How an incentive-based market instrument aimed at consumers could help reduce emissions 

At least 25 countries and the European Union have set legally binding net zero targets; a further 54 have net zero pledges in relevant policy documents. While these developments demonstrate progress towards decarbonization, credible plans for achieving the targets are in short supply, and often avoid politically unpalatable, yet unavoidable, routes to achieving net zero.

The UK’s Climate Change Committee estimates that 62% of the actions required to achieve the country's net-zero targets will involve some element of behavioural change on a societal scale. These include changes to the way we heat our homes, travel and shop.

Thus, changing consumer behaviour that hundreds of millions of spending choices they make daily encapsulates is crucial to achieving net zero. When we choose to spend on emission-intensive products and services we signal to markets that generating emissions is good for business, thereby reducing the risk associated with running an emission-intensive business.

Although we should like to do otherwise, we are unlikely to spend on low emission goods unless we are economically constrained to do so. This is the classical tragedy of the commons problem, an economic problem where the individual consumes a resource at the expense of society and why activist interventions will not substitute for creating the economic incentives in the drive to address climate change.

Here we explore an ambitious agenda for creating such an economic incentive using an incentive-based market instrument for channelling for consumer action on climate change.

Despite the general acceptance among economists that the same overall economic and behavioural change effects of incentive-based instruments – for example, cap and trade – could be achieved by applying them at various points in the chain of producing and consuming products, there has been very little interest in undertaking a significant research effort to explore its validity.

Indeed, application of incentives at different points in the value chain may raise different issues – potentially in contradiction to pre-conceived theoretical expectations. Incentive-based instruments, such as cap and trade schemes are mainly currently deployed at the producer level, where producers are required to engage in trading emission permits.

The practical decision to apply instruments on producers is justified by transaction costs: producers are better able to bear the burden of participating in trading or accounting for taxation, and governments are also better able to enforce regulations on aggregate entities, i.e., companies.

In such a system, products requiring more emissions to produce, all things being equal, become more expensive. As consumers will tend to substitute away from more expensive products, they will tend to substitute away from higher emission consumption toward lower emission consumption.

Given that consumers only need to observe price, the existence of the instruments does not add cognitive burden to their decision-making; and because consumers still express preferences, these instruments in principle allow the system to discover the efficient way to achieve the desired levels of emissions without pre-specifying which consumption behaviour to change.

Theoretically, this approach simplifies important features involved in the practical implementation of carbon pricing. To achieve the desired outcome, an instrument must achieve the correct pricing of the externality from emissions and effect the signalling of that price to consumers in some form – for example, in the form of higher product prices.

However, even if prices are close to the desired levels needed to achieve policy goals, product price signals alone do not provide the information consumers need to make behavioural course corrections.

Prices change over time – in some markets quite rapidly – for reasons not directly related to emissions, and consumers do not necessarily accurately attribute the reasons for price changes. Misattribution can have important consequences for emissions-reducing behavioural change when it comes to consumption.

Consumers can be systematically misinformed about the environmental consequences of their consumption, and the effectiveness of alternatives and of mitigation actions. For example, one study showed that consumers in their survey are focused primarily on curtailment such as turning off lights and therefore underestimate the effectiveness of efficiency improvements such as investing in energy-saving light bulbs.

Under a producer-level instrument, the useful behavioural change of swapping out light bulbs would be driven by consumers forecasting correctly that they would be better off by doing so, due to the relative prices in the long term of light bulbs and electricity.

However, as electricity prices can be volatile, and the relationship between emissions and price opaque, in practice, consumers do not have the information or capacity to make the forecasts that theory requires them to.

Embedding the emissions consequences of consumption entirely in the price signal also limits the ability of consumers with pro-environmental preferences to express these fully, limiting a potential driver of change.

Some consumers do not make decisions solely on price; many products are marketed because of their (real or claimed) “green” credentials, and thus the environmental consequences of consumption choices do appear in the consumer’s decision-making.

Consequently, the practical benefits of limiting the cognitive burden on individual consumers by applying incentive-based instruments at the producer level are limited.

To address the misattribution challenge, we could consider applying incentives to the consumer level. An approach would be to exploit the digital transformation in financial services, which allows for real-time online processing of transactions to log the emission intensity of our consumption.

Specifically, we could combine environmental, behavioural and economics theory with fintech, to develop the theoretical and practical foundations for a consumer emissions trading scheme (CETS) – a scheme in which individuals/households can trade ‘emission permits’ subject to dynamic emission permits budgets that, in aggregate, correspond to an economy-wide emissions cap.

CETS would lead to the emergence of an emissions-constrained economy where consumers operate under both economic and environmental constraints, with the potential effect of capital moving from emission-intensive pursuits to low carbon investment.

Simply put, if people significantly reduce their consumption of emission-intensive items, the cost of capital for producing such items will become prohibitive, further raising their price.

This would even the playing field for low carbon innovation and sustainable investment options broadly, thus making us more likely to meet net zero targets as set.