Tragedy of the commons
If a business was pumping mercury into a river depended upon by a village, you would hear collective outrage. The affected village has a strong interest in stopping the pollution, and will beat on the war drums to spur the rest of us into action.
Carbon diffuses through Brownian motion, distributing itself uniformly across the globe. Therefore, no one directly faces an uneven and excessive concentration of CO2, though some are more vulnerable to rising tides and unpredictable weather patterns.
It is irrational to act individually by spending more to reduce your carbon footprint – such as buying items manufactured with less damage to the climate – if everyone else is spending less while polluting. Neither do countries have an incentive to unilaterally crack down on heavy-emitters or compel them, for fear that businesses will leave, taking their economic activity with them.
In order to surmount the tragedy of the commons, the best way is to make people pay a price that considers the total negative impact generated by their actions. In economics, this is known as internalising the externality. The two main mechanisms are through taxes and quotas.
The theoretical efficient mechanisms
Taxation: Pigou (1920) introduced the concept of a charge on pollution as tax. More generally, a Pigouvian tax is a levy imposed on activities that generate negative externalities — costs that are borne by society rather than the individual or firm responsible for the activity. The aim is to internalise these external costs, aligning private incentives with social welfare. In the context of carbon emissions, a Pigouvian tax is applied to the production, consumption, or use of fossil fuels to reflect the social cost of the resulting greenhouse gas emissions. By increasing the cost of carbon-intensive activities, such taxes encourage firms and consumers to reduce their carbon footprint, switch to cleaner technologies, or adopt energy-efficient practices. Theoretically, the optimal Pigouvian tax would equal the marginal social cost of the pollution, ensuring that firms and consumers only emit carbon when its value to them exceeds its cost to society. Carbon taxes are seen as a more predictable and transparent alternative to carbon trading schemes, although setting the “correct” tax level is a key policy challenge.
Quotas: Carbon credits are tradable certificates that represent the reduction or removal of one metric tonne of carbon dioxide (CO₂) or its equivalent in other greenhouse gases from the atmosphere. They are a key component of market-based climate strategies aimed at mitigating global warming. Companies, governments, and individuals can purchase carbon credits to offset their emissions, thereby supporting projects like reforestation, renewable energy, or methane capture. There are two main markets for carbon credits: compliance markets, where companies are legally required to offset emissions, and voluntary markets, where businesses and individuals do so as part of corporate social responsibility or sustainability initiatives.
On the legal front, governments can set quotas on the total amount of carbon emitted. The European Union’s Emissions Trading System (EU ETS) does exactly that. So does China, which has a carbon market with quotas set relative to output. This means that someone living in the UK can emit 1kg of carbon dioxide if they pay to grow enough trees to sequester that 1kg. Based on the Coase Theorem, this helps to increase efficiency in the market. From a problem enmeshed in a global tragedy of the commons, quotas enforced rigorously would force individual incentives. This creates a new market where the invisible hand can drive optimisation across costs and carbon.
Tax vs Quota
We know that there are mechanisms to limit the amount of carbon to an optimal amount. However, what is the optimal amount? Despite all the resources pumped into climate science, this remains an uncertain quantity.
Weitzman (1974) found that when there is uncertainty about the optimal quantity of pollution, taxes are better when the cost of making a mistake is low. Weitzman illustrated that when we cannot precisely predict the optimal level of pollution, taxes are more effective if the cost of deviating from the optimal level is relatively low. This is particularly true when the marginal cost of reducing pollution rises steeply compared to the marginal benefits of doing so. For example, imagine a scenario where reducing emissions slightly beyond what is necessary causes a sharp rise in costs, but the additional environmental benefit is small. In such cases, a tax is more flexible because it sets a consistent price on emissions, allowing polluters to make their own cost-benefit calculations about how much to emit without rigidly capping the total quantity.
On the other hand, quotas are preferable when errors could lead to severe consequences, such as crossing a dangerous environmental threshold. This applies in situations where the marginal benefits of pollution reduction increase rapidly as emissions approach critical levels, even if the costs of achieving those reductions also rise. For instance, if exceeding a certain concentration of atmospheric CO₂ would trigger irreversible climate tipping points, quotas can provide more certainty by directly limiting the total emissions, even if enforcing those limits comes at a higher cost.
Applying Weitzman’s theory to climate policy, the decision boils down to the stakes of uncertainty. If we are relatively unsure about the precise costs of carbon emissions but confident that catastrophic outcomes are unlikely in the near term, carbon taxes may be a better tool because they provide predictability and encourage gradual reductions. However, if we believe that crossing specific thresholds poses an existential risk to ecosystems and societies, quotas become essential, as they guarantee emissions stay within safer bounds. Given the increasing awareness of the urgency of climate change, quotas may be a natural evolution from taxation.
Practical Difficulties: Verification and Scams
In order to avoid crushing regulations, governments often allow for carbon offsets to reduce the amount of carbon being regulated under a quota or subject to a tax.
Karbon Beijing has been accused of misrepresenting carbon credits projects – facilities deemed to be green turned out to be an abandoned chicken coop. Meanwhile, auditors were found to have reported inaccurately – even on basic facts such as the number of tanks present at a site.
A levy to cover the use of fossil fuels was avoided by buying carbon offsets from Colombian emission reduction projects, though the impact on preventing deforestation has been reported to be overstated.
This means people may 1) Spend more to assuage themselves of the guilt of carbon emissions, only to line the pockets of the conniving 2) Result in increased prices, again to the benefit of scammers.
Practical Difficulties (II): Miscalculated Benefits
What is the benefit of planting a tree? Carbon sequestration definitely mitigate climate change. But the devil is in the details. When we act for climate reduction, we need to keep conservation and maintenance in mind too. There are cases where huge swaths of monocultures of fast-growing trees are grown as an offset to the deforestation of diverse tree ecosystems. This adversely impacts conservation efforts, as the lack of tree diversity supports a vastly reduced range of flora and fauna. The monocultures are also more susceptible to disease outbreaks.
The Way Forward
When you take the theoretical economics lens – carbon quotas can appear to be a superb method for reducing carbon emissions to avert a climate disaster at the smallest possible loss of quality of life around the world. Yet, when you introduce new metrics to judge businesses, the practical effect is that people are going to use these metrics to obfuscate and profit from the confusion.
Technological solutions are unlikely to solve this. After all, the difficulty is translating an audit from an on-the-ground observation to data on a screen. Solutions boasting tamper-proof records miss the point; it doesn’t matter how secure your data is if the data source is corrupted from the start.
We can invest in strengthening verification of carbon credits as well as improve measurement systems. This will involve higher compliance costs. The alternative is to impose harsh penalties – theoretically, if you could lop the heads off those who game the system, it would create serious disincentives to not do that. While the death penalty is a bit extreme, we should definitely ensure that perpetrators are adequately deterred.
We can also abandon carbon credits and instead revert to a critical footing on climate. This is what some climate activists are defacing paintings for. I would argue that this comes from a privileged perspective. It’s one thing to avoid taking a flight from climate concerns, it’s another to jack up prices of basic commodities because you impose curbs on palm oil, leading to aggravated poverty.
As a consumer, I would never pay more for carbon offsets. The sheer uncertainty about where my money is going does nothing to quell any climate guilt I face.
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