Olaf Corry

Push for carbon markets with buyer liability

The main obstacle to climate change mitigation in industrialised countries is surely a version of the problem of collective action: unless other big emitters are committed and complying, the incentive and political room for manoeuvre to take effective national measures will remain small.

Cap-and-trade systems have the advantage that the trading of emissions permits creates an incentive for low emitting (historically or per capita) countries to join the scheme because they can raise money by selling permits. However, enforcing a tradable permit without carbon leakage has proved difficult.

Under the present system permit-selling countries may exceed their allotted quota at any time without paying any real price, bar prestige. Buyers of permits that turn out not to be ‘going spare’ pay no premium at all. Permit-buyers and sellers currently have an incentive to collude to inflate the validity of a traded carbon permit or the supposed carbon reductions of a Clean Development Mechanism project.

This can partly be tackled if industrialised countries make it a priority to push for a system with buyer liability in carbon markets*. Buyer liability would make carbon markets similar to bond markets. With buyer liability, if a UK company planning to emit more than its share buys a carbon permit from a Chinese company, and China at the end of the year is judged to have exceeded its expected emissions, the Chinese permits would be marked down, leaving the buyer short of emissions permits. The UK company would have to go out and buy more permits or bring down its own emissions. As a buyer it would be liable. Companies from permit-short countries would look to buy safe permits from countries with reliable emission controls (increased demand would push up the market price of such permits). In the interests of fair competition, buyers would pressurise their governments to ensure that other companies buying permits were made to live up to their allotted quotas. Bailouts of those who bought permits that turned out to be dodgy would be very unpopular with conscientious permit-buyers. There would, in other words, be incentives for compliance amongst competing permit-buyers.

For their part, permit-selling companies would pressure their respective governments to live up to their national climate obligations since defaulting (by over-emitting) would reduce the market value of the permits that such companies would hope to sell in the future. Permit-selling countries would have an incentive to demonstrate reliability or provide the market with credible plans for how they propose to keep their emissions under control in the future. There would thus be an in-built incentive to achieve compliance rather than an incentive to collude in making fake reductions.

The whole system does not presuppose any international carbon capping police but does require an independent assessment body that judges whether a country has stayed within its overall cap. The rest would be up to the market for permits and internal pressure for national regulation.

For any cap and trade scheme, countries will have to accept the meaningful limits on emissions in the first place. But all things being equal, with better prospects for compliance – and thereby wider participation with less fear of free-riders – the prospects for success at the Copenhagen summit would be vastly improved.

*This idea has been argued at length by David Victor (2001) The Collapse of the Kyoto Protocol and the Struggle to Slow Global Warming and more recently by Robert Keohane and Kal Raustiala Towards a Post-Kyoto Climate Architecture, available online at

http://belfercenter.ksg.harvard.edu/files/Keohane%20and%20Raustiala%20HPICA1.pdf

Olaf Corry, Research Associate at the Centre of International Studies at the University of Cambridge

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