Why CDR regulation could deter climate mitigation

The risk of 'moral hazard' tends to increase when governments intervene

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Moral hazard refers to the tendency for individuals or institutions to take on more risk when they are insulated from the potential consequences of their actions. The term originates from the insurance industry and recognises that those with some level of protection might be more careless compared to those without.

For example, doing without expensive off-street parking for your vehicle if its insured against being vandalised, cycling fast down a steep hill safe in the knowledge that your helmet will save you should you fall, or speculating with OPM (other people’s money) confident that any gains will be yours, while losses are for someone else to worry about.

Moral hazard has nothing to do with morality. It has everything to do with incentives, and how people behave when risk sharing is skewed.

Moral hazard can make insurance markets more expensive and less efficient. Safety features make cyclists and drivers feel safer, but perhaps at the expense of pedestrians. Meanwhile, moral hazard can also cause financial markets to depart from any sense of fundamental value. But without insurance, road safety improvements, and financial markets, a great many things would be impossible to do.

And despite much hand-waving regarding it’s impact, there is surprisingly little research into understanding how big a problem moral hazard is. The challenge is that moral hazard costs are conjectural, difficult to quantify, and often only become apparent with the benefit of hindsight, sometime in the distant future.

Moral hazard in carbon markets

The argument that companies reliance on carbon credits is delaying action to decarbonise is well known. Critics suggest that by purchasing carbon credits, moral hazard looms larger and larger. Net zero claims give those who purchase credits - as well as other heavy carbon emitters - undue comfort that climate targets can be easily met. You just need to shell out a few dollars per tonne of CO2 to cover your emissions. Job done! The outcome some fear is that this leads to ‘mitigation deterrence’, a slightly misleading term that more accurately means deterring emission reductions.

Fortunately, there is very little evidence that moral hazard exists in the verified carbon market (VCM). Indeed, the opposite is true. Analysis by Trove Research found that firms that voluntarily purchased a ‘material’ number of carbon credits cut their emissions by 6% per annum between 2017 and 2022 (based on the median), double the rate of decarbonisation as those firms that did not purchase carbon credits (see Carbon credits - a permission to pollute, or a signal to decarbonise?).

Carbon dioxide removal (CDR) is fast becoming the next battleground.