Can economic models solve all the intractable problems with climate change?
I wrote about creating economic levers to address the short comings of the Voluntary Carbon Credits Markets and proposed a Carbon Default Swap as a mechanism with sufficient flexibility to factor in forward looking data. It also incentivises transparency and disclosure, which you could argue is good governance (the often overlooked element of ESG).
In illustrating the concept of Carbon Default Swaps I used an example of forestry led carbon capture. There are other types of CO2e offsetting, such as Carbon Recovery Certificates based on Carbon capture and storage such as biochar, Direct Air Capture (DAC). On paper the capture and long term storage is very easily verified that CO2 has been mineralised or stored deep in the ground. Not all projects are equal and may require more data to validate that the storage is as long term as predicted. There is also a mechanism being used where projects are pre-selling certificates to raise the capital they need in order to build the capture and storage solutions. It is not clear whether the pre-capture certificates are being used as off-sets as they should be considered options and have not been delivered.
There is a case for applying CDS to the capture and storage market to cover defaults, should the projected CO2e not be delivered.
Agricultural emissions and biodiversity
The Kyoto and Paris summits established a market for CO2 emissions. The EU Emissions Trading System (EU ETS) is a cap and trade scheme is a good example of creating a price and market for combatting climate change.
Biodiversity is a very important to the resiliency of the planet and yet there have not been any similar mechanisms implemented to the cap and trade of CO2e. Biodiversity is a deep crisis according to the Intergovernmental Science-Policy Platform on Biodiversity and Ecosystem Services (IPBES).
Could we develop economic models to nudge the right behaviour as we did with the CO2e and CDS?
Let’s consider agriculture in the Netherlands which is highly productive and well developed. It is the second biggest exporter of agricultural products after the USA.
Wheat yields in the Netherlands are 9.6tonnes per hectare in 2022 with the external cost of generating one of the highest amounts of nitrogen in Europe. This has an impact on pollution, and a measurable impact on biodiversity.
The EU has set limits for the emissions of Nitrogen forcing the Dutch government to act and it is proving unpopular with the farming community. The government has developed a plan to meet its obligations with incentives and regulations.
Tackling the problem
How can the farmers continue farming productively while ensuring that there is a reduction of nitrogen produced and that biodiversity is considered? It will need a change in the current practices as well as investment.
The case for rewilding and farming using ancient methods seen as more sustainable as a way of fixing the issue of external costs of farming should not be seen as a viable solution from a socio-economic viewpoint and the loss of food production would be seen as irresponsible.
It must also be stated that there is no simple fix or the farming community would have done it years ago.
Biodiversity, soil health (linked to carbon storage), and curbing emissions of nitrogen should be seen together as a package. There are farmers following alternatives to the intensive farming methods.
The implementation of regenerative farming using techniques of no-till see reductions of yields of wheat of 2% in temperate regions. No-till has been proven to improve the soil and make it a valuable store of carbon
The use of legumes, such as red clover, as cover crops act has several benefits; weed suppressant, reduce the amount of windblown soil or runoff, reduction in the amount of fertiliser needed and the biomass from the legume can be used for feedstock or digested to produce energy.
Wildlife corridors for butterflies, flowers, beneficial insects alongside the arable land create the right environment for biodiversity as well as reducing the need for pesticides.
Mob or flash grazing is a technique of high density, short duration grazing which if combined with cover crops or intercropping is beneficial to both the animals, and the soil health, and helps in reducing the need for fertlisers, reducing the pollution of nitrogen and phosphates.
Can we make it add up?
We currently have a system where the yield of a hectare of wheat is 9.6t per hectare, the price per tonne is €239 or €2,294 per hectare. There are input costs of fuel, machinery, fertiliser, pesticides, herbicides, fungicides and labour.
The loss of biodiversity is an external cost. The pollution from nitrogen run off an external cost. The low amount of carbon stored in the soil can be partially calculated as the difference between the amount help and the amount that could be stored using different methods.
How do we price biodiversity? Soil health? Nitrogen and phosphate pollution? How do we create incentives to encourage biodiversity, improved soil health, and pollution mitigation not just added costs or red tape. If we load all the costs onto the farmers how do they compete in a global market where the price of grain is set irrespective of how it is grown? Consumers are notoriously price sensitive and given the choice between a loaf of bread made using flour sourced from sustainable or intensive farms, the consumers will generally buy the cheaper one.
It goes without say that by adding biodiversity as a criteria will mean that there will have to be some productive land taken out of use and made into wildlife corridors. We can now look at the loss of yield as a cost, let’s say for every 10 hectares we need 0.5 hectares to support biodiversity. Taking the base cost of wheat per hectare of €2,294, the 0.5 hectare now set as biodiversity represents a loss of revenue of €1,147, accounting for the ratio of 0.5 hectares of biodiversity for every 10 hectares:
€2,294-((€2,294*10)-€1,147)/10) = €114.7 per hectare
We arrive at a price of €114.7 per hectare that would be paid to compensate the loss of yield had the farmer not set aside land for biodiversity. This needs to be the minimum price or the net price a farmer would receive after the costs of setting up and maintaining the biodiversity land?
There are many problems with this as you can imagine. How do you prevent someone buying grain and claiming the €114.7 per hectare despite it being grown with no associated biodiversity land. What is the criteria of biodiversity? Is there a minimum number of species of plant, beetle, or moth? How is this measured? How often is it measured? Who checks that 0.5 hectares per 10 hectares are maintained to support biodiversity? With a 100 hectare farm who would bears the cost of monitoring? The income from biodiversity represents €11,470 which makes up for the loss of income that the farmer would have otherwise had got for farming the land. Taking funds out of that seems unfair as the farmer loses. Does the burden of proof fall on the farmer?
A similar pattern emerges when looking at soil health. What is the target soil structure? There is a price for verified CO2e held by the soil and this can be measured. How can this be connected to the price of wheat per hectare? Again, does the burden of proof fall on the farmer? It would be reasonable to set a price at €100 per hectare. A further €10,000 gross income for a 100 hectare farm. The potential costs of establishing and running a monitoring programme or paying for an accredited third party could easily swallow this up.
The N+P pollution remediation is difficult to measure. Is there a benchmark of pollution before measurements begin? How are there rewards calculated for not doing something in an economic model? How do we measure the source of pollution? Who pays for the monitoring? Is it impartial? N+P can be reduced using cover crops, precision application, and there has been work done to increase the nitrogen uptake in plants using bacteria that by definition means less is needed to be applied.
One alternative approach is to tax the price of the N+P inputs, but that risks making the crops unviable as the farmers compete in a global market and the competition may not be liable to N+P tax.
There are clear objectives, namely to sequester more CO2e through healthy soil, reduce N+P usage which in turn has an impact on pollution levels, increase biodiversity while maintaining yields to feed people.
The intractable problem is that it is not simple, cannot be done piecemeal where we create winners and losers through regulations and/or taxes, especially where the farm outputs are commodities that have a global market.
To be able to develop an economic model to reward the desired and punish the undesired behaviour there needs to be reliable, impartial data measuring pollution, biodiversity and soil health. The good news is that there are international initiatives looking into monitoring such as that by the IEAA . Companies are launching products and services using satellites and machine learning to measure CO2e, Methane and Nitrogen such as Caeli and the Nitrosat intiative will launch in 2025.
Let’s say that we can collect the necessary data which becomes meta-data attached to a tonne of wheat, demonstrating biodiversity, low levels of N+P, and good soil health. There is a precedence for this as wheat is checked for purity (not mixed with dirt), and moisture levels. Make the metrics part of the contract. The big difference is that the link is quickly lost when grain is aggregated as the existing measures check the physical commodity.
The onus cannot be placed on the farmers alone to fix this, through levers such as legislation or taxation as this can only be done on a country or trading block level. Nor is it fair to put the responsibility on the end consumers to check that the loaf of bread has been sourced from grain that has been produced with sustainable levels of N+P, grown in carbon rich soil on a farm with good biodiversity. We cannot wait for global consensus on how to solve this through enforceable frameworks.
What are the possibilities or are we doomed?
It is not all doom and impossible to resolve. The best economic model is starting with the price for a tonne of wheat. One possible fix is a timely intervention.
It begins with the grain merchants who buy from the farmers. The farmers with the digital biodiversity, soil health, and low N+P certificates unload their grain in one bin, those without in the other. The one with certificates is paid a premium, the one without a discount. The same applies at the ports where imported grain is handled. Note this would require legislation and that may prove tricky in EU as there is pressure to ease new green legislation from some political groups citing the cost of living pressures and the Ukraine war. There would need to be some registration of grain merchants. There would need to be thought about how to deal with scenarios where a farmer with non-certified grain sells direct to a mill, the flour is then untraceable.
Now this is where the intervention needs to take place. The certified grain becomes cheaper as the uncertified grain now has a mandatory surcharge levied. The surcharge is not designed as a profit for the grain merchant rather it is collected to assist developing countries build sustainable practices of food production. This is important as there is an element of capital investment needed. Note the revenue derived from the surcharges will decline as the producers are motivated to invest to achieve certified status.
It is important that certified grain is not used as a protectionist mechanism to exclude producers. Effort should be made to ensure equal access to the satellite data and analysis platforms that are a key part of the certification. This will mean that the ML algorithms will need training to recognise biodiversity across many geographical regions.
There are regular inspections at the grain merchants stores to ensure the switching of grain does not happen and that the certificates are valid.
The commodity traders and middlemen trade the tonne of wheat based on whether it is certified or not, just as they would for different grades of oil.
The buyers such as flour mills, bread makers, supermarkets pay the lower price for the certified grain. The consumer has the information about the origins and the price of the loaf is lower than the non-certified.
The second part
So far I have explored the grain markets using the Netherlands as an example. A similar mechanism would also apply to other other grains such as barley and oats, sugar and root vegetables, potatoes and sugar beet.
Animal farming is slightly different as they can be relatively small plots of land housing many animals such as pig or poultry and do directly have an impact on biodiversity.
There is an argument that we should eat far less meat as the land use for feedstock is high and ruminants emit high levels of methane. This topic is more about behavioural change, although meat could be priced to make it an occasional meal rather than every day it would be politically unpopular from both the farmers and the end consumers who expect cheap food.
Let’s begin with the animal feed issue, such as the provenance of the meal fed to the animals such as soya grown on land that was felled rainforest. In a similar mechanism we use pricing discounts to steer behaviour so that feed merchants buy non-soya based protein and charge duties or surcharges on imported proteins.
In the case of cattle what mechanisms can be put in place where grass is grown with high N+P inputs, poor soil quality and no biodiversity for the production of silage? It is often grown and harvested for use by the farmer for the cattle held on the same farm. The only lever is the price of the outputs, namely the cattle or milk. A similar mechanism to the grain, a premium for certified cattle or milk, a discount for uncertified, the farmer then has an incentive to ensure that certification is achieved to reach the better price.
The buyer, as with the grain, applies a surcharge to the non-certified cattle or milk, and that premium is used to support developing countries as before.
Animal waste is either a problem or a solution depending on your viewpoint. It is a problem if the waste is applied to fields and the nutrients run off into the water system. Anaerobic digesters are a solution to process the animal waste and generate electricity. However, the consistency of feedstock and the complexity can be off-putting to farmers. There is also an issue what to do with the sludge remaining, especially if the farmer has little land.
Making more controllable ADs and putting a price on the sludge, which can be a valuable input for precision fermentation or biorefining, is the quickest fix.
The purpose of this blog post was to highlight the complexities of emissions and biodiversity and apply the same thinking as the Carbon Default Swaps to find economic solutions as a quick way to address the issues. We have seen very gradual progress between the world summits and can’t rely on frameworks or global treaties as quick fixes. Faced with uncomfortable trade-offs the political discourse can also turn the debate into a polarised shouting match and nothing is achieved.
