Energy Transition: Investing in Emission Reduction vs. Purchasing Carbon Certificates: A Cost-Benefit Analysis

The main agreements reached by the international community at COP28 (Dubai, 2023) included decisions to phase out the use of hydrocarbons, committing countries to: a) transition away from fossil fuels to achieve net-zero emissions by 2050, and b) triple renewable capacity by 2030. More recently, during COP29 (Baku, 2024), it was further decided to facilitate the development of an international market for carbon credits, allowing countries to trade permits to meet their emission quotas, thus trying to keep global temperature from rising above 1.5 degrees Celsius. 

In a companion article,¹ I claim that we could speed up the energy transition towards renewables if the international community established an (enforceable) international rule mandating the measurement and control of the Carbon Footprint of Products (CFP) traded internationally. If the CFP of traded goods could be easily measured and certified by an international standard procedure, then products with a CFP higher than the allowed maximum (CFP_max) would not be permitted to enter a country unless the local importer (or the foreign exporter) purchased carbon certificates that compensated for the difference by the amount of (CFP - CFP_max) x P_C dollars per ton of final product, where P_C would be the market price of carbon certificates in [$ / ton of CO₂]. This price would be ideally set by the world aggregate supply and demand for carbon emission permits.

In what follows, I develop a very simple cost-benefit analysis that any manufacturing firm should conduct to decide whether (or when) to invest in emission reduction technologies or when to buy carbon certificates in the market to be able to sell products that comply with the maximum allowed levels of CFP.²

Do I invest in emission reduction, or do I purchase carbon certificates? A Cost-Benefit Analysis

Imagine a firm that manufactures a product for export to a destination country that has set an allowed maximum CFP_max in tons of CO₂ emitted to manufacture each ton of final product. Assume that this firm has its own actual CFP that it can measure and certify through the application of internationally accepted standard procedures. To export this manufactured good to the destination country though, the firm’s own CFP has to be less than or equal to the CFP_max set by the destination country. Assume further, that the firm’s CFP is a function of the money that the firm invests in emission reduction technologies ( I )  defined as the amount of money that the firm spends trying to reduce its CFP to (eventually) reach the target level CFP_max and it is measured in $ per ton of CO₂ (per ton of final product).³ Furthermore, assume that the functional relationship between CFP and I is negative, i.e. the more money the firm invests in emission reduction technologies, the lower its final CFP, as illustrated by Graph 1 below.

Intuitively, the firm will have an initial CFP₀ at zero investment (I = 0) in emission reduction. As the firm spends more on emission reduction (i.e. I > 0) CFP will fall, eventually reaching the allowed maximum level of CFP_max set by the destination country (horizontal red line in Graph 1).⁴ The cumulative amount of investment will then be the shaded area under the CFP curve between I = 0 and I_max representing the cumulative money invested to reduce CFP₀ down to CFP_max.

If, however, a market for carbon certificates exists, the firm can choose between investing in emission reductions per ton of product and per unit of time or purchasing a carbon certificate. The latter is a permit to release a ton of CO₂ for a price equal to P_C, ideally set by global supply and demand for carbon certificates. The choice between investing in emission reductions vs. purchasing carbon certificates will depend on the relative prices of both alternatives as Graph 2 below shows.

In Graph 2, the price P_C of carbon certificates (vertical green line) is higher than the investment necessary to reach the allowed CFP_max (P_C > I_max)_. In this case, then, it is more convenient for the firm to try to comply with the allowed maximum by investing in emission reductions rather than by purchasing carbon certificates. Investing in emission reductions would cost the firm the shaded area A (curved grey triangle) below the CFP curve between I = 0 and I_max while purchasing carbon certificates to release [CFP₀ - CFP_max ] tons of CO₂ per ton of final product would cost the firm area Z + A, which is [CFP₀ - CFP_max ] x P_C dollars.

This illustrates why allowances should not be given for free to private firms like power generating plants or energy-intensive manufacturing firms. If the authorities gave an allowance of [CFP₀ - CFP_max ] for free, then the private company could sell it in the secondary market collecting Z + A dollars but spending only A in investment to reach CFP_max and pocketing the difference Z. If allowances were auctioned off, then the firm would bid up to area A dollars for the right to release [CFP₀ - CFP_max ] tons of CO₂ per ton of final product into the atmosphere. Money that could be collected by the government and used to finance renewable energy projects.

In the second case (Graph 3), the allowed maximum CFP_max set by the authorities is low, and the necessary investment that the firm would have to make to reach that CFP level should be greater than the market price for carbon certificates P_C  (I_max > P_C).

In this case, between CFP₀ and CFP_C (i.e. the CFP level at which the necessary investment per ton of CO₂ is equal to the market price of carbon certificates P_C) investing in emission reductions will be preferable to buying carbon certificates because area A is smaller than area Z + A. For CFP levels between CFP_C and CFP_max however, the opposite occurs, and buying carbon certificates at P_C per unit will always be cheaper than investing in emission reduction because area C (in green) is smaller than area C + B. Buying carbon certificates then saves the company area B.⁵

Concluding Remarks

In sum, and assuming: a) a negative functional relationship between CFP and investment in emission reduction, b) the existence of an enforceable international trade rule that can measure and control CFP, and finally c) the existence of a global market for carbon certificates, then the benefit-cost analysis calls for an optimal combination of investment in emission reduction technologies for CFP levels greater than CFP_C and for the purchase of carbon certificates for CFP levels lower than CFP_C, where CFP_C is the CFP level at which the investment in emission reduction per ton of CO₂ becomes equal to the market price of carbon certificates P_C.

1 See  https://www.jdsupra.com/legalnews/a-faster-energy-transition-towards-8337875/

2 This basic model assumes that the world has adopted a Cap-and-Trade or an Emissions Trade System (ETS) such as the ones in place in California and in the European Union where the authorities set allowances (i.e. amounts of CO₂ allowed to be emitted), in tons of CO₂ / ton of final product, that the governments either give out for free or through auctions. These allowances are set per sector of the economy, i.e. electricity generation, manufacturing, mining, etc. For more details See https://ww2.arb.ca.gov/es/our-work/programs/cap-and-trade-program and https://climate.ec.europa.eu/eu-action/eu-emissions-trading-system-eu-ets_en. 

3 This     investment     can    be   made    by   either  purchasing  raw  materials  that have themselves a lower  CFP  or  by,  for  example, signing   a   Power  Purchase    Agreement   (PPA)    with  a   renewable source of energy.

4 Two clarifications are in order though, first: the firm does not know the shape (i.e. slope) of this functional relationship. In other words, the firm does not know by how much CFP will fall per unit of investment I, it will have to proceed by approximation. It will start investing $I per ton of product per month and it will observe by how much CFP falls, then it will have to start calibrating its investment over time to eventually (by trial and error) reach CFP_max. Second, there will always be a minimum CFP level (i.e. CFP_min) that the firm will never reach, even as its investment level tends to infinity. This is due to the fact that there would always be small traces of CO₂ in the product’s manufacturing process that would be uneconomical and unnecessary to remove. 

5 In the only case that giving out allowances for free would be optimal is if CFP_C coincided with CFP₀ but it that case P_C would be equal to zero. 

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