Researchers Offer Market Solutions For Boosting Use Of Carbon Offsets

By Gabe Rivin, Carbon Control News

Environmental policy experts are recommending that federal officials discount the value of carbon offsets to make them slightly more expensive to use than emission credits purchased by utilities and other industrial facilities to comply with carbon controls. The added cost of using carbon offsets, according to the researchers, is intended to resolve lingering uncertainties about offsets as a way to boost their use in emerging cap-and-trade programs.

The researchers’ recommendations are included in a report, “Designing Cap and Trade to Account for ‘Imperfect’ Offsets,” released earlier this month by Duke University’s Nicholas Institute, which supports carbon controls. The report evaluates three policy responses to potential problems with offset projects. According to one of the authors, the report is intended to influence the development of offset standards by federal agencies, such as EPA and the Department of Agriculture, under any new authorities they might have as part of a federal cap-and-trade program.

The recommendations could be useful in deflecting criticisms of offsets by environmentalists and others who question industry’s use of the them to avoid emission reductions by planting trees or investing in energy efficiency projects, among other measures. The role of offsets is regarded as key to gaining broad political support for an economy-wide cap-and-trade program, with most of the leading congressional proposals on climate change promoting use of offsets as way to reduce compliance costs. Offsets have also played an important role in both regional and state-level carbon trading systems.

The Northeast’s Regional Greenhouse Gas Initiative (RGGI), for example, allows its power company participants to purchase offsets in order to comply with the program’s emissions cap, and a cap-and-trade system being developed in California is expected to allow use of offsets. Both systems are considered potential models for a future federal carbon trading system.

The Nicholas report acknowledges potential flaws with offset markets. Activities credited as offsets have the potential to be “non-additional” -- or that emission reductions would have occurred anyway because of other requirements. And offsets have the potential to cause emissions “leakage,” or shifts in emissions to uncapped industries, the report notes.

But while some critics entirely oppose the use of offsets because of these and other concerns, the report says that offsets are an important way to ease compliance costs for regulated entities. “Perhaps the most compelling case for offsets use is that it can increase the cost-effectiveness of a compliance-based cap-and-trade system,” according to the report.

The report says that applying a penalty to each credit could be the most politically palatable method for addressing concerns with offsets. That method, known as discounting, was included in the House-passed climate bill, which broadly defined offsets’ value but left the development of key standards to EPA and the Department of Agriculture, the author says.

Using the discounting methodology, the penalty would be applied either for offset buyers, requiring them to purchase more credits, or for suppliers, who would have to perform more emission-reduction activities to earn credits. The costs to both sides would be the same under either scenario, the author says. The penalty could be determined by estimating aggregate non-additional emission reductions and using that figure to reduce the value of offsets, according to the report. Under this method, regulators would not need to screen out poor-quality offsets.

Another policy response would involve evaluating each offset project to ensure that emissions would actually be reduced. But that, according to the report, would be difficult. For example, “Screening out non-additional projects . . . would be difficult due to the issue of information asymmetry; that is, the regulator could not perfectly distinguish what actually is non-additional and thus would not be able to design tests to eliminate it completely,” the report says.

Moreover, testing individual projects has proved cumbersome and slow in practice. The author says that the Clean Development Mechanism, an offset market established for the Kyoto Protocol that allows industrialized countries to invest in clean energy and other projects in developing countries, has proven to be “a very bulky system.” Currently, there are more projects “in the pipeline than out the door,” he adds.

A third option would involve tightening the emissions cap to account for offsets’ flaws. This could greatly simplify the process for regulators, the report says. “Regulating agencies would not have to worry about creating and applying myriad rules to address non-additionality, leakage, etc., but instead be able to reconcile offset mitigation at the system-wide level.”

But simply tightening the emissions cap also has its pitfalls, according to the report. By tightening the cap, regulated entities would face greater costs than if a discounting penalty were applied to offsets. Additionally, a tighter cap would provide a windfall for offset suppliers at regulated entities’ expense. “Although our analysis suggests that the capped sector will be paying to resolve the welfare distortion no matter what approach is implemented, it pays by far the most under the cap adjustment option,” the report says.

“Whether the simplicity benefits of cap adjustment outweigh the perceived inequities remains a political judgment call,” it adds.

However, the report suggests that discounting offsets may represent a middle ground between the “relative impracticability” of evaluating each offset project and the inequitable costs of raising the emissions cap. Compared to eliminating offsets, a discounting approach would lower compliance costs for regulated entities while still benefiting offset providers, the report says.