Why Carbon Trading Is Losing Credibility Fast

While plenty of people seriously doubt the ability of the Rudd Government’s emissions trading scheme to make a significant difference to Australia’s emissions, more evidence is emerging that casts doubt on the usefulness of ETS schemes in general for preventing dangerous climate change.

Adding salt to the wound, there are also signs from existing carbon markets that any sort of carbon trading establishes another speculative industry prone to the same market flaws that were behind the recent global financial crisis.

Since the European Union’s carbon market was set up in 2005, a number of European and American banks have begun to invest in carbon credits. Activity in this market is dominated by trading among banks and speculators. One of the key sectors of this market is the trade in (often highly dubious) carbon offsets from outside Europe.

Global carbon markets are projected to be worth as much as $10 trillion a year and already carbon credits are being packaged into the same types of complex and opaque financial products that precipitated the global financial crisis.

One of the major similarities between the financial derivatives market spawned during the sub-prime mortgage fiasco and the emerging carbon markets is the way risk, uncertainty and ignorance are dealt with in this type of trading.

Fundamentally, this relates to how to deal with three different types of future events. For the first type of event (a "risk" event), we know the event could occur and the probability of the event occurring is calculated based on past events. An example is a coin toss where the probability over time of a heads or tails result is known.

The second type of future event (an "uncertainty" event) is when we know the event could occur but don’t know the probability. An example is the destruction of a forest by fire or insect pests.

The third type of future event (an "ignorance" event) is completely unforeseen. An example is the damage caused to the ozone layer by CFCs.

The mathematical tools that economics relies on can only legitimately incorporate the first of these future events ("risk" events). However, as US economist William Janeway observes, modern finance theory (and practice) has over the past 40 years blurred the very real distinction between uncertainty and risk.

The credit default swaps, collateralised debt obligations and other complex financial products developed during sub-prime were dressed up to look like they had a calculable level of risk. As we now know, the financial models used to design these products were unable to anticipate the major uncertainty event that occurred, namely the collapse of the US housing bubble. (Of course in standard neoclassical economic theory, there is no such thing as a price bubble — the market always correctly prices every product and service).

Unfortunately, it looks like the same financial models that came unstuck during the GFC have already been incorporated into the emerging carbon markets.

This is directly relevant to Australia’s emissions trading scheme (the Carbon Pollution Reduction Scheme, or CPRS) because Treasury’s 2008 modelling shows that the CPRS won’t reduce Australia’s domestic carbon emissions until after 2030. Instead, for the next 20 years, the CPRS will rely entirely on importing a large number of carbon offsets.

For these carbon offsets to be effective in actually reducing carbon emissions (rather than being just an accounting trick), they need to pass three main tests.

Firstly, the activity claiming the offset must be something that would not have occurred without the carbon offset payment, that goes beyond existing legal requirements and that will not be counted in any other emission reduction scheme (the "additionality" test). This immediately eliminates activities that are already occurring such as indigenous "caring for country", or retaining carbon on farming land. Similarly, trees that cannot be cleared under existing legislation cannot be counted as an offset.

In order to establish whether an activity is genuinely additional, you need to determine what would have occurred without the project (the baseline). This is a very complex process that allows manipulation by carbon traders who have a financial incentive to overestimate the amount of carbon offset achieved. There is plenty of concrete evidence of widespread rorting of the additionality principle with little or no reduction in pollution, often in ways that actually make the situation worse.

The second test of the validity of a carbon offset is assessing whether the activity in question succeeds in reducing total emissions, or if it merely moves those emissions to another place where it’s not being accounted for (the "leakage" test). For example, putting limits on forest logging in one area may simply increase logging somewhere else. Again, this is a criterion that is very open to accidental and deliberate exploitation, with questionable benefits.

Thirdly, the offsets need to be permanent (the "permanence" test). Carbon dioxide (the main greenhouse gas) is very long-lasting in the atmosphere (50 years or more) so carbon offset projects should have a similar longevity. For example, forests planted as carbon sinks should be safe from destruction by fire or insect pests for at least the next 50 years.

These are the tests which carbon offsets have to meet. Unfortunately, each type of carbon offset is, in its own way, compromised when measured against these tests.

Those types of offsets are: biological sequestration (trees and soil), renewable energy projects, energy efficiency and reduction of non-carbon dioxide greenhouse gas emissions. Biological sequestration is fatally flawed in relation to the leakage and permanence tests and is also prone to multiple counting.

Renewable energy projects are weak on the additionality test; for example, if the projects are part of achieving mandatory renewable energy targets now or in the future. (To date higher cost has drastically limited the take-up of renewable energy offset projects). Energy efficiency projects are particularly weak on the additionality test as they often provide cost savings; they tend to be weakened by "rebound effects" whereby efficiency improvements often encourage greater energy use than before. The last category (reduction of non-CO2 emissions) has been the subject of widespread rorting as it provides incentives to manufacture more of these gases than is required by end users, solely to claim carbon offsets by destroying the gases.

Leading US economist William Nordhaus believes that cheating will probably be widespread in the emissions trading schemes, noting that neither buyers nor sellers have any incentive to ensure that real reductions have been made.

Overall, carbon offsets are seriously contaminated by uncertainty and ignorance about what will happen in the future to the offset activities themselves, or what will happen to the public policy environment in which they exist. The convenient assumption that these issues don’t matter is another dangerous factor this market has in common with other market theory. Nobel Prize-winning economist Joseph Stiglitz, describing the so-called "rational expectations theory" which assumes that all players in a market have the same information and also have the same understanding of how the world works, called such assumptions a "triumph of ideology over science". Carbon offset markets are fundamentally the same in this regard, and just as vulnerable to distortion and collapse.

Despite recent experience demonstrating the need for markets to reflect the real value of the things they trade, carbon traders are undeterred by the idea that carbon offset projects can’t demonstrate their bona fides in reducing emissions. For example in November 2008, a major European bank began packaging up carbon credits from 25 different offset projects to create three bundles of securitised products, allegedly with different risk levels.

Where does this leave Australia’s CPRS? Unfortunately, it looks very much like another "triumph of ideology over science".

Economic theory asserts that putting a price on carbon will allow the market to produce "least cost" emission reduction. This notion depends alarmingly on the same assumptions that allowed the GFC to occur, namely that all risk/uncertainty/ignorance is incorporated into the market price.

The catastrophic uncertainty/ignorance here of course is that known and unknown positive climate feedbacks (such as the release of methane from melting permafrost) will cause an escalating increase in global temperature. Scenarios like this are in the realms of uncertainty and ignorance and so cannot in principle be factored into the models that the carbon traders currently rely on.

The emerging carbon markets, based as they are on current economic theory, are therefore theoretically unsound and too fragile to provide sufficient certainty that carbon emissions will be effectively reduced. In designing a robust response to climate change, we need to put in place systems with backup components in recognition of our uncertainty and ignorance about the future.

Clearly, the internal workings of emissions trading schemes mean that they are a profoundly flawed mechanism. More fundamentally, however, there’s strong evidence in recent history to suggest that we can’t rely on market prices to achieve the kind of structural change needed to prevent catastrophic global warming. Effectively addressing global warming requires construction of the large-scale renewable energy infrastructure that will produce real carbon emissions reductions. As US climate activist Ted Nordhaus (nephew of William Nordhaus) puts it "we didn’t get the internet and personal computers by taxing fax machines or capping typewriters. We did this with massive public investment in … these new technologies."

The task of reducing carbon emissions requires a robust strategy able to cope with uncertainty and ignorance about the future. This task is definitely not something to leave to the traders and speculators who brought us the GFC.