Internalizing our main externality

How do carbon credit markets work (idea is to penalize higher pollution, reward less pollution and pay for environmental / clean energy projects), different solutions and different types of carbon markets

Climate change is already part of our daily lives. It is a phenomenon that is both undeniable and already noticeable in our daily lives, as it causes climatic 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 estimated that this number can be underestimated and, in reality, be closer to 50 billion tons per year. If this is the real number of our global pollution, 50 billion, 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 (ie, buying carbon credits) of around 40 billion tons annually - or $ 1 trillion in the current average price of credit carbon in the world.

What is the concept of carbon credit? And what is an “externality”?

Carbon credits put a cost on pollution. The idea of the carbon credit market is to penalize those who pollute more, reward those who pollute less and remunerate environmental / clean energy projects.

Pollution is economically considered an “externality”. For those who did not study economics in college or are not familiar with the “dismal science,” 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 society, and that humans were always superior beings who dominated nature and exploited its endless resources (at least that was the consensus view of the time). In mainstream economics, nature has always been considered an entity apart from the economic system.

Therefore, any positive or negative effect of nature is considered (even today, oddly enough) as an externality by classical / 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 contemplate nature as an integral part of the economic system and its resources as scarce, so that we have a complete view of the functioning of our society and our planet (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 that generated by the Silicon Valley, where there is a concentration of several technical and engineering colleges. The positive side effect of these colleges located close to one another is the generation of high-level technical jobs, higher economic development and constant technological innovation. 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 pollution. This is a negative externality, and Petrobras' behavior is a good example of how it works.

Petrobras pollutes or emits 60 million tons of CO2 per year. If the company emits two billion tonnes, or two trillion, it makes no difference to Petrobras and it will not change its activity at all, as Brazil is not a regulated market. Petrobras is not forced to pay for the cost of this pollution, but this pollution 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 deleterious effects on us.

How does one "internalize" this "externality" then? How is it that a polluting company 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 pollute less and do not harm the planet? Well, the solution is to put a price on pollution, and to force polluting companies to pay for it. It is from this concept that the carbon credit market and trading system emerged.

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

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, pollution 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 was 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 polluter in the world. Even Brazil was regulated in a system called “cap and trade”, which works as follows: to create pollution limits (“cap”) and to force higher pollution companies to buy from lower pollution companies (“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 sectoral targets. The airline industry as an example has had its own goals from the outset. Let us illustratively set a target of 2 million tons per year. In the case of Europe, if Alitalia polluted 3 million (ie 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 pollute), in organized carbon exchanges in Europe. In other words, Alitalia, because it pollutes more than the target / limit, would have a financial cost due to its extra pollution. Since the “allowance” currently costs US$ 25, Alitalia has a financial cost of US$ 25 million because it polluted 1 million more than the target.

In contrast, if another European company like Lufthansa emitted (polluted) in the same year 1 million tons of CO2 (1 million less than the target), the company would have a financial benefit by certifying the issuance of one million “allowances” that it can sell in the market. Lufthansa would therefore be rewarded US$ 25 million for its greater efficiency. In other words, the system creates an incentive for the most polluting companies to pollute less (because they have a higher cost for pollution above the target and it hurts their finances) and companies that pollute 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

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 most polluting 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 pollution.

Carbon Tax (Scandinavia, France)

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 less polluting 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!