Environmental Economics

The Problem

Carbon capture, carbon offsetting and carbon trading are all born of economic theory that says damage caused to the environment by human activity is actually brought about by market failure. All economic activity has ‘externalities’, i.e. actions that impose a cost somewhere else, a cost that will not be recognised or incorporated in the cost of production or consumption. Environmental economics seeks ways of quantifying and ‘internalising’ these sort of costs into their economic acts, the idea being to create the incentives that lead to optimum production/consumption.  For instance, a shoe factory that pollutes a river by using it as a free dump incurs first an environmental cost to the river, then maybe a social cost as people who use the river fall ill, and next a financial one to whoever ultimately cleans it up. But with no need to include that cost in the selling price of the shoes, you'll get more people buying more artificially low-priced shoes, and the river beside the shoe factory takes even more abuse.

The problem outlined above is summarised in a now famous 1968 paper – The Tragedy of the Commons – by Garret Hardin. Hardin explains how, due to the collective acts of self-interested individuals the usual positive outcomes of a free market are likely to be lost. His explanation takes for its example ‘the commons’ - public grazing land, open for the collective use of all herdsmen who (he suggests) will ultimately add cow after cow to their personal herd until the commons are overgrazed to extinction. Even when all of the herdsmen collectively recognise the perils of owning too many cows, there may still be a lack of trust, and there will always be those who break the rules.

Environmental economics says that this pattern applies, unfortunately, to the whole of society. It's easy to see how it applies to our ‘global commons’ with its over-fished oceans and polluted atmosphere. There appear to be only two solutions: (a) regulation or (b) the making sure that goods and services reflect their true cost to society, meaning on the whole we buy and use less of them.

Whether we’re removing too much (e.g. in the form of overfishing, biodiversity loss, species extinction) or adding too much (e.g. greenhouse gases, nuclear waste, etc.) something finite is being used up.  In the case of the atmosphere, this finite resource is time - the time left until irreversible harm is done to the planet.


 The goal of internalising externalities and achieving a socially optimum level of output can be approached in two ways: (a) a ‘green tax‘; (b) carbon credits/offsetting mechanisms.

With the imposition of a ‘green’ tax on production the tax raised is supposed to be equal to the social costs of the given activity. In theory you could claim a ‘double dividend’ here - based on the premise that socially optimum output has been achieved plus revenue raised for government to be spent on some environmental benefit. But experience shows that green taxes are never really set high enough to influence consumer behaviour (e.g. UK flight taxes don’t really stop us flying and the money raised doesn’t go to environmental projects).

The second option is to create a market in permits for harmful activity, such as the system created by the Kyoto Protocol.  A limit is set on a given activity (e.g. greenhouse gas emissions) and the set number of permits is issued (like vouchers) giving the user the right to carry out the emission-causing activity. If the user manages to operate without using up all their permitted CO2 ‘vouchers’ they can sell them. The system is a sort of musical chairs – there must be fewer ‘vouchers’ (seats) available than total previous emissions (people waiting to grab a seat when the music stops) – leading to lower overall emissions.

Extending the musical chairs analogy – this method is seen as being efficient and not bureaucratic because it is blind to who occupies the remaining chairs, and leaves the participants to sort it out amongst themselves. The first place this was tried was in the US, with the so called Acid Rain (sulphur dioxide) permits. Experience showed that emissions reductions were successfully achieved ahead of time and at substantially lower cost than anticipated. The EU Emissions Trading Scheme is also such a scheme.

At Forest Carbon none of our partners is subject to any mandatory scheme – they are acting purely voluntarily in reducing their emissions and capturing the balance through carbon credits issued from UK woodland creation (like the ‘vouchers’ mentioned above, but representing carbon dioxide captured by trees as they grow). These businesses are making sure they account for a much better reflection of the true cost to society of their goods and services, and bringing benefit to us all at the same time.