissions trading system, generators were allocated free permits in the first phase of the European emissions trading scheme (European Commission 2008).

Unlike the US case, the free issue of permits has been the subject of intense controversy. Critics such as Grubb (2006) focused attention on electricity sector profits from the combination of free allowances and the passing through of increased costs to final consumers. The second phase of the scheme maintained the practice of issuing free permits. However, the European Commission has proposed auctioning 60 per cent of permits in the Third Phase, beginning in 2013, and an increasing proportion thereafter. The policy of auctioning permits is gaining increased acceptance. The Regional Greenhouse Gas Initiative is a co-operative effort to reduce CO2 emissions from power plants by ten north-eastern and Mid-Atlantic States in the United States. Under this scheme, which starts in 2009, there will be no free allocation of permits to electricity generators (Regional Greenhouse Gas Initiative 2008).

In summary, international experience with grandfathering pollution permits cautions against a generous free allocation, which can lead to an increase in profits in the electricity industry given the ability of generators to pass the increased costs on to consumers. Current policy discussions In recent discussions of the design of an emissions trading scheme for Australia, grandfathering has been a central issue. Different forms of grandfathering have been proposed in different cases. Exemptions from participation in the scheme have been proposed for some sectors, both on grounds of practicality (such as the difficulty of assessing and monitoring emissions from agriculture) and on the grounds that trade-exposed, energy intensive industries should not be required to reduce emissions in the absence of a more comprehensive international agreement. It has also been suggested that the impact of the scheme on motor transport should be offset by reductions in fuel taxes. Garnaut (2008) argues that current emitters should not receive free permits and offers a number of supporting arguments. First, the costs of emissions permits, like other costs of production, will ultimately be passed on to consumers, so there is no need to compensate producers through the allocation of free permits. This argument will be formalised below. Second, Australian governments have not, in general, compensated asset owners for losses associated with economic reforms or resulting from the internalisation of externalities. In general, it has been assumed that such losses are similar in character to those arising from adverse changes in demand patterns or from the entry of new competitors, and that firms and investors should use their own judgement. Third, structural adjustment measures would be more appropriate than compensation. Structural assistance includes measures to help displaced workers to find new jobs, and to encourage the establishment of new industries in communities affected by structural change. In addition, such assistance could include incentives for investment in lower emissions technologies such as carbon capture and storage. In Garnaut's view, these alternative structural adjustment assistance measures are likely to yield greater benefits than compensation to owners of electricity generating plants.

6. reasons why a carbon emission permit is not a well-defined commodity is because of below reasons

• Complex. It can become complicated deciding how many permits to allow. For example when the EU introduced a system of carbon trading, in the initial period of 2005-07 the price of carbon permits were driven down to zero because the EU misjudged the number of permits. However, any scheme will take a while to be effective.
• The difficulty of measuring how much a firm is actually polluting.
• Transaction costs involved in buying and selling permits.
• Free Rider Problem. The problem of excess carbon emissions is a global problem. Therefore, there needs to be a global solution. If carbon trading is introduced in one country but not others, it may cause production to shift to countries without the scheme. Often countries don’t start carbon trading precisely for the fear other countries will be free-riding on their efforts.
• Carbon Tax may be more simple, transparent and easy to administer.
• Carbon Trading may have a greater impact on those with low incomes and poor areas who have less flexibility to change their lifestyles

7.

The future costs and benefits of climate change are uncertain and unevenly distributed. For example, the costs of dealing with the impacts of climate change will disproportionately fall on developing countries, while the financial costs of cutting emissions to mitigate those impacts fall mostly on developed nations.

According to Morgan Stanley, climate-related disasters cost the world $650 billion from 2016-2018. Already, more variable weather has likely made crops more difficult to grow. A warming world could depress growth in agricultural yields up to 30% by 2050, affecting as many as 500 million small farms worldwide. Large coastal and delta cities are predicted to flood more frequently, incurring clean-up and, in some cases, moving costs.

Measures that help people adapt to these impacts also incur costs, but evidence shows that the future benefits of action overwhelmingly outweigh the future costs of inaction. The UK National Audit Office, for instance, estimates that for every £1 spent on protecting communities from flooding, around £9 in property damages and wider impacts can be avoided.

Climate change may affect economies in many ways, including through compromising water resources. Image: World Bank Photo, Creative Commons licence

Some climate impacts are inevitable because GHGs already in the atmosphere will affect the climate for decades, even centuries to come. Governments therefore have a choice of whether or not to prepare for those impacts.

Policies to combat climate change may also affect growth and prosperity. Despite wind and solar photovoltaics (PV) now being cheaper than fossil fuels in most countries, some forms of low-carbon energy are still more expensive, such as hydrogen. But climate policies that subsidise or support emerging low-carbon technology can prove cost effective in the long run, for example by making energy cheaper, avoiding climate impacts and producing co-benefits, such as reducing the health impacts of air pollution.

The Global Commission on the Economy and Climate concluded that transitioning to a low-carbon, sustainable growth path could deliver a direct economic windfall of $26 trillion and create over 65 million new jobs by 2030 compared with business-as-usual. The Energy Transitions Commission has even shown that decarbonising ‘hard-to-abate’ sectors — such as steel, aluminium, cement and heavy transport — is technically feasible by 2050 with technology that already exists. The total cost to the global economy would be less than 0.5% of GDP by mid-century — and could be reduced even further.

Climate change has cost U.S. taxpayers more than $350 billion over the past decade, according to a report released last year from nonpartisan federal watchdog the Government Accountability Office. By 2050, that figure will be $35 billion per year. Costs include clean up and disaster assistance from flooding and storms, which are set to increase under rising temperatures.

Discount rates are one of the most contentious and consequential aspects of social cost of carbon estimates. The effects of climate change will be felt over many hundreds of years, whereas cutting emissions costs money now.

How should we weigh the value today of costs and benefits in future? Economists approach this question using discounting. One way to measure this is “social time preference”, reflecting human impatience. People would rather have $100 now than $100 in 10 years. They might even take $70 now over $100 in 10 years.

A second approach is the “social opportunity cost” of a choice between alternative investments. If you invest $70 at an interest rate of 5%, you would have $114 after 10 years. Some argue that investing in climate mitigation ought to give a better rate of return than the market. Others ask if high, debt-fuelled returns can last and, additionally, argue that uncertainty about future growth translates into lower discount rates.

The choice of discount rate strongly affects the social cost of carbon. The current US SCC ranges from $10 at a 5% discount rate through to $50 at 2.5% (see below). The conservative thinktank the Heritage Foundation calls for a 7% rate, which it says would reduce the SCC by 80%.

A high discount rate suggests those alive today are worth more than future generations. A third approach to discounting, based on ethics, says this is wrong, and argues for a very low or even zero rate. This is why the Stern Review on the economics of climate change published in 2006 adopted a rate of 1.4%.

US government guidance is to use discount rates of both 3% and 7% for valuing costs and benefits within a single generation of, say, 30 years. It suggests using a lower rate, for time horizons that cross generations.

UK government guidance from HM Treasury is to use a 3.5% rate. However, it says: “The received view is that a lower discount rate for the longer term (beyond 30 years) should be used.” It sets out a sliding scale falling to 1% for time periods greater than 300 years.

In a major survey of 197 economists, the average long-term discount rate was 2.25%. The survey found almost all were happy with a rate of between 1 and 3%, whereas only a few favoured higher figures.

To learn more, check out David Roberts’ fun piece on discounting and otters, which introduced one of the thought experiments above. For a longer treatment, try this OECD paper on approaches to carbon valuation.

8.

In neoclassical economics, perfect competition is a theoretical market structure that produces the best possible economic outcomes for both consumers and society. A market that experiences perfect competition may be referred to as a "perfect" market by economists that subscribe to this school of thought. So, some economists use perfect competition as a benchmark to compare the performance of real markets. While some industries may exhibit certain characteristics of perfect competition, very few industries can be described as perfectly competitive because it is an abstract, theoretical model. In addition to perfect competition, the other types of market structures (all with varying degrees of competition) are monopoly, monopolistic competition, and oligopoly.

In a perfectly competitive market, firms can only experience profits or losses in the short-run. In the long-run, profits and losses are eliminated because an infinite number of firms are producing infinitely-divisible, homogeneous products. Firms experience no barriers to entry, and all consumers have perfect information. There are so many firms producing the same products that none of the firms can attain enough power in the long-run to influence the industry. Thus, in the long-run, all of the possible causes of profits are eventually assumed away in the model of perfect competition.

Perfect Markets Achieve Allocative and Productive Efficiency

It has also been theoretically demonstrated that a perfectly competitive market will reach an equilibrium in which the quantity supplied for every product or service is equal to the quantity demanded at the current price.

Allocative efficiency and productive efficiency are both characteristics of perfect competition. Allocative efficiency refers to an optimal distribution of goods and services to consumers in an economy. Productive efficiency refers to a firm or a market that is operating at maximum capacity; it can no longer produce additional amounts of a good without lowering the production level of another product. In a perfectly competitive market, every firm is considered to have achieved both allocational and operational efficiency.

In the theoretical model of perfect competition, a firm will achieve allocational efficiency in the short-run. In the short-run, any producer faces a market price that is equal to its marginal cost of production.

In the short-run, perfect markets are not necessarily productively efficient. But in the long-run, productive efficiency is achieved as new firms enter the market. Increased competition reduces price and cost to the minimum of the long-run average costs. At this point, price equals both the marginal cost and the average total cost for each good.

9.

Offsetting is a way of paying for others to reduce emissions or absorb CO2 to compensate for your own emissions. For example, by planting trees to suck carbon out of the atmosphere as they grow, or by delivering energy-efficient cooking stoves to communities in developing countries. Sounds great, right?

Sadly, the way out of the climate emergency is just not that simple.

Don’t get me wrong – protecting forests and restoring natural ecosystems is vital both for wildlife and the climate, but we should be doing that as well as cutting emissions directly, not as a substitute.

The big problem with offsets isn’t that what they offer is bad – tree planting or renewable energy and efficiency for poor communities are all good things – but rather that they don’t do what they say on the tin. They don’t actually cancel out – er, offset – the emissions to which they are linked.

Offsetting projects simply don’t deliver what we need – a reduction in the carbon emissions entering the atmosphere. Instead, they’re a distraction from the real solutions to climate change. As a result, offsetting allows companies like BP and Shell as well as airlines to continue with their unsustainable behaviour while shifting their responsibility for the climate onto the consumer.

10.

Carbon pricing is an approach to reducing carbon emissions (also referred to as greenhouse gas, or GHG, emissions) that uses market mechanisms to pass the cost of emitting on to emitters. Its broad goal is to discourage the use of carbon dioxide–emitting fossil fuels in order to protect the environment, address the causes of climate change, and meet national and international climate agreements.

A key aspect of carbon pricing is the “polluter pays” principle. By putting a price on carbon, society can hold emitters responsible for the serious costs of adding GHG emissions to the atmosphere; these costs include polluted air, warming temperatures, and various attendants ills (threats to public health and to food and water supplies, increased risk of certain dangerous weather events). Putting a price on carbon can likewise create financial incentives for polluters to reduce emissions.

The benefits of carbon pricing are very significant. It is one of the strongest policy instruments available for tackling climate change. It has the potential to decarbonize the world’s economic activity by changing the behavior of consumers, businesses, and investors while unleashing technological innovation and generating revenues that can be put to productive use. In short, well-designed carbon prices offer triple benefits: they protect the environment, drive investments in clean technologies, and raise revenue.

How Carbon Pricing Instruments Work

Carbon pricing instruments can take many forms. A wide range of approaches and paths allows governments, businesses, and institutions to select the method best suited to the broader policy environment.

• A carbon tax puts a direct price on GHG emissions and requires economic actors to pay for every ton of carbon pollution emitted. It thus creates a financial incentive to lower emissions by switching to more efficient processes or cleaner fuels (i.e., less pollution means lower taxes). This approach provides a lot of certainty about price because the price per ton of pollution is fixed; but it offers less certainty about the extent of emissions reduction.

• An emission trading system (ETS)—also known as a cap-and-trade system—sets a limit (“cap”) on total direct GHG emissions from specific sectors and sets up a market where the rights to emit (in the form of carbon permits or allowances) are traded. This approach allows polluters to meet emissions reductions targets flexibly and at the lowest cost. It provides certainty about emissions reductions, but not the price for emitting, which fluctuates with the market.

• Under a crediting mechanism, emissions reductions that occur as a result of a project, by a business or government, or policy are assigned credits, which can then be bought or sold. Entities seeking to lower their emissions can buy the credits as a way to offset their actual emissions. This approach requires a formally recognized third-party verifier to sign off on the emission reduction before it is credited.

• Under a results-based climate finance (RBCF) framework, entities receive funds when they meet pre-defined climate-related goals, such as emissions reductions. Like crediting mechanisms, this approach requires the involvement of independent verifiers (in this case, to confirm that a goal has been met). By linking financing to specific results, RBCF facilitates carbon pricing and the creation of carbon markets, helps polluters meet climate goals, and stimulates private sector investment.

• Under internal carbon pricing, governments, firms, and other entities assign their own internal price to carbon use and factor this into their investment decisions. Used as part of a broader decarbonization efforts, this approach encourages investment in low-carbon technologies and prepares institutions to operate under future climate policies and regulations. Internal carbon pricing generally takes two forms:

  • The first assigns a shadow price to carbon use—that is, determines its hypothetical cost. Entities calculate this price for their activities with the goal of managing climate risks and identifying opportunities in operations, projects, and supply chains to lower emissions and avoid locking their investments in long-lived high-carbon capital and infrastructure. For example, the World Bank Group has announced plans to apply a shadow carbon price to relevant investment projects using a price consistent with the recommendations of the High-Level Commission on Carbon Prices.

  • The second form is an internal carbon fee that companies voluntarily charge their business units for their emissions. Funds generated from this fee are channeled back into cleaner technologies and greener activities that support low-carbon transition.

Although the design of carbon pricing schemes will vary depending on specific policy objectives and contexts, effective schemes share some common characteristics. The FASTER Principles for Successful Carbon Pricing, a guide jointly developed by the World Bank and the Organisation for Economic Co-operation and Development (OECD), distills six key characteristics of successful carbon pricing based on the practical experience of different jurisdictions:

• Fairness. Effective initiatives embody the “polluter pays” principle and ensure that both costs and benefits are fairly shared.

• Alignment of policies and objectives. Carbon pricing is not stand-alone mechanism. It is most effective when it meshes with and promotes broader policy goals, both climate and non-climate related.

• Stability and predictability. Effective initiatives exist within a stable policy framework and send a clear, consistent, and (over time) increasingly strong signal to investors.

• Transparency. Effective carbon pricing is designed and carried out transparently.

• Efficiency and cost-effectiveness. Effective carbon pricing lowers the cost and increases the economic efficiency of reducing emissions.

• Reliability and environmental integrity. Effective carbon pricing measurably reduces practices that harm the environment.

11.

Carbon pricing is a recurrent theme in debates on climate policy. Discarded at the 2009 COP in Copenhagen, it remained part of deliberations for a climate agreement in subsequent years. As there is still much misunderstanding about the many reasons to implement a global carbon price, ideological resistance against it prospers. Here, we present the main arguments for carbon pricing, to stimulate a fair and well‐informed discussion about it. These include considerations that have received little attention so far. We stress that a main reason to use carbon pricing is environmental effectiveness at a relatively low cost, which in turn contributes to enhance social and political acceptability of climate policy. This includes the property that corrected prices stimulate rapid environmental innovations. These arguments are underappreciated in the public debate, where pricing is frequently downplayed and the erroneous view that innovation policies are sufficient is widespread. Carbon pricing and technology policies are, though, largely complementary and thus are both needed for effective climate policy. We also comment on the complementarity of other instruments to carbon pricing. We further discuss distributional consequences of carbon pricing and present suggestions on how to address these. Other political economy issues that receive attention are lobbying, co‐benefits, international policy coordination, motivational crowding in/out, and long‐term commitment. The overview ends with reflections on implementing a global carbon price, whether through a carbon tax or emissions trading. The discussion goes beyond traditional arguments from environmental economics by including relevant insights from energy research and innovation studies as well.

Climate change possesses several characteristics that must be accounted for in the formulation of climate policies to guarantee their effectiveness. Sources of anthropogenic GHG emissions are diverse and cover all economic sectors. Emissions arise principally from the combustion of fossil fuels, in very distinct activities, including resource extraction, production, consumption, transport, and waste management activities. This explains the heterogeneity of the many abatement options and associated costs. The GHG emissions accumulate in the atmosphere with residence times stretching from decades to millennia. Therefore, abatement incentives should last through time and be dynamic, that is, responsive to economic and technological change. The location of GHG emissions does not affect climate change as GHGs mix uniformly in the atmosphere. Hence, a reduction of emissions has the same global effect independently of the distribution of abatement efforts across space. Mitigating climate change lacks a simple end‐of‐pipe solution. Even though carbon capture and storage technologies may be part of the solution, these apply especially to large point sources and thus cannot provide an overall answer. Indeed, combating climate change represents such an immense and immediate challenge that relying on the promise of one option would be very risky. Instead, many options are required, including altering the composition of demand (using less energy), structural change in the composition of the economy (dirty vs cleaner sectors and products, and different input mixes in production), low‐carbon transport, more energy‐efficient technologies, and low‐carbon (notably renewable) energy sources. Finally, particularly challenging for international negotiations is that abatement activities are generally costly and contribute to a global public good, meaning that others can benefit from them without undertaking any effort. This motivates the need to coordinate actions by countries and polluters to avoid free riding and international carbon leakage. Worldwide consistent policies are required to ensure cost‐effectiveness of total abatement, fair economic competition between countries, and limited transboundary displacement of emissions.

We will argue that carbon pricing supported by a climate agreement is able to respond to these characteristics of climate change. This becomes clear by considering seven unique advantages of it, as explained in the next section.

12.

The purpose of this paper is to investigate what the consequences are if environmental regulation in terms of a price mechanism (effluent charges) erodes moral motivation (crowding-out). The findings suggest that a regime relying on voluntarism can do better than a mandatory regime depending on the number of individuals being intrinsically motivated, degree of moral motivation, crowding effects, and whether or not ethical utilities are accounted for. The optimal tax scheme is a discriminatory one with rates that differ across moral and non-moral individuals. This tax-scheme induces the first-best solution when social costs are considered, while the same solution becomes unattainable for a social welfare function. The model provides a rationale for why governments sometimes rely on voluntary effort.