How to Build Truly Sustainable Carbon Markets


“Where Did All the Markets Go?”1 was a question prominent amongst environmental economists in the 1990s when they realized the lack of market-based approaches in environmental policy practice with despair. The neoclassical economic theory of politics – or Public Choice –answered that question by claiming a “market tendency for the political process to resist market mechanisms for rationing scarce environmental resources.”2 And, while recently climate policy cap-and-trade programmes have spread across the globe and even at different governance levels, most carbon markets’ ambition is grossly insufficient.

Despite important criticisms of why carbon trading has fallen short of expectations3, carbon markets offer a number of advantages over alternative policy instruments. In view of the tremendous challenges of the Paris Agreement and the necessity to decarbonize the global economy within this century, any policy option should be (re-)considered without prejudices. Yet, exactly because there is no time to waste, carbon markets can only be considered a valuable policy option if they are both sustainable and politically feasible. So, the question is: Can sustainable carbon markets ever be made politically feasible?

In this article we argue that it is possible. In order to support this, first, we will summarize environmental economics’ arguments in favor of cap-and-trade and add a sustainability rationale for carbon markets, but from selected case studies we will also identify problems representative for many carbon markets in practice. We then identify the political barriers of sustainable carbon markets applying Public Choice reasoning. Last, we show how to overcome political obstacles and implement efficient, effective, and fair carbon markets by referring to best-practice examples and lessons from modern environmental governance literature.

Where We Stand and Where We Want to Go: Carbon Markets in Theory and Practice

Economists have long been outlining the advantages of cap-and-trade. As proposed by its inventor John H. Dales,4 a cap-and-trade approach should do the following: it fixes a total amount of allowed emissions for a region and a certain time period (cap); it distributes emission allowances to polluters and obliges them to cover each and every unit of emissions by respective allowances (distribute); it then allows polluters to transfer emission allowances amongst each other (trade). Economic theory has proven that cap-and-trade is capable of accurately reaching any environmental target at minimum cost to society independent of the initial distribution of emission allowances.5 In addition, cap-and-trade also sets steady innovation incentives, implements the polluter-pays-principle, and reduces administrative as well as transaction costs.6 Not least, linking domestic markets allows for developing a global carbon market, the most efficient solution, from the bottom up.7

Recognizing the limits of economic growth, Herman Daly explicitly emphasized that cap-and-trade is an exemplary way of separating and prioritizing the decisions on scale, distribution, and allocation in a sustainable economy beyond growth.8 With cap-and-trade, governments decide about both the scale by fixing the cap and the distribution by allotting emission allowances to polluters. Only then does the market facilitate an efficient micro-allocation of emission rights.

Building on an earlier study, we argue that carbon market design can be made sustainable provided a set of characteristics.9 By applying environmental economics’ and social justice’ concepts (Table 1), we derive a set of design requirements (Table 2, column 2), which, if followed, would establish a carbon markets that is environmentally effective, economically efficient, but also takes social justice considerations into account.

Source: authors
Table 1 – Sustainable carbon market design

From an environmental economics perspective we argue, e.g., that an absolute volume cap in line with the 2°C target would create a scarcity price signal, which leads to an efficient allocation while also limiting emissions to the necessary degree and setting innovation incentives. From the social justice perspective, such a target reflects the necessary result-orientation, makes the polluters pay, and protects future generations and countries suffering most from climate change from further injustices. Full auctioning, in addition, would lead to the most immediate optimal allocation, while auction revenues could be used for cushioning regressive cost effects on low-income households or for paying climate debts. Surprisingly, the resulting design recommendations do not exhibit major contradictions between environmental, economic, and social goals, but rather point in the same direction (Table 2, column 2).

In policy practice, the merits of carbon markets have led to the spreading of the instrument across the globe and all governance levels.10 Building on the Kyoto protocol’s Flexible Mechanisms, in 2005 the European Union (EU) established what can still be considered the world’s flagship, supra-national carbon market. At the national level carbon markets also exist in Switzerland, New Zealand, South Korea, and Kazakhstan. Japan and Australia used to have national programmes in place, abolished them after political resistance, but are now re-considering implementation. China, has just re-scheduled the start to 2018, having postponed the launch of its national carbon market several times. And additional big emitters such as Brazil, Canada, and Mexico are now vividly discussing a national scheme as well. Recently sub-national action has become even more dynamic and increasingly supported by the scientific and political community.11,12,13 China has implemented city and regional level schemes e.g. in Beijing and Shanghai, as pilots for their national program, Tokyo has been using a carbon market since 2010, and US states in co-operation with Canadian provinces have advanced the establishment of a bottom-up, inter-linked North American carbon market.

The empirical evidence on the performance of more mature domestic carbon markets such as the EU Emissions Trading Scheme (EU ETS), The Regional Greenhouse Gas Initiative (RGGI), the California Cap-and-Trade Program (CalCaT), and the Tokyo Metropolitan Government Emissions Trading Scheme (TMG ETS), is ambivalent at best. The design of these programmes only partly complies with the criteria for sustainable carbon markets, and while California currently operates the most promising scheme, even the good programmes suffer from serious deficiencies (see Table 2, columns 3-6).

Source: authors
Table 2 – Sustainable carbon market design and compliance in practice

Most programmes have been heavily criticized for their low carbon prices and for shady accounting practices.14 In the ETS, the initial over-allocation and the economic crisis after 2008 in combination with the specific banking rules have resulted in an allowance price drop from around 30 € in 2006 to 5.50 € in December 2016, inducing some commentators to call the EU ETS “clinically dead”.15 While a low carbon price neither jeopardizes compliance with the cap nor static cost efficiency, there is a well-founded fear that the innovation incentives generated are insufficient for decarbonizing the EU economy within this century in a dynamically efficient way. In California, the allowance price stagnates at a low level of around 13 US$ just above the auctions’ minimum price, while in the RGGI region even the dramatically reduced cap has only generated a CO2 price of 7.50 US$/t.16 And Tokyo’s CO2 price has dropped from an expected level of around 100 US$/t to about 15 US$ in October 2016.17

However, it has to be kept in mind that all implemented programmes have at least achieved three important goals: they have overcome political opposition against market-based approaches in climate policy; they have established an overall cap on emissions and a carbon price; and they have reduced emissions at lower cost to society than most alternative instruments. Compliance has been almost 100% in all programmes and actual emissions have even stayed significantly below the cap. In addition, other soft goals are also important to mention. The EU ETS overcame the political EU climate policy stalemate at the beginning of the 2000s.18 RGGI achieved a cap reduction of more than 50% in a pre-schedule revision, while California has achieved coverage of more than 80%.19 And Tokyo effectively used stakeholder consultations in the decision-making process and reduced energy-end-use emissions by 25% in four years.20,21

Still, in sum, while carbon markets’ theoretical advantages as well as some noteworthy achievements in practice are indisputable, the programmes selected here cannot be considered sustainable. The major design flaws leading to unsatisfactory results are limited coverage, loose caps, a big share of free initial allowances allocation, and a too low price collar. The reasons for these insufficiencies can be attributed to political failure, which is why now we turn to discuss the political economy dimension of these market processes.

The Obstacles in the Way: The Political Economy of Carbon Markets

The Public Choice (PC) approach can be described as “the application of economics to … the subject matter … of political science”.22 By underpinning neoclassical principles, it analyzes political decision-making by assuming rational, self-interested actors (homo economicus), who engage in quasi-markets for political outcomes. For instance, the PC approach views politicians as providers of political programs that benefit voters and in return voters offer their votes in general elections. Ideally, in a perfect market, the so-called “Trick of Democracy” should match the sovereign’s preferences with political programmes, just like Adam Smith’s “Invisible Hand” is expected to match consumer preferences with producers’ production plans.23,24 But just like markets for goods and services, political markets are oftentimes imperfect and lead to unsatisfactory results. In this area, the PC approach can be useful to capture the political obstacles of market-based environmental policy.25

To begin with, when utility-maximizing voters cast votes, climate policy is often not a priority topic.26,27 While a stable climate certainly is a vital prerequisite for well-being, at least three arguments support its relatively low-priority status in democratic elections. First, public goods such as a stable climate compete with private goods such as jobs for voters’ attention in elections, especially when climate policies are seen as potentially impacting industrial development. In this situation, self-interested voters cast votes based on policy programmes that provide private goods, which are enjoyable in the short-term, while free-riding on others’ efforts to provide public-good based policies. Second, economic policy such as employment policy provides immediately perceivable monetary benefits, while climate policy tends to only promises non-monetary future benefits. Third, the costs of climate policy are born by current generations and are easily perceivable, while the benefits mostly affect to future generations and are less easy to observe.

The same pessimistic view applies to voters’ perception of carbon markets. If climate policy in general is not a priority, instrument choice is even less central. This leads to two misunderstandings: 1) while carbon markets generate stock market prices for CO2 allowances, which can be easily perceived by the general public, CO2 standards hide the real costs of emission abatement behind non-monetary environmental regulations, such as maximum pollutant charges per cubic metre of discharged air; 2) the general public can easily (mis)perceive the sheer number of regulations as a sign of effectiveness, while carbon markets aim at minimizing the number of individual regulations.

On the one hand, if voters do not put pressure on politicians for effective climate policies, then vote-maximizing politicians are unlikely to make climate a policy priority. Instead, other policy issues such as tax and employment policy will feature more prominently in political programmes. On the other hand, even if politicians pay attention to climate requirements, they tend to do so by taking into consideration the preferences of other interest groups, most likely industries negatively affected by climate-based reforms, thus leading to less stringent interventions. The reason for that is that politicians’ daily legislative work heavily depends on interest groups’ support, while (re-)election is only required every few years. In addition, politicians are less interested in the real effects of policies but more in voters’ perception of their actions.28 Hence, to make policies attractive to politicians, benefits have to be perceivable, attributable to the individual politician, and expressible in quantitative terms. Costs, on the other hand, should be diffuse and not easily quantifiable. In this sense, climate policy and carbon markets are rather unattractive given that benefits are shared widely while costs are concentrated. And this is true even though efficient policies would spare national budgets and auctioning of emission allowances would generate revenues. In contrast, by prescribing emission standards and state-of-the-art abatement technology in a command-and-control regime, politicians suggest that a strong government does everything it can to curb environmental degradation.

From a PC approach, polluters’ industry organizations tend to be significantly more influential than environmental non-governmental organizations (NGOs) for several reasons. First, heterogeneous NGOs suffer from diseconomies of scale, while polluting companies form a rather small and homogeneous group with only minor incentives to free-ride.29 Second, NGOs’ goal of protecting the climate promises only future, non-monetary returns, while industry groups argue with current jobs and incomes. Third, polluters’ interests are often aligned with their employees’ concerns about production costs and jobs, making industry groups and labor unions natural allies. Fourth, industry groups execute market-power on the labor market and can threaten to transfer production and jobs abroad. Fifth, polluters are quasi-monopolists in providing political decision makers with technical information on production and abatement technology as well as on related costs. Sixth, the financial resources of the industry-union-coalition are substantially larger than those of their NGO counterparts. Finally, industry commands over well-established formal and informal contacts with policy makers in the legislative and executive branch of the government, originating from long-time information exchange and collaboration in various fields, while NGOs only possess recently established networks among ecologically-minded stakeholders.

NGOs can be expected to support stringent carbon markets, because, first, from the outset, protecting the environment is the founding principle of NGOs and cap-and-trade promises to achieve pre-set emission reduction targets most accurately. Second, re-interpreting the economic principle, cap-and-trade’s cost efficiency allows for achieving maximum environmental effects at given expenditures. Third, carbon markets incentivize abatement technology innovation. Fourth, auction revenues can be used for additional climate protection projects. And fifth, although environmentalists tend to be skeptical about fully-fledged rights-to-pollute and the conversion of nature into a marketable commodity, tradeable emission allowances make industry pay for the use of natural resources, hence complying with the strong polluter-pays principle.

Profit-maximizing industries, on the other hand, tend to resist environmental measures that generate net costs. Carbon markets, however, should be preferred over command-and-control, because they minimize overall compliance costs. Yet, overall cost savings are widely dispersed across the economy, and no single company profits noticeably. Quite in contrast, carbon markets make polluters fully pay for each and every unit of emissions, while command-and-control leaves emissions below the standard free-of-charge.30 In addition, environmental technology standards often used in command-and-control regimes can lead to significant market entry barriers, when incumbents’ technologies are prescribed for market newcomer. Furthermore, growth-oriented companies might fear the absolute emission cap to act as a limit to growth. Not least, emission allowance markets can be subject to unpredictable price fluctuations.

The environmental bureaucracy is expected to support environmental protection, as this is the principle justification of its existence, but they turn out to be skeptical towards market-based approaches.31 Bureaucrats’ primary goal of budget maximization makes them prefer policies that are resource- and labor-intensive with high administrative oversight requirements, because it is exactly this type of policy that calls for extensive budgets. In addition, the use of carbon markets not being in line with established command-and-control routines devalues specialized technical knowledge about emission standards and induces additional costs of restructuring and adapting. Budget maximization also forces environmental bureaucrats to take into account budget-providing politicians’ interests. Conflict minimization, a second goal of bureaucrats, encourages them to also seriously consider the concerns of politically influential polluters. But while politicians’ influence on bureaucrats suffers from information asymmetries, polluters’ skepticism towards carbon markets significantly influences environmental bureaucrats’ point of view.

And most certainly, the bureaucrats’ political influence has been increasing, oftentimes only leaving the mere legitimization of laws to the legislative branch. Bureaucrats, in turn, are in charge of both implementing regulations and preparing politicians’ decisions. And in fact the relation between the actual sub-ordinates and the budget-providing politicians is characterized by information asymmetries that allow bureaucrats to act in their own interest instead of following politicians’ intentions. On the other hand, in a more and more complex world, bureaucrats increasingly depend upon interest groups’ support. And, with only industry being able to provide the most valuable information about production technologies and respective abatement costs, this leads to a significant state of dependence.

In sum, the PC approach substantiates the “market tendency for the political process to resist market mechanisms for rationing scarce environmental resources” with theoretical arguments, some even being supported by empirical data.32 And despite of its severely constricted perspective on policy making, it can teach important lessons on the political feasibility of sustainable carbon markets.

The By-pass to Success: Lessons from Carbon Market Best-practice

Facing the huge challenge of keeping the global average temperature increase below 2°C, any policy instrument that promises a significant contribution to solving the problem should be most welcome, provided it can be made truly sustainable. On the one hand, almost fifty years of theoretical research on cap-and-trade as well as numerous practical experiences have taught us important lessons about how to design sustainable carbon markets.33 On the other hand, there remain crucial theoretical and empirical barriers to the implementation of sustainable carbon market, as evidenced by the PC approach. Considering the sum of these theoretical and empirical lessons, the following five Go’s promise to open bypasses around some of the major political obstacles of effective, efficient, and fair carbon markets:

Go sustainable! Future carbon markets have to fulfill ambitious criteria of sustainability (see Table 2). First of all, they have to be environmental effective in the sense that they significantly contribute to reaching the Paris Agreement target and to de-carbonizing the economy within this century. Secondly, they have to minimize the costs of achieving this target, because wasting money in times of limited national budgets and multiple societal problems means ignoring the urgency of reaching other goals such as the provision of clean air, water and soil, the protection of biodiversity, the reduction of poverty and injustices, the improvement of education and gender equality, and, not least, world peace; all prominently outlined in the UN Sustainable Development Goals. Thirdly, carbon markets have to be socially just, a requirement described in detail below. Any inadequacy in the design will not only jeopardize the positive impacts of carbon markets, but also imperil the political feasibility and long-term survivability the respective scheme. Prominent examples for this are, first, the windfall profits in the EU ETS, which led to widespread criticisms of the programme.34 Then, the price fluctuations experienced in the EU ETS, predominantly caused by over allocation as a result of effective industry lobbying in the early 2000s,35 led to complaints by covered entities themselves but were also used as arguments against carbon markets in general by opposing forces in other countries such as Japan.36 And finally, unambitious caps and the resulting low carbon prices made even former supporters in the environmentally minded (scientific) community express their skepticism about the effectiveness of carbon markets.37 Hence, the sustainability of carbon markets is not only a requirement for its environmental, economic, and social success but also for their political feasibility.

Go fair! Social justice can be expected to be one key issue in reforming established carbon markets or introducing new ones in the future, given international competitiveness concerns as well as the regressive effect of energy prices. This will be particularly true once the low-hanging fruits of cheap emission abatement options have been picked and costs are starting to increase more rapidly with increasing scarcity of emission rights. While free allocation of emission rights provides polluters with unjustifiable extra benefits and tends to favor politically powerful polluters, full auctioning is more promising. This is particularly true, if auction revenues are fully and reasonably recycled. If the cap is tight enough, if market functioning is guaranteed, and if leakage is taken care of by border adjustments, revenue recycling should be focused on compensating households. Empirical experiences for that are manifold. Revenues can be used for lowering especially lower bracket income taxes (British Columbia Carbon Tax), for reducing social security contributions (German Ecological Tax Reform), or even for directly supporting low-income households or disadvantaged communities (California Cap-and-Trade Programme). Barnes, instead, proposes a per capita redistribution of revenues based on the idea of equal per capita rights to the use of natural resources.38 In any case, communicating the monetary benefits of any re-distribution scheme (in addition to possible employment benefits) to the public is key for increasing the public acceptability of higher carbon prices and energy prices.

Go in steps! An ambitious, truly sustainable carbon market represents a rather dramatic deviation from the status quo of energy use and the generation of economic wealth. In order to make transformations such as this sustainable and politically feasible, a step-by-step approach is most promising, given it keeps up with the pace of emission reductions necessary to stabilize global warming well below 2°C, hence following Costanza and Daly’s operational principles of strong sustainability for keeping total natural capital intact.39 The step-by-step approach should particularly apply to design elements crucial for the political feasibility of carbon markets. First, coverage could be extended in terms of polluters and/or pollutants. For instance, California started with big polluters only and then expanded to transport and heating fuels. Second, like all implemented carbon markets in fact do, the cap size could be dynamically reduced from status-quo emissions to the necessary level. Third, auctioning of emission rights could be phased in as it has been done in the EU ETS. For all these approaches, a pre-scheduled roadmap is most promising, determining minor design changes but also general revision schedules. In practice, the EU ETS and RGGI have undergone major revision processes, which in each case significantly improved the design and performance.

Go participatory! The PC approach teaches us that major opposition to sustainable carbon markets is to be expected from covered polluters in alliance with polluter-friendly decision makers; hence, a balancing power is needed. Case study evidence shows that, under certain conditions, NGOs can act as an effective counterforce. However, in order to be able to exert pressure, NGOs have to be granted equivalent access to the political process, to policy planning, decision making, and implementation. The example of Tokyo, in which decisive  citizen and NGO participations through local government prevented the industry from weakening or even preventing the scheme, shows how continuous and fair stakeholder consultations can help equilibrate industry’s power.40 Moreover, NGOs have to closely co-operate within their own community but also with other pro-active forces. Ecological research institutes, open-minded politicians from green parties or green wings of other parties, and environmental bureaucrats are natural allies. The German example shows most vividly how the latter two stakeholder groups were much more EU ETS friendly than the PC approach would have predicted.41 This example also teaches that coordinating positions within the environmental community will increase NGOs political power. Third, NGOs have to be financially empowered by governments, e.g. by tax reliefs, to defend the environment, which represents the classical case of a public good with strong incentives to free-ride. The German and US experiences with cap-and-trade show how financially strong NGOs such as World Wide Fund for Nature (WWF) or Environmental Defense Fund (EDF) effectively used funds for campaigning in favor of cap-and-trade programs.42

Go sub-national! Recent carbon market dynamics especially in North America and Japan have shown that local and regional schemes face less obstacles than federal level programs. In spite of the eventual failure in 2010 of both the Waxman-Markey-Bill in the US and the Integrated Domestic Market of Emissions Trading in Japan, RGGI, the WCI, and Tokyo succeeded in implementing sub-national carbon markets.43,44 The New Environmental Federalism strongly supports this idea of sub-national jurisdictions, after warnings of a “race to the bottom” dominating an efficient “voting by feet” have proven to be exaggerated.45 Recently, sub-national jurisdictions are considered to act as policy laboratories, in which measures can be tailor-made to match locals’ preferences but can also be tested for federal or even supra-national applications. In climate policy, this idea is also supported by Elinor Ostrom’s poly-centric approach.46 It is true, though, that the cost savings from carbon markets compared to non-monetary instruments is greatest in a global or at least national market, but linking sub-national carbon markets can be considered a viable second-best solution for developing a more comprehensive market from the bottom up.47 The California-Québec link-up under the WCI with more members to join on the horizon, the Tokyo-Saitama conjunction, as well as the upcoming EU-Switzerland nexus are best-practice examples for successful carbon market linkages. And the US Clean Power Plan, although seriously threatened by the Trump administration, even provides a model rule for state-level carbon markets, which, if applied by states, provides almost guaranteed compliance with federal emission standards. Not least, Prime Minister Trudeau’s October 2016 carbon pricing initiative also gives province-level action priority over a federal level Canadian pricing scheme.

In sum, building a global carbon market step-by-step from the bottom up by linking sub-national schemes can still be considered a valuable strategy for climate policy. However, a truly sustainable design, which specifically considers social justice concerns, as well as a participatory approach to political decision making and policy implementation, which particularly empowers the environmentally minded civic society, are indispensable for the short-term and long-term political success of ambitious carbon markets.

Acknowledgements

This article results from research projects funded by The University of Newcastle 2017 International Research Visiting Fellowship Scheme (IRVF) and The Japan Society for the Promotion of Sciences Grants-in-Aid for Scientific Research (KAKENHI No. KK20160009).

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