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A global market that trades in the rights to produce carbon emissions and to use the atmosphere’s limited absorptive capacity is rapidly emerging. The global carbon market was valued at $126 billion in 2008, only several years since trading began in earnest. Some credit the carbon market with leveraging capital for emissions reductions, clean energy and energy efficiency. Others fear profiteering from the sale of illegitimate emissions reductions credits that could undermine global emissions reduction goals.

Carbon is the most ubiquitous input into economic activity; we produce emissions by powering our industries, homes, and cars, by producing and transporting our food, by deforesting our landscapes, and by other activities. The carbon market, therefore, has the potential to become the world’s largest commodity market. In this day and age when markets have met with intense scrutiny for engendering ruinous boom-bust cycles, it  seems almost an anathema to defend the carbon market as a tool for addressing climate change. Yet, this defense of carbon markets is rooted in the notion that markets often fail.

The market system fails to price carbon emissions accurately to reflect the social, ecological, and economic costs from each additional ton of carbon produced. The effective price of carbon in the global economy is zero. Economists, however, estimate that the real social cost of carbon - the expected damages from every ton of carbon that goes into the atmosphere – ranges from a low of $13 per ton under optimistic scenarios regarding climate change impacts, to a high of $798 per ton. The social costs associated with carbon emissions represent the greatest market failure of all time.

Absent government regulation of carbon emissions, or at least the expectation that regulations are forthcoming, there is little reason for any country, corporation, or individual to mitigate emissions. This is because emissions reduction is a public good. The benefits of reduced emissions are shared by all, irrespective of who contributes to emissions reduction.  

Regulation, therefore, is needed to create the demand for emissions reduction. A cap on carbon emissions, for example, limits access and establishes user rights, to the atmospheric commons. These user rights, since they are scarce, become highly valuable and the ability to sell these user rights imputes a price to carbon emissions that never before existed. Without a cap on emissions, there can be no carbon market. These user rights establish who has the right to emit what. Trading can not begin until there is a clear agreement on the number of tons of carbon dioxide that each entity has the right to produce. Each seller must be able to demonstrate it has “title” to the carbon emissions rights it sells. This means that every entity must have a well determined limit – otherwise, it could sell infinite amounts and no market would exist.

The global carbon market began when the Kyoto Protocol, the current international agreement on climate change, entered into force in 2005. The Kyoto Protocol assigned binding emissions reduction commitments to participating countries. It also established mechanisms for countries to trade credits from emissions reduction. This gave countries the flexibility to finance reductions in areas of the world where it cost least. The global carbon market has facilitated $23 billion in sales of credits from emissions reductions in developing countries, an amount equivalent to 40% of total European Union emissions in 2004. This potential to connect global emissions reduction to the broader goal of sustainable development is perhaps, the most promising aspect of carbon trading. It creates incentives for developing countries to adopt clean technologies and ‘leapfrog’ into the future – using cleaner forms of energy than developed countries did during their industrialization.

But what about here at home? A small carbon market has emerged within the U.S., due primarily to demand for emissions reductions from the Regional Greenhouse Gas Initiative in the northeast, and voluntary transactions from companies eager to demonstrate a commitment to addressing climate change, or strategically positioning themselves in these markets early before emissions reductions are required. Unless federal legislation mandating emissions reductions is enacted, however, US carbon market activity will remain marginal, at best.

Are ecosystem markets prone to fraud? If the credits sold for emissions reduction do not reflect real, verifiable emissions reductions beyond what would have happened in the absence of trading, carbon markets could undermine emissions reduction goals. As with all money-making opportunities, the incentives for fraud run high. Effective monitoring and measurement is essential to the judicious use of carbon trading. But unlike markets that arise from a profit-seeking response to unmet demands for goods and services, ecosystem service markets are born from a regulatory response to market failure.

Fixing markets by creating more markets seems contradictory, somewhat akin to the addict who substitutes methadone to heal her addiction to heroin. But markets that originate in regulation can be better designed from the outset to serve the common interest rather than Wall Street’s interests. In many markets, the necessary regulatory apparatus lags behind the creation of new products. This was the case with capital markets in recent years, where new “products” were neither well-anticipated nor well-understood.

Carbon markets, however, will not succeed without a regulatory apparatus in place that creates the demand for emissions reductions. Nor will they succeed without clear and transparent standards that define what can be traded. The carbon market begins with the horse in front of the proverbial cart, but neither the cart nor the horse can get moving without a firm and consistent public policy response to the climate crisis.

Unfortunately, it is still a very long hill to climb.