Streetwise Professor

In 2010, along with my UH colleagues Victor Flatt and Praveen Kumar, I taught what I believe was the first academic carbon trading course in the world. My lectures in the course related to the economic challenges of creating traded commodities, specifically the challenges of merely defining what the commodity is and monitoring adherence to the standards so established.

Now, this may seem trivial, but even something like “wheat” poses challenges due to heterogeneity related to quality (even within a given variety, such as soft red winter wheat) and monitoring whether the wheat traded under a contract adhered to the relevant terms agreed to by the parties. Indeed, as I noted in an early article of mine, the genesis and early development of commodity exchanges like the Chicago Board of Trade and the Liverpool Cotton Exchange was not driven by the desire to trade futures: these were cooperative, private efforts to define property rights and to create a mechanism to standardize commodities and to adjudicate contractual disputes primarily over quality. Only after these challenges were met was it possible to trade futures. Standards (and their enforcement) are obviously a necessary condition for trading standardized instruments like futures.

The major intended takeaway from my lectures in 2010-11 was that the problems of standard definition and especially standard enforcement were even more daunting in carbon than in traditional commodities like wheat or cotton, and that this was especially true with respect to carbon offsets–things like contracts to plant trees to capture carbon.

How do you define what is being bought and sold? How do you monitor whether the offset contracted for performs as agreed? How do you address contract performance failures? The Chicago Board of Trade struggled for years to overcome these issues in wheat and corn and oats in the post-Civil War era, even though the trade was relatively geographically concentrated, the contracts were of relatively short duration (typically for a single consignment), and the commodity was relatively simple.

All of these challenges are far greater for carbon, let alone for offsets. Sources of carbon emissions are numerous and diffuse and costly to monitor. With respect to offsets, they are highly heterogeneous; have very long lives; require continuous investment and upkeep; and have highly unpredictable performance (e.g., the forest that you plant may burn down, or be ravaged by insects). These contracts are far more complex than a deal to buy 10,000 bushels of SRW winter wheat for delivery in Chicago next month. Moreover, many offsets are located in countries with weak–and sometimes close to non-existent–legal systems.

Furthermore, the incentives of the parties to these agreements can be perverse, especially for “voluntary” offsets. A buyer who pumps its ESG score by purchasing offsets that turn out not to perform seldom suffers serious adverse consequences (although there is some backlash against “greenwashing”), and the seller has a strong incentive to collect the cash and not make the necessary expenditures to ensure that the offset performs as promised.

I taught the class in the immediate aftermath of the Global Financial Crisis, and I suggested that there were a lot of similarities between offsets and the kinds of deals that wreaked havoc in the banking system in 2008-2009, where bankers paid their bonuses upfront based on imagined profits predicted by highly speculative models to be realized over several years churned out garbage securities.

In 2010 I was therefore extremely skeptical about the viability of markets for offsets. And the defects that I talked about have been increasingly recognized in the last year or so.

I believe that the actions of Shell during the last week represent an authoritative recognition that these predictable–and predicted–problems have come to pass. Like other (especially European) energy firms. Shell made ambitious carbon reduction pledges that it intended to meet largely through the use of offsets. But reality has reared its ugly head, and Shell is all but abandoning this strategy. Other companies (e.g., Microsoft) say that they are still committed, but if they are even remotely interested in spending their shareholders’ money wisely, they will eventually have the same come to Jesus moment as Shell.

A Shell-funded mangrove restoration project in Senegal (Bloomberg).

This represents another grievous blow to the ambitions of the Net Zero fanatics. Offsets are a major component of Net Zero plans. Renewables are another part–and reality is catching up with that too (as the travails of Danish renewables developer Orsted and German turbine manufacturer Siemens demonstrate).

But will the fanatics be deterred? Alas, it appears not. Indeed, they appear to be doubling down, as illustrated by lunatics like Michael Gove:

Michael Gove has insisted the UK needs 'big, hairy, audacious' environmental goals such as the ban on the sale of new petrol and diesel cars from 2030, during a live debate at #ftweekendfestival https://t.co/jD1bEkY8c0

— Financial Times (@FinancialTimes) September 2, 2023

Net Zero and the policies intended to bring it about–including extensive reliance on renewables and offsets–are a guaranteed recipe for an impoverished future. This was predictable–and predicted–more than a decade ago. But when will the madness end? I am guessing not before these policies cause economic catastrophe.