Guilt Markets

Carbon Offset Provision with Guilt-Ridden Consumers*

by

Joshua S. Gans University of Melbourne 8th March, 2007

Carbon offsets can be purchased by consumers who wish to mitigate their emissions. In a model where the demand for such offsets is driven by consumers who feel guilt about their emissions, it is show that the introduction of offsets are complements to existing „dirty‟ consumption and can cause such consumption to increase. Net emissions are shown to decline, however, regardless of whether prices are regulated, chosen strategically or offset prices are endogenous. One special case is illustrated whereby emissions might rise if „dirty‟ producers can engage in strategic commitments to impact on offset markets. Journal of Economic Literature Classification Numbers: L94, Q42, Q58. Keywords: carbon offsets, greenhouse gases, electricity markets, strategic behaviour.

*

Thanks to Stephen King and Michael Ryall for helpful discussions. Responsibility for all errors and omissions is my own. The latest version of this paper is available at: www.mbs.edu/jgans. All correspondence to: [email protected].

2

1.

Introduction

Carbon offsets allow individuals, households and firms to cause activities to be taken that mitigate their carbon emissions. A common use for such offsets is to invest in trees and forests that remove carbon from the atmosphere. Another example is „green power.‟ In this situation, consumers pay a premium to subsidise investment in clean electricity generation (usually, wind or solar power). At a first pass, such offsets would seemingly do no harm. Households purchasing them would receive a „warm glow‟ or as I will term here „guilt reduction,‟ emissions would be reduced and welfare increased. There have been suspicions raised that offsets may not actually be inconsequential.1 Specifically, concerns were raised when it was revealed that environmentalist and former US Vice President, Al Gore‟s household consumed 20 times more electricity than the average in the US. Gore countered that the quantity was not an issue as he purchased offsets to reduce his „carbon footprint‟ to zero. But still there were concerns about whether the presence of an offset market might actually increase electricity consumption (notably, from „dirty‟ sources). This paper provides a formal treatment to evaluate such claims. The novelty of the model introduced here is that consumers feel „guilt‟ with regard to the level of greenhouse gas emissions that they generate. Notice that this is distinct from any disutility they might suffer due to the global level of emissions. Specifically, it provides a rationale for voluntary changes in their behaviour to mitigate those emissions. This is critical as it allows for an analysis of their demand for offsets and how this interacts with their consumption of ordinary goods such as electricity. This is not the first paper to model individuals who internalise some of their social negative externalities. Andreoni (1990) deals with „warm glow‟ effects. His applications are focused on charitable giving and do not involve the introduction of green or similar products per se. MoragaGonzalez and Fumero (2002) look at competition between firms for consumers sme of whom prefer environmentally friendly goods. Their analysis does not consider offsets but instead the impact of environmental policies (such as minimum emissions targets) in such markets. Kotchen (2006) analyses markets for green products and identifies potential counter-intuitive impacts. His analysis looks at self-interested individuals who care about a public good and have a discrete impact on it. He examines how they react to the emergence of green products that produce both a private good and contribute to the public good. Such products can cause individuals to reduce their effective public good consumption by substituting away from direct contributions to indirect ones. Kotchen‟s concerns are with the technical characteristics of such goods and does not include much of the pricing and strategic implications that I will consider here.2 The paper proceeds as follows. In Section 2, I introduce the model of demand for electricity (although it could equally apply to any greenhouse gas emitting good or set of goods). The presence of guilt mitigates consumers‟ demand for carbon emitting or „dirty‟ electricity. This also means that if consumers can purchase offsets, they will do so and they will purchase more 1

See, for example, Tyler Cowen or The Economist blog. Kotchen (2005) expands on this model while Ferraro, Uchida and Conrad (2005) explore some empirical aspects of a similar model. 2

3

offsets as their price falls. The first result from this analysis is that purchases of offsets and consumption of electricity are complements. The cheaper are offsets, the more are consumed but this stimulates consumption of electricity as consumers‟ net emissions and hence, guilt falls. That analysis holds prices as given. The remaining sections endogenise them. Section 3 provides a model of the electricity market. It is show that the introduction of offsets when an electricity generator has some market power causes them to lower the electricity prices (as offsets are a complement) but, nonetheless, net emissions are reduced even though electricity consumption is higher. Interestingly, when there are consumers present in the market who are guilt-free rather than guilt-ridden, net emissions still fall. While the guilt-free receive price reductions, the presence of the guilt-ridden mitigates the extent of these and so net emissions are always reduced by carbon offsets being available. Section 4 then considers what happens when offsets are invested in competing „clean‟ electricity capacity such as wind power. It is assumed that the amount of offsets purchased determines the supply quantity of such alternative electricity and that this supply is „non-strategic‟ and not withheld through the exercise of market power. Regardless of whether offset prices are exogenous (fixed at some arbitrary level) or endogenous (set at the net subsidy required), net emissions are reduced by their presence. This is despite the fact that competition reduces electricity prices and causes more consumption overall. The volume of „dirty‟ electricity purchased falls. Section 5 examines the possibility of strategic commitment by „dirty‟ electricity generators that pre-emptively impact the offset market. It is show that when offset prices are fixed or regulated, the „dirty‟ generator sets electricity prices high so as to deter the purchase of offsets (in this model all the way to zero). However, this reduces emissions as production must be curtailed to achieve this. When offset prices are endogenous, the motives of the „dirty‟ generator are reversed. In this situation, flooding the market with „dirty‟ capacity depresses electricity prices but raises offset prices. I demonstrate that when the capital costs of „clean‟ generation are high, this might mean more emissions in equilibrium with offsets than without them. Finally, in Section 6, I examine whether a market where clean producers were not subsidised but acted strategically could actually lead to less emissions than a subsidised/non-strategic situation. Of course, with regulated offset pricing, that price can be adjusted so that this is never the case. But with endogenous offset pricing, I show that if clean generation is cheap enough, then an unsubsidised model is preferable. Put simply, while the clean generator withholds capacity to increase profits, the dirty generator‟s consumers are constrained by guilt and so favour clean generation in any case.

2.

The Demand Model

Suppose that a representative consumer has utility, u(q) – g(q) – pq where q is the quantity of electricity consumed, p is its price and u  0 and g  0 . (It is also assumed that u  g  0 for an interior solution). g represents guilt on the part of the consumer. As they consume more electricity they become more guilt-ridden as this creates more emissions.

4

The consumer solves max q u(q)  g (q)  pq . The first order condition is: u(q)  g(q)  p Notice that the presence of guilt reduces the total consumption of electricity.

(1)

Now suppose that a voluntary carbon offsets scheme becomes available. An offset permit costs t and the consumer chooses o such permits.3 This impacts on the „guilt‟ component which is now written g (q  o) . The consumer now solves: max ( q,o ) u(q)  g (q  o)  pq  to . In this case, the consumer‟s first order conditions become: (2) u(q)  g(q  o)  p (3) g(q  o)  t where the second condition holds with equality for t sufficiently low. To analyse this further, I assume the following: (A1) The demand for offsets is downward sloping. That is, g   0 for o > 0. The idea here is that as the price of offsets fall, the consumer purchases more. This requires that as a consumer emits more, their guilt rises in greater proportion than their emissions. It could be argued that the reverse might be the case. A consumer might be less concerned as they emit more and more but guilty as they move from zero to a little emissions. However, this could still be accommodated. g (0)  0 and then rise thereafter. In this situation, if t falls low enough, q = o. This leads to a first proposition. Proposition 1. The choice of consumption, q* , and offsets purchased, o* , increases as t falls. However, total emissions q*  o* falls as t falls. It suffices to prove this graphically. In Figure 1, without offsets, total consumption is determined by the intersection between u(q)  p and g (q) , the point depicted above q* . When the consumer can purchase offsets at a price of t, if that price is too high – that is, t  g (q* ) -- no offsets are purchased and nothing changes. However, if, as depicted in Figure 1, g (0)  t  g (q* ) , then offsets are purchased up to the point here g(q  o)  t . Consumption is, however, determined not by guilt but by the offset price at a point where u(q)  p  t . As can be seen from Figure 1, the presence of offsets increases electricity consumption. Notice also that as t falls, electricity consumption will increase as will offset purchases. However, the net level of emissions falls. 3

It is assumed here that t is set at cost and so is exogenous. Notice, however that if t was an upward sloping function of the number of offsets purchased, then so long as it did not rise faster than g(.), all of the results here would continue to hold.

5

As t falls to a level where g(0)  t , the consumer chooses to go „carbon neutral.‟ Notice that at this point, their electricity consumption is higher than would be the case without offsets.

Figure 1: Offsets and electricity demand

g’

t u’ - p

qo*  o*

q*

qo*

Quantity

So when it comes to Al Gore, this analysis suggests that while his carbon footprint may be zero, his electricity consumption would have increased as a result of taking those actions. It also indicates that consumers who myopically purchase offsets based on their current consumption levels will find themselves purchasing more offsets in future years as their consumption grows. It is useful at this point to state the following corollary to Proposition 1. Corollary 1. Consider any change to u  p such that electricity consumption increased. Then so long as o*  0 prior to the change any increased consumption will be completely offset by the consumer. This can be seen again from Figure 1 and (3). Notice there that any change in the u  p curve does not impact upon the net emission choice qo*  o* choice of the consumer. It is determined by (3) and so any change in electricity consumption will necessarily lead to an offsetting change in offsets purchased. In particular, this invariance result would apply for a shift in p. Put simply, offsets and electricity consumption are complements. Those with higher intrinsic demand for electricity purchase offsets and a reduction in the offset price causes more electricity consumption. This has a number of testable implications in understanding electricity demand but also the behaviour of electricity companies. Those companies will have an interest in promoting carbon offset plans; at least to the extent that they do not compete directly with their operations.

6

3.

Pricing response

The above analysis takes the price of electricity (the „dirty‟ good) as given. This may be appropriate if p is determined in a competitive market or by regulation (as is often the case with electricity). However, it is useful to consider what happens when p is endogenous. In particular, if it is chosen by a price-setting monopolist. Figure 2 depicts a typical demand curve facing the monopolist based on the model in this paper. Notice that the presence of an offset market has two effects. First, when the consumer purchases sufficient electricity, it expands the demand for that electricity. Second, the demand curve becomes more price elasticity beyond that point.

Figure 2: Demand for Electricity p

With offsets

Without offsets q

It is difficult to analyse the full effects of this with general functions. So here I will use a linear demand set-up with u (q )  aq  bq 2 and g (q  o)  12 (q  o)2 with a marginal cost of electricity assumed to be c (with a > c). Without offsets being available, inverse demand is p  a  (b  1)q and so the monopoly quantity chosen is q* 

a c 2( b 1)

and price is p*  a 2 c . Profits are

( a  c )2 4( b 1)

. When offsets are available, inverse

demand is p  a  bq  (q  o)  to . It assumed that t  q so that the demand for offsets is *

b ) bc b ) t positive.4 In this case, qo*  a2bc1t and po*  ( a t )(1 . In addition, o*  ac12(1 . 2b 1 2b

4

Notice that, if this condition does not hold, then introducing offsets does not result in any change in price and quantity. This because the marginal revenue function only changes slope beyond q*. However, by definition, the monopolist would set marginal revenue less than marginal cost by producing beyond that amount. Hence, that does not happen.

7

As t  q* , it is easy to see that quantity of electricity purchased rises. However, price also rises. This is a direct result of the fact that the demand for electricity becomes more price elastic when offsets are available (Figure 2). Note also that, as with the competitive price model, net emissions qo*  o* must fall as these equal t in equilibrium. Finally, as the monopolist could always choose a price and quantity pair on the original demand curve, profits will rise as offsets become available. It is worthwhile noting too that consumer surplus also increases when offsets are available. The offset option alleviates guilt (at a lower consumer cost than that guilt) while the price of electricity has fallen. As a final exercise, suppose that there were two types of consumers in this market. One set of consumers – the guilt-ridden – have utility functions as specified above. The other set – the guiltfree – have g(.) = 0 for all q – o. It is assumed that there is a unit mass of consumers, a fraction,  of which are guilt-ridden. A concern is that an offset market could increase demand from the guilt-ridden and also cause the monopolist to lower price to all customers. The resulting increase in quantity even from those who do not purchase offsets could mean that net emissions might rise. The following proposition dismisses this possibility: Proposition 2. In the monopoly model with heterogeneous consumers, the introduction of offsets never decreases net emissions. The proof is straightforward. It is easy to show that, without offsets, guilt does not factor into price and so p*  a 2 c . However, it does matter for quantity with q*  ( a 2cb)(( bb1)1 ) . With offsets, c  t )(1 b  ) b ) t )(1b  ) however, po*  ( a c )(12(1b )b)(ct (1b )) , qo*  ( a b(2(1 and o*  ( a c b2(1 . Thus, an offset  b )  ) (2(1 b )  ) market reduces price and quantity. However, net emissions becomes

qo*  o* 

(1b  ) ( a  c )(1 )  (1 2b ) t  b (2(1b )  )

. Thus, for q*  qo*  o* to hold requires a  c  2(1  b)t which

must always be true if o*  0 . So even with heterogeneous customers, net emissions fall when offsets are introduced. Put simply, the extent of the price fall is contingent on the number of guilt-ridden customers purchasing offsets. As these rise, the price fall is larger but so is the share of consumption offset. This latter effect dominates for the functional form assumptions here.

4.

Supply Response

Suppose that the offsets are not used to plant trees (an unrelated industry) but instead are used to purchase cleaner (non-emitting) sources of electricity (e.g,. wind or solar power). For example, investments in wind power might be subsidised by the offset program. This means that the

8

introduction of offsets lead to an expansion in capacity for generation that competes with current generation. Regardless of how p is set (monopolistically, oligopolistically or competitively), subsidies of this kind in competing capacity can cause p to fall. Consumers will take p as given. However, their decision without offsets will now look like Figure 3 where p  p . This results in a shift along their demand curve for „dirty‟ electricity and hence an expansion in their consumption of that. This situation is akin to Corollary 1. In situations where offsets are purchased (that is, t is sufficiently low), the expansion in consumption of „dirty‟ electricity is completely offset. So net emissions are invariant to the competitive response. Net emissions are solely a function of t and not p. What this implies is that, at a base level, concerns that a supply response will cause net emissions to rise are false. Figure 3:Impact of a price change

g’

t u’ – p’ u’ - p

qo*  o*

q*

qo*

Quantity

While this illustrates a rationale as to why a supply response would not cause any unusual patterns in net emissions following the introduction of offsets, it is somewhat incomplete in that the mechanism by which offsets translate into a supply response is unmodeled. In addition, when prices are formed endogenously, strategic issues may come into play. For that reason, the rest of this section is devoted to analysing the monopolist model (as a provider of dirty electricity) and the implications of different offset mechanisms. Strategic responses To begin, using the monopoly model of the previous section, suppose that offsets are translated directly into the output of a competing electricity supplier. It is often the case that green power markets operate in this way. Offsets are used to subsidise wind farms which then are required to bid into electricity pools in a non-strategy manner (i.e., at marginal cost which is usually assumed to be zero). The offsets themselves are used to fund investments in generating capacity.

9

In such a situation, o becomes the quantity choice of the competing electricity supplier. What this means is that a consumer‟s guilt will now be a function solely of q and not depend on o directly. This is because offsets are now direct consumption rather than mitigating offsets caused by dirty consumption; so net emissions are simply q. Thus, the consumer‟s problem becomes: Now the consumer solves: max ( q,o) u(q  o)  g (q)  p(q  o)  to ; where offsets are purchased (at a premium) to be consumed directly. In this case, the consumer‟s first order conditions become: (4) u(q  o)  p  g (q) (5) u(q  o)  p  t where the second condition holds with equality for t sufficiently low. To begin with it will be assumed that the monopolist‟s5 choice of q and the consumers‟ choice of o occur simultaneously. That is, the monopolist cannot commit to q; this assumption will be relaxed below. In this situation, (4) will determine the monopolist‟s demand function which will shift inwards as o increases. Utilising our previous functional form assumptions, from (5), o*  a bp t  q . The first order condition for the monopolist is then:

a  2(b  1)qo*  bo  c This gives qo* 

a  c bo 2( b 1)

and po* 

a  c bo 2

(6)

. Substituting in o* and solving gives: po*  c  (1  b)t ,

b ) t and qo*  t . Notice that so long as t is low enough that o*  0 , then qo*  q* and o*  ac2(1 b emissions fall as a result of offsets being available.

Note also that production of dirty electricity is lower in this case compared to when offsets are used in an unrelated market; that is, a 2cbt  t , however, net emissions are exactly the same in each; equal to t. Endogenous offset prices The analysis, thusfar, takes offset prices as fixed at t. It is arguable that these should be cost based and so, in an electricity market context, this would be equal to the cost of added capacity less revenues the clean energy producer would receive. Thus, if the cost of each unit of clean capacity is r then the offset price, t = r – p. It is also assumed that r  c which is a necessary condition for clean capacity to require a subsidy. (5) now becomes:

u(q  o)  p  r  p 5

I will continue to refer to the producer of dirty electricity as the monopolist.

(7)

10

so that o*  abr  q , while (4) continues to determine the demand function for q. Recalling that qo* 

a  c bo 2( b 1)

and po* 

a  c bo 2

, substituting for o* and solving gives: po*  c(12bb) r , o* 

a (2  b )  bc  2 r (1 b ) b (2  b )

and qo*  2r bc . Comparing this with the prices and quantities when offsets are not present, it is easy to show that so long as o*  0 , qo*  q* , po*  p* and qo*  o*  q* . Thus, offsets have the same qualitative impact as in the above models.

5.

Strategic commitments

One feature of offset programs that create alternative sources of electricity generation is that the subsidised plants are invariably required to be non-strategic. To be consistent with that, the analysis here has maintained that assumption. But it has also been assumed that the strategic „dirty‟ generator of electricity has taken as given consumer and hence, clean generator behaviour. A natural question to ask, however, is what would the impact on emissions be if the monopolist were to act strategically and commit to certain actions to influence that consumer behaviour? In this section, we address this question looking at the cases of exogenous and endogenous offset prices in turn. Exogenous offset price Suppose that the monopolist set p prior to consumers choosing their offset purchases. This would amount to a price commitment on the part of the monopolist. This is something that they could achieve in electricity spot markets where clean generation is bid in at a reservation price of zero and the monopolist‟s bid sets the marginal price for the system. For a given q, consumer behaviour is determined by (5). Substituting this into (4) and the level of q is determined by the condition, t  g (qo* ) . This means that by increasing price, p, the monopolist will not change its own sales volume. However, a price rise will reduce offset purchases. Consequently, the monopolist will set its price so that o*  0 . Using our functional form assumptions this would occur at a price of po*  a  t (1  b) and at this point, qo*  t .6 Compared with a market without offsets notice that, when t  g (q* )  q* , consumers would, if quantity did not change, purchase offsets (that is, if t  2(abc1) ). It is easy to show that if this condition holds then po*  p* so that the introduction of offsets causes electricity prices to rise. As clean electricity production is deterred by this pricing behaviour, total electricity production must fall.

6

Note that this exceeds t and so is an equilibrium.

11

Thus, when it can make a strategic commitment, the presence of the offset market constrains the monopolist. While no offsets are sold and so not actual competition arises, potential competition constrains the monopolist price. This reduces electricity consumption and emissions. Compared to the case where offsets are used in an unrelated market, both consumer and producer surplus are reduced.7 Endogenous offset prices What is the offset price was endogenous with t = r – p. As with the exogenous price situation, when the monopolist sets price first, equilibrium consumption of „dirty‟ electricity would be determined by the condition: t  g (qo* ) or r  po  g (qo* ) . In this case, the monopolist will lose sales if it prices higher as this means that the price of offsets are lower. This then defines the (inverse) demand function facing the monopolist, i.e., po  r  g (qo ) ; with elasticity,  o  rggq  . It is instructive to compare this with the (inverse) demand function that would arise when offsets were not present. In that case, p  u(q)  g(q) and its elasticity is    (uugg) q . Note that:

 o    urgg  ugg 

(8)

 0

The left hand side is positive when prices are positive. Thus, the introduction of offsets with an endogenous subsidy makes the monopolist‟s demand more price elastic. So such competition will constrain its price to be lower. The issue is: even with this lower price, does the quantity of emissions produced fall when offsets are introduced? The following proposition addresses this for our functional form assumptions: Proposition 3. When offset prices are endogenous and are used to fund competing capacity, then offsets are purchased in equilibrium if 2 a 1c(1bb )  r . In this case, the introduction of an offset market will increase total consumption but emissions will fall if and only if

a  bc b 1

r.

PROOF: Note that utilising our functional form assumptions, facing the new demand function, the monopolist chooses qo*  12 (r  c) . Setting r  qo*  a  b(qo*  o) we can solve for o*  2 a (b1)2bc(b1) r and po*  c 2 r . Note, however, that this is only an equilibrium (with positive offset purchases) if 2a  c  r  b(r  c) which can be rewritten to give the condition in the proposition. Notice also that as r  c , then po*  r and so the offset price is positive. Total electricity consumption is

7

2 a c r 2b

. This is less than q* 

a c 2( b 1)

if

If consumers are heterogeneous this conclusion would be softened as the monopolist will factor into account the guilt-free who never purchase the more expensive offset electricity. Thus, the monopolist‟s demand curve would become less than perfectly inelastic.

12

2a  c  r  b(r  a) . If the equilibrium condition holds, it is easy to see that this must hold too. For emissions, these are now at qo* . Comparing this to q* gives the condition in the proposition. The existence condition in the proposition says that if r is too high, then offset prices will be too high and the monopolist producer of dirty electricity will be unconstrained. In that case, there will be no change in behaviour from the introduction of offsets. Given the fact that electricity prices are lower when offsets are introduced, it is not surprising that total electricity consumption rises. In this respect, offsets also offset existing market power by providing a competitive electricity alternative. This raises consumer welfare. More interesting is the possibility that emissions might rise as a result of offsets. The proposition shows that for r  ( abbc1 , 2a 1c(1bb ) ) , the equilibrium condition holds but emissions rise compared with a situation where offsets are not present. This possibility is illustrated graphically as in Figure 4 where it is assumed that c  0 . That figure shows the demand function facing the monopolist with and without offsets; willingness to pay for dirty electricity falls. However, the monopolist prices off its „strategic‟ demand curve that takes into account offset reaction. It is off of this that a marginal revenue function drives the quantity choice is depicted. The intuition for this is that the monopolist‟s behaviour is now driven by its role in offsetting guilt. As the only strategic producer, if the monopolist increases their price, this also decreases the price of offsets and hence allows more competing production. The monopolist, therefore, has incentives to lower price but to achieve this in the face of competition sometimes requires more output than before. Thus, when offset price is endogenous, the strategic incentives of the monopolist are very different. Instead of pricing high to deter offset investment, the monopolist prices low in an attempt to soften competition from such investment. The end result is that emissions may rise when offset price is endogenous.

13

Figure 4: Emissions may increase $

Demand for dirty electricity without offsets

r

p* Demand for dirty electricity with offsets

po*

Strategic demand curve

q*

6.

qo*

r Quantity

Should clean producers be strategic?

The above analysis presumes the need for offsets to be purchased by guilt-ridden consumers in order to subsidise clean electricity production. While it was assumed that such electricity had a higher long-run marginal cost than existing dirty electricity generation, the case for a subsidy would have to be made more carefully. Specifically, it is instructive to consider what happens without an offset market and whether an unsubsidised clean electricity provider – operating strategically – could result in lower levels of emissions than one that is non-strategic and subsidised through offsets. Consider a situation where a dirty and clean producer compete (Cournot) where dirty consumption reduces demand because of guilt but clean production is more expensive with r > c. Then it is easy to show the clean output will only be positive if a 2 c  r . Notice that with just a single dirty producer, p*  a 2 c . Thus, if price with a monopolist dirty producer is less than the marginal cost of clean production, that production will not enter the market.

14

If a 2 c  r , it can be shown that qo*  a3(b2c1) r and o*  a 3cb2r . For the cases where offset prices are exogenous, whether this resulted in lower emissions would depend upon t. Specifically, recall that in those cases, emissions were equal to t and so an unsubsidised producer would lead to lower emissions if a3(b2c1)r  t . As t is presumably a policy choice, this could be achieved. More interestingly, when offset prices are endogenous, the lowest level of emissions are achieved when the monopolist acts non-strategically. In this case, the an unsubsidised clean producer will lead to lower emissions if r  a (21b)2(bb1) c . Thus, it is possible that if a clean producer is efficient enough, an unsubsidised situation would lead to better outcomes than a subsidised one. The intuition here is that when clean production is non-strategic but subsidised, consumers‟ demand for it is limited by the extent of the subsidy. With an unsubsidised model, consumers are not constrained by this but, in fact, prefer it as they do not feel guilt. Consequently, this causes the „dirty‟ producer to compete more aggressively and, in so doing, constrain the market power of clean producers. The end result can mean lower production by dirty producers compared to an offset market case.

7.

Conclusion

This paper has examined concerns that the voluntary purchase of carbon offsets by consumers can lead to unintended consequences that actually cause emissions or net emission to rise. The key feature was to recognise that those purchasing offsets were likely to be those who were already curtailing consumption of „dirty‟ electricity and the like because of personal guilt over their emissions. While it is true that the purchase of offsets allows those people to alleviate their guilt and hence, consume more, on net emissions fall. The consumption effect of offsets does not outweigh their ability to reduce emissions. The paper also examined several mechanisms by which offset purchases may have external effects that were harmful. For example, by causing demand to become more elastic for some commodities, prices might fall increasing consumption by those not purchasing offsets. However, when the proportion of guilt-free consumers is high (suggesting a large external impact), the impact on price is small, mitigating this. So on net emissions still fall. Another mechanism was a direct one whereby offsets generated direct competition with the „dirty‟ good suppliers. Again this might cause a price reduction. However, in all but one model examined, quantity produced by „dirty‟ good suppliers also fell along with price. Offsets increased consumption overall but reduced total emissions. In one case where a strategic commitment was possible then it was possible that offsets could increase emissions. This suggests, however, that such instances are implausible. There are a number of empirical implications from the analysis here. Examining the link between offset markets and total consumption would be interesting as well as the impact between strategic behaviour and offset purchases. From a policy perspective, however, voluntary

15

purchases of offsets would likely reduce environmental harm and should be seen as desirable alongside collective forms of emissions reduction such as emissions caps, carbon taxes and permit trading.

16

References Andreoni, James (1990), “Impure Altruism and Donations to Public Goods: A Theory of WarmGlow Giving,” Economic Journal, 100 (June), pp.464-477. Ferraro, Paul J., Toshihiro Uchida & Jon M. Conrad (2005), “Price Premiums for Eco-friendly Commodities: Are „Green‟ Markets the Best Way to Protect Endangered Ecosystems?” Environmental & Resource Economics, 32, pp.419-438. Kotchen, Matthew J. (2005), “Impure Public Goods and the Comparative Statics of Environmentally Friendly Consumption,” Journal of Environmental Economics and Management, 49, pp.281-300. Kotchen, Matthew J. (2006), “Green Markets and Private Provision of Public Goods,” Journal of Political Economy, 114 (4), pp.816-834. Moraga-Gonzalez, Jose Luis & Noemi Padron-Fumero (2002), “Environmental Policy in a Green Market,” Environmental & Resource Economics, 22, pp.419-447.