Carbon Markets: Silver Bullet or Mixed Blessing?

Carbon credits enjoyed significant popularity a few years back, but a media investigation revealed that most fail to deliver on the promises of conservation and emission reduction.

Nevertheless, many continue to push for expanded carbon credit trading, touting it as a win-win solution. However, this argument may be both flawed and costly.

Earlier this week, the COP29 parties agreed on standards for a global carbon credit market backed by the United Nations, aimed at expanding trade in emissions with a view to providing much-needed funds for the energy transition.

A week earlier, voters in Washington opposed a bill proposing to do away with the state’s carbon credit market. And why wouldn’t they, when the state wrote that “This measure would decrease funding for investments in transportation, clean air, renewable energy, conservation, and emissions-reduction.” Any voter would vote against less money for transportation, clean air, and conservation, after all.

“These aren’t going away, and why would they? These carbon ‘cap-and-trade’ programs are capitalist, free-market solutions that allow companies to hedge and monetize their energy transition,” a portfolio manager at a carbon market ETF told Reuters columnist Ross Kerber in comments on the Washington vote.

There is a certain capitalist aspect to the carbon credit market. Buyers are free to trade them as they see fit. The fact, however, that supply is decided by the government rather than by the market itself shows that carbon credits are not an entirely capitalist product. Indeed, in places serious about their energy transition, the idea for carbon credit markets is to curb supply gradually in order to motivate emitters to reduce their emissions. Incidentally, this would interfere with the financial goal of carbon markets.

This goal is, of course, to raise money for a faster transition away from emission-producing hydrocarbons. As Washington state said, carbon credit trade funds “renewable energy and emissions-reduction.” So does carbon credit trade in Europe, which is pinning some serious hopes on this particular revenue as a source of money for the transition.

What nobody seems to be paying attention to is the inherent paradox.

The first idea of carbon trade is that the government issues a set number of carbon permits to be bought by emitters, who can then sell them at a profit in case they have reduced their emissions and don’t need all the permits. The second idea of carbon trade is to stimulate buyers to reduce their emissions by making them pay for them. That second idea is a powerful motivator – so what happens when everyone starts cutting their emissions?

What happens is what happened in Europe just this year: carbon prices took a dive when everyone in Brussels was expecting them to rise higher and higher, and generate money for more wind and solar. The EU authorities apparently wanted to have sort of a hybrid, market-based-but-centrally-planned product and then forgot the market part of the equation. That part says that when demand falls, supply quickly turns excessive and prices drop. This is precisely what happened as large emitters in Europe found it increasingly hard to afford the permits and simply shrank their operations to cope. On the plus side, emissions went down.

Carbon markets are, then, good at doing the job of reducing emissions. However, if they do that, then the money these markets generate would decline along with the emissions as demand wanes. In other words, carbon markets’ two stated purposes are mutually exclusive. This might seriously compromise their success as a tool for both raising money for the transition and reducing emissions. When you have a cake, you can either keep having it or you can eat it, but never both, except in your dreams.