Market failures occur when the free market fails to optimize its resources and when a lack of regulation allows for exploitation of the market for personal gain at the expense of the greater social good. Carbon markets can be associated with these driving forces listed below in some degree.
The traditional causes of market failure can be attributed to a few core causes.
Allocative inefficiency: Resources are not distributed efficiently.Both carbon taxes and cap and trade schemes must deal with the allocation of quantity and price of emissions.
Monopoly power: Single stakeholders control the market. Example: Fossil fuel reserves are owned by a handful of multinational corporations. These corporations also have the ability to control the price and quantity of available reserves. This results in a lack of market transparency and causes speculation of market price.
Missing markets: Goods and services are not accounted for in a market economy. Example: Ecosystem services such as carbon sequestering, biodiversity and coastal buffering from increasingly powerful storms have not been assigned a monetary value.
Incomplete markets: Valuation of goods or services has not been established. Example: The true costs of climate change are yet to be determined but because its economic costs are based on future projects, they do not directly influence existing markets.
De-merit goods: Goods that are damaging to health, environment or society are not sufficiently regulated.
Negative externalities: When economic activity damages the commons, the burden and costs of externalities are placed on third parties. Example: Air quality and pollution directly affects human health and well-being.
Property rights: Rights to property are not assigned, preventing markets from forming. Example: When companies are awarded or purchase emissions credits they have purchased a valuable property right: the ability to pollute.
Information failure: Incomplete data is used to move goods and services. Whole pictures and long term time horizons are not accounted for. Example: Total global emissions are unknown, resulting in incomplete data and understanding of carbon markets.
Unstable markets: Especially in young markets price equilibriums have not been established, resulting in volatility and instability. This often requires intervention to stabilize. Example: Price volatility in the price of carbon in the EU ETS has historically fluctuated to a lack of market maturity and market speculation.
Inequality: Profits go to a select few, creating gaps in income prosperity. Example: The perspectives of developing nations are not considered in most carbon markets, resulting in social justice issues and north-south imbalances.
These same causes of market failure that occur in traditional economies apply to carbon markets and they are also susceptible to falling victim to the driving forces of market failure. Just like all markets, there exists in carbon trading a culture of competition, driven by the bottom line and the desire for growth of profit and market share. Just like other commodities, a carbon market must operate at an optimum achieved through the efficient allocation of price and quantity if it is to be successful.
Holding unbounded faith in the free market has and will continue to result in vast disparities between rich and poor while perpetuating an unjust hierarchy of global winners and losers. If an economic and ecological optimum for pricing and quantifying carbon emissions is to be found, this system needs to change.
Inefficient allocation of price and quantity leading to market failure:
In his book Bridge at the Edge of the World, Speth presents the main problem with economic markets that attempt to assign a dollar value on natural systems. He writes:
“When the question is whether to allow one person to hurt another, or to destroy a natural resource; when a life or an landscape cannot be replaced; when harms stretch out over decades or even generations; when outcomes are uncertain; when risks are shared or resources are used in common; when the people ‘buying’ harm have no relationship with the people actually harmed – then we are in the realm of priceless, where market values tell us little about the social values at stake (Speth, pg 98, 2008).”
Speth’s argument is that natural systems and the co-benefits that they provide are priceless, but not worthless. This argument can be extrapolated into the case study of cap and trade. Emissions are a consequence of the tragedy of the commons, and cap and trade is the management response by which markets have tried to assign a property right to emissions in order to create a disincentive to pollute.
Both carbon taxation and trading schemes aim to internalize the ‘pricelessness’ of emissions into a market model. However, the process of assigning monetary value to emissions is imperfect in both cases.
Under carbon trading, emissions become a commoditized property right— subject to the will of market traders and their attempts to profit off inefficiencies in the allocation of the price and quantity of emissions. Without a system of fallbacks or an accountable way of disclosing emissions, the going rate of emission permits are arbitrary, based only on what polluters are willing to pay in an ongoing bidding war. This speculative approach to pricing carbon leaves room for traders and polluters to manipulate the going rate of carbon by buying excess credits, creates monetary incentives for disclosing inaccurate emission baselines and emission reductions, and shares insider information with other carbon traders. Until disclosed emissions can be verified to be truthful and the trading of carbon becomes fixed around a stable market price exploitation and gaming will occur within the industry, increasing the probability of speculative market failure.
Danny Cullenward addresses carbon market failure in his chapter of Climate Change Science and Policy, below:
“Price volatility in the largest cap-and-trade system in the world, the European Union’s Emission Trading Scheme (EU ETS), illustrates the point. At the beginning of 2006, EU ETS carbon prices approached $40 per ton of CO2. But when market analysts realized that the EU governments had over-allocated credits (swamping the market with extra permits to pollute), spot market prices crashed to under $1 per ton of CO2…for a standard 500 MW coal power plant, the annual carbon liability would have fallen from $119 million to $3 million (Cullenward, pg. 205, 2010)”
The EU ETS market collapse is evidence that there are flaws in the current design of carbon markets. Carbon credits can be considered what Cullenward calls “a valuable property right.” Meaning, each credit is not just a token to pollute, but because of the trading element of cap and trade, has a substantial monetary value. As a result entities that own large amounts of credits also have a large amount of financial incentive to game the system.
At its core cap and trade programs are just like other capitalistic financial markets and are vulnerable to the capricious nature of traders and investors. The EU ETS collapsed because of speculation, greed and unregulated market gaming that undermined the sustainable goals that the program was built on.
Speth’s critiques of environmental markets and the burst of the EU ETS bubble show that price volatility is a problem that needs to be overcome. For an emissions market to be stable enough to attract investment and corporate participation, the price of carbon needs to be established over long-term time horizons.
Carbon taxation schemes also encounter pricing problems. While it is easy to calculate the annual tolerable quantity of emissions that the atmosphere can internalize without changing the global climate, pricing carbon at a level that will ensure those limits are not exceeded is much harder. If the taxes on emissions are set too low then the disincentive to pollute will not be large enough to create meaningful change. Conversely, if the tax is too high its political viability of a tax law is greatly reduced and compromises will be much harder to reach.
Tax schemes are also at a disadvantage because they do not require as strict accounting as cap and trade programs do. This makes it easier for companies to hide their emissions, resulting in the failure to accurately determine the carbon footprints of polluters. This makes it hard to tell if emission abatement is actually occurring as a result of the tax.