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When Markets Misfire: Carbon Credits and the Case of HFC-23

J. Mijin Cha

One of the strongest arguments against implementing a cap-and-trade scheme is that it is difficult to structure a program in a way that will meaningfully decrease greenhouse gas emissions due to pushback from entrenched interests. For instance, greenhouse gase emitters want the cap on gas emissions to be high and many credits to be given away, which doesn’t really do anything to decrease emissions but keeps credits fairly cheap to purchase and decreases costs to emitters.

In fact, there is another, more damaging reality to a carbon credit scheme that has been going on for several years. Under the Kyoto Protocol’s Clean Development Mechanism, investors in countries with emissions reductions targets can buy carbon credits to offset their emissions by investing in projects that reduce emissions in developing countries. In theory, developing countries get technology and capital transfers and developed countries can offset their emissions. This, of course, incentivizes developed countries to invest in these projects instead of significantly decreases their own emissions. It also, as it turns out, created a market for increasing the manufacturing of greenhouse and ozone destroying gases.

Manufacturers producing the gases used in air-conditioning and refrigeration figured out that they could earn more than 11,000 credits by destroying a ton of a waste gas, HFC-23, released during the manufacturing of a widely used coolant gas, versus one carbon credit for eliminating one ton of carbon dioxide. As a result, production of coolant gas has increased, even though the coolant itself destroys the ozone layer and is meant to be phased out under the Montreal Protocol.

Since 2005, 46 percent of all carbon credits have been awarded to 19 coolant factories. The money plants get from carbon credits is largely pure profit and each plant is estimated to have earned an average of $20 to $40 million a year just from destroying HFC-23. Companies earn twice as much from the credits as from producing the coolant itself and plant processes are deliberately inefficient in order to produce as much waste as possible. The program is so lucrative that when faced with proposals to close this loophole, manufacturers have threatened to just release the gas into the atmosphere if the program were to be stopped. While that practice is illegal in most countries, it remains legal in India and China where a number of plants are located.

The disastrous consequences of the CDM program are a good example of what happens when policy bends too much towards accommodating those whose behaviors are targeted. The ultimate goal of pacts like Kyoto is to decrease greenhouse gas emissions. The most straight-forward way is to tax emissions to incentive changes in behavior. We’ve talked about the benefits -- both environmental and economic -- that comes with taxing bad behavior. In contrast, offering an option to pay your way out of behavior changes is not going to work. We’ve talked extensively about how there is no market incentive for things like environmental protection. The HFC-23 example shows that very clearly.

The HFC-23 example also shows market reality: As long as profit is the main motivation, there will always be an interest wiling to do whatever it takes to increase their profits, even if it means exploiting a provision meant to decrease emissions to do the exact opposite and cause more harm than good. We need sticks, not carrots, to change this reality.