Market Failure – Chasing Tales

An externality is an economic term for a cost (or benefit) that spills over to people who didn’t cause it and aren’t compensated for it. When a coal power plant generates electricity, the plant’s owner counts the cost of coal, labour, equipment, and maintenance. But the plant doesn’t count the cost of the pollution it releases. Those costs exist; they’re just borne by everyone else but not reflected in the price of electricity: put simply, the price of electricity is too low because it doesn’t account for the true social cost of its production. The market has failed. Economists call this a “market failure” (imaginative).¹

In theory, the “cap-and-trade” system would allow markets to figure out the cheapest way to cut emissions. This theory was tested first on acid rain in the United States, and it worked. Factories that could cheaply reduce sulfur dioxide did so and sold their excess reduction “rights” to factories where reduction was expensive. Total sulfur dioxide fell.² ³ Costs were lower than if every factory had been forced to reduce by the same percentage.⁴ This mechanism is explained here.

At the moment, there are two distinct carbon markets operating simultaneously:

The compliance market, where governments make the rules; and
The voluntary market (which is… voluntary)

Within each of these, there are many different programmes and trading systems, but almost everything you hear described as “carbon trading” sits in one of these two buckets.

The compliance market
For example, a government decides that all power plants, cement factories, and steel mills (or whatever sectors it targets) must collectively emit no more than a certain amount of carbon in a given year. This total is the “cap.” The government then divides the cap into “allowances”—each allowance permits one tonne of CO₂ emission. These allowances are either given free to companies or sold at auction (that depends on the design of this new regulation).

Now here’s where the trade happens. At the end of the year:

A factory that emitted less than its allowance can sell its extra allowances to another factory.
A factory that emitted more than its allowance must buy extra allowances from others, or face heavy penalties.

The result: a market price for carbon emerges based on supply and demand. Companies facing high costs to reduce emissions buy allowances from companies where reduction is cheap. Total emissions stay within the cap. Abatement happens where it costs least.

Examples are the EU ETS,⁵ and the California cap-and-trade markets.⁶

The voluntary market
Here, there’s no government mandate. Instead, companies and individuals can choose to buy carbon credits to offset their emissions as part of their net-zero pledges, ESG commitments, or sustainability branding.

In the voluntary market, someone identifies a project that reduces or removes carbon—perhaps reforestation in Indonesia, a wind farm in India, or a methane capture system at a landfill in Brazil.⁷ The project is audited by a third party to verify that it genuinely reduces carbon.⁷ If it does, the project is issued carbon credits. Each credit represents one tonne of CO₂ equivalent reduction or removal.⁸ ⁹

Say, a company in London that wants to offset its emissions can then buy these credits—perhaps from an Indonesian reforestation project. The company retires the credits (removes them from circulation permanently, so they can only be used once- this means credits generated by the reforestation project up until that moment were used up and only newly generated credits can be used from now on),¹⁰ effectively claiming that its emissions have been offset by trees planted elsewhere (no double counting).¹¹

On the surface, this seems elegant: emissions reductions happen where they’re cheap, capital flows to developing countries that need investment in clean energy and conservation, and companies take responsibility for their carbon footprint. In theory, both market mechanisms align economic incentive with environmental goal.

In practice, let’s see how this actually worked out.

Who would have thought.
If you bought carbon credits in 2020 to offset your company’s emissions, what you almost certainly received was a credit from an “avoidance” project.¹² An avoidance project is a carbon offset project that stops emissions from happening in the future, rather than removing carbon that’s already in the atmosphere—something like renewable energy, or methane capture at a landfill.¹³ These credits were cheap, often just a few dollars per tonne, and they dominated the voluntary market.¹⁴ Besides, someone can also always open a new landfill, which generates methane regardless of the credit market.

The core problem with avoidance projects (and why they dominate low-quality carbon markets):

Additionality is hard to prove: Additionality is the concept that a project only gets carbon revenue if there is proof that it would not exist without carbon revenue.¹⁵ This is obviously difficult to prove, since no one can prove a counterfactual.¹⁶ So, did the wind farm only get built because of carbon credits? Or would it have been built anyway because wind is now cheaper to build wind farms and there are regulatory incentives for both producers and consumers of wind energy? If the latter, you’re issuing credits for something that would have happened regardless, and it is an inefficient use of precious climate money.¹⁷
They’re cheaper to credit: A wind farm in India might cost $50 million, generate carbon credits, and people will buy them for $5/tonne because they’re plentiful and easy to verify.¹⁸ Compare that to a “removal” project (direct air capture, or verified reforestation) that might cost $300-600/tonne but is genuinely rare and harder to fake.¹⁹ ²⁰
They create perverse incentives: If a cement factory can buy avoidance credits instead of upgrading its own equipment, why upgrade? The credits let you stay dirty.²¹ ²²

There is also the matter of currency exchange rates. For example, if a project developer in India earns carbon credits and sells them in dollars or euros, they get a currency arbitrage bonus when converting back to rupees. This creates extra incentive to maximise credit issuance, even if the climate impact is questionable.

There are more than a few cases:

In 2022, the NewClimate Institute and Carbon Market Watch conducted a detailed audit of the net-zero pledges of 25 of the world’s largest companies—including Amazon, Google, and Walmart. Their findings were stark: the companies’ headline pledges, on average, only committed to actually reduce emissions by 40%—not the 100% their “net-zero” branding implied. Of the 25 companies, 22 received ratings of either “low” or “very low” integrity. Almost all of them planned to use offsetting credits of varying quality to paper over the gap.²³
In 2024, researchers publishing in Nature Communications analysed the carbon credit purchases of the twenty largest corporate buyers in the voluntary carbon market — including Microsoft, Google, and Amazon — covering the period from 2020 to 2023. They found that 87% of the credits these companies bought carried a high risk of not providing real, additional emissions reductions.²⁴
In one notorious case, chemical manufacturers in China and India deliberately overproduced a potent refrigerant which is a greenhouse gas (HCFC-22, to generate HFC-23 as a byproduct) for no reason other than to destroy it and claim lucrative carbon credits. The practice was eventually curtailed, but it exposed how badly designed crediting rules can actively increase emissions. The fact that this ended only after regulators intervened is proof that market incentives alone are not enough.²⁵ ²⁶

This pattern reveals a fundamental problem with the voluntary carbon market: the market has incentivised volume and price, not integrity.²⁷ Companies with net-zero commitments needed credits fast and cheap. Sellers of credits had incentive to issue as many credits as possible.²⁸ Verification bodies—the third parties meant to audit projects—often lacked independence or rigorous methodology.²⁹ ³⁰ The result was a flood of low-quality credits.³¹

Offsetting vs. Reduction
Beyond fraud and greenwashing, there’s a more fundamental critique of carbon markets, especially the voluntary market: offsetting does not reduce emissions; it merely allows you to claim you did while someone else cuts instead.³²

Climate science is unambiguous on this point: we need to reduce absolute greenhouse gas emissions.³³ If we’re to have any chance of limiting warming to 1.5°C, global emissions need to drop dramatically and rapidly. The window is closing. With the world’s remaining carbon budget for 1.5°C likely exhausted by 2029,³⁴ ³⁵ there is no time for accounting tricks. For a deeper understanding of this, you can read this, and this.

When you buy a carbon credit, you’re ~~typically~~ hopefully buying a reduction that would not happen without the credit. But if the world is serious about climate action, then all reductions should be happening anyway—not because someone paid for them, but because governments have set binding targets or regulations that force them. This creates what researchers call a “delay effect”: by allowing companies and countries to buy offsets instead of reducing at home, carbon markets can actually weaken direct climate action.³⁶ A company might decide: why invest in energy efficiency when we can just buy cheap credits? A country might decide: why transition away from coal when we can buy credits from other countries?

The deeper problem with offsetting is not ethical but physical. Most offsets allow emissions to happen now in exchange for a promise of reduction or removal later.³¹ But climate damage is driven by cumulative emissions over time, not by accounting balances. A tonne of CO₂ emitted today does immediate and irreversible work in the atmosphere: it traps heat, accelerates feedback loops, and eats into the remaining carbon budget while it is most scarce. Promised future removals—whether from trees that may burn or technologies that may not ever happen—do not undo that damage in the critical near term. Offsetting assumes that emissions across time are fungible; climate physics does not. From the perspective of the climate system, emitting now and “neutralising” later is not equivalent to not emitting in the first place.³⁷

Article 6
Article 6 of the Paris Agreement, operationalised in 2024³⁸ creates two pathways for international carbon trading:

Article 6.2 allows countries to trade emission reductions bilaterally. Country A reduces emissions and sells the reduction to Country B, which counts it toward its Paris Agreement target.³⁹
Article 6.4 creates a centralised UN-supervised market, similar to the CDM but with supposedly stronger safeguards against fraud and double-counting.⁴⁰

This has happened before. Under the Kyoto Protocol, the main international offset scheme was the Clean Development Mechanism, or CDM.⁴¹ However, Article 6 permits legacy credits from the CDM—the very scheme that was riddled with systemic failures⁴²—to be transferred into the new market. This means all the problematic reductions from discredited projects can continue to be traded under a new label. There are an estimated 2-5 billion⁴³ unused CDM credits sitting in registries (we don’t know the exact figures, or even a close estimate, that’s just the state of the industry at the minute). An honest carbon market would not include these. Moreover, there is already evidence that countries are using Article 6 not to supplement domestic emission reductions but to substitute for them.⁴⁴ Wealthier nations are buying cheap credits instead of pursuing binding, domestic decarbonisation.

Is there something better?
Given all the problems, why do carbon markets persist?

First, they’re better than the alternative that was on the table:⁴⁵ ⁴⁶ When countries negotiated the Kyoto Protocol, the question wasn’t “should we have carbon markets or not?” It was “how do we get countries to commit to emission reductions at all?” Carbon markets, by offering flexibility and cost-effectiveness, made it politically possible for countries to agree to binding targets.
Second, they mobilise capital:⁴⁷ ⁴⁸ ⁴⁹ The voluntary carbon market, flawed as it is, has channeled billions of dollars into clean energy, reforestation, and conservation projects in developing countries. That capital likely wouldn’t exist without the market—it wouldn’t exist as development aid or climate finance in that volume.
Third, they create a price signal:⁵⁰ ⁵¹ By putting a price on carbon—even an imperfect one—markets have shifted some business behavior.
Fourth, there’s no consensus on the alternative: Some argue for pure regulation—carbon taxes, efficiency mandates, technology bans. Others argue for direct public investment in the clean energy transition.⁵² Some combination of all three is likely needed. But the question of how much regulation versus how much market remains genuinely contested among serious climate economists.⁵³ Carbon markets represent a compromise position: market mechanisms with increasing regulatory guardrails.

None of this implies that voluntary offsetting can substitute for domestic emissions cuts; carbon markets can only play a supporting role once those cuts are underway. Carbon markets should be treated as a supporting tool, not a primary solution. Their most appropriate role is in marginal abatement—financing emissions reductions or removals that are otherwise prohibitively expensive, after binding domestic caps and regulatory measures ensure all major emitters reduce at home.

So why isn’t carbon reduction mandatory?
There are three overlapping answers: politics, power, and timing.

1. Strong climate policy creates very visible losers and mostly invisible winners⁵⁴

A high carbon price or hard cap raises energy and fuel costs in the short term, which hits households and energy‑intensive industries directly.⁵⁵ ⁵⁶
The benefits—less climate damage in 2040, fewer heatwaves in 2050—are diffuse, delayed, and hard to attribute to any single law.⁵⁷

2. Concentrated interests vs. diffuse publics

Then there’s power. Fossil fuel companies, energy‑intensive industries, and regions built on coal, oil, or gas have a lot to lose from hard caps, and they’re extremely well organised.⁵⁷

Political economy research finds that “concentrated losers”—carbon‑intensive firms with big sunk investments—lobby hard, sue, and threaten job losses to weaken or block carbon pricing and strict regulation.⁵⁸
Fossil fuel companies have spent decades funding denial, delay, and scare campaigns arguing that climate policy will wreck the economy, delaying or watering down action in the EU, US, and elsewhere.⁵⁹
The people who benefit from strong climate policy—future generations, workers in new industries, people spared from extreme heat—are diffuse and poorly organised.⁵⁴

3. The free‑rider and “competitiveness” problem

Finally, climate change is a classic free‑rider problem. If Country A imposes strict reductions on its industries while Country B doesn’t, firms in A will complain about “losing competitiveness” and threaten to move.⁶⁰

The climate benefits of A’s ambition are global and shared; the economic costs are local and concentrated.⁶¹
That creates a strong temptation to wait for “others” to move first—and to rely on offsets or imported credits instead of hard domestic cuts.⁶²

This is the political backdrop against which carbon markets were sold. Cap‑and‑trade and offsetting were pitched as ways to make climate action more “flexible,” cheaper for businesses, and less politically suicidal for governments: don’t force everyone to cut by the same amount; let them trade responsibilities around, and let rich countries buy reductions wherever they’re cheapest.

Carbon markets were built on an elegant economic insight: if pollution has a price, markets can help reduce it at lowest cost. But elegance in theory does not survive contact with weak governance, asymmetric power, and human incentives. The only way to make the carbon market truly into a market of real climate action is to make verification and third party audits mandatory, including regulations around mandatory domestic reductions in wealthy credit-buying nations first, strict limits on offsets, removal-only credits, short credit lifetimes, and public registries with no double counting.

The next phase of the carbon market will be determined by whether we can build systems rigorous and honest enough to prevent a collision with human nature.

Sources

Tag: Market Failure

Carbon Markets 101 – Introduction

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