It’s easy to view markets as being heartless, even anti-social, that they involve greedy people and unethical corporations and cannot possibly be an effective way of advancing the common good. Surely governments are best positioned to provide the services that contribute to social progress?

Markets are driven by self-interest so they can’t do any good, right? Let’s explore this idea by invoking the thoughts of the father of economics, Adam Smith. In An Inquiry into the Nature and Causes of the Wealth of Nations written almost 250 years ago, Smith observed: 

It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own self-interest.

Sounds greedy, doesn’t it? But this was not Smith’s accusation. Rather, he was observing a reality: that people engage in producing and trading goods and services to advance their self-interest. Yes, self-interest might include greed and unethical behaviour such as cheating each other in transactions, but it can also include people’s desire to provide for their families or to earn money and give some of it to charity. It might even include a desire for a better world. 

Self-interest is not the same as greed. Whatever constitutes self-interest, it is a powerful motivator. After all, whose interest are you serving if not your own? 

Self-interested people come together as business owners and workers producing goods and services that customers desire and then exchanging them for money. They earn profits and wages in the process. 

Acting in one’s self-interest is not inherently bad behaviour. Nor are markets inherently bad. It’s the nature of the activity that matters.

Competition is good

Smith has been viewed as someone who believes only in money and greed. In fact, Smith was a free marketer; he loathed cartels:

People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.

Collusive behaviour and the formation of cartels are indeed a conspiracy against the public. It’s the main reason that governments enact competition laws prohibiting this sort of behaviour. 

A market for coffee

Consider a competitive market – producing and selling coffee. Café owners would like high prices for their coffee, but if one owner raises the price above the going price, customers will go elsewhere. And all the time, owners are working on how they might gain a competitive edge; finding better blends, attracting the best baristas, and renovating their café. Coffee drinkers would consider this a desirable market.

Suppose the government decided to supply coffee through state-run cafes or gave monopoly rights to a private corporation. Gone, or much diminished, would be the incentive to supply high-quality coffee at the lowest possible prices. And there would be little or no incentive to innovate; to try new blends and find ways to keep costs and prices low. 

This is why in western countries, and even in most countries with socialist systems, the state does not run cafes or give monopoly rights to a private provider.

Externalities

In lots of circumstances, the production and supply of goods and services can produce positive or negative externalities, or as they are called today, spillovers. A firm’s research and development can produce valuable innovations. But since the originating firm cannot capture for itself all the benefits of its research and development, as others copy it either illegally or as patents expire, the firm will under-provide it from society’s viewpoint. Research and development is therefore said to produce positive spillovers and a case can be made for the government to subsidise it. 

This is especially the case for pure research, which might increase human understanding that eventually leads to valuable innovations. But firms will not tend to undertake pure research, because they will not be able to capture for themselves anywhere near the full commercial benefits of that research, which might not materialise for decades of further research and development.

Negative externalities, or negative spillovers, occur when an activity creates damage but is not charged a penalty for that damage. Too much of that good is produced from society’s perspective. The penalty might take the form of an outright prohibition. For example, discharging water polluted with toxic chemicals into a waterway might be made illegal, or an international agreement to ban ozone-depleting chlorofluorocarbons put in place.

Alternatively, a price might be placed on the negative externality. A relevant example is putting a price on carbon emissions. The EU and a few other countries have placed a price on carbon through an emissions trading system. The Australian Government sought to place a price on carbon in 2009 but the legislation was defeated in the Senate. A price was placed on carbon in 2012 but was repealed by the new Australian Government in 2014.

In place of the carbon price, the Australian Government in 2014 began regulating the amount of carbon that could legally be released into the atmosphere by the larger emitters through what is called the Safeguard Mechanism.

Are markets or regulations best to deal with negative spillovers?

Going back to Smith, he marvelled at what he called the “invisible hand” of markets bringing buyers and sellers together and finding a price at which the market clears – where demand equals supply. This “invisible hand” is better at finding a price for coffee that consumers are willing to pay and at which producers are willing to supply coffee.

If governments regulated coffee production and sale, they wouldn’t know the market-clearing price. If the government set the price each day, there would be a surplus of coffee on some days and a shortage on others.

Similarly, putting a price on a negative externality is likely to be far more effective than government officials trying to regulate it. If an overall limit is placed on the amount of carbon a country can emit into the atmosphere, then a market will form and work out the most efficient and effective way of complying with that limit. This is called a cap-and-trade system. A cap is placed on total emissions and businesses can trade in emissions permits, with those businesses that can reduce their emissions more easily selling their permits to businesses that find it harder to do so.

A market for offsetting emissions

Many nations have committed to zero net emissions by 2050 or earlier. Despite the best efforts of humankind, the world will be emitting carbon in 2050. Human and animal life on earth will emit carbon. So will forest fires from lightning strikes. Even if the world achieves zero net emissions by 2050, atmospheric concentrations of carbon dioxide will be at their highest levels in tens of thousands of years; we will only have succeeded in no longer making the situation worse.

That’s why carbon offsets are so important and will increasingly be so. If humankind can store more carbon than we release, we will be making progress. The answer is to release less carbon and store more.

Australia, along with several other countries, has developed a market for carbon offsets. One Australian Carbon Credit Unit (ACCU) indicates that one tonne of carbon dioxide equivalent has been stored or avoided by a project.

ACCUs have been created under the Safeguard Mechanism established in 2014 for use by those emitters that exceed their permissible emission limits. In addition, ACCUs are purchased by businesses that are not covered by the Safeguard Mechanism but have nevertheless committed to reducing their emissions. During 2022, the price of ACCUs was broadly in the range of A$30-60.

The new Australian Government has committed to tightening the limits on permissible emissions for the big emitters covered by the Safeguard Mechanism. As these limits are tightened the value of ACCUs will tend to rise.

The Australian Clean Energy Regulator is in the process of establishing a properly functioning Carbon Exchange for trading in ACCUs. Other countries are establishing carbon exchanges too. These will bring together sellers and buyers of carbon credits. Under Article 6.2 of the Paris Agreement, countries that buy carbon credits of high integrity can count them towards their Nationally Determined Contributions to global emission reductions.

The Clean Energy Regulator intends that the Australian Carbon Exchange provides a premium on the price of ACCUs where the activity improves biological diversity in addition to offsetting carbon emissions. For example, revegetation of cleared land in biologically diverse regions would qualify for a premium.

A separate premium is envisaged where the activity achieves socially desirable goals. For example, early-season savanna burning by remote Indigenous communities reduces carbon emissions relative to those that would be emitted later in the dry season from lightning strikes when the savanna is fully grown. Income earned by these communities from ACCUs is being devoted to improving schools in remote communities, leading to higher attendance rates.

Of course, it is in the interests of the Clean Energy Regulator and in the national interest for carbon offsets to be of high integrity; that one ACCU truly represents one tonne of carbon dioxide equivalent stored or avoided. This maximises the price of ACCUs for those who generate them. The new Australian Government has announced a review of the integrity of ACCUs, which has since reported.

Carbon markets for the common good

Storing and avoiding carbon is for the common good. It is essential to achieving any goal of zero net emissions since the earth will be emitting carbon beyond 2050. Well-designed carbon markets are capable of identifying the best opportunities for storing and avoiding emissions and generating income for those engaged in these activities.

The alternative of government officials finding such opportunities and setting prices for carbon offsets would be as difficult as officials making coffee and setting a price for it or officials replacing Smith’s butchers, brewers and bakers and producing these basic consumer goods. Carbon markets are a good example of harnessing the power of the market for the common good.

Craig Emerson is an economist who previously served as Minister for Small Business and Minister for Tertiary Education and Science in the Rudd and Gillard Governments.