“Quantization” of the environmental impact resource: “transaction-based model” of settlement of the social cost problem
“Agreement is a product of total non-resistance of the Parties”
The paper proposes relatively new approach and way to settle the social cost problem. Summarizing different approaches and numerous algorithms the conclusion is that there still is a place for direct and explicit insertion of environmental costs and values into transactions. Indivisible elementary basis of “quantization” of environmental negative impact, collateral damage resource (including so-called “social cost of carbon”) still is a particular transaction, a deal, which results in distribution of rights and liability in relation to specific portion of the damage and in establishment of the price. Proposed “transaction-based model” is most suitable to bring “carbon pricing”, and environmental costs in general directly to the sphere of regular economic activity, to develop business custom in a natural way as opposed to prescriptions and coercion.
It is quite common for the people stumbling upon complicated issues to set hopes on a central authority to resolve them rather than proposing an algorithm for the individuals to preserve their fundamental right to economic choice and settle problems on peer-to-peer basis. The problem of social costs, of negative externalities, collateral damages, especially related to environmental issues, remains in the focus of economic science for over 100 years and has become critically important in relation to climate change in particular. While Piguvian approach remains dominant, advance of economic thought and technologies allow for implementation of the model based on delimitation of property rights, on values and choices of free individuals. Ludwig von Mises, 1881–1973, the brightest mind of the Austrian School of Economics, precisely defined the core problem: “Carried through consistently, the right of property would entitle the proprietor to claim all the advantages which the good’s employment may generate on the one hand and would burden him with all the disadvantages resulting from its employment on the other hand”.
Ronald Coase, 1910–2013, a British economist, Nobel Prize Winner in Economic Sciences in 1991, proposed a general market-approach to the problem of social cost and a solution based on clearly defined property rights. The approach introduced the concept of clear delimitation of rights to perform activities harmful to third party and provided the basis for the market-based distribution of limited resources as a production factor and for a peer-to-peer settlement of reciprocal damage of part A (the manufacturer) and part B (the third party). “The real question that has to be decided is: should A be allowed to harm B or should B be allowed to harm A? The problem is to avoid the more serious harm”. The focus is on the aspect, which still is mostly ignored: limiting or banning harmful activities of the polluter, party A, harms him just as his activities harm the people, the third party, party B. They either must choose, which side of damage is less costly to compensate or to bargain and settle.
Figure 1 — Reciprocal approach to the problem of social cost
One of the solutions is strict delimitation of right to execute harmful activities, though the process of allocating these rights is costly and bears significant error and corruption risks. It is only in the hypothetical case with zero transaction costs that the initial allocation of the resource would not matter.
There is probably infinite number of algorithms to solve the social cost equation. Typically, resources are managed in a variety of forms: nationalization, licensing, auctioning, prescription of best available technologies, introduction of excise duties and taxes — but resource management always involves some form of quantitative delimitation. Transaction-based approach to negative externality is justified in cases where the costs are high and at least exceed the costs of the research, institutionalization and application of specific solutions. Most of the externalities, obviously, should be allowed to exist without interference from anyone except for the parties directly concerned.
Direct and explicit insertion of environmental costs and values in transactions, into peer-to-peer economic activity is the key to so-called “green economy”. When we talk about “regulation” or control of GHG emissions, as well as other emissions, discharges, pollution, use of exhaustible natural resources or natural capital, from the economic point of view the question refers to calculating the costs associated with the damages and the reimbursement for damage. A second question derives from the legal point of view — — who is liable? Not only do we need to know who is liable but agree on the sum of social costs to be settled. These costs should be weighed against the expenses of producer caused by restrictions imposed on him, which result in increased production costs, and must be covered as well as transaction costs, costs of research, development and implementation of optimal variant of a comprehensive settlement.
Without going into a detailed analysis of the physical and climatic limits to the resource of rights to create and discharge GHG emissions and of the limits set at national, sub-national, corporate, and other levels, it is worth noting that global scale of the resource of right to discharge is disproportionate with management capacity at any governmental or corporate level, except for the global. Without division of this damage or resource to parts, ultimate “quantization”, it is impossible to build any regulation and management system. Differentiation and consequential integration of the transaction-based “quanta” of the negative externalities would be the ultimate solution, if we agree that economic activity is their cause. The most natural and widely used method is division by jurisdictions and by accounting periods, years, and by tons of CO2-equivalent. However, in the context of the economic approach indivisible elementary basis of “quantization” of carbon emissions resource (as well as any environmental impact resource) still is a particular transaction, a deal, which results in distribution of rights and liability in relation to specific portion of the resource and in establishment of market price.
At least three values. i.e. social, production and transaction costs, should be balanced. Neither tax, nor regulatory approaches directly and explicitly account for production costs and institutional costs. Only “trading”, “market-based” or “transaction-based” approaches take into consideration reciprocity of damage and transactional costs. Within the frames of trading-based approach indemnification of social costs by the producer or reimbursement of relevant production costs to the producer are equally eligible. The choice is determined by resulting value of production with social and transactional costs accounted. Rejecting or ignoring at least one part of the equation — i) social costs, ii) production costs, or iii) transaction costs, including costs of research, development and implementation of an optimal algorithm for comprehensive settlement of the resource issue in question — leads to a dead end (essentially to a false solution).
Assumed abstract and subjective legitimacy and fairness of demands of the parties concerned and appeals to insignificance of unsubstantiated claims of the opponent have tertiary relevance if any. The real issues are which of the parties attach more value to the resource, what share of the resource the party may acquire along with corresponding share of rights and liabilities, how rights and duties are enforced, and what is the nature of a legal regime that grants rights and obligations
Before liability for indemnification of social, production and transactional costs is quantified, it performs as subjective values, which must be placed in juxtaposition to find an algorithm of optimal solution.
Subjective perceptions, cognitive metaphor of juxtapositioned values are immanent basis for economic choice and economic activity. Money as an expression of costs and values are one of major a priori semantic concepts, one of fundamental metaphors of values. The problem is that perceptions concerning impact of certain decisions and choices on the environment and future generations are blur, indefinite and far from such a priori semantic concepts.
Within this context, it is not an easy task to develop an algorithm to solve the equation involving costs of searching for solution and implementing most effective variant of settlement for specific social cost issue. i.e. the issue of anthropogenic carbon emissions.
The stakeholders often entirely ignore the costs and efforts needed to solve the problem. Meanwhile neuro-psychic, intellectual efforts, costs are often so high that the issue is just put aside. Evidently, it is yet another part of the equation.
Similar difficulties occur in the animal world, where, according to studies, the behavior — for example, of dogs, wolves — is not always determined by the immediate incentives and stimuli, but by mental representations or “neuro-psychic images”. Under such circumstances some of the hungry animals prefer to abandon the extrapolation problem-solving even supported by positive food reinforcement, and make their choice between food demand and the need to maintain a normal level of nervous tension in favor of the latter, thereby preserving the “psychological comfort”.
Given the extremely high energy-intensity of mental activity, human beings may even more often prefer large physical energy expenditures, proactive stance and practical activity to high mental stress required to develop optimal solutions.
SUMMARIZING MODELS OF SOCIAL COST SETTLEMENT
What are possible models of regulation of greenhouse gas emissions? The challenge is to find a mechanisms to establish limits of the emissions resource, and the optimal delimitation. Among numerous possible mechanisms to limit emissions, the following are typical as an illustration:
- Capping: Most widely spread nowadays is capping the resource by the government for a certain period of time, budget period, and setting allocation of quotas, which in the essence is arbitrary, though certainly ideologically more or less justified, and covers free allocation, partly free allocation, auctioning, more or less rigid cap or target;
- Best Available Technology (BAT): Allocation of quotas based on BAT benchmarking, which basically is no different from previous example, except for justification of the allocation based on technical level for specific sectors of economy;
- Intensity: Rate or intensity of emissions-based uncapped delimitation (which may also involve BAT concept);
- Existing versus New Sources: Limiting the rights for emission only to existing sources, i.e. the given set of sources and installations, while the owners of new sources are required to offset emissions entirely;
- Pricing: Limiting by ceiling price (tax and trade scheme);
- Taxpayer Funding: Fully budget (taxpayers)-financed partial reproduction of the resource (ex. Australia Direct Action Plan) is an exceptional example of production-costs and abatement costs-based scheme.
Most of the models are founded on a very significant element of the resource approach, namely the limitation of the resource. However, they conceal the need for reciprocal settlement of damages, in which the parties come to agreement based on their perceptions of values and establish market price for the portion of common resource in the course of specific transaction. In the carbon emissions’ case, practically all participants or stakeholders are emitters or consumers of the resource, i.e. the party that causes the damage, and at the same time the affected party. Theoretically, anyone can acquire emission rights at the market, to not only produce some goods and services, but also to reduce overall emissions and to tighten restrictions on the emitters, while ensuring that their own requirements in the resource are satisfied.
The government eventually becomes an essential participant, although it is in its best coping with the task of coercion to compel the parties to follow the acceptable behavioral paradigm, customs enshrined in law.
Typically, price of emissions is only included into specific carbon market transactions, while these costs are present in virtually any every-day transaction by companies and average citizens, especially related to energy, power, fossil fuels, carbon-intensive industrial products. If cost of carbon is not covered by contract price or specific climate policy program, emissions become cost-effective by default.
The number and volume of specific deals on transfer of liability and rights to environmentally harmful activities (carbon emissions in particular) at market price determine the ultimate effect of any environmental market (carbon market). Therefore, it seems rational to explore the possibility of direct and explicit inclusion of environmental costs (negative externalities) in any transaction, where such costs amount to substantial share.
A MODEL TO INCLUDE ENVIRONMENTAL COSTS
Let us assume that the parties to challenge the rights and liability related to the resource (carbon emissions) in each transaction that essentially includes cost of carbon are producers and society, producers of goods and services and consumers. Let us also assume that one of the parties, or the parties together, or the community, or the government, acting as the arbitrator, accepts the cost of developing the solution for the settlement.
In this case, the amount of emissions related to each specific transaction and the delimitation of liability are essential to the contract. The seller (supplier) should thus declare the amount of emissions related to specific transaction and may also offer options for settling the liability for emissions, for example by sharing with the customers a commitment to purchase of corresponding number of specific compliance units (offset credits or quotas) at specific price. Therefore, the quid quo pro of the transaction would be offsetting emission to zero or some small (de minimis) increase or decrease in emissions.
Figure 2 — Comprehensive peer-to-peer social cost problem solution
Traditionally, such complicated interactions of the four parties are regulated by the governments, which take possession of the arbitration, assign taxes and fees, quantitative limits and commitments.
In the example with gasoline, the damage is partially controlled by the government, which applies licenses, taxes, fees, penalties, and technical regulations. As a result, the government awards the manufacturer with indulgentia, and the latter transfers the liability to the car owner. The third party, those who are aggrieved by the damage, may try to seek reimbursement, which would be difficult as the manufacture has already acquired legitimate clearance from the government, or take measures to offset, mitigate the damage or adapt to it or take no measures at all (which is the less evil than the interference of the government).
Experience shows that government “corrective” interventions often do not resolve but aggravate problems while blocking alternative ways for optimal settlement. This leads to the need to “correct corrective interventions” and governmental activity starts to circle without positive results with great transaction costs for society.
In fact, solution may be found only if there is no government or any “superior authority” action, only if the parties interact on decentralized peer-to peer basis.
The goal is to arrange for or create low transaction cost institutions to promote settlement between the parties without government interventions. That is where the governments could help: in supporting the creation of such institutions.
Declaration of the quantity of emissions, related to the deal, is a fundamentally important part of the seller’s public offer to the buyer to share the liability for the damage, to include the costs of damage into the cost of production of the goods (services) required by the buyer. Emissions associated with the transaction cover both direct emissions related to production (as in the case of power supply) and emissions associated with direct consumption (fuel, gasoline in particular).
The parties (buyer of the GHG intensive product or service and the seller) together may:
- agree on the part of the emissions, which is subject to offsetting,
- agree on the distribution of shares of liability for the part of the emissions, which is subject to offsetting.
The seller may accept the costs for the calculation of direct emissions related to the deal and for selection of optimal alternatives of their offsetting, and the buyer considering these costs may accept his share of liability for the share of respective emissions.
One of the options is seller’s offer to match the share of emissions that the buyer is willing to offset.
Preliminary examples of such “transaction-based” scheme, which involves insertion of carbon costs into regular everyday transactions, already exist and are quite common. A very common example is the offer of a priori environmentally certified product, produced in environmentally friendly way. This type of products is generically called “carbon-neutral goods.” In this case, the seller allegedly solves the problem of negative externalities on his own, and the buyer agrees with the solution through an increase in the ultimate price of the product or service. However, there is no settlement per se on the amount of damage, costs, price and the delimitation of liabilities between the parties in this case.
Another example of internalizing the cost of GHG damages is voluntary offsetting of the estimated amount of emissions related to air transportation services by the passenger. The next step might be an agreement on distribution of liability for emissions and costs between the passenger and airline operator.
With further development of such business custom, it would be reasonable on the part of the government to impose legal requirements for the seller and the buyer to share responsibility to offset certain part of total emissions related to the transaction. Once the mandatory part of total emissions related to transaction due to be offset reaches 100%, the ultimate target of carbon neutrality of economic activity would be achieved.
Such mandatory legal requirement may relate to:
- investment projects that involve launching of new emission sources,
- transactions on fossil fuel-based energy and energy sources, including power supply, supply of oil and oil products, coal and natural gas,
- transactions on carbon intensive industrial goods,
- export and import of carbon intensive industrial goods.
A “transaction-based model” provides for distributed and decentralized demand for carbon compliance units. As to carbon compliance units and related commitments per se, they should be eligible in accordance with universally recognized criteria, rules and institutions. International climate agreements and institutions, modalities and principles, even though not legally binding, provide solid basis for universally recognized criteria, rules and institutions needed to institutionalize internationally transferable mitigation outcomes.
Universal criteria and compliance requirements provide for decentralized distributed offer of carbon compliance units.
Most of existing and emerging mandatory carbon emissions regulation programs are market-based. The majority of them are cap and trade schemes, which are criticized mainly for high volatility and insufficient price levels. This leads to alleged necessity of governmental or international intervention in order to ensure certainty of investment prospects and effective carbon pricing incentives for transition to low-carbon development.
State or international entities may efficiently regulate market prices once they participate directly as a market stakeholder. They may establish ceiling and floor prices by setting purchase and sale prices for compliance units in a way similar to currency exchange regulation by Central Bank, which would allow for securing desirable price range subject to sufficient liquidity and volume of transactions.
Proposed “transaction-based model” derived from the basics of resource or market-based approach seems to be most suitable to bring “carbon pricing”, and environmental costs in general, directly to the sphere of regular economic activity, to develop business custom in a natural way.
Many countries have developed carbon emissions limiting regulatory programs, applied BAT requirement on select industries and have active consumer groups and other stakeholders that have initiated offsets buying-programs that promote parts of a transactional model, as described above. Many other countries do not yet have formalized carbon emissions limiting programs, or they have a variety of “self-contained” approaches. For the countries that do not have well developed carbon limiting programs or that have only parts of a regulatory or economic regime to limit carbon emissions, a transactional approach offers the following benefits:
- Quick start-up times,
- Limited governmental impositions,
- Promoting a variety of social experimentation, and
- A focus on both the producer and consumer.
More investigation is justified and experiment in specific localities might enrich our understanding of this approach.
 Human action: a treatise on economics / by Ludwig von Mises, 4th rev. ed., San-Francisco, 1996, p. 657
 Ronald H. Coase, “The Problem of Social Cost”, The Journal of Law & Economics, Vol. III, 1960, p. 2
 “What has to be decided is whether the gain from preventing the harm is greater than the loss which would be suffered elsewhere as a result of stopping the action which produces the harm”, Coase, op. cit., p. 27
 “It is necessary to know whether the damaging business is liable or not for damage caused since without the establishment of this initial delimitation of rights there can be no market transactions to transfer and recombine them. But the ultimate result (which maximises the value of production) is independent of the legal position if the pricing system is assumed to work without cost.” (R. Coase, p. 8)
”If factors of production are thought of as rights, it becomes easier to understand that the right to do something which has a harmful effect (such as the creation of smoke, noise, smells, etc.) is also a factor of production. Just as we may use a piece of land in such a way as to prevent someone else from crossing it, or parking his car, or building his house upon it, so we may use it in such a way as to deny him a view or quiet or unpolluted air. The cost of exercising a right (of using a factor of production) is always the loss which is suffered elsewhere in consequence of the exercise of that right-the inability to cross land, to park a car, to build a house, to enjoy a view, to have peace and quiet or to breathe clean air’, Coase, p. 44
 The party that is the most affected by harmful environmental impact of carbon emissions, namely, the future generations, can participate in the transaction only implicitly by being included in the cognitive metaphor of juxtapositioned values of the party directly involved in a particular transaction.
 “There is, of course, a further alternative, which is to do nothing about the problem at all. And given that the costs involved in solving the problem by regulations issued by the governmental administrative machine will often be heavy (particularly if the costs are interpreted to include all the consequences which follow from the Government engaging in this kind of activity), it will no doubt be commonly the case that the gain which would come from regulating the actions which give rise to the harmful effects will be less than the costs involved in Government regulation”, Coase, p.18
 “The kind of situation which economists are prone to consider as requiring corrective Government action is, in fact, often the result of Government action. Such action is not necessarily unwise. But there is a real danger that extensive Government intervention in the economic system may lead to the protection of those responsible for harmful effects being carried too far”, Coase, p. 28
 “That is to say, compensation would be paid in the absence of Government action. The only circumstances in which compensation would not be paid would be those in which there had been Government action”, Coase, p. 31