The great benefit in having a theory that is so strictly defined – regardless of its inability to represent the real world – is that you can be certain when its assumptions and rules are not met, and in such cases you ought to be able to conclude fairly definitively that a market outcome will not be efficient.

Hence it is no surprise that, as Professor Peter Rayner concludes in his Foreword to FoE’s recent critique of carbon trading, A Dangerous Obsession, 'Far from proving to be an economically efficient instrument, carbon trading and offsetting have been beset by inefficiency and, in places, corruption'.

Economics argues for its superiority on the basis of its impeccable theory: in this case the relevant model is the perfectly competitive maket. So to what extent can the market for carbon approximate to this perfect market?

Before we can have a market we need to have a product – only then can the iron law of price-setting via supply-and-demand swing into operation.

What is carbon?

In the case of carbon trading it is pretty difficult to pin down what that product is. Is it a small piece of the global atmosphere? If so, how is that defined? And how much CO2 can be considered to fill it up? With a slippery product like this, it is hard to see how a market could possibly work efficiently.

More fundamentally, the product has no existence independent of politicians who create permits which are later sold. So, unlike a pair of shoes or a new car, it is a product with no real physical existence and is thus inevitably subject to the sort of political manipulation that results in corruption.

Carbon markets

The justification that a market system is better than a system of regulation – or just outright banning of further CO2 production – is that markets distribute products efficiently.

In this case, so the argument runs, the companies that can reduce emissions most cheaply will sell permits to those who would need to spend more to reduce their emissions. Permits are thus allocated in a neutral way to ensure the best outcomes for all by the miraculous invisible hand.

But according to the very same theory, markets only work efficiently when a number of fairly stringent conditions can be met. The first condition is that there should be a large number of players in the market, none of whom is powerful enough to exert any significant influence over the prevailing price.

To what extent is this a fair description of the market for carbon permits?

No market at all

What we are dealing with is no sort of market at all, but rather a political system where the product is created by governments, a limited number of powerful corporations compete over it – and this is to say nothing of the financial intermediaries who are operating to distort the free operation of the market, as identified by the recent FoE report.

The whole theory of perfectly competitive markets specifically excludes certain categories of goods, which are defined as being inconsistent with a competitive system of supply and distribution, namely public goods and goods which enjoy a natural monopoly.

In the case of the carbon market, it could be argued that whatever the amorphous good might be, it would seem to fulfil both these criteria automatically, the global atmosphere being a clear example of a public good, and the right to pollute it being controlled monopolistically by the governments who have established the carbon market.

Impossible

The financial crisis has demonstrated that the commitment to free markets by powerful business interests has always been purely rhetorical.

Creating a carbon market is a policy being pushed by these same businesses not because it will work efficiently to reduce GHG emissions, but because they expect to gain from it. They have no more interest in free competition than they do in sharing democracy with the nations of Africa or protecting the planet for future generations.

It is a shame that the economists who recite the neoclassical catechism have been less than assiduous in pointing out the fundamental impossibility of the concept of a carbon market.