Published On: September 29, 2022Categories: articleTags:

Markets for carbon certificates sell a promise of a more sustainable future. But how they plan to keep that promise is a tricky question. We dive into it.

If you want to think about how carbon markets work, start by wondering what you buy when you buy a carbon certificate.

At one point in the past someone took an action — planted a tree, pumped CO2 deep underground — that promises to sequester carbon for a long time. A carbon market, like markets usually do, allows this person or company, the seller, to trade away the future benefits of that action to a buyer in return for a payment.

Let’s hope that the payment part is straightforward — no problems with credit cards, etc. — and focus on the future benefit that gets transferred in the form of a certificate.

I might, by compensating the seller for the effort, get personal satisfaction out of the good feeling that I helped balance the global carbon household and took a tiny step closer to a 2-degree or a 1.5-degree goal. Or I might buy the carbon certificate in order to offset some other (polluting) action I want to take, voluntarily or because it is required by law.

In either case, my motivation to buy the carbon certificate hinges on my trust that the action will cause the promised consequences. This is where it gets tricky.

If all we know about the certificate is that it sells some vaguely defined action with some warm-and-fuzzy consequences (“every click a tree”), chances are the market for these certificates will quickly be overrun by low-quality offers. There is no clear definition for what planting a tree means, so it could be as simple as kicking over a sack of acorns, or worse, growing a plantation in lieu of old-growth forests.

Another, very simple and very common problem is that a single action is being sold multiple times on multiple markets. It’s not hard to forecast that such a market will contribute little to any climate goals, and inevitably collapse once everyone understands that.

Information asymmetry and how to overcome it

This phenomenon was the subject of a famous economics paper, “The market for lemons: quality uncertainty and the market mechanism” which ultimately brought its author, UC Berkeley’s George Akerlof, the Nobel Prize. Luckily, two economists joined Akerlof in the economics Nobel cohort of 2001 who offered partial solutions to this information asymmetry problem.

Stanford’s Michael Spence offered “signaling” and Columbia’s Joe Stiglitz offered “screening” as solutions to George Akerlof’s quality control problem. Simplified, they are two sides of a coin, and they are used all over the place for quality control across markets, for instance in a job market.

A carbon capture and sequestration process can easily have five or more steps, which themselves can be substeps with handovers between participants.

  1. Inputs
  2. Processes
  3. Outputs
  4. Applications
  5. End products

A carbon market framework

A vintner is trying to sequester grape residue. The local wine cooperative collects all the residue from local vintners and contracts with a chemical plant to turn the residue into stable char. The plant contracts with a shipping company to transport the char to a local storage site, for instance a discontinued mining pit repurposed to collect and store stable carbons. The pit owner can then sell the certificate for the confirmed storage on the carbon market.

It shouldn’t be hard to see that this can become very convoluted and confusing very quickly, especially with current plans to create long-distance carbon networks connected by controversial pipelines. Once things become confusing, the risk of fraud explodes.

Simplified, signaling means the seller is offering the most thorough documentation of all the ingredients, intermediate products, and process up to now. Screening means the buyer is using this documentation to choose the most attractive option among all certificates on effort.

The result is a shared audit trail.

This might not be a perfect system, no supply chain ever is, but we are at the point where we can do most of the monitoring, recording, and reporting digitally, for instance via IoT networks. We are in the lucky situation where we can build such a system from scratch.

And we have the additional benefit of creating shared audit trails that can be analyzed to find the optimal carbonization processes for the wide variety of existing biomass.