Idiosyncratic agency and transmission problems in the institutional design of Carbon Markets?

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Amra Gadzo

There are several major idiosyncratic pitfalls in the design of carbon markets. Some of the key challenges and risks include:

Additionality: One of the main challenges is ensuring that carbon credits represent genuine reductions in emissions that would not have occurred in the absence of the market. This is known as additionality. If emissions reductions are not additional, the market can become flooded with credits that do not represent real emissions reductions, leading to low prices and little impact on emissions.

Measurement and verification: Carbon markets rely on accurate measurement and verification of emissions reductions, which can be complex and expensive to carry out. Without robust and transparent verification mechanisms, there is a risk of fraud and false claims of emissions reductions.

Leakage: Carbon markets can also be vulnerable to "leakage," where emissions reductions in one area are offset by increases in emissions in another area. This can occur if emissions-intensive activities are simply relocated to countries or regions that do not have emissions caps.

Agency problems: There is also a risk of agency problems, where the government invests the proceeds of the carbon market windfall in ways that do not align with the goals of emissions reduction. For example, if the government uses the proceeds to fund tax cuts or other unrelated programs, this can undermine the effectiveness of the market.

Arbitrage mechanisms: Carbon markets can also be subject to arbitrage mechanisms, where market participants exploit price differences between different segments or jurisdictions. This can lead to inefficiencies and distortions in the market, and undermine the effectiveness of emissions reductions.

New class of risk: Carbon markets introduce a new class of risk known as "carbon risk," which refers to the risk that emissions reductions targets are not met, or that carbon assets become stranded due to regulatory or market changes. This can have significant financial implications for investors and companies involved in carbon markets.

In summary, carbon markets are complex systems that require careful design and management to be effective. By addressing key pitfalls and risks, policymakers can create markets that promote genuine emissions reductions and contribute to global climate change mitigation efforts.

Thomas Schuermann

Thank you for your contribution Amra. You state under number 5, that the arbitrage mechanism is destabilizing and inefficient. Could you elaborate on that?