The curious case of greening in carbon markets.

• Author: Boyd, William

Over the last several years, so-called carbon markets have emerged around the world to facilitate trading in greenhouse gas credits. This Article takes a close look at an unexpected and unprecedented development in some of these markets--premium "green" currencies have emerged and, in some cases, displaced standard compliance currencies. Past experiences with other environmental compliance markets, such as the sulfur dioxide and wetlands mitigation markets, suggest the exact opposite should be occurring. Indeed buyers in such markets should only be interested in buying compliance, not in the underlying environmental integrity of the compliance unit. In some of the compliance carbon markets, however, higher quality green credits have emerged in recent years as important currencies for a number of buyers, representing a dynamic that we refer to as "Gresham's Law in reverse"--more stringent currencies arising alongside and even displacing inferior currencies. This Article provides the first recognition and analysis of green differentiation in carbon markets. We explore a range of explanations for this curious development. We then identify potential lessons for the design and evolution of future carbon markets and, more generally, environmental compliance markets.

1. INTRODUCTION II. CARBON MARKETS 101 III. PROBLEMS IN THE CARBON MARKETS--HOT AIR AND ENVIRONMENTAL INTEGRITY IV. LESSONS FROM OTHER ENVIRONMENTAL MARKETS V. GREEN DIFFERENTIATION IN THE KYOTO MARKETS A. Green AA Us B. The CDM Gold Standard VI. EXPLANATIONS--WHY IS THIS HAPPENING? VII. LESSONS--DOES THIS MATTER? VIII. CONCLUSION I. INTRODUCTION

   In 2008, Hungary made news in the climate change world when it announced the sale of six million greenhouse gas (GHG) reduction credits to Spain, the largest sale in the world at that time. (1) The fact that Hungary was selling emissions credits (known as Assigned Amount Units or AAUs) to Spain was not surprising, nor was its earlier sale of two million credits to Belgium. (2) As members of the European Union (EU), Spain and Belgium have committed under the Kyoto Protocol to the United Nations Framework Convention on Climate Change (Kyoto Protocol, Kyoto, or Protocol) to reducing their GHG emissions eight percent below 1990 levels by 2012, (3) and this reduction can be met by a combination of both actual emissions reductions and the purchase of emission reduction credits.

   What was surprising was the sales strategy of Hungary. It proclaimed that its reduction credits were especially valuable because the funds raised by the sale would be invested in energy efficiency projects in residential and public sector buildings rather than simply going into the national treasury to be used on roads, pensions, or some other general need. (4) Nor was Hungary's strategy unique. Over the past three years, Ukraine, the Czech Republic, Latvia, Poland, and other eastern and central European countries have announced similar transactions. (5)

   These all have been described as so-called "Green Investment Scheme" (GIS) deals. (6) GIS is a self-imposed commitment by potential seller countries that the income generated from sale of their credits will go to environmental projects. (7) There has been a comparable development in the Clean Development Mechanism (CDM) market, where an increasing number of certified emissions reductions (CERs) are held out as meeting a "Gold Standard" of exceptional environmental quality. (8)

   It is important to note that these markets for "green" AAUs and CERs are not mandated by the Kyoto Protocol. Nascent and still developing, they are entirely voluntary creations with no regulatory oversight. The problem is that this shouldn't be happening, not if past experience with other environmental compliance markets is any guide.

   Differential "greening" would be perfectly understandable in the development of voluntary markets such as organic produce or paper with recycled content. Here, green consumers are explicitly buying environmental integrity but have difficulty choosing among competing products. (9) To meet this need, information intermediaries such as standards and certification bodies or rating agencies emerge to resolve questions of trust and quality and to fill gaps due to lack of regulatory oversight. (10) Put simply, these bodies ensure that buyers know what they are getting when faced with a range of purchasing options.

   But regulatory markets, such as those created by the Kyoto Protocol, are very different from those for organic produce or recycled paper. These are entirely artificial markets created by law with one product for sale--compliance credits. Belgium and Spain surely are not green consumers. As rational economic actors, they and other buyers in these markets should simply be concerned about the cost of compliance--whether they have enough emissions reduction credits to meet their Kyoto obligations at low cost. This has certainly been the case in other environmental compliance markets.

   Classic pollution reduction markets, such as the Clean Air Act's (11) sulfur dioxide (S[O.sub.2]) (12) and chlorofluorocarbon (CFC) markets, (13) and resource allocation markets, such as individual transferable quota schemes in fisheries, (14) have not tended toward any sort of greening or voluntary differentiation. Nor have offset markets such as wetlands mitigation banking or species banking, even though issues of quality and fungibility are notoriously problematic in these markets. (15) In all of these environmental markets and many more, the trading currency has remained unchanged and unchallenged--whether a kilogram of fish or a ton of pollutant. Unlike apples or oranges, there has been one and only one purchasing option. How sustainably the fish was caught or emission reduction achieved has been irrelevant and will likely remain so. Regulated parties want compliance or access to the resource at lowest cost, period. Yet this is not happening in the Kyoto markets. Something else is going on.

   To understand carbon markets, then, we need to understand why green differentiation is happening when least expected. Why is Gresham's Law (16) occurring in reverse--superior currencies emerging alongside and, in some cases, driving out cheaper currencies? Explaining this development requires that we examine the role of governments as market participants and understand the political economy driving government decision-making in these markets.

   Our central thesis is that carbon markets operate quite differently when governments are major players. This raises obvious questions about market design, whether one might expect to see similar greening dynamics in markets involving private actors, and the evolution of future carbon markets. Indeed, contrary to Gresham's Law, it seems quite likely that the premium "green" currencies currently emerging in the Kyoto compliance markets will lead to tighter rules ,and higher compliance standards for future carbon markets at international, regional, and national levels.

   Part II provides a general overview of the carbon markets, highlighting the differences between the voluntary carbon markets and the compliance carbon markets. Part III discusses the most important environmental integrity concerns that have arisen in compliance carbon markets, in particular the so-called "hot air" problem from over-allocation of emissions allowances under the Kyoto Protocol and lack of additionality associated with certain CDM projects. Part IV considers the lessons from other environmental compliance markets, demonstrating the lack of any green differentiation in these markets. Part V contrasts these experiences with the evolution of greened carbon credits in the Kyoto markets. Part VI offers a range of explanations for these developments and Part VII explores lessons this experience offers for the future of carbon markets.

2. CARBON MARKETS 101

   The theory of emissions trading rests on the premise that reduction and sequestration of GHGs across different sectors, activities, and geographies can be made fungible and therefore amenable to trading. (17) Because GHG emissions are global and well-mixed in the atmosphere, it should not matter from an atmospheric standpoint where the reductions (or sequestrations) occur. (18) Put more crudely, under the standard economic approach to GHG emissions trading, a "ton is a ton is a ton" regardless of whether it comes from a reforestation project in Tanzania, an industrial gas destruction project in China, or reductions at a coal-fired utility in Germany. (19) In theory, this fungibility enables "where and when flexibility" with respect to GHG emissions reductions and sequestration activities, thereby allowing mitigation efforts to proceed in the context of a robust market instrument at the lowest marginal cost. (20) This premise provides the foundation for the so-called carbon markets, (21) which are designed to allow trading of emissions reduction and sequestration credits from various activities in various places as a means of ensuring that overall reductions occur at the lowest possible cost. (22)

   Based on this foundation, today's carbon markets come in two main flavors: voluntary and compliance. In the voluntary markets, buyers and sellers trade carbon offsets of various types for the purpose of offsetting the emissions associated with a particular activity. Many, but not all, of the buyers of voluntary offsets are interested primarily in the reputational benefits that come from offsetting a portion of their emissions, and thus want some assurance that the purchased offsets have environmental integrity. (23) But because of the high information costs of establishing such integrity on a case-by-case basis, multiple information intermediaries have emerged in the form of standards bodies for the purpose of ensuring the credibility of offsets sold in the voluntary markets, including, for example, the Voluntary Carbon Standard, (24) the Climate Action...