A Green Economy Through Carbon Credits
December 09, 2015
by Arjun Nath, MBA’16
Market-mechanisms like cap-and-trade limit emissions, taking an output oriented approach. Another approach is introducing regulations on industries which directly influence their activities (e.g. for manufacturing / power production / etc.). Furthermore, there are tax-based systems which impose a financial cost associated with the social cost of environmental change.
A significant cause of this climate change is human activities resulting in emissions of greenhouse gases (most notably carbon dioxide). Data shows that from the time of industrialization, the concentration of greenhouse gases has risen significantly (figure 1).
Further research by the US Global Change Research Program (USGCRP) highlight that the increasing temperatures are a direct result of human effects (figure 2).
Figure 2: Models that account only for the effects of natural processes are not able to explain the warming over the past century. Models that also account for the greenhouse gases emitted by humans are able to explain this warming. Source: USGCRP (2009), taken from the website of EPA
To avoid a major catastrophe, we have to wean the economy from practices that increase greenhouse gases like carbon dioxide. A key lever of doing this to reduce the use of fossil fuels, most notably coal. There is widespread agreement among environmental economists that market-based programs to deal with the threat of climate change can achieve desired results at a modest cost. These results and costs are discussed further later in this article.
Negative externalities (e.g. the production of greenhouse gases which harm society) cannot be self-corrected by markets. One way to deal with these is to make rules that prohibit or limit behavior that imposes these externalities (e.g. stringent emission standards). However, this ‘blanket’ method is tough to implement. Another way is to impose a price on negative externalities (e.g. a tax or fee reflecting the scale of impact caused) – this has come to be known as a ‘Pigovian tax’.
Another newer method is to create a market-based approach, i.e. the ‘cap & trade’ system. It involves creating a limited number of tradable emissions permits that can be traded in the open market to get the ‘right’ to these emissions. This puts a cap on overall emissions and provides a financial incentive to minimize emissions. This can also be combined with the ‘tax’ method for a hybrid solution. The ‘cap and trade’ model has seen success. The Clean Air Act of 1990 introduced this system for power plants’ emissions of sulfur dioxide, leading to a reduction of almost half the emissions, reducing acid rain.
Taking action does come with a cost, and rough estimates of restricting emissions puts the cost at: a reduction of average annual GDP growth by ~0.03-0.09%. This means that the US economy would be ~1.1-3.4% smaller in 2050 than it would be otherwise. At a global scale, estimates are at ~1-3% of gross world product.
The cost of inaction is huge. Projections indicate a 9-degree Fahrenheit increase by 2100 compared with 2000, changed precipitation patters, more intense storms, rising sea levels, etc. Even if the economy can persist, ecosystems likely won’t. Models show that losses on gross world product would be ~5%. There are arguments that costs in the future should be valued lower today, but if there is a significant chance of utter catastrophe, then that should dominate any cost-benefit calculations, thus making a case for strong climate policy.
The rest of the world also needs to take action, made more difficult since many emerging economies feel that they have a right to emit freely just as what today’s developed countries did for centuries when they were developing. However, this can be mitigated to mutual benefit by allowing international trading in permits.
Another debate is around the speed of execution – the ‘ramp’ vs. the ‘big bang’ approach. The ‘ramp’ advocates argue that the damage of additional carbon at current concentrations is low, and that future costs should not impact policy today. However, in the opinion of Paul Krugman (and I agree), public policy should take a longer view. This would imply a more ‘big bang’ style approach where we strive for big changes as soon as possible, to minimize further harm and slow down the change at a rapid pace.
Finally, execution is critical, and political sentiments across the globe are not in consensus on the topic. There are several risks with cap-and-trade. A trade system requires complex administration. The initial implementation can be tricky – since upper limits are set through permits, it is important to ensure that different sectors get appropriate limits, not based on their negotiating power but based on logic and requirements. The European emissions trading scheme has seen several pitfalls in implementation, not only in initial distribution of permits but also with the recession driving down prices of carbon permits to levels where change was more costly than simple purchase of credits.
However, there are been several promising actions in the recent past which imply the first, of hopefully many, steps towards reduced carbon emissions. The US EPA, along with leadership of President Obama, recently unveiled the Clean Power Plan, which targets strong emissions reductions (reductions of carbon emissions by 32% below 2005 levels by 2030). With this hallmark step, America could lead the way for several other countries to tackle emissions. The World Bank also recently successfully engaged in Carbon Credit auctions, a bond facility that has a capitalization target of ~$100M and is fundraising at the moment. The Ontario government in Canada has recently been forging ahead with the implementation of a cap-and-trade carbon system, although again implementation here will be key to deciding its success.
At the end of the day, the facts remain: the environment is changing and the implications are evident to everyone around the world. Carbon emissions are a key player in causing this change, and in order to mitigate risk, we must put in place systems to check emissions. A well-designed cap-and-trade system has the potential to make this happen through market economics, and must be explored where possible to ensure that we slow down the train heading directly for us.
- Article “Building a Green Economy” by Paul Krugman
- US EPA: http://www.epa.gov/climatechange/science/causes.html
- News articles: http://www.theguardian.com/environment/2015/aug/03/obama-epa-carbon-emissions-cuts-power-plants-climate-change , http://www.theglobeandmail.com/news/politics/ontario-plans-cap-and-trade-on-greenhouse-gas-emissions/article23786538/ , http://www.torontosun.com/2015/08/08/mulcairs-carbon-confusion
Note: This article reflects personal views, and any sources used to get facts, data and others’ opinions have been articulated
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