Introduction
Carbon emissions play a central role in climate change and environmental degradation. According to the Sixth Assessment Report (2021) of the International Intergovernmental Panel on Climate Change (IPCC), global anthropogenic greenhouse gas (GHG) concentrations have far exceeded historical levels. One of the main causes of global temperature rise is the widespread use of fossil fuels, which are a
major source of carbon emissions. While carbon emissions on a global scale have a profound impact on climate change, relying solely on stopping the use of fossil fuels will have a huge impact on the economy. How to achieve carbon emission reduction while ensuring stable economic growth has become an important issue in current policy design. Carbon credits, as a market-based emission reduction mechanism, have been proposed to induce large enterprises to reduce carbon emissions through economic incentives. This paper will analyze the operation mechanism, advantages, challenges and its economic effects of carbon credits from the perspectives of economic theory and empirical data.
Overview of Carbon Credits
What is Carbon Credit?
Carbon credits are tradable emission permits that allow the holder to emit a certain amount of carbon dioxide or its equivalent. Each carbon credit is usually equivalent to one ton of CO2 emissions. Carbon credits are traded based on the Cap-and-Trade mechanism, which is a market-based environmental policy instrument. Under this mechanism, the government sets an overall cap on carbon emissions for each industry or country and allocates these caps to individual sources. Emission sources can obtain carbon emission allowances through allowance auctions or free allocation. Through the market mechanism, companies can buy and sell these allowances, thus optimizing the distribution of carbon emissions and reducing total emissions to a certain extent.
Economic modeling of the carbon trading market:
The operationprinciple of the carbon trading market is in line with the market supply and demand model and the theory of externalities in microeconomics. In a carbon trading market, the cost of carbon emissions is determined by the market through supply and demand, and the externality of carbon emissions is internalized by setting emission caps and trading quotas (Pigou, 1920). This mechanism effectively prices carbon emissions and thus incentivizes firms to choose the least costly way to reduce emissions. For example, when the supply in the carbon market is constrained and the demand increases, the price of carbon credits rises, thus incentivizing firms to invest more in emission reduction.
Role and advantages of carbon credits
Flexibility and cost-effectiveness:
Carbon credits provide flexibility for emission control by creating a market trading mechanism. According to the theory of optimal abatement cost (Hotelling, 1931), in a perfectly competitive market, the cost of carbon trading will equalize, and firms will be able to minimize the total abatement cost through free trading. For example, in the European Union Emissions Trading System (EU ETS), the price of carbon trading in 2019 is €25/tonne of carbondioxide, which is a significant increase compared to €15/tonne in 2018, reflecting the increased market demand for emissionreduction (European Commission, 2020). The price mechanism of the carbon market ensures that companies choose the most cost-effective way to reduce emissions globally, thus reducing the overall economic cost of reducing emissions.
Promote clean energy investment:
A carbon credit system not only encourages companies to reduce their own carbon emissions, but also promotes the development of the clean energy industry. According to the theory of externalities (Pigou, 1920), when market activities lead to social costs (e.g., environmental pollution), enterprises should be compensated through taxes or quotas. In a carbon trading system, the “externality” of emissions is internalized throughmarket-based means, and enterprises will be incentivized to invest in green technology research and development in order to reduce their own emissions, thus promoting the progress of renewable energy and low-carbon technologies. For example, global investment in renewable energy in 2020 will be around $300 billion, accounting for one-third of global energy investment (International Energy Agency [IEA], 2021).
Side effects and challenges of carbon credits
Market price volatility and inequality:
While carbon credits provide flexibility to the market, their price volatility is high, which can put more pressure on small businesses. For example, the carbon price in the EU carbon market fell to about €7/tonne at onepoint in 2018, but recovered to over €25/tonne in 2020as market supply tightened, policies adjusted, and investor confidence rebounded (European Commission, 2020). This price volatility could result in smaller firms facing higher emissions costs and being unable to afford the high cost of carbon credits, thus affecting their competitiveness. In addition, the fairness of the market may also be affected as large multinationals tend to have more resources to purchase carbon credits. This market imbalance can be analyzed through market power theory and information asymmetry theory (Tirole, 1988). Larger firms are able to dominate the market and utilize their capital advantage to purchase more carbon credits, while smaller firms may be forced to bear a higher cost of emissions, resulting in the fairness of the market being compromised.
Carbon leakage:
Carbon leakage refers to the fact that due to differences in carbon emission controls in different countries or regions, firms may shift their production activities to regions that have lower carbon pricing or do not have strict carbon emission controls. According to the theory of international trade and environmental policy (Copeland & Taylor, 2003), if there are too many differences in carbon pricing and emission controls between countries around the world, this may lead to firms choosing to move production to less regulated regions, thereby jeopardizing the achievement of global emission reduction targets. In order to minimize this phenomenon, there is a need for greater international harmonization of carbon markets to ensure the achievement of global emission reduction targets.
Quantitative analysis: economic impact of carbon credits
In order to quantify the impact of carbon trading on the global economy, a dynamic general equilibrium model (GEM) can be used. Assume that the initial price of carbon credits is $20/tonne, and that if emissions reduction policies are strengthened in certain countries, resulting in increased market demand, the price rises to $30/tonne. According to the GEM model, this price fluctuation may result in a loss of about 0.3% of global GDP, but in the long run, global GDP may rebound and achieve higher economic growth as green technology becomes more widespread and investments are made in the clean energy industry (IEA, 2021).
Conclusion
The carbon credit system is a cost-effective market mechanism that can facilitate business investment in low-carbon technologies and renewable energy by creating flexible emission controls. However, in practice, the carbon trading market faces challenges such as price volatility, market inequality and carbon leakage. In order to improve its efficiency, it is necessary to enhance the stability and global governance of the carbon market in the future by improving market design, strengthening international cooperation, and promoting technological innovation. Through the combination of quantitative modeling and economic theory, the carbon credit system shows potential in terms of both economic and environmental benefits, but its success still depends on the consistency of national policies and the coordination of global governance.
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