The Kyoto Protocol recognised the differential role of developed and developing economies in contributing to the stock of carbon through a compliance mechanism of carbon offsets market vide the Clean Development Mechanism (CDM), which was the start of carbon markets. CDM was partly successful if only because of European compliance markets. But the system ended in 2012.
The 2015 United Nations Framework Convention on Climate Change (UNFCCC) Paris agreement conceptualised the need for carbon pricing and an institutional mechanism to address double counting of mitigation providing for inter-governmental and private carbon credit transactions through Article 6. The system is yet to see the light of day. Nevertheless, the buzz around such carbon markets and their expected exponential expansion, in both voluntary and compliance markets, to lead the world towards mitigation outcomes in face of dire climate forecasts is palpable.
The World Bank suggests that carbon markets are a panacea, but IMF differs, favouring some form of carbon taxes. Meanwhile, the differential between what is obtained from carbon pricing, about $6 on an average, and what is required for carbon abatement, of the order of $75, keeps growing.
The underlying theory of carbon markets is price discovery by creating property rights by imposing a cap on emissions and trading carbon offsets. Those who manage carbon emissions better get credits, and those who exceed the cap, need to buy credits. This system is called ‘cap and trade’, which is what emission trading systems are about.
In Voluntary Carbon Markets, credits are decided by mitigation actions taken beyond business as usual — there is no compliance required and credits can be bought by public or private entities who voluntarily support low carbon transition.Carbon markets are being seen as a solution for increasing climate investments even if its scale is miniscule. One hears of carbon credits being considered as a new asset class, as if this were gold or liquid gold or a new synthetic financial instrument, for which carbon markets are being seen as an efficient system of transactions. A good asset is one which is no one’s liability, carries no credit risk, and has demonstrated a secular rise or preservation of value over time.Carbon credits, whether compliance or voluntary, do not meet these basic standards.
First, it is not demand and supply of assets alone that determine carbon price. A highly volatile policy environment has a role to play in cap and trade market structures, and global macroeconomic cycles can affect the extent of GHG emissions in both compliance and voluntary markets.
Second, carbon credits cannot be expected to secularly rise in value/yield as one would expect for equity, or debt in a steady-state environment based on macro-economic fundamentals. The rationale for carbon credits through cap and trade mechanism rests on the premise that there would some economic agents who would do better than the standard (cap), and some would do worse. With a multitude of such enterprises operating under specific emission standards, there would be an exchange mechanism where those who have credits could sell and those who need credits could buy, and demand /supply forces would settle the (surrogate) price on carbon emissions.
However, what is less understood — or left out in this equation — is that as every enterprise tries to improve, thereby reducing total emissions (which is good), the demand for credits would gradually fall and marginal cost of improvement (for generating incremental units of carbon credit) would rise. This means that unless regulations (total cap) keep up with technology — which they rarely do, as has been the case with Indian renewable purchase obligations (RPOs) and energy saving certificates (ESCerts) — the market would fail to function.
Therefore, the expectation that carbon credits would be new asset class is misplaced optimism, and it not surprising that carbon credits have not attracted investments as expected.
At the fundamental level, correcting a classic market failure by only creating artificial markets remains a flawed approach. Carbon taxes, on the other hand, while politically fraught, are simple, universal and possibly more efficient. While it is imperative that carbon emissions be priced, a combination of markets and taxes offers a more pragmatic solution, instead of debating which is a better approach.
Unless we act now, the window for mitigation of emissions will close, and the only options remaining would be that of adaptation and dealing with loss and damage.
Purkayastha is India director, Climate Policy Initiative. Sarkar is professor of economics, IIM Calcutta