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FRÉDÉRIC HACHE
50 ShadeS of Green
THE RISE OF NATURAL CAPITAL MARKETS
AND SUSTAINABLE FINANCE
Policy RePoRt
MaRch 2019
PART I. CARBON
GReen
Finance
obseRvatoRy
Everything that needs to be said has already
been said. But since no one was listening,
everything must be said again.
– andré Gide
However beautiful the strategy, you should
occasionally look at the results.
– WinSton ChurChill
Report “50 Shades of Green: the rise of natural capital markets and
sustainable finance – Part I. Carbon”
Author: Frédéric Hache
Editor: Mark Perrera
Acknowledgments: We are very grateful to Nicolas Bouleau, Jutta Kill and
many others for their invaluable feedback.
Cover photo: Gas platform or rig platform in sunset or sunrise time –
Shutterstock
© Green Finance Observatory 2019.
The contents of this paper may be freely used or reproduced without
permission provided the original meaning and context are not altered in
any way. Where third party copyright has been acknowledged, permission
must be sought from the third party directly. For enquiries relating to this
report, please email contact@gfobs.org
www.greenfinanceobservatory.org
content
Executive summary 4
Introduction 5
A. Global warming – what are the issues, what are the options? 6
B. Two types of carbon trading markets 8
1. Denitions 9
2. Historical background and track record 11
C. Will carbon markets save us? 18
1. Debatable assumptions 18
2. A hybrid market on a pseudo-commodity 25
3. Conceptual issues, some of which are unresolvable 28
4. Financial stability risks linked to the policy response to climate change 41
D. Major developments and a fragile status quo 50
1. Article 6, CORSIA, China 51
2. A political win and an environmental failure 55
Conclusion 62
Bibliography 63
EXECUTIVE SUMMARY
Beyond the well-known excess allowances and cases of fraud, carbon markets also have
major conceptual issues, some of which are unresolvable such as the inexistence of a
price signal. Carbon taxes suffer from some of the same flaws and are therefore only
marginally better.
As carbon becomes an asset class, carbon markets are also likely to be more
vulnerable than traditional markets to market failures and abrupt losses of
confidence from investors, with a high risk of contagion to other asset classes and
the wider economy. The tremendous scientic uncertainty, high regulatory risk and poor
environmental integrity of these markets translate into a high risk of rule changes and
abrupt repricing. The inclusion of carbon in commodity indexes and its perception as an
asset class would create fast contagion channels transmitting these risks and uncertainties
to the rest of the nancial system and the economy.
The unresolvable nature of some of the issues seriously questions the idea that
carbon markets can ever meet their environmental and social objectives. While all
policy tools are equally affected by the current lack of political ambition, effective ones
will work when ambition increases, whereas failed ones like carbon offset markets will
remain ineffective. This calls into question the current push to create new offset markets
linked to the Paris Agreement at the COP25 and offsets for aviation emissions. The logical
conclusion should be to abandon carbon markets for more robust alternatives, such as
traditional binding regulations.
Mandating a progressive phasing out from fossil fuels complemented by targeted tax
policies aimed at ensuring a fair sharing of the related costs would be simpler and
much more effective in addressing climate change. Such a policy tool would also not
create the nancial stability risks attached to carbon markets.
Such binding regulations would incidentally make all finance sustainable with regards
to climate change,1 as the risk-adjusted returns of all companies and economic activities
would automatically adjust to the new regulations and capital would shift accordingly.
In turn, this questions the current political focus on ‘changing nance’ to facilitate the
ecological transition, rather than changing environmental legislation, which would in turn
shift investment priorities.
While there is currently no political appetite for shifting the policy response away from
carbon trading, the current status quo is more fragile than most realize, and only one
major natural catastrophe away from being abandoned. As carbon markets continue to prove
their ineffectiveness while the incidence and amplitude of natural catastrophes increase and
renewable energy prices continue to drop, public pressure is likely to make the current status
quo gradually politically untenable. As a result, the choice between less effective but politically
appealing carbon trading policies and more effective alternatives may shift abruptly.
1 Reference is only here been made to the environmental aspect of sustainability. However, complementary
social and governance regulations would make all nance sustainable with regards to environmental, social and
governance factors.
50 SHADES OF GREEN | PART I. CARBON | 5
INTRODUCTION
Since the 2015 Paris Agreement and adoption of the UN 2030 Agenda for Sustainable
Development we have witnessed a growing political momentum to address the issues of
climate change and ecosystem destruction. A great number of initiatives are underway to
‘shift the trillions’ to nance the great transition and develop a green economy.
In this context, a major development is underway that has been in the works for more than
twenty years: the creation of new nancial markets on environmental degradation and their
integration into mainstream nance via a new European sustainable nance agenda.
Based on the idea that we need to put a price on nature to save it and that market-based
solutions would succeed where traditional environmental policies have failed, these new
markets aim at addressing climate change and ecosystem destruction in a more efcient
and cost-effective way.
In March 2018, the European Commission adopted an action plan on sustainable
nance shortly followed by a package of measures. It stated that ‘
the EU is committed to
development that meets the needs of present and future generations, while opening up
new employment and investment opportunities and ensuring economic growth
’.2
The sustainable nance agenda foresees a new role for private nance in environmental
policies going far beyond the mere nancing of renewable energy or energy efciency
projects. Three goals are put forward: re-orient private capital to fund sustainable and
inclusive growth; strengthen nancial stability by managing the nancial risks linked to
climate change and resource depletion; and foster transparency and long-termism.
Early proposals include establishing a classication system dening what constitutes
‘green’ economic activities, to be used for future ecolabels on nancial products. They also
include creating new low-carbon benchmarks and new disclosure obligations for asset
managers.
Some of these proposals also crucially open the door to new environmental market
mechanisms and instruments. In this, the sustainable nance agenda promises to be a
game changer and a major contributor to the integration of EU environmental policies into
mainstream nance.
Given the crucial importance of these forthcoming changes, there is a need to analyse
the new mechanisms, in order to determine how likely they are to meet their stated
environmental, economic, and social objectives. Assessing these mechanisms is also
essential to contextualise and understand sustainable nance 2.0.
A recent book about articial intelligence began with the sentence, ‘
welcome to the
most important conversation of our time
’. Our policy response to climate change and
biodiversity loss is the other most important conversation of our time.
2 European Commission Action Plan: Financing sustainable growth, 2018, https://ec.europa.eu/transparency/
regdoc/rep/1/2018/EN/COM-2018-97-F1-EN-MAIN-PART-1.PDF
6 | GREEN FINANCE OBSERVATORY REPORT
Photo: Mike Mareen, Shutterstock/1280426032
A. GLOBAL WARMING – WHAT ARE THE
ISSUES, WHAT ARE THE OPTIONS?
Sections A and B are intended to provide a quick overview for novice readers.
Others may skip directly to section C.
50 SHADES OF GREEN | PART I. CARBON | 7
Photo: Mike Mareen, Shutterstock/1280426032
Climate change refers to signicant change in climate systems over long periods of time. Within
climate change, anthropogenic global warming describes surface temperature increases caused by
human activities leading to changes in greenhouse gas concentrations.
While the main concern is the increase of carbon dioxide (CO2) levels due to emissions from
fossil fuel combustion, major greenhouse gases also include methane (CH4), nitrous oxide (N2O),
chlorouorocarbon-12 (CFC-12), hydrouorocarbon-23 (HFC-23), sulphur hexauoride (SF6), and
nitrogen triuoride (NF3).
There are three main policy responses to climate change: mitigation, adaptation and geoengineering:
Mitigation policies aim at reducing greenhouse gas emissions (GHG) and/or increasing the
ability of natural carbon reservoirs such as plants and the ocean to absorb GHG from the
atmosphere. They range from switching to renewable energies and increasing energy efciency
and conservation to reforestation.
Adaptation policies aim at increasing our ability to deal with the consequences of climate
change. Examples include improving infrastructure, using drought resistant crops, and
irrigation. As it is recognised that poor populations will be disproportionately affected by climate
change, adaptation policies also aim at reducing poverty.
Geo engineering policies seek to deliberately modify the climate by removing greenhouse
gases from the atmosphere and increasing sunlight reection. Projects include injecting
sulphate aerosols into the stratosphere to reect some sunlight before it reaches the surface
of the earth,3 and ocean iron fertilization - introducing iron particles into the ocean to stimulate
phytoplankton growth and sequester more CO2 in the ocean.4 Thirteen ocean iron fertilization
experiments have already been performed since 1990.5
Such policies are extremely controversial and risky, possibly disrupting regional weather patterns
with catastrophic effects on water availability and food production,6 and altering oceans’ chemistry
with potentially dramatic and poorly understood impacts on the marine food webs.7 Some view
these policies favourably due to their lower cost8 and potentially quick implementation, and as
complementing mitigation policies in extreme circumstances.
Coming back to mitigation policies, one of their main priorities is to incentivise industrial sectors to
reduce their carbon emissions. This can be achieved via three main policy tools: binding regulations
(also called command and control) imposing a reduction in emissions, changes in technology or
curbing fossil fuel extraction; carbon taxes; and carbon emissions trading schemes.
3 The Guardian, Keith G, Wagner D, Fear of solar geoengineering is healthy – but don’t distort our research, 29 March 2017,
https://www.theguardian.com/environment/2017/mar/29/criticism-harvard-solar-geoengineering-research-distorted;
MIT Technology Review, J Temple, Harvard Scientists Moving Ahead on Plans for Atmospheric Geoengineering Experiments,
24 March 2017, https://www.technologyreview.com/s/603974/harvard-scientists-moving-ahead-on-plans-for-atmospheric-
geoengineering-experiments/
4 The New York Times, Fountain H, A Rogue Climate Experiment Outrages Scientists, 18 October 2012, https://www.nytimes.
com/2012/10/19/science/earth/iron-dumping-experiment-in-pacic-alarms-marine-experts.html
5 Yoon et al 2016, Ocean Iron Fertilization Experiments: Past–Present–Future with Introduction to Korean Iron Fertilization
Experiment in the Southern Ocean (KIFES) Project, https://www.researchgate.net/publication/310822713_Ocean_Iron_
Fertilization_Experiments_Past-Present-Future_with_Introduction_to_Korean_Iron_Fertilization_Experiment_in_the_Southern_
Ocean_KIFES_Project
6 Geoengineering monitor, Hands Off Mother Earth!, October 2018,
http://www.geoengineeringmonitor.org/wp-content/uploads/2018/10/HOME_manifesto-EN-Nov21.pdf
7 Nature, Brent K, McGee J, McDonald J, Rohling E, International law poses problems for negative emissions research,
30 May 2018, https://www.nature.com/articles/s41558-018-0181-2
8 The Guardian, Carrington D, Solar geoengineering could be ‘remarkably inexpensive’ – report, 23 November 2018,
https://www.theguardian.com/environment/2018/nov/23/solar-geoengineering-could-be-remarkably-inexpensive-report
8 | GREEN FINANCE OBSERVATORY REPORT
B. TWO TYPES OF CARBON
TRADING MARKETS
© Spyridon Natsikos
50 SHADES OF GREEN | PART I. CARBON | 9
1. DEFINITIONS
A. CAP AND TRADE
Definition
Cap and trade is a programme where a central authority (typically a government) gives or
sells a limited number of permits to emit a specic quantity of a specic greenhouse gas
during a specic period. Polluters are required to have sufcient permits to match their
emissions during the allotted time period. If their emissions exceed the quantities allowed
by their permits, they are allowed to purchase permits from other participants. Conversely,
if they have not used all of their permits, they are allowed to sell them.
Cap and trade typically requires the central authority to dene which sectors are covered
and to establish annual, decreasing caps on emissions. As the cap decreases, the price
of permits is expected to increase and emissions are thus expected to decline to a target
limit.
Where cap and trade covers more than one greenhouse gas, it also requires the denition
of equivalences between greenhouse gases in order to trade only the emissions of one gas
and thus increase market liquidity.
Benefits
Cap and trade is based on the polluter pays principle: the idea that polluters should bear
the costs of their pollution.
It is considered more exible and cost-effective for corporations as they can achieve the
environmental objective at the lowest cost: by allowing the trading of permits, companies
that can reduce their emissions at low cost will do so and sell their permits to companies
who cannot. In such a way, the cost to corporations of complying with relevant regulations
is minimised and the allocation of permits is deemed more efcient.
Cap and trade also promotes economic growth by being able to respond faster to
economic shocks via a decline in the price of permits than a carbon tax.
Lastly, cap and trade is expected to provide more certainty over the amount of emissions
reductions than a carbon tax, as the quantity of emissions is xed by the cap, whereas a
carbon tax xes the price but not the quantity.
B. CARBON OFFSET MARKETS
Definition
Carbon offsetting is an action, such as planting trees to store carbon dioxide, made to
compensate for emissions of CO2 or other greenhouse gases into the atmosphere, on the
assumption that both are equivalent.
10 | GREEN FINANCE OBSERVATORY REPORT
Parties engaging in such activities receive carbon offset permits in exchange, which can
be sold and used to compensate for the emissions of other parties. As an example, a wind
farm will receive carbon offset permits, measured in tons of CO2 equivalents, for producing
renewable energy that it will sell to a coal-red power plant. The coal-red power plant
will then be able to use these permits to ‘compensate’ for its own emissions and comply
with environmental regulations, by claiming that its purchase resulted in new non-polluting
energy.
This is signicantly different from cap and trade in several respects. Firstly, there is no cap
to the number of credits that can be generated through offsetting. The only limit is on the
proportion of parties’ binding targets that are allowed to be achieved via offsets.
Secondly, determining the quantity of emissions avoided by the activity generating the
offsets requires setting up a baseline and hypothetical scenarios to determine what would
have happened without the offsetting activity. This is called additionality: the effect of the
project or activity to reduce greenhouse gas emissions below the level that would have
occurred in the absence of the project or activity.
Benefits
Carbon offsets have two main stated benets: reducing GHG emissions in the atmosphere,
and lowering the cost of achieving emission reduction targets, as carbon offsets are
typically cheaper than credits in cap and trade schemes.
Many offset projects also claim complementary benets such as improving the quality of
life for local populations (e.g. better air and water quality, healthier communities), or better
preservation of forests and thus habitats for wildlife.
50 SHADES OF GREEN | PART I. CARBON | 11
2. HISTORICAL BACKGROUND AND TRACK RECORD
A. CAP AND TRADE
Historical background
The rst cap and trade market was the US sulphur dioxide trading market created in 1995.
Sulphur dioxide emissions from coal-red power stations were generating so-called ‘acid
rain’ with disastrous consequences for human health and the environment. Yet, the Reagan
administration and some Democrats concerned about adverse economic consequences
opposed any regulatory attempt to control sulphur dioxide emissions. Trading was
presented as the way to combine curbing sulphur dioxide emissions with a market
mechanism that appealed to some Republicans.9
110 electric power generating plants were given a set quantity of SO2 emission allowances.
For each ton of SO2 emission reduced below the emission limit, plant owners received an
emission allowance that could be saved for future use or sold on a new market managed
by the Chicago Board of Trade. Plants would be ned USD 2000 for each ton of SO2
emitted in excess of allowances. This was a landmark in environmental policies and
inspired subsequent emissions trading schemes.
In 2005, the European Union set up the biggest carbon market worldwide as the main
policy tool to meet its commitments under the Kyoto protocol. Encompassing the CO2
emissions of 11000 large power plants and energy-intensive factories, the EU ETS
programme (European Emissions Trading Scheme) covers roughly 45% of EU CO2
emissions. The original objective was to reduce CO2 emissions in the European Union by
8% by 2012, relative to 1990 emissions levels. The EU ETS originally only covered CO2
emissions, but two other greenhouse gases were subsequently added to the scheme.
What pushed Europe towards carbon trading rather than the initially preferred carbon tax is
in good part because the EU legislative remit simply does not cover scal policies such as
carbon taxation.10 In addition, passing tax measures requires EU member states unanimity
whereas emissions trading only requires a qualied majority. Given that the idea of a
carbon tax faced vehement opposition from industry and from particular Member States
(notably the UK),11 a trading scheme was chosen.
In 2015, the United States under President Obama unveiled the Clean Power Plan, a new
policy that created a cap and trade programme12 and had the strong support of businesses
9 MacKenzie, Finding the Ratchet: The Political Economy of Carbon Trading, http://www.sociology.ed.ac.uk/__data/
assets/pdf_le/0015/3417/DMacKenzieRatchet16.pdf
10 World Bank, State and trends of carbon pricing, 2015, http://documents.worldbank.org/curated/
en/636161467995665933/pdf/99533-REVISED-PUB-P153405-Box393205B.pdf
11 MacKenzie, Finding the Ratchet: The Political Economy of Carbon Tradinghttp://www.sps.ed.ac.uk/__data/assets/
pdf_le/0015/3417/DMacKenzieRatchet16.pdf
12 UNFCCC, US Clean Power Plan Raises Carbon Trading Prole, 24 August 2015, https://unfccc.int/news/us-clean-
power-plan-raises-carbon-trading-prole; Brookings Institute, Maurice A, Weber E, To comply with the Clean
Power Plan, states should tax carbon, 2 September 2015, https://www.brookings.edu/opinions/to-comply-with-
the-clean-power-plan-states-should-tax-carbon/
12 | GREEN FINANCE OBSERVATORY REPORT
such as Goldman Sachs and eBay.13 However, in 2017, President Trump signed an
executive order calling for a review of the Clean Power Plan, followed shortly by a proposal
by the Environmental Protection Agency to repeal it.
Today, 25 carbon emissions trading schemes exist, with prices ranging from USD 1 to USD
25 /ton of CO2.
Source: World Bank and Ecofys. 2018. “State and Trends of Carbon Pricing 2018 (May)”, by World Bank,
Washington, DC. Doi: 10.1596/978-1-4648-1292-7
Track record
During the rst phase (2005- 2007), almost all permits were given to businesses for free
and the total amount of permits issued exceeded actual emissions, due to a lack of reliable
emissions data and to the pressure of Member States to protect their national industries.
This led to the price of carbon permits falling from EUR 10 in early 2005 to zero in 2007.
Phase II (2008- 2012) saw a lowering of the cap but the nancial and economic crisis of
2008 led to major emission reductions, creating a massive surplus estimated to be 1.5-
2bn permits. Once again this led to a crash of the carbon price. While the crisis is often
blamed for the excess permits, it is worth noting that according to the UK Committee on
Climate Change, even without the crisis the allowance to use offset permits from Kyoto
mechanisms meant that in effect no emission reduction within the EU was required to meet
the phase II cap.14
Phase III (2013-2020) saw a tightening of the allowance to use offset permits, following
13 Rollingstone, Taibbi M, The Great American Bubble Machine, 5 April 2010, https://www.rollingstone.com/politics/
politics-news/the-great-american-bubble-machine-195229/; The Guardian, Vaughan A, Obama’s clean power plan
hailed as US’s strongest ever climate action, 3 August 2015, https://www.theguardian.com/environment/2015/
aug/03/obamas-clean-power-plan-hailed-as-strongest-ever-climate-action-by-a-us-president
14 “
At the EU level, however, the allowed use of offset credits is sufciently generous that there will need to be no
emissions reductions within the EU to meet the Phase II cap.
” UK Committee on Climate Change 2008, Building a
low-carbon economy, http://archive.theccc.org.uk/archive/pdf/TSO-ClimateChange.pdf
Figure 1 / Summary map of regional, national and subnational carbon pricing initiatives implemented,
scheduled for implementation and under consideration (ETS and carbon tax)
ETS implemented or scheduled for implementation
Carbon tax implemented or scheduled for implementation
ETS or carbon tax under consideration
ETS and carbon tax implemented or scheduled
Carbon tax implemented or scheduled, ETS under consideration
ETS implemented or sched uled, carbon tax under consideration
The circles represent subnational jurisdictions. The circles are not representative of the size of the carbon pricing
instrument, but show the subnational regions (large circles) and cities (small circles).
Note: Carbon pricing initiatives are considered “scheduled for implementation” once they have been formally
adopted through legislation and have an ocial, planned start date. Carbon pricing initiatives are considered “under
consideration” if the government has announced its intention to work towards the implementation of a carbon pricing
initiative and this has been formally conrmed by ocial government sources. The carbon pricing initiatives have been
classied in ETSs and carbon taxes according to how they operate technically. ETS not only refers to cap-and-trade
systems, but also baseline-and-credit systems as seen in British Columbia and baseline-and-oset systems as seen in
Australia. The authors recognize that other classications are possible. Due to the dynamic approach to continuously
improve data quality, changes to the map not only reect new developments, but also corrections following new
information from ocial government sources, resulting in the addition of the carbon tax covering only F-gases in Spain.
Tally of carbon pricing initiatives
implemented or scheduled for
implementation
National level
21
16
8
45
Subnational level
25
2
23
NORWAY
UK
PORTUGAL
FRANCE
SWITZERLAND
SLOVENIA
POLAND
LATVIA
ESTONIA
FINLAND
SWEDEN
DENMARK
IRELAND
LIECHTENSTEIN
SHANGHAI
SHENZHEN
SINGAPORE
TAIWAN
FUJIAN
BEIJING
TIANJIN
HUBEI
CHONGQING
GUANGDONG
TOKYO
SAITAMA
CHILE
SãO PAULO
NEWFOUND-
LAND AND
LABRADOR
NEW
BRUNSWICK
PRINCE
EDWARD
ISLAND
NOVA SCOTIA
TURKEY
UKRAINE
CHINA
NORTHWEST TERRITORIES
CANADA
BRITISH
COLUMBIA
WASHINGTON
OREGON
CALIFORNIA
MEXICO
SASKATCHEWAN
ONTARIO
QUéBEC
MASSACHUSETTS
BRAZIL
RIO DE JANEIRO
SOUTH AFRICA AUSTRALIA NEW
ZEALAND
THAILAND
EU KAZAKHSTAN REPUBLIC
OF KOREA
JAPAN
ICELAND
COLOMBIA
VIETNAM
ALBERTA
RGGI
VIRGINIA
ARGENTINA
CATALONIA
MANITOBA
CôTE D’IVOIRE
9Executive summary
Figure 1 / Summary map of regional, national and subnational carbon pricing initiatives implemented,
scheduled for implementation and under consideration (ETS and carbon tax)
ETS implemented or scheduled for implementation
Carbon tax implemented or scheduled for implementation
ETS or carbon tax under consideration
ETS and carbon tax implemented or scheduled
Carbon tax implemented or scheduled, ETS under consideration
ETS implemented or sc heduled, carbon tax under consideration
The circles represent subnational jurisdictions. The circles are not representative of the size of the carbon pricing
instrument, but show the subnational regions (large circles) and cities (small circles).
Note: Carbon pricing initiatives are considered “scheduled for implementation” once they have been formally
adopted through legislation and have an ocial, planned start date. Carbon pricing initiatives are considered “under
consideration” if the government has announced its intention to work towards the implementation of a carbon pricing
initiative and this has been formally conrmed by ocial government sources. The carbon pricing initiatives have been
classied in ETSs and carbon taxes according to how they operate technically. ETS not only refers to cap-and-trade
systems, but also baseline-and-credit systems as seen in British Columbia and baseline-and-oset systems as seen in
Australia. The authors recognize that other classications are possible. Due to the dynamic approach to continuously
improve data quality, changes to the map not only reect new developments, but also corrections following new
information from ocial government sources, resulting in the addition of the carbon tax covering only F-gases in Spain.
Tally of carbon pricing initiatives
implemented or scheduled for
implementation
National level
21
16
8
45
Subnational level
25
2
23
NORWAY
UK
PORTUGAL
FRANCE
SWITZERLAND
SLOVENIA
POLAND
LATVIA
ESTONIA
FINLAND
SWEDEN
DENMARK
IRELAND
LIECHTENSTEIN
SHANGHAI
SHENZHEN
SINGAPORE
TAIWAN
FUJIAN
BEIJING
TIANJIN
HUBEI
CHONGQING
GUANGDONG
TOKYO
SAITAMA
CHILE
SãO PAULO
NEWFOUND-
LAND AND
LABRADOR
NEW
BRUNSWICK
PRINCE
EDWARD
ISLAND
NOVA SCOTIA
TURKEY
UKRAINE
CHINA
NORTHWEST TERRITORIES
CANADA
BRITISH
COLUMBIA
WASHINGTON
OREGON
CALIFORNIA
MEXICO
SASKATCHEWAN
ONTARIO
QUéBEC
MASSACHUSETTS
BRAZIL
RIO DE JANEIRO
SOUTH AFRICA AUSTRALIA NEW
ZEALAND
THAILAND
EU KAZAKHSTAN REPUBLIC
OF KOREA
JAPAN
ICELAND
COLOMBIA
VIETNAM
ALBERTA
RGGI
VIRGINIA
ARGENTINA
CATALONIA
MANITOBA
CôTE D’IVOIRE
9Executive summary
50 SHADES OF GREEN | PART I. CARBON | 13
blatant abuses and massive scams15. It also saw the inclusion of other sectors and gases
and the auctioning off of some of the allowances: free allocations to industry were capped
at 43% of all allowances.
Despite the enormous surplus of permits from phase II, participants were allowed to use all
their unused phase II permits in phase III, in addition to the new phase III permits issued.
Phase III therefore started unsurprisingly with a new price low of EUR 2.81 per ton of CO2.
It was also estimated that phase III would end with a surplus of 2.2bn permits in 2020.
Prices saw a minor rebound after the disastrous start to 2013 but remained stuck between
EUR 4 and EUR 7 until early 2018, where the approval of signicant reforms for the next
period led to an abrupt rise in prices above EUR 20.
Amongst the most important reforms, Phase IV (2021-2030) will see an increased pace
of emission cuts, with the cap - the overall number of emission permits - declining at an
annual rate of 2.2% from 2021 onwards, compared to 1.74% currently. In addition, the
number of permits put in the Market Stability Reserve – a mechanism to reduce the surplus
of permits in the market – will double to 24% of the permits in circulation.16
So, is the EU ETS working? The objective to minimize the cost of compliance for private
corporations has been achieved beyond expectations, due to the extremely generous
and mostly free allocation of permits. This has enabled several prominent corporations to
make windfall prots from the sale of extra permits and from charging customers for the
hypothetical cost of carbon permits that they received for free. Not only did free permits
contradict the polluter-pays principle, but they rendered the EU ETS effectively a subsidy
factory for polluters instead of a scheme to incentivise technological change. A recent report
estimated that the EU handed industry EUR 24 billion in windfall prots from 2008 to 2014.17
Conversely, the EU ETS has so far failed to contribute meaningfully to curbing emissions
of greenhouse gases. While emissions have indeed decreased since 2005, according to
scientic studies and a report from the European Commission18 the economic crisis rather
than the market mechanism has been the major cause of the emission reductions, as it led
to a decline in growth and energy demand.
This is not surprising given that since the creation of the ETS, allocated allowances have
frequently been higher than actual emissions, not to mention the additional allowances
generated through the Kyoto carbon offset markets. In fact, two-thirds of the over-supply can
15 The Guardian, Carrington D, EU plans to clamp down on carbon trading scam, 26 October 2010,
https://www.theguardian.com/environment/2010/oct/26/eu-ban-carbon-permits ;
Environmental Investigate Agency, China’s greenhouse gas vent threat in bid to extort billions, 8 November 2011,
https://eia-international.org/china-threat-to-vent-super-greenhouse-gases-in-bid-to-extort-billions/
16 The Oxford Institute for Energy Studies, The EU ETS phase IV reform: implications for system functioning and for
the carbon price signal, September 2018, https://www.oxfordenergy.org/wpcms/wp-content/uploads/2018/09/The-
EU-ETS-phase-IV-reform-implications-for-system-functioning-and-for-the-carbon-price-signal-Insight-38.pdf
17 Carbon Market Watch, Industry windfall pro ts from Europe’s carbon market 2008-2015, http://carbonmarketwatch.
org/wp-content/uploads/2016/11/CMW-Industry-windfall-prots-from-EUs-carbon-market-2008_2015.pdf;
CE Delft, Calculation of additional prots of sectors and rms from the EU ETS 2008-2015, December 2016,
http://www.cedelft.eu/publicatie/calculation_of_additional_prots_of_sectors_and_rms_from_the_eu_ets/1763
18 Nature, Feng K, Davis S, Sun L, Hubacek K, Drivers of the US CO2 emissions 1997–2013, 21 July 2015, https://
www.nature.com/articles/ncomms8714; European Commission, The state of the European carbon market in 2012,
2012, https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:52012DC0652&from=EN
14 | GREEN FINANCE OBSERVATORY REPORT
be blamed on the use of offset credits according to the NGO Carbon Market Watch.19 In the
words of one banker
‘the EU ETS has done nothing to curb emissions
’,20 and many nancial
professionals such as George Soros have harshly criticised carbon markets’ effectiveness.
The cost effectiveness of carbon markets has also been challenged: a UBS research report21
found that the EU ETS had cost the continent’s consumers USD 287 billion for ‘
almost
zero impact
’ on cutting carbon emissions, and that had the money been used as part of
a targeted approach to replace the EU’s dirtiest power plants, emissions could have been
reduced by 43 per cent, ‘
instead of almost zero impact on the back of emissions trading
’.
Other unlikely critics of cap and trade include its creators22: the economists behind
the sulphur dioxide market have questioned the usefulness of cap and trade to address
global warming, highlighting the high volatility and uncertainty it creates for businesses and
favouring a carbon tax instead.
It remains to be seen whether the recent price increase will have a more meaningful effect,
as the price currently remains below the level of USD 40-80 per ton that most economists
estimate to be the minimum necessary to trigger fuel switching.23 Crucially, it also remains
to be seen to what extent forthcoming offset markets – that will be described later in this
report – will be allowed to link with the EU ETS and impact its cap.
The fact that the market stability reserve now foresees the release of millions of allowances
in case of a strong rise in the price of EU emission allowances also questions the political
appetite to let the carbon price rise to a meaningful level.
Fraud
Beyond the excess allowances, the credibility of the EU ETS has also been plagued by
cases of fraud, from the theft of EUR 7m of emission permits from the Czech Republic’s
carbon registry24 to phishing scams.25 The most prominent scandal was a massive VAT
fraud in 2009, where Europol that up to 90% of all market activity in some European
countries estimated in 2009 was undertaken by fraudsters, and that carbon credit fraud
caused more than EUR 5 billion worth of damage to European taxpayers.26
19 Carbon Market Watch, Emissions trading and national carbon markets – Beware of past mistakes!, March 2013,
http://carbonmarketwatch.org/emissions-trading-and-national-carbon-markets-beware-of-past-mistakes/
20 As reported in The Corner House, Lohmann L, Carbon Trading: Solution or Obstacle?
http://www.thecornerhouse.org.uk/sites/thecornerhouse.org.uk/les/Indiachapter.pdf
21 The Global Warming Policy Forum, Europe’s $287 billion carbon waste: UBS report, 22 November 2011, https://
www.thegwpf.com/europes-287-billion-carbon-waste-ubs-report/; The Australian, Maher S, Europe’s $287bn
carbon ‘waste’: UBS report, 23 November 2011, https://web.archive.org/web/20111128113617/http://www.
theaustralian.com.au/national-affairs/europes-287bn-carbon-waste-ubs-report/story-fn59niix-1226203068972
22 The Wall Street Journal, Hilsenrath J, Cap-and-Trade’s Unlikely Critics: Its Creators, 13 August 2009,
http://www.wsj.com/articles/SB125011380094927137
23 Carbon Pricing Leadership Coalition, 2016-2017 report, http://pubdocs.worldbank.org/en/183521492529539277/
WBG-CPLC-2017-Leadership-Report-DIGITAL-Single-Pages.pdf
24 Reuters, Chestney N, Harrison P, EU locks carbon market after security breach, 19 January 2011, https://www.
reuters.com/article/us-carbon-czech/eu-locks-carbon-market-after-security-breach-idUSTRE70I55120110119
25 EU Observer, Phillips L, Cyber-scam artists disrupt emissions trading across EU, 3 February 2010,
https://euobserver.com/environment/29403
26 Europol press release, Carbon credit fraud causes more than 5 billion euros damage for European taxpayer, 9
December 2009, https://www.europol.europa.eu/newsroom/news/carbon-credit-fraud-causes-more-5-billion-
euros-damage-for-european-taxpayer; Euractiv, Robert A, Multi-billion EU carbon market fraud operated from
Poland, 18 July 2016, https://www.euractiv.com/section/energy/news/polish-broker-faces-seven-year-prison-
sentence-for-vat-fraud-on-eu-carbon-market/
50 SHADES OF GREEN | PART I. CARBON | 15
B. OFFSET MARKETS
Historical background
At the Earth summit of Rio in 1992, 165 nations signed an international environmental
treaty -– the United Nations Framework Convention on Climate Change (UNFCCC) –
aimed at stabilising GHG concentrations in the atmosphere at a level that would prevent
dangerous interference with the climate system originating from human activities.
In 1997, the Kyoto Protocol, a treaty extending the UN framework, dened legally binding
greenhouse gases emission reduction targets for developed countries, for the rst time.
These limits pertained to the period between 2008 and 2012, and were later amended
to include the period 2013-2020. Six GHG were included in the Protocol: carbon-dioxide
(CO2), methane (CH4), nitrous oxide (N2O), hydrouorocarbons (HFCs), peruorocarbons
(PFCs), and sulphur hexauoride (SF6).
The Kyoto Protocol also introduced three so-called ‘exible mechanisms’: Emissions
Trading; the Clean Development Mechanism (CDM) and Joint Implementation (JI). Their
main purpose was to lower the overall costs of achieving emission reduction targets, by
authorising parties to achieve their targets in other countries.
The Emissions Trading Mechanism is an allowance-trading scheme broadly similar to that
of the US pertaining to sulphur dioxide, while the two other mechanisms are offset-based:
they allow industrialised countries with binding targets to meet part of their commitments
by buying certicates linked to emission reduction projects in developing countries where
cutting emissions is cheaper, instead of by reducing emissions at home.
The crucial difference between the Joint Implementation and the Clean Development
Mechanisms is that the former requires emission reduction projects to take place in
countries with binding commitments, whereas the latter allows emission reduction projects
to take place in developing countries with no binding targets.
Interestingly, the USA under President Clinton had pushed strongly for the inclusion of
these exibility mechanisms before withdrawing from the Kyoto Protocol due to US Senate
opposition. One of the staunchest supporters of these marked-based mechanisms had been
Enron, a big sulphur dioxide market player that stated in an internal memorandum that Kyoto
would ‘
do more to promote Enron’s business than almost any other regulatory initiative outside
the restructuring [of] the energy and natural gas industries in Europe and the United States
.’27
Participants in the European cap and trade market can use international credits from
Kyoto’s JI and CDM mechanisms to full part of their obligations under the EU ETS until
2020. The EU ETS is currently the biggest source of demand for international credits, with
an inow of more than 1.5 billion international credits occurring since 2013.28
27 The Washington Post, Morgan D, Enron Also Courted Democrats, 13 January 2002,
https://www.washingtonpost.com/gdpr-consent/?destination=%2farchive%2fpolitics%2f2002%2f01%2f13%2fenr
on-also-courted-democrats%2fdb9d5f82-b371-40d2-ae75-6b86dfb47f1a%2f%3f&utm_term=.a872e1bbb2e9
28 I4CE, Exploring the EU ETS beyond 2020, November 2015, https://www.i4ce.org/wp-core/wp-content/
uploads/2015/11/rapport-i4ce-BAT.pdf; IETA, Use of offset credits across emission trading systems and carbon
pricing mechanisms, May 2014, https://www.ieta.org/resources/Resources/3_Minute_Briengs/use%20of%20
credit%20offset%20across%20etss_%20brieng_nal%20version.pdf
16 | GREEN FINANCE OBSERVATORY REPORT
As the Clean Development Mechanism ends in 2020, it is most likely to be replaced by the
Sustainable Development Mechanism, a new carbon market instrument that is part of the
2015 Paris Agreement. Less publicised than the 2°C target headline, article 6 of the Paris
Agreement provides the ability to create an international carbon offset market through
the use of ‘internationally transferred mitigation outcomes’ to achieve nationally
determined contributions. These internationally transferred mitigation outcomes are
carbon offset credits. As a prominent think tank noted at the time ‘
the absence of the word
“market” is deliberate, not accidental.
’29
Track record
After starting to trade at around EUR 20 per ton of CO2 in 2008, Certied Emissions
Reductions (CER)30 prices experienced a decline to around EUR 4 per ton in 2012 and
have remained close to zero since 2013. A combination of a growing oversupply of offset
credits, demand coming only from the EU ETS and the economic downturn following the
2008 nancial crisis led to a saturation of demand and the crash of CER prices.31
Analysts now expect that only demand from the forthcoming carbon offset market for
aviation emissions may revive the ailing Clean Development Mechanism.32
2.2.2
International carbon pricing
outside of the UNFCCC
Voluntary carbon market In 2014, carbon osets
worth US$395 million were purchased, representing a
volume of 87 MtCO2e, up 13.6 percent with respect to
2013. However, the annual issuance volumes and prices
of carbon osets continue to fall, as shown in Figure 10.
is trend can be attributed to the policy uncertainty
and the diminishing number of new corporate osetting
programs.54 Yet the issuance and price decreases seen
in the voluntary market are less substantial than in the
CDM market.
Reducing Emissions from Deforestation,
Forest Degradation, and the role of con-
servation, sustainable management of
forests, and enhancement of forest carbon
stocks (REDD+) On June 9, 2015, an agreement
was reached on the outstanding items on the agenda for
the UNFCCC’s REDD+ mechanism: safeguards, non-
market-based approaches, and non-carbon benets.55
Draft decisions on these issues have been forwarded for
consideration and adoption at COP 21. If these deci-
sions are adopted in Paris, there will be adequate guid-
ance for implementation of REDD+, complementing
the Warsaw Framework on REDD+ adopted at
COP 19.56 Countries are making progress on establishing
54 Forest Trends’ Ecosystem Marketplace, Ahead of the Curve: State of the Voluntary Carbon Markets 2015, June 2015.
55 UNFCCC, Methodological Guidance for Activities Relating to Reducing Emissions from Deforestation and Forest Degradation and the Role of Conservation, Sus-
tainable Management of Forests and Enhancement of Forest Carbon Stocks in Developing Countries, June 9, 2015.
56 Gustavo A. Silva-Chávez, Surprising Development at UN Climate Meetings: REDD+ Is Finished, Forest Trends, June 9, 2015.
Annual and cumulative CER and ERU issuance, secondary CER prices (left), and voluntary offset issuance and prices (right)Figure 10
Source: UNFCCC for CDM and JI data on issuances, Intercontinental Exchange ICE for CDM data on prices, Forest Trends’ Ecosystem Marketplace for data on voluntary offsets.
Annual CER issuance
Annual ERU issuance
Cumulative CER issuance
Cumulative ERU issuance
Secondary CER prices
Annual voluntary
offset issuance
Cumulative voluntary offset issuance
Annual average voluntary credit prices
CDM and JI credit issuances and CDM credit prices
Voluntary offset issuances and prices
1,600
1,400
1,200
1,000
800
600
400
200
0
Volume (MtCO2e)
40
35
30
25
20
15
10
5
0
Unit price
(US$/tCO2e)
2011
2010
2008
2007
2006
2004
2009
2005
2012
2013
2014
Volume (MtCO2e)
1,600
1,400
1,200
1,000
800
600
400
200
0
2011
2010
2008
2007
2006
2009
2005
2012
2013
2014
pre-2005
37
Source: Alexandre
Kossoy, Grzegorz Peszko,
Klaus Oppermann, Nicolai
Prytz, Noémie Klein,
Kornelis Blok, Long Lam,
Lindee Wong, Bram
Borkent. 2015.
State and Trends of
Carbon Pricing 2015
(September), by World
Bank, Washington, DC.
Doi: 10.1596/ 978-1-
4648-0725-1
29 CEPS, Marcu A, Carbon Market Provisions in the Paris Agreement (Article 6), January 2016, https://www.ceps.eu/
system/les/SR%20No%20128%20ACM%20Post%20COP21%20Analysis%20of%20Article%206.pdf
30 Certied Emissions Reductions (CER) is the name of the credits traded in the Clean Development Mechanism
31 CDC Climat, Will there still be a market price for CERs and ERUs in two years time?, May 2012,
http://www.cdcclimat.com/IMG/pdf/12-05_climate_brief_no13_-_supply_demand_for_cer_eru_in_the_ets.pdf
32 Carbon Pulse, Airlines will be CDM’s lifeline, but expect CER price slump rst, say analysts, 27 April 2016,
https://carbon-pulse.com/18995/
50 SHADES OF GREEN | PART I. CARBON | 17
More worryingly, a 2017 study published by the European Commission33 found that 85%
of the offset projects used by the EU under the UN’s Clean Development Mechanism
failed to reduce emissions. ‘
Only 2% of the projects and 7% of potential CER supply
have a high likelihood of ensuring that emission reductions are additional and are not
over-estimated. Our analysis suggests that the CDM still has fundamental aws in terms of
overall environmental integrity. It is likely that the large majority of the projects registered
and CERs issued under the CDM are not providing real, measurable and additional
emission reductions.
’
What this rather damning assessment means in practice is that the use of CDM credits
towards climate targets has in fact increased global greenhouse gas emissions. ‘
In the EU
alone, emissions increased by over 650 million tonnes of CO
2
as a result of the use of CDM
credits in the EU Emissions Trading System. This is because an overwhelming majority
of CDM projects essentially issue ‘junk’ credits that do not lead to real-world emission
reductions.
’34
This comes in part from the fact that the Clean Development Mechanism has been riddled
with fraud, including Chinese companies manufacturing greenhouse gases to later destroy
them and collect credits;35 fake forestry credits;36 organised criminal groups in Russia
and Ukraine taking advantage of lax oversight and loopholes;37 and the re-use of expired
credits by a European member state.38
33 Öko Institut, Study prepared for DG CLIMA, How additional is the Clean Development Mechanism?, March 2016,
https://ec.europa.eu/clima/sites/clima/les/ets/docs/clean_dev_mechanism_en.pdf
34 Carbon Market Watch, Open letter to ICAO council representatives & national delegates on ending the Clean
Development Mechanism, 29 October 2018, https://carbonmarketwatch.org/publications/open-letter-to-icao-
council-representatives-national-delegates-on-ending-the-clean-development-mechanism/
35 The Guardian, Carrington D, EU plans to clamp down on carbon trading scam, 26 October 2010,
https://www.theguardian.com/environment/2010/oct/26/eu-ban-carbon-permits;
Wara M, Victor D, A Realistic Policy on International Carbon Offsets, Stanford Working Paper, April 2008,
https://law.stanford.edu/wp-content/uploads/sites/default/les/publication/258646/doc/slspublic/Wara%20
Victor%20Realistic%20Policy.pdf
36 The Atlantic, Jacobs R, The Forest Maa: How Scammers Steal Millions Through Carbon Markets, 11 October
2013, https://www.theatlantic.com/international/archive/2013/10/the-forest-maa-how-scammers-steal-millions-
through-carbon-markets/280419/;
Euractiv, Crisp J, Leaked paper exposes EU countries’ abuse of climate loophole, 24 March 2017, https://www.
euractiv.com/section/climate-environment/news/leaked-paper-exposes-eu-countries-abuse-of-climate-loophole/
37 The Climate Examiner, UN carbon trading hit by massive fraud, 27 August 2015,
http://theclimateexaminer.ca/2015/08/27/un-carbon-trading-hit-massive-fraud/
38 The Corner House, Lohmann L, “Strange Markets” and the Climate Crisis, 2010,
http://www.thecornerhouse.org.uk/sites/thecornerhouse.org.uk/les/Strange%20Markets.pdf
18 | GREEN FINANCE OBSERVATORY REPORT
Photo: Lumppini, Shutterstock/768499267
C. WILL CARBON
MARKETS SAVE US?
50 SHADES OF GREEN | PART I. CARBON | 19
C. WILL CARBON
MARKETS SAVE US?
While the practical aws of and fraud associated with carbon markets are already widely
known, there is less awareness of the underlying assumptions and conceptual aws of
these markets, which are the focus of this section.
1. DEBATABLE ASSUMPTIONS
A. TRADITIONAL REGULATIONS HAVE FAILED
One of the key implicit assumptions of market-based environmental policies is that
traditional regulations have failed to address environmental issues, and that markets will
succeed where binding regulations have not. Yet such an assumption is incorrect. In the
words of a foundation, ‘
regulations and prohibitions have always provoked resistance
but have also proved highly effective. From the introduction of mandatory seat belts and
catalytic converters to the prohibition of asbestos – regulatory policy can look back at a
history of acceptance and success.
’39 The hole in the ozone layer was also successfully
addressed via a ban on chlorouorocarbon chemicals. The recent ban on single use plastic
bags is another success.
Studies have found that ‘
the prevailing view that command-and-control is inevitably
inefcient or less efcient than alternative “economic instruments” such as efuent taxes
and marketable pollution permits-is inaccurate both as a matter of economic theory and
experience.
’40
In most cases where regulations have been put in place, they have proven highly effective.
Therefore, the issue has not been the lack of effectiveness of regulations but instead a lack
of political will to set up and implement more regulations.
In this respect it is important to realise that political will is a limited quantity that affects
all policy instruments equally: a limited political appetite to regulate pollution would
translate similarly into a carbon market with excess allowances or a regulation mandating
a progressive withdrawal from fossil fuel extraction over an excessively lengthy period
of time. Conversely, strong political will would translate both into a shorter schedule
for withdrawing from fossil fuel extraction or a carbon market with a lower number of
allowances. The assumption that market-based solutions would lead to better results
than binding regulation for a given amount of political will ignores this political reality.
Likewise, the idea that traditional binding regulations are more coercive is incorrect,
as a given amount of political will translates equally across policy tools. Binding regulations
are only more coercive in that they typically offer less loopholes.
39 Heinrich Böll Stiftung, Fatheuer T, New economy of nature, a critical introduction, 2014, https://www.boell.de/sites/
default/les/new-economy-of-nature_kommentierbar.pdf?dimension1=ds_oekonomie_natur_en
40 Cole D, Grossman P, When Is Command-and-Control Efcient? Institutions, Technology, and the Comparative
Efciency of Alternative Regulatory Regimes for Environmental Protection, 1999,
https://www.repository.law.indiana.edu/cgi/viewcontent.cgi?article=1591&context=facpub
20 | GREEN FINANCE OBSERVATORY REPORT
B. THE POLLUTER PAYS PRINCIPLE
First mentioned in 1972, the polluter pays principle (PPP) was later included in the Single
European Union Act of 1987 and in the UN Rio Declaration of 1992. The principle states
that polluters should ‘
bear the cost of pollution, with due regard to the public interest and
without distorting international trade and investment.
’41
According to the European Commission, ‘
the preventive function of the PPP is based
on the assumption that the polluter will reduce pollution as soon as the costs which he
or she has to bear are higher than the benets anticipated from continuing pollution.’ ‘If
environmental costs are not internalized (…) this could lead to distortion of international
trade and investment. Thus, due application of the principle also protects economic
interests.
’42
This denition raises a number of remarks:
i. First, it introduces the non-neutral concept of externality: the Oxford dictionary
denes this as ‘
a consequence of an industrial or commercial activity which
affects other parties without this being reected in market prices.
’ Environmental
degradation and pollution are thus considered as externalities of economic activity
that needs to be internalized.
It is important to note that this framing is not neutral but is instead linked to a
specic value system, utilitarianism, a theory viewing nature as a resource and
service supplier to humans.43 It also reects a neo-classical economic perspective,
that views the environment as a subsystem of the economy and maximising
efciency as the ultimate objective. From this perspective, integrating environmental
externalities into economic decision-making improves efciency and can enhance
economic growth, instead of jeopardizing it. Addressing pollution and environmental
destruction becomes a technical task of getting the price ‘right’.44 As I will explain
later, this framing generates severe limitations.
ii. It also assumes implicitly that polluting is free today. This is an incorrect
assumption as many existing regulations impose nes on pollution, such as water
pollution caused by nitrates.
iii. Individuals are also assumed to act rationally, responding in consistent and
predictable ways to price incentives, an assumption that has been rebuffed by
behavioural economist and Nobel laureate Daniel Kahneman among others.45 It has
41 United Nations, Rio Declaration on Environment and Development, 1992,
http://www.un.org/documents/ga/conf151/aconf15126-1annex1.htm
42 European Commission, workshop, The Polluter Pays Principle,
http://ec.europa.eu/environment/legal/law/pdf/principles/2%20Polluter%20Pays%20Principle_revised.pdf
43 Loreau M, Reconciling utilitarian and non-utilitarian approaches to biodiversity conservation, Ethics in Science and
Environmental Politics, Vol. 14: 27–32, 2014, https://www.int-res.com/articles/esep2014/14/e014p027.pdf
44 Gómez-Baggethun E, Muradian R, In Markets We Trust? Setting the Boundaries of Market-Based Instruments in
Ecosystem Services Governance, Ecological Economics n°117, April 2015,
https://www.researchgate.net/publication/275103765_In_Markets_We_Trust_Setting_the_Boundaries_of_Market-
Based_Instruments_in_Ecosystem_Services_Governance
45 Tversky A, Kahneman D, Rational Choice and the Framing of Decisions, The Journal of Business, Vol. 59, No. 4,
Part 2: The Behavioral Foundations of Economic Theory. (Oct., 1986), pp. S251-S278. http://www.cog.brown.edu/
courses/cg195/pdf_les/fall07/Kahneman&Tversky1986.pdf
50 SHADES OF GREEN | PART I. CARBON | 21
also been shown that ‘
the effect of incentives on behaviour is mixed at best and is
frequently perverse. When people are paid to do something that was previously part
of their social norms–donating blood for example–the amount of the social good
provided can decline (Gnezzy and Rustichini, 2004). The presence of an award (or
penalty) may actually have an opposing (or reinforcing) inuence on what cognitive
psychologists refer to as intrinsic motivation. This calls into question the relative
importance of ‘getting the prices right’ in environmental policy, over potentially more
effective non-price adjustments.
’46
iv. Policy decisions are transformed into cost-benefit analyses: the assumption
is that when the cost of polluting exceeds benets for corporations, pollution will
decline. Corporations assess whether it is more protable for them to curb polluting
or continue and pay the cost of internalising their externalities. Pollution thus
becomes a cost of doing business.
Such a shift is a fundamental change, as calculation of risk and prot opportunities
replace political judgement. It raises an important and legitimate question: on what
basis do we decide that environmental policies should be subject to a cost-benet
analysis, when many other key areas of policy making are not? For example, law
enforcement and defence are not subject to cost-benets analyses; the decision to
create the European Union was also not based on a cost-benet analysis but was
instead a political project.
Interestingly, the US supreme court took the opposite view, ruling that the Clean Air
Act’s standards were absolute, and not subject to cost-benet analysis.47
v. A conceptual shift from responsibility to rights: the framing of emissions in terms
of rights instead of responsibilities is both a conceptual and practical shift. There is
no human right to pollute, whereas there is a human right to live in an environment
free of pollution. As philosopher Michael Sandel wrote ‘
whether pollution is a crime
or a purchasable and tradable permit makes a difference
.’
It is also a new forward-looking way to look at monetary compensation: historically,
monetary compensation has not been paramount: ‘
in most if not all judicial
traditions, monetary compensation may play a role but (..) the issue is not the
economic ‘accuracy’ of the ne (..), but its place in a larger, socially-accepted
process to right a wrong.
’48 Economic valuation risks reducing the importance of
non-monetary aspects, such as public apologies, public recognition of the wrong
and commitment to change future behaviour.
Monetary compensation is also ‘
used in two very different contexts. One context
is retrospective: Courts have to determine what losses or damage individuals or
communities have suffered because of an oil spill or other accident. The Chevron-
Texaco case in Ecuador and the Exxon Valdez case in Alaska are familiar examples.
Even in those cases, compensation is understood to consist of much more than
46 Gowdy J, Erickson J, Ecological economics at a crossroads, Ecological Economics, January 2005,
https://www.uvm.edu/giee/pubpdfs/Gowdy_2005_Ecological_Economics.pdf
47 Mayer J, Dark Money: The Hidden History of the Billionaires Behind the Rise of the Radical Right, 2016.
48 Heinrich Böll Stiftung, Kill J, Economic Valuation and Payment for Environmental Services Recognizing
Nature‘s Value or Pricing Nature‘s Destruction?, September 2015, https://www.boell.de/sites/default/les/e-
paper_151109_e-paper_economicvaluenature_v001.pdf
22 | GREEN FINANCE OBSERVATORY REPORT
a mere transfer of money from one bank account to another, as briey touched
on above. In the other context, compensation becomes part of a forward-looking
project evaluation, in which a decision has to be made whether to allow future
destruction. In many such examples, the people to be compensated reject the idea
of monetary compensation altogether.
’49
C. A NEO-CLASSICAL ECONOMIC FRAMING THAT IGNORES DISTRIBUTION
AND SCALE
Carbon markets are rooted in the neo-classical economic framing that views nature as a
subsystem of the economy, providing resources for economic activity. As neo-classical
economics see the economy as the whole, then the economy can expand without limits.
Neo-classical economics also assumes that natural resources can be replaced by human
labour and technology, and are therefore not concerned by limits to natural resources but
focus instead on the optimal allocation of resources as the ultimate goal and measure of
good.
People are assumed to be insatiable, therefore overall well-being ‘
is increased through the
ever-greater provision of goods and services, as measured by their market value. Thus,
unending economic growth is typically considered an adequate, measurable proxy for the
desirable end.
’50 Efciency and optimum allocation are considered to be objective criteria
of ‘the good’.
Yet it has been argued that ‘
a model that abstracts from the environment and considers
the economy in isolation from it cannot shed any light on the relation of the economy to the
environment.
’51 This is known as the fallacy of misplaced concreteness, the error of treating
a model made to understand one aspect of reality as if it was adequate for understanding
everything.
Ecological economics by contrast views the economy as embedded within an
environmental system, and rejects the assumption that human labour and technology can
replace natural resources. If the economy is the whole, it can expand without limits,
whereas if it is a part, its growth is limited and has an opportunity cost. This view
is supported by the rst and second law of thermodynamics, that state that matter and
energy cannot be created or destroyed, and that we can recycle materials and energy but
never 100%. As economic growth is correlated with energy use, this means that unlimited
growth is not possible.
49 Heinrich Böll Stiftung, Kill J, ibid
50 Daly E, Farley J, Ecological Economics: Principles and Applications, second editionhttps://islandpress.org/books/
ecological-economics-second-edition
51 Daly, Farley, ibid
50 SHADES OF GREEN | PART I. CARBON | 23
Source: Annual global carbon dioxide and gross domestic product growth. Data from the EU
Joint Research Centre and World Bank. Illustration by The Guardian, Dana Nuccitelli; https://www.
theguardian.com/environment/climate-consensus-97-per-cent/2017/oct/30/new-data-gives-hope-for-
meeting-the-paris-climate-targets
This introduces the notions of uneconomic growth and of the optimal scale of the
economy. Growth becomes uneconomic past a certain point when the scale of the
economy relative to the ecosystem is not sustainable. Past this point, additional growth
costs us more than it benets us. However, while growth must end, this does not imply
an end to development: whereas growth is a quantitative increase, development is a
qualitative increase in the quality of goods and services measured as an increase in human
well-being for a given quantity.
Empirical evidence has already shown that the contribution of US GDP growth to increased
welfare since 1947 is weak, and probably non-existent since 1980.52
Discussing the end of growth however implies a need to open the politically fraught
question of distribution, ‘
both for future generations and for current one living in poverty,
as limits to growth removes the promise of a share of a bigger pie as an alternative
to curbing inequalities.
’53 By dismissing the existence of trade-offs between growth,
resources and inequalities, the neo-classical economic framing makes instead the trade-
offs invisible and depoliticizes the political discourse.
As it does not address the issues of scale and distribution, neo-classical economics may
not be well suited to the task at hand of addressing climate change. Even the UN recently
52 Daly, Farley, ibid
53 Daly, Farley, ibid
24 | GREEN FINANCE OBSERVATORY REPORT
challenged the neo-classical economic model in a report it commissioned, arguing that
‘
today’s dominant economic theories, approaches, and models were developed during the
era of energetic and material abundance. These theories were challenged only temporarily
by the oil crises of the 1970s and the 1990s; no signicant theoretical or political changes
were made. Thus, dominant economic theories as well as policy-related economic
modelling rely on the presupposition of continued energetic and material growth. The
theories and models anticipate only incremental changes in the existing economic order.
Hence, they are inadequate for explaining the current turmoil.
’54
D. THE EFFICIENT MARKET ASSUMPTION
The efcient market hypothesis is a theory that states that asset prices fully reect all
available information and it is therefore impossible to consistently ‘beat the market’ on a
risk-adjusted basis.
This theory has been a cornerstone of nancial economics for two generations. It is at the
core of the belief that markets provide the best capital and risk allocation and that market-
based solutions are more efcient than government regulations.
The European Commission relies on it when it states for example that markets ‘
frequently
offer a more effective means of achieving environmental policy objectives than traditional
environmental policy instruments such as direct regulation of polluting activities
’, and that
‘
markets also have another important advantage. Society normally benets most when
resources are allocated to their most productive use — the use that generates the greatest
earnings. Market allocation often furthers this goal because the users generating the
highest returns will bid most for the resource. For these reasons, society will often gain if
resources are allocated through the market.
’55
The assumptions of the theory have been shown not to hold in reality: from asset prices’
random walk; to the rationality of investors; low transaction costs; the existence of
complete markets; and perfect information. A number of Nobel laureates, from James
Tobin56 to Richard H Thaler, Daniel Kahneman and Joseph Stiglitz57 have also shown that
markets are not efcient in the strong or semi strong form.58 It is commonly accepted today
that only the weak form may exist in reality.
54 Järvensivu P & al, Governance of the Economic Transition, Global Sustainable Development Report 2019,
https://bios./bios-governance_of_economic_transition.pdf
55 European Environmental Agency, Towards efcient use of water resources in Europe, 2012,
https://www.eea.europa.eu/publications/towards-efcient-use-of-water
56 Cunningham L, From Random Walks to Chaotic Crashes: The Linear Genealogy of the Efcient Capital Market
Hypothesis, 1994, https://pdfs.semanticscholar.org/b35c/c8503fd493d645d6c2f623fa68acae0c1e70.pdf
57 Grossman S, Stiglitz J, On the Impossibility of Informally Efcient Markets, The American Economic Review 1980,
https://www.jstor.org/stable/1805228?seq=1#page_scan_tab_contents;
The Chicago Maroon, Levterova B, Nobel winner: Efcient market hypothesis powerful, but wrong, 19 Feb 2010,
https://www.chicagomaroon.com/2010/2/19/nobel-winner-efcient-market-hypothesis-powerful-but-wrong/
58 There are 3 forms of efciency: ‘weak’, ‘semi-strong’, and ‘strong’
Weak: prices on traded assets already reect all past publicly available information. Past information does not
enable to predict future prices, prices follow a random walk
Semi strong: prices reect all publicly available information and that prices instantly change to reect new public
information. There is no protable arbitrage and fundamental analysis is useless.
Strong: prices instantly reect even hidden ‘insider’ information. It is therefore not possible to take advantage of
non-public information about an asset to predict its future price. You can’t beat the market.
50 SHADES OF GREEN | PART I. CARBON | 25
Stiglitz also argued that as some government interventions can make all individuals better
off, ‘
not only is there no presumption that competitive markets are efcient, but there
is a presumption that they are inefcient.
’59 He showed, furthermore, that governments
have several marked advantages over markets in risk bearing, as they can avoid adverse
selection problems60 plaguing markets; can mitigate the effects of moral hazard;61 can
engage in intergenerational transfers of risk unlike markets; and are more incentivised to do
a good job as they bear the cost of failure.
2. A HYBRID MARKET ON A PSEUDO-COMMODITY
Carbon markets are vastly different from traditional capital markets in their objectives,
structure, the nature of their underlying assets and their horizon. It is worth highlighting
these differences as they have important consequences on their functioning and
robustness.
A. OBJECTIVES
Cap and trade markets have the dual stated objectives of providing a price signal
that incentivises changes in behaviour and technology, and of minimising the cost of
compliance for polluters.
Incentivising a change in behaviour is a traditional remit of the state, typically via taxes
and binding regulations. No traditional nancial market whether the stock, bond, currency,
commodity, or derivatives markets aims at changing behaviour.
In practice however, the systematic distribution of excess permits over the past fourteen
years indicates that minimizing the cost of compliance has been largely prioritised over
the other objective. The design of the European cap and trade market also fails to foster
changes in technology as it does not distinguish between emission reductions stemming
from technological change or from maintenance improvements.
B. MARKET STRUCTURE
Carbon markets are also different from traditional nancial markets in two major respects:
their underlying assets and their structure.
Carbon markets are markets created by the need to comply with a regulation. Without
regulation requiring polluters to obtain credits to pollute, there would be no demand for the
credits and no market.
59 Stiglitz J, The role of the state in nancial markets, The International Bank for Reconstruction and Development /
World Bank, 1994, http://documents.worldbank.org/curated/en/239281468741290885/pdf/multi-page.pdf
60 When buyers and sellers have different information, for example the seller of a used car knows more about the car
than the buyer, then sellers are not incentivised to disclose any issue, buyers are suspicious of all used cars, and
information asymmetry results in mostly defective cars being traded.
61 Moral hazard describes a situation where someone takes more risk as someone else bears the cost of that risk.
The 2008 nancial crisis is a good example.
26 | GREEN FINANCE OBSERVATORY REPORT
As regulation denes the rules of the market – what is allowed to be traded and when
– and sets the cap on emissions, this is also a market with much more government
intervention than traditional markets. In this respect, carbon markets are a hybrid
instrument between market and binding regulation, where regulation sets the
environmental objective and the trading element only aims at minimizing the cost
of compliance. This hybrid nature means that carbon markets are subject to both high
government interference and what former US Federal Reserve chairman Alan Greenspan
called ‘the irrational exuberance of markets.’
C. NATURE OF THE UNDERLYING ASSETS
The fact that carbon markets have to be created by regulation stems from the nature
of the underlying assets being traded: unlike stocks, bonds, and currencies (before the
abandonment of the gold standard), or commodities, carbon credits have no intrinsic value.
Their value only comes from the requirement to use them to comply with a regulation.
Air pollution is also not a standardised, clearly delineated and readily tradable asset.
Transforming air pollution into a tradable asset requires what is called a commoditisation
process62:
The goal of overcoming fossil fuel dependence is replaced by a goal of limiting
emissions
A large pool of emission reductions is created through regulatory means by
abstracting emissions from place, technology, history, and gas type, making a
liquid market and cost savings possible. ‘
A large class of tradeable reductions is
then constructed by stipulating that a reduction of a certain number of molecules
achieved at one place or time by one technology is climatically ‘the same’ as a
reduction of an equivalent number of molecules of a range of pollutants by another
technology at another place or time.
’63
Additional tradable emission reductions equivalents are created by offset projects
usually taking place in regions not covered by any cap and added to the commodity
pool for additional liquidity.
These tradable assets are then transformed into nancial instruments that can
themselves be traded.
Carbon emissions thus become what is called a pseudo-commodity. This has
important consequences: rst, while the scalability benets of traditional markets have
no drawbacks, in the case of carbon, scalability and market liquidity imply a need to
generate equivalences and simplify to the extreme complex non-linear climate processes,
weakening environmental integrity in the process.
62 Lohman L, Uncertainty Markets and Carbon Markets: Variations on Polanyian Themes, New Political Economy,
http://www.thecornerhouse.org.uk/sites/thecornerhouse.org.uk/les/NPE2high.pdf
It has been argued that carbon credits are not so much commodities but rather a form of rent where users pay for
a right to be allowed to produce, as no process of value creation takes place. In this way it bears some historical
resemblance to the rent that was paid by the industrial Bourgeoisie to the aristocrats owning the land.
See Felli R, On climate rent, 2014, https://www.academia.edu/8762087/On_climate_rent?auto=download
63 Lohman, ibid
50 SHADES OF GREEN | PART I. CARBON | 27
Secondly, as pseudo commodities require regulation to create a market, they are
potentially exposed to much more frequent and potentially disruptive government
interventions than traditional markets: this is known as regulatory risk.
Third, while there is a political decision on the total amount of GHG that can be released,
the distribution of this limit amongst producers does not require an explicit political choice,
and in this way depoliticises the allocation of pollution rights.
D. A MARKET IN COMPLIANCE COSTS, NOT EXTERNALITIES
As discussed earlier, while regulation is responsible for the environmental objective of
the market by setting the cap and determining what can be traded and when, the trading
element merely aims at minimizing the cost of compliance for polluters as it is deemed
welfare enhancing.
Acknowledging that different polluters have different abatement costs – the cost to remove
or reduce pollution, imposing the same cost on all polluters is considered less efcient as
it would impose too high a cost on some and too low on others. Allowing the trading of
carbon credits is thus seen as a way to ensure that companies whose cost is lowest will
reduce pollution rst, thereby minimizing the overall cost of complying with regulation for
all polluters.
What is traded is therefore the cost of compliance with regulation. While minimizing
the cost of compliance is in itself a legitimate objective, it raises interesting questions.
The carbon market is very similar to a driving licence point system: in both cases a
limited allowance is given to act in socially undesirable ways, as it is considered necessary
for the greater good. In the case of carbon, a limited allowance is given to pollute as it is
viewed as necessary for the economy to function; in the case of driving licence points, a
limited allowance is given to ignore trafc regulations and potentially cause accidents as
this is viewed as necessary for uid transportation and public buy-in. Yet, there are two
major differences: driving licence points were introduced as it was recognised that nes
alone were not an effective deterrent against reckless driving; in carbon markets however,
paying a compliance cost is considered sufcient.
Secondly, in the case of carbon, the free trading of carbon credits is allowed as it is
considered more cost effective, whereas it is forbidden for driving licence points. It could
however be argued that allowing the free trading of driving licence points would also be
more cost-effective and therefore welfare enhancing, as different drivers have different
abatement costs.
In other words, do we consider that allowing the free trading of driving licence points
just as we allow the free trading of carbon credits would bring a greater good? Doing
so would mean that compliance with the law is a question of nancial means, as wealthy
drivers would purchase their way out of complying. As importantly, a ipside of the cost
effectiveness would in all likelihood be that more points would be used, more offenses
28 | GREEN FINANCE OBSERVATORY REPORT
committed and more road accidents would occur than under the current situation, as
people with ‘unused points’ would sell them to serious offenders, who would thus be able
to exercise less respect for trafc regulations.
Likewise, the trading of carbon credits means more emissions overall, as companies
with extra quotas sell them to others instead of letting them expire unused. The cost-
effectiveness benets of trading thus weaken the environmental objective. In turn, this
begs the following question: on what basis do we decide that allowing the trading of
compliance with regulation is desirable in some domains and not others?
3. CONCEPTUAL ISSUES, SOME OF WHICH ARE
UNRESOLVABLE
A. DEBATABLE EQUIVALENCES
1. Assuming burning biomass is neutral and failing to distinguish between biotic or
fossil origin of emissions
The EU ETS currently considers that biomass (organic matter from plant or animal) burned
in European installations does not create emissions because the carbon released when
biomass is burned is said to be stored again in the vegetation as it builds up biomass in
regrowth. This assumption has been shown to be untrue.64 A recent study by BirdLife,
the European Environmental Bureau and Transport & Environment found that the annual
smokestack emissions from biomass in the EU ETS are between 90 and 150 million tonnes
of CO2.
Furthermore, carbon offset projects attempt to equate the carbon released from fossil fuels
with the carbon stored in trees, plants and soils, ‘
founded on the mistaken belief that the
release of the former can be negated (or ‘offset’) by increasing (or even simply protecting)
the storage potential of the latter.
’65 Yet, there is a fundamental difference between
capturing carbon in trees and soils where it is stored for a few decades and emissions
from fossil fuels which are permanent. As a prominent NGO put it ‘
if this fundamental
difference between fossil and terrestrial carbon is not recognised, then carbon ‘savings’
from land use change may be used to justify the continued combustion of fossil
fuels, substituting irreversible fossil fuel emissions with temporary terrestrial stores.
The very real possibility that stored carbon will be released again after only a short time
risks not a netting-off of carbon, but an increase of cumulative atmospheric GHG within a
relatively short time frame.
’
64 Euractiv, Calvo Ambel C, Biomass’ ‘zero’ ETS rating burns us all, 19 March 2015,
https://www.euractiv.com/section/energy/opinion/biomass-zero-ets-rating-burns-us-all/
65 FERN, Misleading numbers – the case for separating land and fossil based carbon emissions, January 2014,
https://fern.org/sites/default/les/news-pdf/misleadingnumbers_full%20report.pdf
50 SHADES OF GREEN | PART I. CARBON | 29
In addition, we are unable to accurately measure land use carbon emissions, due
to the very high number of variables and proxies, inconsistencies in denitions and
methodological factors, which lead to uncertainty levels of around 50% in most studies.66
This does not mean that storing carbon in forests and soils is not desirable, but that
doing so should not count against fossil fuel emissions and enable more emissions
from fossil fuel burning.
2. Equivalences between gases are gross oversimplifications
Greenhouse gas equivalences are admitted to be gross oversimplications, as the effects
and lifetimes of different greenhouse gases in different parts of the atmosphere are so
complex and multiple that any straightforward equation is impossible.67 ‘
Each gas behaves
qualitatively differently in the atmosphere and over different time spans, and the control
of each has a different effect on fossil fuel use. Even the IPCC nds itself revising its
calculations of the CO
2
-calibrated Global Warming Potential of various gases every few
years, and insists on giving gases different Global Warming Potentials over 20-year, 100-
year and 500-year time horizons.
’68
As an example, the original carbon dioxide equivalence gure for HFC-23 of 11,700
originally put forward by the IPCC in 1995/1996 was revised in 2007 to 14,800, and the
error band of this estimate is still an enormous plus or minus 5,000.
‘
Problems have arisen in trying to compare the role of the different GHGs by converting
their concentration – accounting for different radiative properties and residence times in
the atmosphere – into a single carbon metric (that is, CO
2
equivalent). Such calculations
risk assuming away the uncertainty involved in measuring, comparing and aggregating, but
seem appealing to those trained on the single pollutant model.
’69
3. Abstraction from time and place of emission cuts
Abstracting from time and place of emission cuts, a necessary condition for the
commoditisation process described earlier, leads to ignoring the different effects that
pollution can have on different ecosystems.
In addition, equating reductions in place A and B also obscures a number of geographically
specic factors that make a difference to energy transitions, such as the fact that reducing
emissions in a high-income country may promote more technology development than
reducing them in a low-income country.
66 FERN, ibid
67 Lohman L, Carbon Trading, Climate Justice and the Production of Ignorance: Ten Examples, September 2008,
https://www.researchgate.net/publication/5219951_Carbon_Trading_Climate_Justice_and_the_Production_of_
Ignorance_Ten_Examples
68 Lohman L, The Endless Algebra of Climate Markets, 28 October 2011,
https://www.tandfonline.com/doi/abs/10.1080/10455752.2011.617507
69 Spash C, The brave new world of carbon trading, New Political Economy vol 15, June 2010,
https://www.clivespash.org/wp-content/uploads/2015/04/2010_Spash_Brave_New_World_NPE1.pdf
30 | GREEN FINANCE OBSERVATORY REPORT
4. Wrong equivalences between technologies
What matters is not only how much emissions are reduced but also how this is done.
Emission cuts resulting from a switch to renewable technologies and away from
fossil fuel dependency is entirely different from emission cuts resulting from routine,
low-cost efficiency improvements. The former is a structural change contributing to the
overall objective and potentially leading to major future cuts, whereas the latter entrenches
existing practices by delaying long-term non-fossil investments. Yet both are treated as
equivalent in carbon markets, undermining the environmental objective.70
‘
Equating CO
2
e reductions that result from different technologies (…) makes it possible,
indeed necessary to make climatically wrong choices in the name of molecule prices.
’71
If long-term structural alternatives are not available, not even the highest prices can
compel anyone to choose them. Yet, by abstracting from time and place and equating
emission cuts from different sources, carbon markets have no built-in incentives to
design these structural alternatives. This strengthens the view that carbon markets are
designed to favour incremental over structural change and questions the idea that they are
reformable.
5. Intergenerational equity, discount factor and inability to handle long term
Addressing climate change is a long-term endeavour affecting not only the current
generation but also all future ones, and carbon markets are thus characterised by very long
horizons and a very high intergenerational dimension not present in traditional nancial
markets.
There are several competing approaches to the intertemporal distribution of resources:
ecological economics views it in terms of obligations to future generations and suggests
that we could assign inalienable resource property rights to future generations. Neo-
classical economics on the other hand argues that as nancial markets can tell us today’s
price of the future value of things, it can address the issue of intergenerational allocation.
Financial markets typically translate the future value of things in today’s euros via a
discount rate. EUR 1 today does not have the same value as EUR 1 a year from now
as it could be invested protably: EUR 1 today will be worth in one year EUR 1 plus the
interest that could be earned by investing it. By the same token, EUR 1 a year from now is
worth today EUR 1 minus the interest. This translation relies on an interest rate called the
discount rate, typically the rate of return of a low risk investment over the relevant period.
Discounting in the context of environmental policies raises several concerns: the mere act
of discounting implies that the future value of resources is less important than their value
70 Lohman L, Uncertainty Markets and Carbon Markets: Variations on Polanyian Themes, New Political Economy.
http://www.thecornerhouse.org.uk/sites/thecornerhouse.org.uk/les/NPE2high.pdf;
Lohman L, Carbon Trading, Climate Justice and the Production of Ignorance: Ten Examples, September 2008,
https://www.researchgate.net/publication/5219951_Carbon_Trading_Climate_Justice_and_the_Production_of_
Ignorance_Ten_Examples
71 Lohman L, The Endless Algebra of Climate Markets, 28 October 2011,
https://www.tandfonline.com/doi/abs/10.1080/10455752.2011.617507
50 SHADES OF GREEN | PART I. CARBON | 31
today, or put differently it discriminates against future generations by considering that they
are less important than the current one.
Discounting also transforms an ethical and political choice about sharing resources
with future generations into a technical debate over the choice of an interest rate. As
it creates an equivalence between today’s pollution and tomorrow’s emission reductions,
discounting also enables the postponement of emission cuts. Discounting also enables
to equate perpetuity with a hundred years or less, as what happens beyond is valued at
near zero; it thus enables to equate permanent environmental degradation with temporary
‘compensation’, when arguably the outcome of an offset should last as long as a project’s
impact.
Mainstream economics provides several justications for the use of a discount rate: rstly,
individuals have a preference for the present, i.e. they prefer to consume today rather than
wait. Secondly, the cost of capital: resources available today could be invested to generate
further benets that would be lost if the resources are used today. The third argument is
an assumption of continued economic growth. According to a project commissioned by
the European Commission ‘
fairness requires per capita income over all generations to
be the same. Thus, if future generations are likely to be richer than we are (measured by
economic growth in consumption (..)), we have a moral right to discount.
’72 They however
acknowledge that ‘
philosophers have long argued that a positive social discount rate
for general well-being is not ethically defensible because it discriminates against future
generations just because they are not present today (Dasgupta, 2007). This philosophical
argument is convincing in terms of general well-being, but one must remember that this
does not consider the potential for economic growth. Thus, one may still believe this
philosophical argument, i.e., that the social rate of time preference is zero, but, given a
(plausible) positive economic growth forecast in consumption, one may still believe in a
positive social discount rate based on ‘fairness’.
’
In other words, discounting is acknowledged to be unethical and discriminatory, but
under an assumption of continued economic growth we would have a moral right
to discount to ensure that future generations are not richer than we are. As the
assumption of unending economic growth is widely acknowledged to be unrealistic,
this justification for discounting is very weak.
The level of the discount rate is also a crucial decision. A positive discount rate means that
what happens tomorrow is less important than what happens today. The higher the rate,
the less the future is valued. As an example, EUR 100 in 50 years is valued today at EUR
60.8 with a discount rate of 1%, but only at EUR 8.7 using a rate of 5%. It has been argued
where a discount rate is used, it should be zero – meaning that future generations have an
equal right to natural resources – or negative, to incentivise the preservation of resources
for future generations and counterbalance our natural preference towards the present.
Beyond discounting, the ability of markets to handle very long-term horizons is
72 REMEDE draft: Toolkit for Performing Resource Equivalency Analysis to Assess and Scale Environmental Damage
in the European Union, July 2008, https://web.archive.org/web/20100602054339/http:/www.envliability.eu:80/docs/
D13MainToolkit_and_Annexes/REMEDE_D13_Toolkit_310708.pdf
32 | GREEN FINANCE OBSERVATORY REPORT
questionable. Financial markets by design incentivise short-termism, as performance
is measured over a one-year horizon and failure to perform within that time frame by a
fund can lead to investors withdrawing their money. In addition, most fund managers
are vulnerable to strong short-term price uctuations, as their mandate forces them to
withdraw from an investment when a temporary decline in its value reaches a specic
threshold, even though they remain condent of the long-term prospects.
There are also severe doubts about the ability of markets to manage and enforce contracts
over very long periods of time, as they typically do not trade beyond 20-30 years.
B. MARKETS ARE UNABLE TO PRICE SCARCITY
There is plenty of empirical evidence of nancial markets’ inability to price scarcity
adequately. Oil is a good example: despite resources growing steadily more scarce, while
new uses for oil have multiplied, the mean price of oil remained relatively stable in real
terms between 1879 and 2002, with the notable exception of the oil embargoes and Middle
East crises of the 1970s. Production surpassed new discoveries in 1982 and consumption
currently exceeds new discoveries by a factor of two to six. In addition, while there are
now more substitutes available, we have created far more technologies that depend on
oil than technologies that substitute oil.73 The price does not appear to reect the scarcity
of the resource in the ground. Prices also appear to fail to signal to producers the need
to develop new substitutes. High prices merely incentivise more effective extraction
technologies
Another major issue is that prices can’t reect future scarcities, as future generations
cannot bid on resources. ‘
It is essentially impossible to accurately price irreproducible
resources unless we assume future generations have no rights whatsoever to natural
resources.
’74
A number of reasons explain this failure. Firstly, rather than being determined by supply
and demand, oil prices are determined to a considerable degree by speculation on
derivatives:75 the exchange of speculative bets on the future price of oil. As an example, oil
prices rose by more than 60% during the rst months of 2008 despite a decline in demand
and an increase in spare production capacity.
While derivatives are traditionally viewed as deepening market liquidity, there is
considerable evidence of the destabilising effect and determining influence of
derivatives on commodity prices, including carbon.76 Put simply, when the proportion
73 Daly E, Farley J, Ecological Economics: Principles and Applications,
https://indomarine.webs.com/documents/Ecological_Economics_Principles_And_Applications.pdf
74 Farley J, The Role of Prices in Conserving Critical Natural Capital, January 2009, Conservation Biology 22(6):1399-
408, https://www.researchgate.net/publication/23657743_The_Role_of_Prices_in_Conserving_Critical_Natural_
Capital
75 Derivatives are nancial contracts whose value is linked to that of an underlying asset. Essentially, they are nancial
bets on anything, from the rise of a particular stock or commodity to the weather next week.
76 Chester L, Rosewarne S, What is the relationship between derivative markets and carbon prices?, https://www.
researchgate.net/publication/228451083_What_is_the_relationship_between_derivative_markets_and_carbon_
prices
50 SHADES OF GREEN | PART I. CARBON | 33
of speculators in a market is high, the price uctuations of nancial bets unrelated to the
supply and demand conditions of a physical commodity end up determining to a large
extent the price of that commodity. In the case of carbon, it has been found that since
2010, derivatives accounted for 99% of trades in the EU ETS.77
The dominance of the information effect over the scarcity effect also explains this
disconnection:78 as we deplete the stock of a resource, we acquire new information by
making new discoveries and developing new technologies. The information effect of new
discoveries and new technologies increases the amount that is accessible and reduces
the costs of extracting it. As long as the information effect is dominant, the price of the
resource will decrease. As the scarcity effect eventually comes to dominate however, this
leads to a sudden rapid increase of the price. Practically this suggests that instead of a
gradual increase, the price of oil will steadily decline before abruptly rising. This contradicts
the idea that market prices consistently reect scarcity and provide a signal to producers
to change technologies.
C. NO PRICE SIGNAL
Market-based solutions are based on the theory of incentives, which states that agents
receive price signals and make decisions accordingly. The existence of a price signal
is indeed at the core of market-based solutions, as prices provide the incentive for
stakeholders to change their behaviour and reduce negative environmental impacts. The
European Commission itself asserted that improving price signals was one of the main
advantages of marked-based instruments as a policy tool.79
However, mathematician and former research director at the Ecole des Ponts ParisTech,
Nicolas Bouleau, recently demonstrated that there is no price signal and there cannot be
one when we need it.80 As price volatility81 reaches a certain level, prices are unable to
transmit any information. Yet the end of natural resources like copper and oil will go
hand in hand with a rise in volatility, meaning that prices will be unable to transmit any
relevant information to corporations and policy-makers.
As he explains it, ‘
there are two types of imperceptible phenomena: very slow evolutions
and the average trend of very irregular variables. The rst one is well-known, e.g. shifts
in tectonic plates. The second one is more insidious, as we can observe changes but are
77 Bertat N, Gautherat E, Gun O, Transactions in the European carbon market: A bubble of compliance in a
whirlpool of speculation, August 2016, Cambridge Journal of Economics, https://www.researchgate.net/
publication/305951143_Transactions_in_the_European_carbon_market_A_bubble_of_compliance_in_a_whirlpool_
of_speculation
78 Daly E, Farley J, Ecological Economics: Principles and Applications,
https://indomarine.webs.com/documents/Ecological_Economics_Principles_And_Applications.pdf
79 European Commission, Green paper on market-based instruments for environment and related policy purposes, 28
March 2007, https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:52007DC0140&from=EN
80 Bouleau N, Le mensonge de la nance, Editions de l’Atelier, 2018,
https://www.amazon.fr/mensonge-nance-math%C3%A9matiques-signal-prix-plan%C3%A8te/product-
reviews/2708245554/ref=dpx_acr_txt?showViewpoints=1
81 Price volatility describes the degree of variation of prices, the higher the volatility, the larger the prices uctuations.
Volatility is measured by calculating the standard deviation of the quoted instantaneous prices over a given period
of time.
34 | GREEN FINANCE OBSERVATORY REPORT
unable to detect a trend. For example, by observing waves come and go for a short
period of time, we are unable to tell whether the tide is rising or falling. Market prices
are variables uctuating irregularly that hide the underlying trends that are nevertheless
the most important information for the future.
’ Volatility is like a fog that conceals the price
signal and its impact has been largely underestimated by economists. ‘
When randomness
goes beyond a certain level, it is impossible by looking at the trajectory to measure
what it would have been without the randomness. In other words, the trend cannot
be seen on what is objectively observable.
’ This can be demonstrated mathematically.
This is a major issue. ‘
Everyone believes that the end of oil and other mineral
resources will lead to a rise in price reflecting their scarcity, and that this scarcity
will divert corporations and consumers from these resources. The rise in uncertainty
will however increase volatility and completely obscure this crucial information by an
increasingly chaotic and disorderly agitation.
’ Derivatives instruments as a hedge are
unable to replace the price signal that disappeared, as in the absence of an observable
trend insurance does protect but does not indicate any direction. ‘
Price uctuations will
look like a punk haircut followed by a collapse.
’
Yet high volatility is an inherent feature and the main characteristic of nancial markets, as
explained by arbitrage theory. The creation of derivatives markets enabling hedging in the
1970s was expected to curb volatility but the opposite happened, and volatility has been
increasing constantly ever since. Volatility stems from speculation, the largest activity of
nancial markets, representing up to 80% of trading in some markets.82
High price volatility linked to speculation had already been agged as a major issue in food
and agricultural markets, contributing to the 2007-2008 food price crisis. Carbon price
volatility is also already extremely high at around 60%,83 and OECD experts expect climate
change to lead to additional volatility in the future.84
82 For example, it has been shown that in 2008 commodity speculators represented 69% of long open interests
in commodity markets, while according to the Food and Agriculture Organisation just 2% of commodity futures
contracts end with delivery of the physical good. Likewise, it is estimated that around 80% of trades in the
currency market are speculative in nature. Testimony of Michael W. Masters, Managing Member / Portfolio
Manager Masters Capital Management, LLC before the Committee on Homeland Security and Governmental
Affairs United States Senate, May 20, 2008, https://www.hsgac.senate.gov/imo/media/doc/052008Masters.pdf;
Transnational Institute, Financialisation: a primer, September 2018, https://www.tni.org/les/publication-
downloads/nancialisation-primer-sept2018-web.pdf;
ESRB, D’Errico M, Roukny T, Compressing over-the-counter markets, working paper 44, May 2017,
https://www.esrb.europa.eu/pub/pdf/wp/esrbwp44.en.pdf;
The Guardian, Andreou A, The rise of money trading has made our economy all mud and no brick, 20 November
2013, https://www.theguardian.com/commentisfree/2013/nov/20/money-trading-economy-foreign-exchange-
markets-economy
83 Barchart, ICE EUA Futures Dec ‘20 implied volatility,
https://www.barchart.com/futures/quotes/CKZ20/volatility-greeks
84 OECD, Price Volatility in Food and Agricultural Markets: Policy Responses, 2 June 2011,
http://www.oecd.org/agriculture/pricevolatilityinfoodandagriculturalmarketspolicyresponses.htm
50 SHADES OF GREEN | PART I. CARBON | 35
To give an indicative visual illustration, the chart below shows the price evolution of an
asset over one year with an upward trend and zero volatility.
The chart below now shows one of the possible price evolutions of the same asset over
the same period with the same trend but with 10% annual volatility. Can you still observe
the upward trend?
The nal chart below shows one of the possible price evolutions of the same asset over the
same period with the same trend but with 63% volatility. If you were asked what trend can
be observed on this chart, what would you say?
Now imagine that you were the CEO of a carmaker company having to decide on your
industrial strategy for the next 15 years. What information could you derive from the
chart? What level of price should you rely on to determine whether it would be nancially
advantageous to refocus your factories and strategy towards the production of electric
cars or not? Should you use EUR 20, EUR 12, EUR 26, or the average?
36 | GREEN FINANCE OBSERVATORY REPORT
According to Nicolas Bouleau, it is illusory to try and control speculation. Recent empirical
evidence from the EU regulatory response to the nancial crisis conrms his assessment.85
Attempts at introducing position limits on speculation were watered down and a regulatory
proposal to separate the speculative activities and retail activities of banks was abandoned
under pressure from the banking lobby.86 The IMF even recently warned about the risks
linked to the failure to reform the nancial system post crisis.87
Introducing a oor and cap on the carbon price would also fail to address the issue
comprehensively: either the corridor would be wide and volatility would remain very high
within it, or it would be narrow and this would essentially transform it into a carbon tax.
More importantly, this would fail to address the issue of imported volatility from oil and
other energy commodities. Put more simply, the strategic decisions of big polluters on
whether to switch or not towards green technologies would still be adversely impacted by
the wild swings in oil prices.
‘
We are entering a phase where volatility will play a growing role (..) The illegibility of prices
today does not enable the world economy to take the right decisions. On the contrary, it
connes decision makers in a universe of meaningless prices, whose short-term variations
no longer reect anything but the mimetic anxiety of traders.
’88
The inexistence of a price signal around the end of a natural resource has major
implications. What it means is that no matter how high the price of carbon, its wild
uctuations prevent corporations from making strategic decisions based upon it. A price
growing gradually from EUR 8 to EUR 15 to EUR 30 would provide decision-makers with
information that they could use to plan ahead for a switch away from fossil fuels and
towards renewable technologies; however, a price changing from EUR 5 to EUR 22 to
EUR 6 to EUR 35 to EUR 10 etc… would paralyse them and prevent any action to curb
emissions meaningfully.
Beyond a certain level, price fluctuations matter more than the actual price level. In
this respect, the recent price increase of carbon towards EUR 20 that was applauded by
elected ofcials fails to address the issue of excess volatility and absence of a price signal,
and it would be therefore incorrect to see it as a sign of success.
In essence, the impossibility of a price signal around the end of natural resources
combined with the unlikelihood of a biting cap, means that carbon markets will never
work and should be abandoned as a policy tool to address climate change, as this issue
is not resolvable. This is sobering news.
85 Finance Watch, Ten Years After: Back to Business as Usual, September 2018,
https://www.nance-watch.org/wp-content/uploads/2018/09/10YA-FW-report.pdf
86 Finance Watch policy brief, Structural reform to refocus banks on the real economy, August 2014,
https://www.nance-watch.org/wp-content/uploads/2014/07/Finance-Watch-Policy-Brief-August-2014.pdf
87 The Guardian, Inman P, World economy at risk of another nancial crash, says IMF, 3 October 2018,
https://www.theguardian.com/business/2018/oct/03/world-economy-at-risk-of-another-nancial-crash-says-imf
88 Bouleau, ibid
50 SHADES OF GREEN | PART I. CARBON | 37
Practically, let us imagine that governments suddenly decide to act more decisively. In the
case of the EU ETS, this would translate into a drastic reduction in the number of permits
and a related rise in the price of carbon permits. This would only incentivise a change of
technology if:
1. There are affordable and scalable renewable technology alternatives, which is now the
case.
2. There is a real biting cap, i.e. the number of permits is signicantly below current
emissions; the use of offset permits in the ETS is fully banned; and the cap
is expected to remain stable or decrease over time irrespective of changes in
government. International competitiveness concerns and the need to generate
demand for the forthcoming offset markets suggest that this is unlikely to happen.
In addition, Brexit, the election of Trump and of Bolsonaro show that betting on
continued political support is a risky proposition.
3. Within the cap, the price of permits is high enough relative to the price of fossil energy
to make fossil fuel extraction and use unprotable: yet this would require a stable
price signal that is not possible due to current and future volatility.
In the case of offset markets, more political will could translate into a ban on offset
projects with the worst and least calculable additionality, strengthening monitoring and
only allowing offset projects to take place in countries with binding targets. Yet, as these
markets have no cap and only rely on a price signal, this means that they would still fail to
incentivise a change of technology.
Incidentally, the absence of a price signal also questions the idea that carbon markets
minimize the cost of the transition for corporations: while at a given instant the trading
of carbon permits does indeed reduce the cost of compliance, the fact that carbon prices
are unable to provide certainty and visibility for the industry is actually very costly for
corporations, as it prevents them from planning ahead and making strategic decisions. The
only scenario under which carbon markets would ultimately prove less costly for polluters
is the one that assumes that polluters will not be required to switch and that the status quo
will continue indenitely.
Agreeing with Nicolas Bouleau, the issue of high volatility also means that a carbon
tax would only be marginally better: while a tax would not be volatile itself, it would
still make the transition conditional upon a cost-benefit analysis for polluters, and
this cost-benefit analysis would be adversely impacted by the high volatility of oil
and other fossil energy prices. The incentive effect provided by an expected gradual
increase in the tax would be muddled by the frequent changes in opportunity cost. When
the price of oil is low, the tax acts as an incentive to switch away from fossil fuels, but
when the price of oil is high, the tax no longer has any incentive effect and is merely a cost
of doing business. As oil prices fluctuate wildly, the incentive effect from the tax keeps
on appearing and disappearing, and corporations find themselves unable to make
any decisions. As oil prices are unable to reect scarcities – as explained above – but are
instead likely to become more and more volatile as the end of the resource approaches,
the incentive effect will become more and more inexistent.
38 | GREEN FINANCE OBSERVATORY REPORT
Crude oil prices over the past 30 years
Source: https://datahub.io/core/oil-prices#resource-wti-daily
The volatility of oil prices also uctuates itself. The crude oil volatility index of the Chicago
Board of Exchange has uctuated between a low of 6% and a high of 98% over the last
year alone.
CBOE crude oil volatility index
Source: http://www.cboe.com/delayedquote/advanced-charts?ticker=OVX
50 SHADES OF GREEN | PART I. CARBON | 39
This questions the appropriateness of price-based mechanisms to address climate
change and suggests instead the need for traditional binding regulations that are
not affected by these issues: a mandatory scheduled withdrawal from extracting fossil
fuels over the next decade(s) would indeed provide far more certainty and visibility to
corporations and decision-makers and thus clearly incentivise a technological change
towards renewable energies. The increased visibility would also enable industries to
prepare and thus curb their costs. In addition, it would provide the necessary time to
retrain workforces. Green taxation would prove a very useful complement to ensure a
fair sharing of the cost of transition and to prevent the imposition of excessive costs on
categories of citizens that have no alternatives.
D. CONCEPTUAL ISSUES LINKED TO OFFSETS
Offset markets create a number of specic additional issues, some of which cannot be
resolved:
Offsets remove the ‘cap’ in cap and trade:
Allowing the trading in the EU cap and trade system of carbon offset credits that can
be created without limit means that the real cap becomes the ofcial cap plus the
proportion of offset credits that are allowed in the EU ETS. This further aggravates
the issue of excess allowances and practically removes the scale element of the
scheme. While CDM offset credits have been banned from the EU ETS from 2021
onwards, it is very likely that offset credits from its successor the Sustainable
Development Mechanism will be allowed.
Offset markets assume no residual impact of offsets:
As offset markets have no cap, they implicitly assume that offset projects perfectly
compensate for fossil fuel emissions taking place at different places and times. Yet
as we have seen this is not the case. This unmonitored and wilfully ignored residual
impact is a serious aw.
Emissions are not reduced, but at best displaced and responsibility shifted:
A common misconception is that offsets reduce emissions. Offsetting is at best
a zero-sum game and by design does not reduce emissions: done properly it
merely compensates for emissions growth by a reduction elsewhere. If it lacks
environmental integrity (i.e. does not represent real emission reductions) it leads to
an overall increase of emissions.89
Offsets exchange certain losses for uncertain gains: at best they displace
emissions, at worst they increase them. In no scenario are emissions reduced, despite
the misleading name of UN offset credits called Certied Emissions Reductions.
In addition, offsets allow companies and governments in developed countries
that have a historical responsibility to clean up the atmosphere, to buy credits from
projects undertaken in developing countries. In so doing, offsetting provides a
means to delay domestic action in industrialised countries and entrenches the status
quo instead of promoting transition.90
89 Carbon Market Watch, The CORSIA: ICAO’s market based measure and implications for Europe, October 2016,
http://carbonmarketwatch.org/wp-content/uploads/2016/10/Post-Assembly-Policy-Brief-Web-1.pdf
90 Carbon Trade Watch, Carbon offsets, http://www.carbontradewatch.org/issues/carbon-offsets.html
40 | GREEN FINANCE OBSERVATORY REPORT
Additionality is not calculable (not resolvable):
One of the crucial and unresolvable issues of offsets is that the impact of offset
projects is not calculable. Calculating it would require being able to determine with
reasonable certainty a hypothetical world without the project and then assign a
single number to the greenhouse gas emissions associated with that world over
the next 100 years – the approximate residence time of carbon dioxide in the
atmosphere. To put in perspective the staggering level of uncertainty involved, ‘
if you
can imagine Marconi and the Wright brothers getting together to discuss whether
in 2009, EasyJet and the internet would be facilitating each other through internet
booking, that’s the level of … certainty you’d have to have over that period. You
cannot have that.
’91
The United States General Accounting Ofce stated in its assessment of the
Kyoto CDM program that ‘
it is impossible to know with certainty whether any
given project is additional.’
92 In the words of a journalist ‘
offsets are an imaginary
commodity created by deducting what you hope happens from what you guess
would have happened.
’93
More recently, a San Diego court rejected for the third time a climate action plan
relying on carbon offsets, ruling that using carbon credits, or offsets from around the
world, was not acceptable, calling the mitigation unveriable.94
A devastating social impact:
Many carbon offset projects have been documented to result in land use and land
ownership conicts, land grabs and human rights violations against indigenous
communities.95 Documented issues include a private company blocking access to
land vital for the livelihoods of local communities in Uganda in order to claim credits
for planting forests, and hydroelectricity projects exacerbating land rights conicts
and damaging biodiversity in Chile and Guatemala.
In addition, ‘
one of the more tragic ironies of the Kyoto Protocol is that “carbon
sinks” (forests, oceans, etc.) can only qualify for emission credits if they are managed
by those with ofcial status. This means that an old-growth rainforest inhabited for
91 Lohman L, Uncertainty Markets and Carbon Markets: Variations on Polanyian Themes, New Political Economy,
http://www.thecornerhouse.org.uk/sites/thecornerhouse.org.uk/les/NPE2high.pdf
92 United States General Accounting Ofce, ‘International Climate Change Programs: Lessons Learned from the
European Union’s Emissions Trading Scheme and the Kyoto Protocol’s Clean Development Mechanism’, GAO
Report GAO-09-151 (November 2008), p. 39, https://www.gao.gov/new.items/d09151.pdf
93 The Guardian, Davis N, The inconvenient truth about the carbon offset industry, 16 June 2007,
https://www.theguardian.com/environment/2007/jun/16/climatechange.climatechange
94 KPBS, Anderson E, Court Rejects San Diego County’s Climate Action Plan Again, 26 December 2018,
https://www.kpbs.org/news/2018/dec/26/court-rejects-san-diego-countys-climate-action-pla/
95 Carbon Market Watch, The Clean Development Mechanism: Local Impacts of a Global System, 29 October 2018,
https://carbonmarketwatch.org/publications/the-clean-development-mechanism-local-impacts-of-a-global-
system/;
Bachram H, Climate Fraud and Carbon Colonialism: The New Trade in Greenhouse Gases, Capitalism, Nature,
Socialism Vol 15, December 2004, http://www.carbontradewatch.org/pubs/cns.pdf;
Carbon Market Watch, Open letter to ICAO council representatives & national delegates on ending the Clean
Development Mechanism, 29 October 2018, https://carbonmarketwatch.org/publications/open-letter-to-icao-
council-representatives-national-delegates-on-ending-the-clean-development-mechanism/;
Friends of the Earth, New report on human rights violations linked to REDD in Acre, Brazil, 8 December 2014,
https://foe.org/news/2014-12-new-report-on-human-rights-violations-linked-to-redd/ ;
The Oakland Institute, Carbon Colonialism: Failure of Green Resources’ Carbon Offset Project in Uganda, 2017,
https://www.oaklandinstitute.org/carbon-colonialism-failure-green-resources-carbon-offset-project-uganda;
Motherboard, Ahmed N, Carbon Colonialism: How the Fight Against Climate Change Is Displacing Africans, 1
December 2014, https://motherboard.vice.com/en_us/article/kbzn9w/carbon-colonialism-the-new-scramble-for-
africa
50 SHADES OF GREEN | PART I. CARBON | 41
thousands of years by indigenous peoples does not qualify under Kyoto rules as
“managed,” and cannot get credits. However, a monoculture plantation run by the
state or a registered private company does qualify.
’96
The nancialisation of carbon offset projects via securitisation further disempowers
local communities, just as the securitisation of subprime mortgages did to mortgage
borrowers prior to the nancial crisis: as the future cash ows from carbon offset
projects are repackaged and sold to international investors, local communities are left
with even less ability to negotiate with decision-makers, as ownership of the project
has been transferred and split amongst a myriad of foreign investors.
4. FINANCIAL STABILITY RISKS LINKED TO THE POLICY
RESPONSE TO CLIMATE CHANGE
In his famous speech ‘Breaking the tragedy of the horizon’,97 Bank of England governor Marc
Carney highlighted three risks for nancial stability stemming from climate change: physical
risks (damage to property affecting the value of nancial assets); liability risks (people
seeking compensation affecting the prots of reinsurers and polluters); and transition risks
(reassessment of the value of nancial assets linked to a shift to a low carbon economy).
This assessment is correct: furthermore, the current policy response to climate change
and its most prominent tool – carbon markets – also carry significant potential
financial stability risks that need to be looked into.
These risks have not materialised so far due to the limited size and lack of real functioning
of carbon markets for now. However, the recent spike in carbon prices following the review
of the EU ETS has reawakened the interest of banks and hedge funds, with trading volumes
spiking 45% in 201898 and carbon being called the City’s hottest trade this year.99 In addition,
a number of factors will in all likelihood lead to a complete change of scale over the coming
years: from increased political pressure to act following more frequent natural catastrophes;
to the newly nalised carbon offset market emerging from the COP25; the new aviation
carbon offset market CORSIA; the ambitious sustainable nance agenda integrating carbon
capture and storage into mainstream nance; and China’s new carbon market.
As these markets grow, the aforementioned risks should be given due consideration and
integrated into environmental policy-making and nancial regulation.
96 Bachram H, Climate Fraud and Carbon Colonialism: The New Trade in Greenhouse Gases, Capitalism, Nature,
Socialism Vol 15, December 2004http://www.carbontradewatch.org/pubs/cns.pdf;
Carbon Trade Watch, Protecting carbon to destroy forests: Land enclosures and REDD+, April 2013, http://www.
carbontradewatch.org/publications/protecting-carbon-to-destroy-forests-land-enclosures-and-redd.html
97 Carney M, Breaking the tragedy of the horizon – climate change and nancial stability, speech at Lloyd’s of
London, London, 29 September 2015, https://www.bis.org/review/r151009a.pdf; Financial Times, Banks should
recognise the risks of climate change, 18 December 2018, https://www.ft.com/content/0f530242-02c1-11e9-9d01-
cd4d49afbbe3
98 Carbon Pulse, Global CO2 trading volume spikes 45% in 2018, value soars 250% amid reforms -analysts, 15
January 2019, http://carbon-pulse.com/67069/
99 Financial Times, Sheppard D, Hedge funds and Wall St banks cash in on carbon market’s revival, 7 September
2018, https://www.ft.com/content/6e60b6ec-b10b-11e8-99ca-68cf89602132;
The Telegraph, Evans-Pritchard A, Soaring carbon prices turn Europe’s energy landscape upside down, 27 August
2018, https://www.telegraph.co.uk/business/2018/08/27/soaring-carbon-prices-turn-europes-energy-landscape-
upside/?WT.mc_id=tmgliveapp_iosshare_ArLV4BmcTJ6M
42 | GREEN FINANCE OBSERVATORY REPORT
A. HIGH SCIENTIFIC AND REGULATORY UNCERTAINTY COMBINED WITH LOW
ENVIRONMENTAL INTEGRITY AND OVERSIMPLIFICATIONS CREATE A HIGHER
RISK OF MARKET FAILURE AND BRUTAL LOSS OF INVESTOR CONFIDENCE
Climate systems are characterized by non-linear complex relationships, threshold effects
and feedback loops, some of which are still being discovered.100
Our knowledge of climate systems is also incomplete: we are currently incapable of even
accounting for carbon dioxide ows, the most basic piece of the puzzle. How much
carbon is being absorbed by oceans or terrestrial ecosystems? How will it affect these
ecosystems? Several studies have found that accounting for greenhouse-gas emissions
reductions is quite impossible.101 There are still ongoing debates among scientists to nd
out where some missing emissions have gone; there are also still large margins of error and
questions over whether some parts of the carbon cycle are net sources or sinks.102
The incredible magnitude of the uncertainties that are involved in climate-change analysis
presents a major challenge for carbon markets. Here it is important to distinguish between
different types of uncertainty: risk, uncertainty, and ignorance. ‘
When I throw a dice, I
cannot say in advance what the outcome will be, but I do know the possible outcomes and
their probabilities. This type of uncertainty is referred to as risk. Pure uncertainty occurs
when we know the possible outcomes, but cannot assign meaningful probabilities to them.
Ignorance or absolute uncertainty occurs when we do not even know the range of possible
outcomes.
’103
While nancial markets are designed to handle risk, they are not able to handle uncertainty
and ignorance. In fact, according to the BIS,104 ‘
the main problem with the prevailing
economic paradigm is that there is no well-developed process, in either the corporate or
the public sector, that recognizes and deals with market uncertainty. (..) As a consequence,
the nancial system is liable to the build-up of unrecognized and unmanaged market
uncertainty in good times and can suddenly fall apart leaving the stakeholders of the socio-
economic system guessing ‘what went wrong?’ (..) The prevailing paradigm’s view is that
because the “unknown information set” is not identiable, market uncertainty does not
matter, and even if it does matter nothing can be done about it.’ Yet ‘from the perspective
of market instability, the most important factor is the degree of market uncertainty.’ ‘Assets
with a higher degree of market uncertainty are more liable to sudden and unexpected
shocks.’ ‘The dot.com boom as well as the recent nancial crisis serve as good examples
of market mispricing due to limited or diminishing knowledge.
’
100 Steffen et al, Trajectories of the Earth System in the Anthropocene, Proceedings of the National Academy of
Sciences of the United States of America, 14 August 2018, http://www.pnas.org/content/pnas/115/33/8252.full.
pdf
101 Lohmann 2005, 2010 and 2011; MacKenzie 2009; Spash 2010, mentioned in Felli R, On climate rent,
https://www.academia.edu/8762087/On_climate_rent?auto=download
102 Spash C, The brave new world of carbon trading, New Political Economy vol 15, June 2010,
https://www.clivespash.org/wp-content/uploads/2015/04/2010_Spash_Brave_New_World_NPE1.pdf
103 Daly E, Farley J, Ecological Economics: Principles and Applications,
https://indomarine.webs.com/documents/Ecological_Economics_Principles_And_Applications.pdf
104 Slovik P, Market uncertainty and market instability, IFC Bulletin No 34,
https://www.bis.org/ifc/events/5ifcconf/slovik.pdf
50 SHADES OF GREEN | PART I. CARBON | 43
No probabilities can be attached to the many unknowns, indeterminacies, unknowables
and positive feedbacks of the climate system.
This high uncertainty means that carbon markets are even less efcient than traditional
markets as the validity of prices is inversely proportional to the level of uncertainty. This
contradicts the claims that market-based solutions are the most efcient policy instrument
for climate change mitigation.
The very high scientific uncertainty about climate systems and their response to
climate change combined with the higher regulatory uncertainty of hybrid markets
also means a much higher risk of unforeseen shocks and market failures in carbon
markets than in traditional financial markets. Both the price of carbon permits and the
rules and regulations governing carbon markets (number of allowances, equivalences etc.)
are vulnerable to abrupt changes following climate shocks, new scientic discoveries and
changes in public opinion.
The lack of environmental integrity of carbon markets compounds this risk, heightening
in turn the risk of a brutal loss of condence from investors in these markets. While
uncertainty is an inherent feature of climate systems, carbon markets compound the issue
by requiring gross oversimplications that weaken environmental integrity in order to
increase market liquidity.
The higher regulatory uncertainty is a consequence of the hybrid nature of carbon markets,
that is, the fact that they are created by regulations that need to be reviewed on a regular
basis and are subject to the inuence of political changes or changes in public opinion.
This higher regulatory uncertainty is also necessary to integrate into market rules new
scientic discoveries about climate change. In practice however, this means that carbon
markets are much more exposed to potential abrupt changes of rules and political
interference than traditional markets.
B. COMPLEXITY, ASYMMETRY OF INFORMATION AND SECURITISATION
COMPOUND THESE RISKS BY FAVOURING ADVERSE SELECTION AND THE
SUBCONTRACTING OF DUE DILIGENCE
The difculty to asset additionality in offset projects and the asymmetry of information
between project developers and investors also means a higher risk of adverse selection
and a likely transfer of due diligence to third parties, as happened with subprime mortgage
securitisation,105 increasing the risk of an indiscriminate re sale in the event of a downturn.
As investors nd themselves unable to calculate additionality and distinguish adequately
between good and bad offset projects, they are implicitly incentivised to arbitrage the rules
instead and favour the cheapest-to-deliver projects. Yet, as the subprime mortgage market
showed, it is unhealthy to have a separation between those who understand the risk and
those who take the risk.
105 Instead of themselves assessing the quality and risk of the large number of mortgage loans involved in pre-crisis
securitisations, investors often relied on the opinion of rating agencies
44 | GREEN FINANCE OBSERVATORY REPORT
The securitisation106 of carbon offset projects, by bundling together a very large number of
projects of mixed types and origins using complex nancial structures, magnies the risks
of adverse selection, disincentivises due diligence and fosters subprime carbon.
Subprime carbon107 refers to contracts or projects that carry a high risk of not being
fullled and may collapse in value. These may come from projects using controversial
methodologies to verify emissions reductions, or projects where additionality is nearly
impossible to calculate. Subprime carbon is comparable to subprime loans or junk bonds,
which are debts that have a high risk of not being repaid. As hundreds of projects at
various stages of regulatory approval are pooled together, it could be extremely difcult
to assess the quality of the underlying projects. As a result, the rating downgrade or
unexpected price decline of one securitisation may spark undue panic among investors.
A 2010 report from the French Ministry of the Economy108 already highlighted that the
development of collateralised debt obligations (CDOs)109 on carbon offset projects ‘
can
create risk valuation issues and, should their importance grow signicantly, involve a risk
of destabilisation of the related market. In the case of CO
2
, this risk appears in addition
increased by the short maturity of the underlying market that may intensify valuation
issues.
’ The report emphasized that carbon CDOs appear more risky than traditional CDOs
due to the lack of historical data available to measure accurately the probability of project
failure and risk correlations.
C. CARBON AS AN ASSET CLASS WOULD CREATE A HIGH RISK OF A BUBBLE
AND CONTAGION TO OTHER ASSET CLASSES, AS SHOWN BY LESSONS
FROM COMMODITY DERIVATIVES. THESE CONTAGION CHANNELS WOULD
TRANSMIT THE HIGH UNCERTAINTY OF CARBON MARKETS TO OTHER
MARKETS AND THE WIDER ECONOMY.
In the early 2000s a number of institutional investors who had suffered as a result of the
declining equity market of 2000-2002 began to look at commodity markets as a potential
new asset class. Commodities looked attractive as they had been historically uncorrelated
to other asset classes, and as the 2000 Commodity Futures Modernization Act (CFMA)
had just deregulated commodity markets. As a result, nancial investment in commodity
futures has increased 10 times since 2000 and has almost doubled since 2006,110 while the
proportion of speculators rose from 20% to 50%.111
106 Securitisation is the activity of repackaging and selling to investors a pool of nancial assets such as mortgage
loans
107 Friends of the Earth, Subprime Carbon? Re-thinking the world’s largest new derivatives market, March 2009,
http://www.reimaginerpe.org/les/SubprimeCarbonReport_0.pdf
108 La régulation des marchés du CO2 - Rapport de la mission conée à Michel PRADA, April 2010,
http://www.ladocumentationfrancaise.fr/rapports-publics/104000201/
109 Collateralised Debt Obligations are a particular type of securitisation
110 Spratt S, Food price volatility and nancial speculation, Future-Agricultures working paper, January 2013,
https://pdfs.semanticscholar.org/3af2/d8cf9fdc5a15131e1002757a1428d950de49.pdf
111 Better Markets, Frenk D, Review of Irwin and Sanders 2010 OECD Reports Speculation and Financial Fund
Activity and The Impact of Index and Swap Funds on Commodity Futures Markets, 30 June 2010, https://www.
newconstructs.com/wp-content/uploads/2010/10/FrenkPaperReutingOECDStudy_IrwinAndSanders.pdf
50 SHADES OF GREEN | PART I. CARBON | 45
This nancialisation of commodity markets in the mid-2000s had several major
consequences. A report by UNCTAD, the UN body in charge of trade and investment,
found that it changed fundamentally the behaviour of commodity prices, leading to price
distortions, herding effects and increasing volatility.112
As prices from derivatives contracts became the benchmark for the prices of actual
physical commodities, the demand from institutional investors drove higher the price
of essential goods. The steady injection from 2003 to mid-2008 and then rapid
withdrawal (later 2008) of speculative money in commodity derivatives markets has
been found to be behind the inflation and then sudden bursting of the food price
bubble and related food crisis. 113
The level of volatility witnessed in commodity prices through 2008 was unprecedented
throughout history, and completely unheard of before the tidal wave of speculative money
that followed the passage of the CFMA.114
As importantly, UNCTAD reported on how this higher volatility came from a different type of
speculation called index trading. As commodities began to be perceived as an asset class,
a new category of participants arrived: index speculators, who were markedly different
from traditional speculators. Index speculators replicate passively the price movements
of an index based on a basket of commodities at whatever price is necessary. Their
insensitivity to prices however has been found to multiply their impact on commodities
markets, driving prices up and down with no linkage to economic fundamentals and
amplifying market uctuations: ‘
one particularly troubling aspect of index speculator
demand is that it actually increases the more prices increase. This explains the
accelerating rate at which commodity futures prices (and actual commodity prices) are
increasing. Rising prices attract more index speculators, whose tendency is to increase
their allocation as prices rise. So their prot-motivated demand for futures is the inverse of
what you would expect from price-sensitive consumer behaviour’.
”115
Last but not least, the increased participation of nancial investors has been shown to
greatly increase the risk of contagion to other markets. As index speculators take
positions in commodities as an entire group and not according to the supply and demand
of specic physical markets, prices are disconnected from fundamentals and tied more
closely to the movements of stocks and bonds.116 Recent research found that in the
presence of institutional investors, shocks to any index commodity spill over to all storable
112 UNCTAD, Price formation in nancialized commodity markets, June 2011,
https://unctad.org/en/docs/gds20111_en.pdf
113 Finance Watch, Investing not betting, April 2012,
https://www.nance-watch.org/publication/mid-ii-position-paper-investing-not-betting/
114 Better Markets, ibid
115 Testimony of Michael W. Masters Managing Member / Portfolio ManagerMasters Capital Management, LLC before
the Committee on Homeland Security and Governmental Affairs United States Senate May 20, 2008,
https://www.hsgac.senate.gov/imo/media/doc/052008Masters.pdf
116 Silvennoinen A, Thorp S, Financialization, crisis and commodity correlation dynamics, Journal of International
Financial Markets, Institutions and Money, 2013, vol. 24, issue C, 42-65, https://econpapers.repec.org/article/
eeeintn/v_3a24_3ay_3a2013_3ai_3ac_3ap_3a42-65.htm; BIS, Lombardi M, Ravazzolo F, On the correlation
between commodity and equity returns: implications for portfolio allocation, July 2013, https://www.bis.org/
publ/work420.pdf; Transnational Institute, Financialisation: a primer, September 2018, https://www.tni.org/en/
publication/nancialisation-a-primer
46 | GREEN FINANCE OBSERVATORY REPORT
commodity prices.117 Increased cross-market correlations between equity and commodity
and between currency and commodity have also been evidenced.118
The transformation of carbon into an asset class and its inclusion in commodity
indices be would likely to result in the same consequences: higher volatility, carbon
bubbles, and a high contagion risk to other markets.
The inclusion of carbon permits in commodity indices and the creation of new sustainable
indices would be likely to result in a greater market participation by index investors and
lead to a similar increase in carbon price volatility, further obscuring the price signal. The
bundling of carbon contracts with agricultural and non-agricultural contracts in commodity
index funds would also let carbon volatility inuence the price of food commodities.119
Likewise, a large and rapid inux of investor funds could create a speculative bubble with
too much money chasing too few viable investments, and threaten nancial stability. As
carbon markets are already characterised by very high levels of uncertainty complicating
the price discovery mechanism, the potential for bubbles and crashes seems even higher
than with other commodities.
US hedge fund manager Michael Masters warned that speculators will end up controlling
carbon markets, triggering the same boom-and-bust cycles that have affected other
commodities.120
Carbon as an asset class would create contagion channels to other assets:
Portfolio management techniques, whereby a trader facing losses on one of his
investments closes other, unrelated positions to lock in some prots that compensate
his losses, have been shown to transmit shocks to other, economically unrelated
assets.121
The inclusion of carbon in commodity indices would be likely to create contagion
channels to other commodities and asset classes, as discussed earlier.
More broadly, the mere fact of viewing carbon as an asset class is also likely to
increase price correlations with other asset classes, as happened with commodity
prices. This is explained by the fact that all asset classes are looked at from the prism
117 Basak S, Pavlova A, A Model of Financialization of Commodities, 10 June 2015,
http://faculty.london.edu/apavlova/Commodities.pdf
118 Basak S, Pavlova A, A Model of Financialization of Commodities, 10 June 2015, http://faculty.london.edu/apavlova/
Commodities.pdf; UNCTAD, Price formation in nancialized commodity markets, June 2011, https://unctad.org/en/
docs/gds20111_en.pdf
119 Institute for Agriculture & Trade Policy, Suppan S, Lilliston B, Speculating on Carbon: The Next Toxic Asset, 24
December 2009, https://www.iatp.org/documents/speculating-carbon-next-toxic-asset
120 Bloomberg, Kassenaar L, Carbon Capitalists Warming to Climate Market Using Derivatives, 4 December 2009,
http://www.bloomberg.com/news/articles/2009-12-04/carbon-capitalists-warming-to-climate-market-using-
derivatives
121 Broner F, Gaston Gelos R, Testing the portfolio channel of contagion: the role of risk aversion, October 2003,
https://pdfs.semanticscholar.org/30ce/02acbf895c4944ce6e1fc97dea49756964c3.pdf
50 SHADES OF GREEN | PART I. CARBON | 47
of investor risk appetite122 and relative-risk adjusted returns for portfolio allocation
purposes. As a result, all asset classes are affected to some degree by investors’
reactions to the same external shocks, whether US–China trade disputes, Brexit or
others, for example. As JP Morgan research put it, ‘
in times of high macro uncertainty,
the prices of equities, risky bonds, oil, gold, and emerging market currencies are largely
driven by changes in the macroeconomic outlook
.’123
These contagion channels would in turn transmit the high uncertainty and risk of
market failure of carbon markets to other asset classes and the wider economy.
Command and control policies on the contrary would not build a direct connection
between environmental shocks and financial markets and the economy. In this respect
they appear more suited to the European Commission objective of strengthening nancial
stability by incorporating risks stemming from climate change into investment decision-
making.
There is however a major difference between carbon and agricultural commodities.
In theory an inux of new passive investors could be expected to generate a quick rise
in the price of carbon as happened with the price of agricultural commodities. Yet, the
ability to create unlimited offsets combined with the implicit political cap on the price
trajectory of carbon makes it very unlikely that the influx of institutional investors
will lead to a significant rise in the carbon price. As a rapid rise in the price of carbon
could be painful for utilities, airlines, and manufacturers, ‘
it is believed that there are
political limits on how high prices can go
.’124 Several fund managers have been quoted as
saying that ‘
they did not expect a political backlash unless the credits approached €50 a
tonne
.’125 This already happened in Southern California in 2000: as electricity generators
had to rely more on old gas-red plants for electricity production, the price of NOx permits
skyrocketed; as a response the State decided to remove electricity generators from the
trading scheme.126
This implicit political cap could take several forms, and is already enshrined in the Market
Stability Reserve, that foresees that 100 million allowances would be released in case of a
strong rise in the price of EU emission allowances. What that means in practice is that the
only environmental benefit that could be expected from transforming carbon into an
asset class, namely a big rise in the price of carbon, is very unlikely to materialize.
122 Risk appetite is the level of risk that an investor is prepared to accept in pursuit of his objectives. The Chicago
Board Options Exchange Volatility Index (VIX) is commonly treated as a quick and easy proxy for risk appetite,
because it is derived from S&P 500 options, which investors buy and sell to change the amount of risk to which
they are exposed Financial System Review, Illing M, Aaron M, A Brief Survey of Risk-Appetite Indexes,
https://www.bankofcanada.ca/wp-content/uploads/2012/01/fsr-0605-illing.pdf
123 JP Morgan, Global Equity Derivatives & Delta One Strategy, Rise of Cross-Asset Correlations, 16 May 2011,
https://pdfs.semanticscholar.org/15d0/3022164c5038d44378147a2c0cf668a4daa1.pdf
124 The Telegraph, Evans-Pritchard A, Soaring carbon prices turn Europe’s energy landscape upside down, 27 August
2018, https://www.telegraph.co.uk/business/2018/08/27/soaring-carbon-prices-turn-europes-energy-landscape-
upside/?WT.mc_id=tmgliveapp_iosshare_ArLV4BmcTJ6M
125 Financial Times, Sheppard D, Hedge funds and Wall St banks cash in on carbon market’s revival, 7 September
2018, https://www.ft.com/content/6e60b6ec-b10b-11e8-99ca-68cf89602132
126 Climate Justice Alliance, Carbon pricing, a critical perspective for community resistance,
https://www.arb.ca.gov/lists/com-attach/247-scopingplan2030-BjRBZFU7jUV0FAc2z.pdf
48 | GREEN FINANCE OBSERVATORY REPORT
D. HYBRID MARKETS MAKE BEHAVIOUR PREDICTABLE AT CERTAIN POINTS,
LEADING TO A HIGHER RISK OF MARKET MANIPULATION
Prudential rules generate arbitrage opportunities as the behaviour of a number of
participants is constrained and therefore predictable in the vicinity of the application
thresholds of the rules. As carbon markets are subject to more rules than traditional
markets, this risk is higher.
Using predictable behaviour to gain an edge and make easy prots is a common
occurrence in traditional markets. For example, in currency markets, when aware of
another bank’s large position in a currency pair – a large option barrier or large option
expiry close to the current spot price – traders will typically try to ‘push’ the market in order
to take advantage of this information, as hitting the barrier, for example, means that the
spot price will accelerate in a predictable direction. Likewise, knowing, for example, that a
certain utility has a signicant shortage of carbon permits close to the end of the reporting
period means that they will have to buy and the price is likely to increase.
Appropriate regulation is necessary to prevent market manipulation and insider trading
in carbon markets: the ability to inuence outcomes and trade on it at the same time, as
in the case of a large offset developer trading carbon credits must be strictly regulated,
just as a company must follow strict rules on the trading of its own stock around key
announcements.
On a related topic, the recent scandal of coco bonds sold to Spanish retail investors127
shows the need to ensure that inappropriate regulatory risk is not repackaged and
transferred to retail investors. As carbon becomes an asset class, banks are likely to be
very creative in transferring regulatory risk and there is a signicant risk of mis-selling. As
an example, being exposed to the risk of carbon credits not being approved by the UN,
or the risk of being left with partial ownership of the land of a failed restoration project
in a faraway country, or having your return conditional upon a utility company hitting
its emission target, are not suitable risks for non-professional investors. Environmental
performance bonds where the issuer pays an extra return if it fails to meet its
environmental target is also not a risk that a retail investor can reasonably be expected to
assess. While carbon scams targeting retail investors already exist,128 inappropriate transfer
of risk is different and investor protection regulation should make sure it keeps pace with
forthcoming innovations.
127 Spanish retail investors were sold bonds that would automatically convert into equity when the issuing bank’s
regulatory capital reached a certain threshold. As the conversion would occur when the bank’s solvency was
fragile, it would be likely to translate into losses for the investor. It has been recognised that non-professional
investors cannot be reasonably expected to assess the likelihood of a bank’s capital falling below a certain
threshold. Financial Times, Gallo A, Regulators must act on coco bond risks, 7 May 2014,
https://www.ft.com/content/dbef9b1a-cede-11e3-8e62-00144feabdc0
128 REDD monitor, Lang C, A cautionary tale about carbon credits, involving Eco Business Management, Eco Asian
Consulting, SJL Risk and Abacus Advisory. Oh, and Montague Pitman, Carbon Neutral Investments, MH Carbon
and Eco-Synergies, 16 October 2014, https://redd-monitor.org/2014/10/16/a-cautionary-tale-about-carbon-
credits/; Lang C, The carbon credits sold to private individuals as investments are worthless, 4 June 2015,
https://redd-monitor.org/2015/06/04/guest-post-the-carbon-credits-sold-to-private-individuals-as-investments-
are-worthless/
50 SHADES OF GREEN | PART I. CARBON | 49
E. MORAL HAZARD MUST BE AVOIDED
Moral hazard is dened as a lack of incentive to guard against risk where one is protected
from its consequences. For example, during the 2008 nancial crisis, large international
banks expected to be bailed-out in case of bankruptcy and this encouraged them to take
on excessive risks, as they would collect the prots in the case of success, while taxpayers
would bear the cost of failure.
As governments – and citizens – will bear the ultimate cost of failure of climate change
mitigation policies, there is a non-negligible risk that this could encourage excessive risk-
taking by private actors in carbon markets. Speculators and end-users trading on carbon
markets have no built-in incentive to ensure that GHG emissions decline and technologies
change towards renewable ones. The former only care about making prots from trading
carbon credits, and the latter care about complying with mandatory requirements at the
cheapest cost.
By contrast, in command and control policies governments both dene the rules
mandating the trajectory of emission reductions and technological change, and have a
vested interest in their success as they are ultimately responsible. Moral hazard and the
risk of a related public backlash are thus minimised.
Should carbon nevertheless become an asset class, there would be a strong need for
supervisory authorities to develop robust regulations to try and mitigate some of these
risks. Lessons from commodity derivatives may prove useful in the design of rules aimed at
curbing speculation and limiting contagion channels to other asset classes and the wider
economy.
50 | GREEN FINANCE OBSERVATORY REPORT
Photo: De Vadven, Shutterstock/1116414122
D. MAJOR DEVELOPMENTS AND
A FRAGILE STATUS QUO
50 SHADES OF GREEN | PART I. CARBON | 51
1. ARTICLE 6, CORSIA, CHINA
Sustainable Development Mechanism: as Kyoto’s carbon offset markets approach their
end, a number of new markets are emerging. Kyoto’s Clean Development Mechanism is
likely to be replaced by the Paris Agreement’s Sustainable Development Mechanism and
its new carbon offset market. The Paris Agreement guidelines will shape ‘
the way forward
for international market mechanisms and the linking of domestic carbon pricing initiatives
under the new international climate accord.
’129 While the specic rules of this market are
expected to be dened at the COP25 in 2019 in Chile,130 disagreement with some countries
such as Brazil means that it may still be a few years away.
CORSIA: aviation is one of the fastest growing sources of greenhouse gas emissions,
with global aviation emissions expected to grow 300-700% by 2050,131 and the number of
aircraft and passenger-kilometres own expected to double over the next 20 years.132 In
this context and under the stated objective to make aviation’s growth carbon neutral,
a new carbon offset market for international civil aviation emissions was created in 2016.
Under this new agreement, called CORSIA (Carbon Offsetting and Reduction Scheme for
International Aviation), airlines will be required to buy carbon offsets to compensate for their
growth in CO2 emissions. Carbon offsets will be generated through the implementation of
carbon reduction projects in developing countries.133 Flights subject to CORSIA are expected
to account on average for over 600 million tons of CO2 per year between 2021 and 2035,
making CORSIA one of the largest carbon pricing instruments in the world.
A number of serious concerns have already been expressed:
As domestic ights are not included, only 60% of civil aviation ights are covered.
As CORSIA is an offset market instead of cap-and-trade, there is no cap on the aviation
related emissions that may be produced by an airline or a country.
Offsetting will not reduce aviation emissions but will instead allow airlines to pollute
more while buying carbon offsets to compensate. As a Bloomberg article put it, ‘
rather
than make their aircraft more fuel-efcient, airlines will be allowed to negate their post-
2020 emissions growth on paper, through the purchase of offsets – for example, by
paying to plant trees somewhere in the world.’
134 It has been found that CORSIA could
nearly double emissions from the airlines industry.135
129 World Bank, State and trends of carbon pricing, 2017,
http://documents.worldbank.org/curated/en/468881509601753549/State-and-trends-of-carbon-pricing-2017
130 Carbon Market Watch, COP24 overshadowed by market failure as countries fail to agree on basic accounting
principles and the future of the CDM, 15 December 2018,
https://carbonmarketwatch.org/2018/12/15/cop24-overshadowed-by-market-failure-as-countries-fail-to-agree-on-
basic-accounting-principles-and-the-future-of-the-cdm/
131 European Commission, Reducing emissions from aviation,
https://ec.europa.eu/clima/policies/transport/aviation_en
132 Heinrich Böell Stiftung, Heuwieser M, The illusion of green ying, 21 September 2018,
https://www.boell.de/en/2018/09/21/illusion-green-ying
133 IATA, What is Carbon Offsetting and Reduction Scheme for International Aviation?,
https://www.iata.org/about/worldwide/asia_pacic/Pages/What-is-CORSIA.aspx
134 Bloomberg, A Weak Deal on Airplane Emissions, 14 October 2016,
https://www.bloomberg.com/view/articles/2016-10-14/a-weak-deal-on-airplane-emissions
135 Institute for Policy Studies, Reyes O, Why a New Global Deal on Aviation Emissions is Really Bad News, 28
September 2016, https://ips-dc.org/new-global-deal-aviation-emissions-really-bad-news/
Photo: De Vadven, Shutterstock/1116414122
52 | GREEN FINANCE OBSERVATORY REPORT
The lack of explicit language on international oversight and environmental safeguards
opens the door to risky offset credits.136
ICAO, the UN agency in charge of aviation has recognised that the agreement is not
compatible with the 1.5°C goal of the Paris Agreement. The trade association for
airlines called CORSIA ‘aviation’s licence to grow’.137
As participation in the scheme is voluntary until 2027, it is already clear that CORSIA
will not even reach its insufcient goal.
CORSIA is already being instrumentalised by airline associations to push for the
invalidation of existing, more effective measures,138 such as the current inclusion of
airline emissions into the European Cap and Trade system.139 IATA the main airline trade
association is also using CORSIA as a way to push back against carbon pricing or
airline ticket taxes.140
China’s cap-and-trade: after testing seven regional pilot markets since 2008, China
ofcially launched its carbon cap-and-trade scheme in December 2017. Starting initially
with the power generation sector, the system will be extended over time to cover seven
other sectors including cement, steel, and aluminium. The Chinese carbon market is
expected to soon dwarf all the others and set the de facto carbon price.141 China has also
developed almost 100 forest carbon offset projects that will generate offset credits for the
national emissions trading scheme.142
As China’s cap and trade starts to function effectively over the coming years, it is likely to
be linked to other cap and trade schemes: in Japan; South Korea; and also Europe. Such
linkages are not only difcult, as they involve design differences and sovereignty issues,
but they also raise environmental integrity questions: should we, for example, authorize
the use of Chinese offset credits in the European cap-and-trade system with a risk of
weakening the cap? Will we be able to assess the difference in environmental integrity and
additionality between offset credits created under different systems? Will the prominence
of the Chinese ETS further reduce the ability of European policy makers to send policy
incentives through carbon prices?
136 Carbon Market Watch, The CORSIA: ICAO’s market based measure and implications for Europe, October 2016,
http://carbonmarketwatch.org/wp-content/uploads/2016/10/Post-Assembly-Policy-Brief-Web-1.pdf
137 IATA press release, Historic Agreement on Carbon-Neutral Growth, 3 June 2013,
https://www.iata.org/pressroom/pr/Pages/2013-06-03-05.aspx
138 CE Delft, A comparison between CORSIA and the EU ETS for Aviation, December 2016,
https://www.transportenvironment.org/sites/te/les/publications/2016_12_CE_Delft_ETS_CORSIA_nal.pdf
139 Transport & Environment, EU urged to stand rm on aircraft emissions, 6 October 2018,
https://www.transportenvironment.org/news/eu-urged-stand-rm-aircraft-emissions; GreenAirOnline, Airlines
and NGOs spell out differing positions over CORSIA implementation and the future of the Aviation EU ETS, 18
September 2018, http://www.greenaironline.com/news.php?viewStory=2523; T&E, Carbon Market Watch, Aviation
Environment Federation, Open letter to Vice President Šefcovic, Commissioner Violeta Bulc, Commissioner Miguel
Arias Cañete, European Commission, 12 September 2018, https://www.transportenvironment.org/sites/te/les/
publications/2018_09_EuroICSA_letter_Commision_re_CORSIA_ETS.pdf
140 IATA Fact sheet: CORSIA & carbon pricing, December 2018,
https://www.iata.org/policy/environment/Documents/corsia-factsheet-carbon-pricing.pdf
141 Foreign Affairs, DiPerna P, China’s Carbon Markets How Beijing Is Leading With Cap-and-Trade, 18 August 2016,
https://www.foreignaffairs.com/articles/china/2016-08-18/chinas-carbon-markets
142 Carbon Pulse, China builds forest carbon offset portfolio ahead of ETS launch, 29 November 2018,
http://carbon-pulse.com/64235/
50 SHADES OF GREEN | PART I. CARBON | 53
Carbon removal crypto-markets143
Finally, it is necessary to mention here a recent push supported by the UN towards using
new technologies such as blockchain144 to help address climate change.145
Among the many potential uses of blockchain, some companies are pushing to create
a new nancial market on carbon removal using crypto-currencies and blockchain
technology.146 While there is no related legislative initiative at the time of writing, political
support for it may grow over time and it deserves monitoring. The pitch is indeed very
compelling: under headlines such as ‘blockchain for climate’, it combines two of the
hottest policy topics of the moment.
Carbon removal, also called carbon capture and storage (CCS), is the process of capturing
waste CO2 generated by electricity production or industrial processes, and transporting
it and storing it elsewhere where it will not enter the atmosphere. Storage locations
are typically geological rock formations several kilometres below the surface; depleted
oil elds; or deep saline aquifer formations. CCS can also describe geoengineering
techniques such as the chemical removal of CO2. It is presented as complementary to
existing carbon markets focused on reducing present and future emissions, as it aims
instead at removing emissions.147
‘
CCS is controversial for a number of reasons. It’s expensive, unproven, and according
to researchers at Duke University, there’s the troubling possibility that captured carbon
could leak into groundwater aquifers, potentially rendering water undrinkable.
’148 Captured
carbon could also leak into the atmosphere, compromising climate mitigation.149 Two major
cases of leakage have already occurred. The rst one occurred in 1986, when naturally
sequestered CO2 rose from a lake in Cameroon and asphyxiated 1,700 people. A 2011
study also found evidence of CO2 leakage in the land above the world’s largest carbon
capture and storage site in Canada.150
143 Crypto-markets refer to the trading of crypto-currencies such as Bitcoin.
144 Blockchain is a digital database that securely stores a list of data such as Bitcoin transactions.
145 UNFCCC, How Blockchain Technology Could Boost Climate Action, 1 June 2017,
https://unfccc.int/news/how-blockchain-technology-could-boost-climate-action
146 Medium.com, Gambill P, Why a carbon removal market belongs on the blockchain, 15 November 2018,
https://medium.com/nori-carbon-removal/why-a-carbon-removal-market-belongs-on-the-blockchain-
91da31127228;
Nori.com, A blockchain-based marketplace for removing carbon dioxide from the atmosphere, https://nori.com/
147 Bloomberg BNA, Magill B, Carbon Removal Firms See Opportunity in U.N. Climate Report, 12 October
2018https://www.bna.com/carbon-removal-rms-n73014483159/;
The Hill, Atkinson R, Carbon removal: An opportunity for American innovation, 20 November 2018, https://thehill.
com/opinion/energy-environment/417706-carbon-removal-a-new-opportunity-for-american-innovation
148 Fast Company, Schwartz A, The Problem With Carbon Capture: CO2 Doesn’t Always Stay Captured, 19 November
2010, https://www.fastcompany.com/1704105/problem-carbon-capture-co2-doesnt-always-stay-captured
The New York Times green blog, Barringer F, What if Captured Carbon Makes a Getaway?, 19 November 2010,
https://green.blogs.nytimes.com/2010/11/19/what-if-captured-carbon-makes-a-getaway/
149 Phelps J, Blackford J, Holt J, Polton J, Modelling large-scale CO2 leakages in the North Sea, International
Journal of Greenhouse Gas Control Volume 38, July 2015, https://www.sciencedirect.com/science/article/pii/
S1750583614003144?via%3Dihub;
IPCC Special Report. Carbon Dioxide Capture and Storage. Technical Summary, http://docplayer.net/20437054-
Ipcc-special-report-carbon-dioxide-capture-and-storage-technical-summary.html
150 GEOCHEMICAL SOIL GAS SURVEY A Site Investigation of SW30-5-13-W2M Weyburn Field, SASKATCHEWAN,
27 August 2010, https://web.archive.org/web/20110219025128/http://www.ecojustice.ca/media-centre/media-
release-les/petro-nd-geochem-ltd.-report/at_download/le
54 | GREEN FINANCE OBSERVATORY REPORT
Beyond the risks of leakage, CCS has documented adverse environmental effects such
as the additional use of chemicals, and reductions in air quality. As additional energy is
required for carbon capture, this in turn increases the use of chemicals needed for the
extraction of coal and gas, and increases emissions of other air pollutants.
Some companies are pushing to create a carbon removal market using crypto-currency
and blockchain.151 They are offering to issue cryptocurrencies that could be exchanged
for carbon credits and regular currencies. The selling points of such a proposal include
better carbon accounting (i.e. more measurable additionality); additional liquidity; lower
transaction costs; and secure payments. They hope to attract new people looking for more
environmental integrity, farmers looking for a new revenue stream, and crypto-currency
enthusiasts.
Blockchain could certainly improve transparency and reduce transaction costs. However,
beyond the major environmental concerns associated with carbon capture and storage
and with crypto-currencies,152 it is also worth highlighting that such a market would add the
extreme volatility of crypto-currencies to the already very high volatility of carbon markets.
In practice, it would mean that such a market would belikely to have an even more
inexistent price signal and be a recipe for bubbles and crashes.
While these huge emerging markets are still a few years away, they strongly indicate a
forthcoming change of scale and that carbon will eventually become an asset class.
151 Nori.com, https://nori.com/
152 The Independent, Gabbatiss J, Expanding Bitcoin use will push global warming above 2C in two decades, nds
study, 29 October 2018, https://www.independent.co.uk/environment/bitcoin-climate-change-global-warming-
cryptocurrency-mining-electricity-a8607036.html
50 SHADES OF GREEN | PART I. CARBON | 55
2. A POLITICAL WIN AND AN ENVIRONMENTAL
FAILURE
A. BETTER THAN NOTHING? AN OFT HEARD COMMENT IS THAT CARBON
MARKETS MAY NOT BE PERFECT BUT THEY ARE BETTER THAN NOTHING:
BUT ARE THEY?
Carbon markets have been shown to be instrumentalised to dismantle existing effective
regulations or to prevent new ones.153 Incidentally, in a surprisingly candid statement Shell’s
Chief Climate Change Adviser David Hone recently took credit for the inclusion of a carbon
market in the Paris Agreement154 as a way to pre-empt other regulations. Carbon markets
also divert precious and limited political attention away from more robust alternatives. They
nally can create a perception that climate change is being addressed to a greater extent
than it is in reality, thereby reducing public pressure for structural change.
The question of whether carbon markets are better than nothing is also a moot one, as
there wouldn’t be nothing: it would be politically untenable to have nothing and therefore
the choice has never been between carbon markets and nothing. This seems to indicate
that unworkable carbon markets are in fact worse than nothing.
B. KNOWING ALL THE ISSUES, WHY DO WE CONTINUE?
A large number of prominent economists, business gures, and free-market advocates
have publicly expressed strong scepticism about carbon markets: from Nobel laureate
Joseph Stiglitz to Georges Soros, Harvard’s Lawrence Summers and former US Federal
Reserve chairman Alan Greenspan.155 Even the Wall Street Journal provided a damning
assessment, writing that while a lot of money can be made from carbon trading ‘
don’t
believe for a minute that this charade would do much about global warming
.’156 Given all
the issues identied here, their poor track record, and the strong criticism raised, one may
wonder why we are continuing down the road of carbon markets.
A combination of factors contributes to the current status quo, including globalisation: it
has been evidenced that by reducing states’ sovereignty, the formulation of policy in favour
153 “
The EU’s Integrated Pollution Prevention and Control (IPPC) Directive was modied to explicitly exclude CO2
emission limits for the “installations” (power stations and industrial plants) which are covered by the EU ETS amid
fears that it could lead to energy efciency improvements, reducing demand for emissions allowances and in so
doing weaken carbon prices. Similarly, the revision of the Energy Taxation Directive was weakened (and ultimately
abandoned) for fear of affecting carbon prices.
” Corporate Europe Observatory, EU emissions trading: 5 reasons
to scrap the ETS, 26 October 2015, http://corporateeurope.org/environment/2015/10/eu-emissions-trading-5-
reasons-scrap-ets
154 The Intercept, Aronoff K, Shell oil executive boast that his company inuenced the Paris Agreement, 8 December
2018,
https://theintercept.com/2018/12/08/shell-oil-executive-boasts-that-his-company-inuenced-the-paris-agreement/
155 Lohman L, Carbon Trading: Solution or Obstacle? April 2008,
http://www.thecornerhouse.org.uk/sites/thecornerhouse.org.uk/les/Indiachapter.pdf
156 The Wall Street Journal, Cap and Charade, 3 March 2007, https://www.wsj.com/articles/SB117287909501625359
56 | GREEN FINANCE OBSERVATORY REPORT
of market principles,157 regulatory capture by private interests,158 and procrastination in the
face of massive and scary changes, is encouraged. The renowned economist and diplomat
John Galbraith once said that ‘
faced with the choice between changing one’s mind and
proving that there is no need to do so, almost everyone gets busy on the proof.
’
Two factors in particular play a decisive role:
1. Disputes over cost-sharing / avoiding the politically fraught question of distribution:
current policies are rooted in the prioritization of short-term growth, jobs and competitiveness
over environmental concerns, because not doing so would open a political Pandora’s box.
As discussed earlier, acknowledging that there are limits to growth would remove the
promise of a share of a bigger pie, and in turn open the question of the sharing of the pie.
In other words, removing the promise of growth would force us to address the question of
rising inequalities, a question most politicians are reluctant to ask.
Many governments of developed countries assess that a signicant share of their citizens
express conicting preferences: wanting both climate change to be addressed and not
wanting to change their way of life / additional taxes. Such a framing downplays the
distributional aspect: most of the resistance to new environmental taxes and regulations
is likely to come – depending on their design – either from lower income groups that
cannot afford them and do not have any alternative, or from private lobbies that oppose
any regulation that reduces their protability. The recent French
gilets jaunes
protests offer
an example of the low public buy-in for a socially regressive environmental tax and the
inescapable distributional aspect of environmental policies.
The weak outcome of international climate negotiations also comes from disputes over
cost-sharing. Some nations such as the United States consider that from a cost-benet
perspective, it is not in their best interest to cooperate, even or especially if all other parties
comply. From their perspective, they would have to bear the lion’s share of the cost of
emissions reductions, whereas they expect to lose relatively less from climate change than
other nations. Developing countries have a very different perspective, considering that
since developed countries are responsible for most of the global warming, it is only fair that
they should bear a much higher cost. In addition, as developed countries have outsourced
the industrial production of most of the goods they enjoy, they have also outsourced the
corresponding emissions, which should be taken into account. As Stiglitz put it, ‘
The
only principle that has some ethical basis is equal emission rights per capita (with some
adjustments - for instance, the US has already used up its share of the global atmosphere,
so it should have fewer emission allowances). But adopting this principle would entail
such huge payments from developed countries to developing countries, that, regrettably,
157 Global Policy Journal, Wall K, The end of the welfare state? How globalization is affecting state sovereignty, 17
August 2012, https://www.globalpolicyjournal.com/blog/17/08/2012/end-welfare-state-how-globalization-affecting-
state-sovereignty-0
158 A situation where regulatory agencies may come to be dominated by the industries or interests they are charged
with regulating. As a result, the agency charged with protecting the public’s interest instead acts in ways that
benet the industry it is supposed to be regulating.
50 SHADES OF GREEN | PART I. CARBON | 57
the former are unlikely to accept it.
’159 International climate negotiations thus resemble
passengers fighting over the cost sharing of a lifeboat on the Titanic.
Flexible tools such as carbon markets play a politically useful role in this context, as their limited
effectiveness enables the buy-in of more countries while not committing to much in reality.
As an added benet, carbon markets create a new asset class offering the promise of both
diversication benets and attractive returns to the trillions of assets under management
currently looking for new investment opportunities. A nancial newspaper titled ‘only the
ecology can save capitalism’160 explained that ‘
capitalism lacks projects, companies give back
money to shareholders instead of investing it. Only the ecological transition could satiate it
.’
2. Carbon markets are both an environmental failure and a political success, making
it difcult for politicians to abandon them. As a recent example, while the recent rise in the
carbon price following the reform of the EU ETS does not address the absence of a price
signal, the rising price has been hailed by politicians as an indication that the EU scheme is
nally working.
More broadly, emissions markets ‘
gain their political force from their capacity to create
alliances between ‘left-wing’ environmentalism and ‘right-wing’ pro-market sentiment,
and to attract business leaders such as BP’s John Browne.’
161 They receive broad support
from across the political spectrum, from business lobbies opposing any increase in climate
ambitions162 to a number of well-intentioned NGOs disillusioned after decades of failure
and blinded by the excessive technicality and the win-win rhetoric.163
The broad political support enjoyed by market-based solutions is rooted in the misguided
hope that all competing interests will get what they want: environmentalists will get
159 The Guardian, Stiglitz J, Carbon-taxing the rich, 7 December 2007, https://www.theguardian.com/
commentisfree/2007/dec/07/carbontaxingtherich
By contrast, the United States judged that addressing the hole in the ozone layer was in their best interest from
a domestic cost-benet analysis perspective. They therefore supported the Montreal Protocol, an international
agreement that succeeded in addressing the issue.
A research paper trying to understand the dramatic difference between the Montreal Protocol that had successfully
eliminated the production and use of ozone-depleting chemicals, and the Kyoto Protocol that had has spurred
only modest steps toward stabilizing greenhouse gas emissions concluded that “
both the success of the Montreal
Protocol and the mixed picture for the Kyoto Protocol were largely driven by the decisions of the United States,
and those decisions were driven in turn by a form of purely domestic cost-benet analysis.
”
Sunstein C, Montreal versus Kyoto: A Tale of Two Protocols, University of Chicago Law School working paper, 2006,
https://chicagounbound.uchicago.edu/cgi/viewcontent.cgi?article=1194&context=public_law_and_legal_theory
160 Euractiv, Simon F, Business lobby prepares pushback against EU climate goals update, 19 September 2018,
https://www.euractiv.com/section/climate-environment/news/business-lobby-prepares-pushback-against-eu-
climate-goals-update/;
Les Echos, Vittori JM, Seule l’écologie peut sauver le capitalisme, 10 July 2018, https://www.lesechos.
fr/10/07/2018/lesechos.fr/0301925350136_seule-l-ecologie-peut-sauver-le-capitalisme.htm;
Also see the 2009 statement of the Chief Executive of American Electric Power, if anyone claims that the “
only
reason American Electric Power wants to [invest in a forest offset project in Bolivia] is because it doesn’t want
to shut down its coal plants, my answer is, ‘You bet, because our coal plants serve our customers very cost-
effectively.’
”The Corner House, Lohmann L, “Strange Markets” and the Climate Crisis, 2010, http://www.
thecornerhouse.org.uk/sites/thecornerhouse.org.uk/les/Strange%20Markets.pdf
161 MacKenzie, Finding the Ratchet: The Political Economy of Carbon Trading,
http://www.sps.ed.ac.uk/__data/assets/pdf_le/0015/3417/DMacKenzieRatchet16.pdf
162 Liberation, Massiot A, Quand le lobby du patronat européen veut «minimiser» les efforts climatiques, 19 Septembre
2018, https://www.liberation.fr/planete/2018/09/19/quand-le-lobby-du-patronat-europeen-veut-minimiser-les-
efforts-climatiques_1679840
163 Bachram H, Climate Fraud and Carbon Colonialism: The New Trade in Greenhouse Gases, Capitalism, Nature,
Socialism Vol 15, December 2004, http://www.carbontradewatch.org/pubs/cns.pdf page 11
58 | GREEN FINANCE OBSERVATORY REPORT
environmental integrity, and business lobbies will get a marginal cost of compliance. This
misguided hope comes both from a lack of knowledge about nancial markets amongst
civil society and many politicians, and the ability of carbon markets to give the perception
that the issue is being addressed to a greater degree than it actually is.
Through the continued hope that once the price is higher everything will work out,
markets are able to maintain more political support over time than alternative policy tools
with a comparable track record. A carbon tax set 14 years ago at the level of carbon
market prices would have been likely to generate more public outcry for governments to
increase it. Likewise, a scheduled phasing out of fossil fuels implemented 14 years ago
and planning no action for the rst 14 years would have in all likelihood been untenable
politically.
Carbon markets can thus also be understood as a policy tool offering more political room
for manoeuvre than more binding policy alternatives. The political appeal of carbon
markets rests on their limited effectiveness and simultaneous ability to promise
future performance ‘once the price is right’. Such a combination can be politically useful
to reach global agreements between countries with diverging interests, enabling them to
save face while not committing to much in reality. This in turn begs the interesting question
of whether it is preferable to have a robust agreement with less signatories or a weak one
with more signatories.
From a civil society perspective, after decades of failure to create political room for action,
many NGOs and politicians have understandably given up on non-pricing mechanisms.
Yet, we nd ourselves in the paradoxical situation where public pressure for real solutions
will increase over the coming decade while more doomed carbon offset markets are being
created. It is perhaps time to acknowledge that endorsing market mechanisms has failed in
equal measure to achieve any meaningful outcome. Now is therefore arguably not the time
for NGOs to endorse more disadvantageous mechanisms but instead to raise awareness
about the difference between effective tools and doomed ones.
All these reasons may explain why more attention is dedicated to making Paris the capital
of green nance164 and to creating new carbon offset markets than to working out robust
policy alternatives.
C. THE ALTERNATIVE – MONTREAL VS KYOTO
Traditional environmental regulations phasing out fossil fuels would be a much more
effective alternative to carbon pricing.
Such a policy tool was used not long ago to address the hole in the ozone layer: The
Montreal Protocol is an international treaty signed in 1987 designed to protect the ozone
164 France Info: Le brief éco. Paris veut devenir la capitale mondiale de la nance verte, 11 December 2017,
https://www.francetvinfo.fr/replay-radio/le-brief-eco/le-brief-eco-paris-veut-devenir-la-capitale-mondiale-de-la-
nance-verte_2486793.html
50 SHADES OF GREEN | PART I. CARBON | 59
layer by phasing out the production of numerous substances that are responsible for ozone
depletion. As a result, the issue has been successfully addressed and the hole in the ozone
layer above Antarctica is slowly recovering. According to former UN Secretary General Ko
Annan, ‘
perhaps the single most successful international agreement to date has been the
Montreal Protocol
’.
Such a policy tool would have a number of benets:
It would be much simpler and cheaper to implement and monitor as it addresses the
cause rather than the symptoms.
It would work. Any policy tool is impacted by the current lack of political ambition;
as ambition grows however over time with the end of some natural resources,
environmental regulations would progressively become more binding and effective.
Carbon markets on the other hand would still be unable to deliver a price signal
meaning that carbon offset markets would still fail. Similarly, the wild uctuations in oil
prices would still continue to severely weaken the incentive effect of a carbon tax.
It would minimise nancial stability risks by starting the transition earlier and with a
more predictable path. It would also not create the nancial stability risks linked to
carbon as an asset class.
It could be implemented quickly and deliver change faster than markets could. While
some believe that markets are ‘
humanity’s most effective mechanism for delivering
change at speed and scale
’,165 this is in fact incorrect in the case of carbon markets,
as they are designed for incremental and not structural change. By fostering structural
change, binding regulations could be as fast as we want them to be – once a law is
passed it can be in theory implemented overnight – only slowed down by our desire to
phase them in and smoothen the transition.
The impact on jobs would be positive: a scheduled and progressive phasing out of
fossil fuels would enable a more coordinated shift compared to a later and more abrupt
one. In turn, this would provide more time to plan ahead and retrain workforces, and
thus minimize the impact on jobs.
In addition, while industry lobbying has brandished for years the threat of job
relocation in case of stronger climate regulation, the most thorough study on the topic
funded by the European Commission found no evidence of such risk.166
By legislating for outcomes, binding regulation would also, most importantly,
foster innovation. As an industry gure put it recently, it is a fundamental error to
see putting a price on emissions as an efcient market-based solution. ‘T
he fact is
the private sector competes only on price and through innovation, so if government
wants to liberate the private sector to nd solutions, regulation must not dictate price
or solutions.
’167 Instead, she argues, governments should focus on legislating for
outcomes (…) and leave it up to private sector companies to gure out how to deliver
those outcomes at the lowest cost.
165 Six Lessons From Nori’s Director Of Carbon Economics,
https://www.linkedin.com/pulse/six-lessons-from-noris-director-carbon-economics-richard-roberts/
166 Carbon Leakage Evidence Project, Study commissioned by DG CLIMA, September 2013,
https://ec.europa.eu/clima/sites/clima/les/ets/allowances/leakage/docs/cl_evidence_factsheets_en.pdf
167 Six Lessons From Nori’s Director Of Carbon Economics,
https://www.linkedin.com/pulse/six-lessons-from-noris-director-carbon-economics-richard-roberts/
60 | GREEN FINANCE OBSERVATORY REPORT
Traditional environmental regulation would also incidentally make all finance
sustainable with regards to climate change.168 As technologies relying on fossil
fuels would be progressively phased out, the risk-adjusted returns of all economic
activities and companies would automatically adjust and capital would automatically
shift towards renewable alternatives whose relative protability would suddenly have
increased.
In turn, this questions the current political focus on ‘changing nance’ to facilitate the
ecological transition. It argues instead for changing weak climate policy regulations, which
would in turn change nance.
The political focus on sustainable finance can thus be understood as a choice
to incentivise the transition via financial regulation rather than induce it via
environmental regulation.
The issues are of a political nature:
The main opposition to binding regulations comes from industry who perceive it as
too coercive. As awareness is growing about the nancial risks of climate change and
the business case for transitioning to renewable energies grows stronger, things will
certainly evolve although probably too late to avoid an abrupt transition.
A major difference between addressing the hole in the ozone layer and addressing
climate change is that producers of CFC169 gases did not own massive reserves of gas.
As a result, there were less vested interests in maintaining the status quo and avoiding
effective regulations. Nations owning huge reserves of fossil fuels on the other hand are
extremely reluctant to abandon this source of enormous economic power and therefore
unlikely to agree to effective climate regulations until a critical mass of their citizens
requests it.
Changing policy tool will not by itself address the lack of political ambition and the
prioritisation of short-term self interest over common long-term interest. However, as
discussed earlier, environmental regulations would be able to reect any future increase
in political ambition, unlike carbon markets that would still be plagued with excessive
volatility and uncertainty thereby preventing any progress.
In addition, by offering less loopholes and room for regulatory avoidance and being
generally more transparent than market mechanisms, binding regulations would greatly
increase accountability.
168 I use sustainable in this section in the narrow sense of climate friendly, i.e. focussing on the Environmental
aspect of ESG. However complementary social and governance regulations would make nance truly and
comprehensively sustainable.
169 Chlorouorocarbons (CFCs) are a family of gases used for refrigeration and as spray can propellants and
responsible for creating a hole in the ozone layer.
50 SHADES OF GREEN | PART I. CARBON | 61
D. TOO LATE TO CHANGE COURSE?
A frequently used argument is that even though carbon markets may not work, it is now
too late to change course. While there is indeed currently no political appetite for shifting
the policy response away from carbon prices, the current status quo is more fragile than
most realize, and only ‘
one major natural catastrophe away from being abandoned
’ in
the words of a senior industry lobbyist who wishes to remain anonymous. As he explains it,
‘
everybody knows that carbon markets do not work and never will. We thought they were
going to die and were happily surprised when the Paris agreement saved them. However,
we are just buying time. Over the next decade a major city like London will be under water
and then politicians will drop it overnight for a carbon tax or something else.
’
As carbon markets continue to prove their ineffectiveness to address climate change
while the incidence and amplitude of natural catastrophes increase, the status quo is
likely to gradually become politically untenable.
The path of least political resistance seems therefore likely to change significantly
over the coming years under the combined effect of increased public pressure and
technological development.
While more robust climate mitigation policies were until recently dismissed as not being
pragmatic, pragmatism may well now precisely require not waiting for overwhelming public
pressure to shift political course, as the sooner we do, the less disruptive the transition will
be and the more time that will be available to make the necessary adjustments.
In addition, up to now the political cost of acting – challenging the economic paradigm
at the risk of not being re-elected – was perceived to be higher than the political cost of
waiting – public unrest and growing distrust of institutions. This is likely to change over
the coming decade. The political benets of acting are also currently underestimated:
addressing climate change could be the common project that Europe needs to revitalise
much needed faith in its institutions; counterbalance fear of the future and the temptation
of a retreat to nationalism; and generate a renewed sense of optimism.
62 | GREEN FINANCE OBSERVATORY REPORT
CONCLUSION
Beyond the well-known excess allowances and cases of fraud, carbon markets also
have major conceptual shortcomings, some of which are unresolvable: such as the
inexistence of a price signal towards the end of natural resources. Carbon taxes are also
affected by such shortcomings and are only marginally better.
As carbon becomes an asset class, carbon markets are very likely to be more
vulnerable than traditional markets to market failures and abrupt losses of condence
from investors, with a high risk of contagion to other asset classes and the wider economy.
The unresolvable nature of some of the issues seriously calls into question the idea
that these policies can ever meet their environmental and social objectives. While
all policy tools are equally affected by the current lack of political ambition, effective ones
will work when ambition increases; whereas failed ones such as carbon offset markets will
remain ineffective. As the evidence points to the continued failure of these latter policies,
the logical conclusion should be to abandon them for more robust alternatives. Yet two
new potentially major carbon offset markets are arriving: one linked to aviation emissions;
and the other to the Paris Agreement.
Mandating a progressive and time-bound withdrawal from fossil fuels complemented
with tax policies aimed at ensuring a fair sharing of the costs would be far more
effective and have more environmental integrity. Such a policy tool would not create the
nancial stability risks attached to carbon markets. It would provide businesses with more
certainty and ability to plan.
Binding regulations would also incidentally make all finance sustainable with regard
to climate change, as the risk-adjusted returns of all companies would automatically
adjust to new regulations.
While there is currently little political appetite for shifting the policy response to
climate change away from carbon pricing, the current status quo is more fragile than
most realize, and only one major natural catastrophe away from being abandoned. As
carbon markets continue to prove their ineffectiveness while the incidence and amplitude
of natural catastrophes increase and the cost of renewable energy continues to drop,170
public pressure is likely to make the current status quo gradually become politically
untenable.
170 The Independent, Gabbatiss J, Renewable energy set to be cheaper than fossil fuels by 2020, according to new
report, 15 January 2018, https://www.independent.co.uk/environment/renewable-energy-cheaper-fossil-fuels-
2020-uk-green-climate-change-global-warming-report-irea-a8160051.html
50 SHADES OF GREEN | PART I. CARBON | 63
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50 SHADES OF GREEN | PART I. CARBON | 71
ABOUT US
The Green Finance Observatory is an independent
NGO whose mission is to analyse new nancial
markets and instruments linked to environmental
policies, to assess whether they can meet their stated
environmental, economic and social objectives.
We are a small team of ex nancial market, advertising
and policy advocacy professionals. Our respective
experiences led us to conclude that while there was
a tremendous expertise on environmental matters in
the CSO universe, fewer civil society organisations
were engaging in complementary and essential angles
such as nance, looking at the nuts and bolts of green
nancial markets and instruments.
Find out more about the organisation on our website:
www.greennanceobservatory.org
GReen
Finance
obseRvatoRy
GReen
Finance
obseRvatoRy
