What is a voluntary carbon market (Part 1)?
This blog post is going to be slightly more academic than my past ones. Comments or questions are welcome.
Before jumping into what makes a voluntary carbon market, lets define more broadly what we mean by a voluntary program or market in the context of greenhouse gas (GHG) emissions.
Voluntary programs or markets can include:
i) programs or initiatives that attempt to overcome problems of incomplete information by those making investment decisions (e.g., EPA’s Green Lights program),
ii) a related category, eco-labeling, provides information as well as other “warm glow” benefits of a credence good [1],
iii) voluntary emissions reporting and commitment programs (e.g., EPA Climate Leaders),
iv) opt-in provisions for uncapped entities to take on an obligation under a cap-and-trade emissions trading system [2],
v) markets where credit buyers face a scarcity due to an emissions cap but may offset their emissions by purchasing credits from emission reduction projects outside the cap’s boundaries, and
vi) voluntary emission offset markets that do not involve caps on the buying or selling entities and where trading only occurs via emission reduction credits that are calculated relative to an agreed baseline.
When we talk about voluntary carbon markets, we typically are referring to categories “iv” through “vi,” all of which involve emissions trading. Category “vi” also has characteristics that make it similar to charitable giving. [3] For this blog post I am going to focus on categories “iv” and “v.” I will address category “vi” in Part 2.
The economic argument for including voluntary offset provisions in mandatory emission trading markets proceeds assuming that equalizing marginal abatement costs over a broader number of sources and sectors will improve the cost-effectiveness of the overall policy. Whether an entity is capped (i.e., participation is mandatory) or an entity enters voluntarily (i.e., opts-in or sells offset credits) only changes who pays the cost of abatement. Theoretically, the actual mitigation measures implemented in both cases will be the same. [4] These provisions are acceptable because, in the case of GHGs, the location of abatement (and to some degree the timing) is independent of its environmental impact.
The political argument for voluntary provisions is that they give policy makers a mechanism by which to address political interests and issues of equity. The ideal emissions trading market would have all sources under a mandatory cap. Domestically, governments can coerce participation and require entities to participate. However, it may be politically difficult to mandate participation of certain sectors. Instead, they may be allowed to voluntarily opt-in to a mandatory program (e.g., during phase I of the U.S. Acid Rain program). Allowing the use of offset credits by regulated entities under a cap can address similar issues of political power because both purchasing and selling parties benefit from these transactions. In addition, it may be impractical to include certain sources or sectors in a capped system because they cannot be easily monitored or in some other way lack the capacity to participate as a capped entity.
Nearly identical issues arise at the international level, where the entities in question are nation states. The issue at this level, though, is that no governing body has the power to coerce participation. [5] Parties eager for agreement may then need to provide incentives for parties less willing to participate. [6] Reluctant parties can be encouraged to “opt-in” through the use of side payments. Or they can be allowed to participate by being a supplier of offset credits from emission reduction projects. As above, there may also be issues with the capacity of a party to take on a cap because they lack the legal, technical, financial, and/or other administrative infrastructure for monitoring and compliance.
There are three key problems with voluntary participation provisions in both domestic and international emission abatement policies: adverse selection, transaction costs, and reduced incentives for innovation.
Because they can participate voluntarily, those entities, projects, and parties that would have participated anyway will do so. In the case of emission offset projects, it is this adverse selection bias that additionality determinations are intended to thwart. The requirement to determine the additionality of projects, as well as project-by-project administration, likely entails greater transaction costs than a simple cap-and-trade system. Also, it may be that the sources, sectors, or parties least able to participate (e.g., because they are poor and lack the technical capacity) have the largest potential for emission reducing technological improvements.
Endnotes:
[1] Baksi, S. and P. Bose (2007). “Credence Goods, Efficient Labeling Policies, and Regulatory Enforcement.” Environmental and Resource Economics 37(2): 411-430.
[2] The fraction of entities mandated to participate versus the fraction that voluntarily opt-in can vary from zero to one. For example, under the U.S. Acid Rain program, the ratio is essentially one (mandatory), while for non-governmental systems, such as the Chicago Climate Exchange, the ratio is zero (entirely voluntary).
[3] See http://www.nature.com/climate/2007/0711/full/climate.2007.58.html#B4
[4] This interpretation is based on a neoclassical economics understanding of behavior of rational economic actors. More recent work in behavioral economics (see work of Daniel Kahneman) shows that agents are more adverse to give up something than to purchase it, suggesting that Coase’s claim that the initial allocation of property rights is immaterial to the outcome is not how people actually behave.
[5] I am assuming here that we are dealing with a transnational or global public problem where provision of that good requires cooperation between parties.
[6] The reasons a party is less willing to participate may vary, but will likely be dominated by a perception that the costs of full participation (without side payments) will be greater than the benefits it receives in the form of the public good provided.
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