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Solving the Scope 3 prisoner’s dilemma
Lessons from international climate negotiations show how supply chain coalitions and carbon insetting could solve the Scope 3 prisoner's dilemma.
Climate change is a global problem. Problems at that scale have no easy solutions. In 1992, the international community came together to recognize climate change formally. Five years later, they took the first step in tackling it in Kyoto, Japan.
The Kyoto Protocol established an international emissions trading system. Each country's emissions were limited (the cap), and they could buy or sell their emissions rights (the trade). This cap-and-trade system cemented the role of carbon pricing as a key mechanism to incentivize companies and governments to reduce their emissions at the lowest possible cost. However, the Kyoto Protocol was voluntary, the US and Canada withdrew without consequences, and no new countries signed on.
One of the limitations with the Kyoto Protocol — and subsequent Paris Agreement of 2015 — is the structure does not deter free-riding behavior. The atmosphere is a global public good, so cooperation on GHG emission reduction and removal presents a prisoner's dilemma.There are incentives for actors to pursue their interests without contributing to the cost of abatement. More specifically, since the Kyoto Protocol and Paris Agreement are voluntary, there's a strong incentive for countries not to participate and for those that do to understate their emissions and miss objectives. Even if governments are motivated to reduce their emissions — perhaps for international political reasons — there is still an incentive not to participate in the international agreements. Cooperating with other countries would place more accountability on those internal efforts, especially countries with large footprints. The result is a noncooperative free-riding equilibrium where a few countries undertake strong climate change policies, but we're worst off overall.
We typically think about this problem from a geopolitical perspective, with each actor being a public entity. However, the same problem is encountered with voluntary emissions reduction efforts in supply chain networks, compounding the lack of progress on the international stage.
To illustrate the problem in supply chain networks, we need to look at how companies measure GHG emissions. The GHG Protocol, with three "scopes" of emissions, is one of the most common frameworks. Scope 1 emissions are from sources owned or controlled by a company. Scope 2 emissions are from electricity purchased by the company. Scope 3 emissions are everything else. Except for highly vertically integrated companies and the special carveout for electricity, supply chain emissions are in Scope 3.
We could debate the merits of this framework; however, if we focus our lens on supply chain networks, the segmentation is straightforward: emissions from sources owned or controlled by the company versus its supply chain network.
Before moving on, it's worth considering Scope 2. Electricity is one of the largest sources of emissions for many companies, and there are many opportunities to increase energy (electricity) efficiency. Electricity is also typically supplied through a grid providing unique opportunities to incentivize lower-emissions generation. The same can't be said for Scope 3, which may be why the GHG Protocol, Science-Based Targets, and other accounting, goal-setting, net-zero, and climate-neutral frameworks consider Scope 3 optional or provide exceptions/exemptions.
With international climate negotiations, the structure of those agreements led to a prisoner's dilemma and free-riders. The same problem occurs in voluntary efforts within supply chain networks. Scope 3 emissions reduction can be a cooperative effort among network actors. However, the incentives for those actors are not to participate in emission reduction of any kind (scenario 1), or those who do to focus on Scope 1 and not cooperate on Scope 3 (scenario 2). Let's unpack this a bit further.
There are two scenarios in this incentive structure, resulting in a lack of cooperation on Scope 3 emissions ("Scope 3 paralysis"). The first scenario is a classic free-rider company enjoying the benefit of the efforts of other companies without any of the cost. The second scenario is a company that is motivated to reduce emissions, but the incentive structure encourages them to focus on Scope 1. And just like in international negotiations, they are incentivized to underestimate their Scope 1 emissions. One difference is there may be less incentive for them to miss their voluntary targets because accountability to those targets may be customers and investors outside of the Scope 3 network. However, both cases still trap actors in the prisoner's dilemma. The result is a noncooperative free-riding equilibrium where a few companies undertake strong climate change policies, but we're worst off overall. Sounds familiar.
Despite the impasse, there may be solutions we can draw on from international negotiations for voluntary efforts.And since the scale of voluntary emissions reduction efforts is smaller, and private sector actors can often act more nimbly, we may be able to test these solutions quickly. On the international stage, there is an opportunity in Glasgow this fall to build upon the Paris Agreement, but I won't speculate where international climate negotiations may go given the turbulence in the political area.
One of the challenges with climate change is it's a global problem, and it's natural to attack it with global solutions. However, we can narrow the scope of cooperation to a smaller number of powerful actors and change the incentive structure. William Nordhaus calls this a "Climate Club."Countries who join the club agree on a common objective and penalize those who are not in the club. This scope is similar to regional and bilateral trade agreements. The difference with trade agreements is that instead of lowering trade barriers, a climate agreement would use carbon pricing mechanisms to harmonize in-club objectives and impose penalties on countries outside the club.
Carbon pricing is a critical component of this strategy. The basic idea is to attach the costs associated with GHG — typically focused on CO2 — emissions to the source of those emissions. In addition to abatement costs, significant costs come with the accelerating frequency of destructive fires, floods, hurricanes, heatwaves, and other manifestations of climate change. The problem is homeowners, businesses, and taxpayers pay those costs irrespective of their contribution to the problem (GHG emissions).
Two basic parameters define a carbon pricing strategy: quantity and price. Regulatory and voluntary systems differ based on what parameter is variable (or market-based) versus policy-based. We hold one parameter constant — and change it based on a separate policy — while the other will be variable.
Governments use two carbon pricing strategies: carbon taxes (or fees) and emission trading systems (ETS). Many economists argue that a carbon tax is the most cost-effective lever to reduce carbon emissions at the scale and speed necessary to address climate change.With a carbon tax or fee, policy sets the price of carbon, and the payer's emissions determine the quantity. This strategy incentivizes payers to lower their emissions and lets market forces determine how best to do so.
In contrast, an ETS defines a limit or baseline for emissions quantity and leaves the market to determine the price. The Kyoto Protocol was a cap-and-trade system based on emissions limits. Some ETSs use a baseline rather than a limit (called "baseline-and-credit" systems). If a regulated emitter exceeds their baseline, they surrender credits. If they reduce their emissions below their baseline, they receive credits that can be sold to other emitters.
So far, over 60 jurisdictions worldwide have implemented carbon taxes or ETSs, representing over 20% of global greenhouse gas (GHG) emissions.Europe has the largest and arguably most successful carbon market with the EU Emissions Trading System (EU ETS). This month, the European Commission laid out plans to expand the EU ETS to sectors that were previously exempt — notably maritime shipping and aviation — and introduced a new tariff called the Carbon Border Adjustment Mechanism (CBAM). The CBAM aims to protect European companies from foreign competitors that are not subject to EU climate policies. Essentially, the EU is pursuing the general approach outlined by Nordhaus. They have a robust ETS that harmonizes the price of carbon across a broad swath of the EU economy, and the CBAM penalizes imports from outside of the EU climate-strategy club. (The CBAM also has the potential to encourage other countries like the US to follow, but I'll save that discussion for another post.)
Let's consider this solution for Scope 3 emissions reduction in a supply chain network. First, we narrow the scope of cooperation to a relevant segment of the supply chain network. In some cases, we can narrow the scope to parties connected to the physical supply chain. However, physical traceability is challenging. For agriculture-related industries, the Value Change consortium proposes a market connection in a "supply shed."For sustainable aviation fuel, the Smart Freight Centre and MIT's Center for Transportation & Logistics broaden the scope to any actors in the value chain, including fuel producers/distributors, air carriers, third-party logistics companies (3PLs), travel management companies, as well as shippers and business travelers who purchase air transportation services.
For the air cargo value chain, a shipper may purchase air cargo services from a small list of 3PLs they have contracts with and trust to manage the movement of their cargo. If the shipper wants to reduce emissions associated with that air cargo — Scope 3.4 — they would do so by working with their 3PL partners. These 3PLs would then work with air carriers — the companies that directly manage the aircraft — and the air carriers would work with their fuel suppliers. This cascade builds a coalition of partners within the supply chain network, collaborating on emissions reduction related to air cargo.
Moreover, that emissions reduction coalition is the same supply chain network already working together to move air cargo. And that's precisely the point. Supply chain networks are primed for cooperation on emissions reduction.
These coalitions are not without precedent as well. In aviation, the World Economic Forum has convened a coalition of organizations, including Rocky Mountain Institute, the Energy Transitions Commission, Airbus, Boeing, Heathrow Airport, KLM, Shell, and others. Their objective is to "align on a transition to sustainable aviation fuels as part of a meaningful and proactive pathway for the industry to achieve carbon-neutral flying."Similar coalitions are forming around emissions transparency, raw material supply chains, and other complex topics.
In addition to coalitions, we need a mechanism to harmonize carbon prices and protect companies inside the coalition. Carbon pricing is often considered a regulatory mechanism, but there are regulatory and voluntary mechanisms, and both are growing in importance.
The most common voluntary pricing mechanism is a carbon credit used for offsetting. A voluntary carbon credit is similar to regulatory credits generated in cap-and-trade or balance-and-credit systems, but parties in a voluntary market are not required to buy or sell credits. For voluntary buyers, carbon credits offer a way to "reduce" their emissions by paying another party to perform the reduction or removal. This strategy is typically more cost-effective than investing in the processes and technology needed to reduce emissions in their operation. Not surprisingly, offsets are controversial, and for this discussion, we can set that debate aside.
In our supply chain coalition, we can use the same carbon credit concept to standardize how we collaborate on emissions reduction. If we are the company that needs cargo flown by air, we are concerned with our Scope 3 emissions. However, since we do not own the aircraft or produce the fuel, we must work with those companies to deploy the emission reduction processes and technologies (e.g., sustainable aviation fuel). This process of directly intervening in our supply chain network with a carbon credit-like mechanism is called "insetting."
Putting this all together, we can sketch out a potential solution to our Scope 3 paralysis. Rather than ignoring those emissions or buying offsets, we can work toward direct intervention in our supply chain by forming coalitions with our suppliers and customers ("Climate Clubs"). Within these clubs, we harmonize the price of carbon using an insetting mechanism, which builds on some of the infrastructure used for offsetting (e.g., accounting methodologies, verification protocols, registries, etc.).
To complete the analogy with Nordhaus, we still need a way to "penalize" companies outside of our club. However, there is a more natural solution for this in the private sector. We don't need a tax, which would run afoul of collusion and other regulations. Since we already have business relationships with the coalition members, we strengthen those relationships by collaborating on emissions reduction. In some cases, those relationships may be one or more linkages removed, which strengthens the network. That's good business practice and means more business will get done. I'll buy more from you, you'll sell more to me, and the "penalty" for those outside of our club is they're left out of this flywheel of decarbonizing growth.
Enough for now! I'll be exploring these topics in future posts — including carbon pricing and insetting, game theory and supply chain sustainability, and more — so subscribe today!
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