Carbon Trading and Carbon Offsets

Theoretical Foundations of Emissions Trading

Carbon trading can be traced to the mid 20th century, when economists began to examine the issue of social costs of economic activity. These externalities represent a form of market failure that arises when an economic exchange among one set of actors leads to impacts among other actors who are not participants in the exchange. Impacts may be positive, negative, or a combination, and environmental pollution is a classic example of a negative externality.

Prior to the introduction of market-based environmental regulation, the primary means of reducing pollution was through government-imposed limits. This approach was criticized because it restricts economic activity and does little to promote innovation. Alternative ap proaches were proposed, predicated on the theory that although pollution has negative social costs, so does the restriction of economic activity that causes pollution. Based largely on the work of economist Ronald Coase, the theory holds that the problem is reciprocal rather than one-sided. For example, if pollution emitted by A causes damages to B, the initial reaction may be to limit A's pollution. However, reducing the damages on B inflicts harm on A by adding abatement costs or forcing cuts in A's production.

Theoretically, there is an “optimal” level of pollution at which the net benefits to society can be maximized. In economists’ jargon, this is the level of pollution at which the marginal social benefit of an additional unit of pollution equals the marginal social cost. However, finding an optimal level of pollution is more complex than this simple description implies. First, in Coase's original formulation, both A and B were single actors incurring individual costs and benefits. In reality, there may be multiple As releasing pollutants with [Page 330]similar impacts on B. There may also be many Bs, each incurring costs that can be difficult to enumerate or attribute to a single polluter. Furthermore, A may deploy technical experts and litigators who challenge B's claims. Additional complications arise if B is displaced spatially or temporally from A. Moreover, the impacts of pollution are typically transmitted through air or water, which lack well-defined property rights. GHGs possess all these complicating factors, which is one reason why consensus on mitigation has been so elusive.

...