What is a cap-and-trade system?

Cap-and-trade regulatory schemes attempt to combine traditional regulatory tools with the power of market incentives. Unlike many other regulatory programs that prescribe technologies to lower pollution, cap-and-trade programs set a target level for pollution, commonly referred to as a cap, and allow the emitters to determine how to meet the cap. The cap is made up of allowances that permit the holder to emit a specified amount of pollution. Firms must hold allowances equal to the amount of emissions they produce to be in compliance. Once the cap is set and allowances are created and allocated, the flexibility of the market-based regulatory mechanism comes into play. Cap-and-trade programs allow regulated parties to buy and sell allowances as they see fit. Variation in emission levels and reduction costs among firms creates economic efficiency gains because the exchange of allowances is advantageous for both potential buyers and sellers, and compliance is generally achieved at a lower cost than without trading.

What is an allowance?

In most current climate policy proposals, an allowance is a unit of measurement equal to one metric ton (t)[1] of carbon dioxide or a carbon dioxide equivalent (CO₂e). A carbon dioxide equivalent is used to compare differences in the ability of each greenhouse gas—carbon dioxide (CO₂), methane (CH₄), nitrous oxide (N₂O), or other compounds (e.g., hydrofluorocarbons [HFCs], perfluorocarbons [PFCs], sulfur hexafluoride [SF₆])—to trap heat relative to other greenhouse gases. All greenhouse gases are quantified in units of warming relative to the warming potential of carbon dioxide. For example, one ton of methane has a warming potential approximately 25 times greater than one ton of carbon dioxide. Thus, whereas one allowance corresponds to one ton of carbon dioxide, it would take 25 allowances to equal one ton of methane.[2]

What is an offset and how does it work?

In cap-and-trade systems, some sectors of the economy or specific activities remain unregulated or uncapped. In most U.S. policy proposals, uncapped sectors include agriculture and forestry, and additional uncapped sources include landfills, wastewater, and coal mine facilities. Voluntary greenhouse gas emissions reductions or sequestered carbon by these uncapped entities can be translated into a commodity (i.e., a carbon offset) which a capped entity (e.g., a coal-fired power plant) can purchase to satisfy its emission compliance requirements if making internal reductions is too difficult and/or cost-prohibitive. Offsets can also be generated overseas. Developing countries do not yet regulate greenhouse gases; they are uncapped.[3] Thus, in these countries, offsets can be generated not only in the agricultural and forestry sectors, but also in the energy, manufacturing, and transportation sectors. Since the climate responds to the total global greenhouse gas burden, the origin of the emissions or reductions does not matter.

Example. A coal-fired utility can emit 100 extra tons of CO₂ and still meet its emission target by purchasing 100 offsets from farmers who are sequestering the equivalent of 100 extra tons of CO₂ in their soil. The reductions generated by the farms are in a different sector and a different location.

What are the benefits of incorporating offsets into a cap-and-trade system?

Including offsets in a larger cap-and-trade system can provide the following benefits[4]:

• Reduced costs. Estimates suggest that many opportunities for mitigation in uncapped sectors are likely to be less expensive than those available to capped facilities.[5] Offsets may be an important interim tool to help capped facilities meet compliance targets in the short term while they shift toward lower-carbon facilities. For these and other reasons, a sufficient supply of offsets can be a vital element, if not the most important element, for reducing the overall cost of meeting the cap.
• Engagement of additional constituencies. Offsets can deliver financing and new technology to sectors and countries outside of the cap, thereby giving them a reason to engage in a cap-and-trade policy. Domestically, an offset market can provide an additional revenue stream for forest and agricultural landowners. Internationally, the Clean Development Mechanism (CDM), an offset program sanctioned by the United Nations Framework Convention on Climate Change (UNFCCC) under the Kyoto Protocol, has been key in engaging the two fastest growing greenhouse gas emitters, India and China, in climate negotiations.
• Co-benefits. Mitigation (offsets) in uncapped sectors can produce a number of environmental benefits in addition to greenhouse gas reductions, such as improving air and water quality and restoring wildlife habitat.

What are the concerns about incorporating offsets into a cap-and-trade system?

Concerns associated with the incorporation of offsets into a cap-and-trade system include:

• Damage to the integrity of the cap. If offsets are not real and additional reductions in emissions or increases in sequestration, they will not maintain the environmental integrity of the program and may undermine the carbon market linked to the offsets program. As a result, offsets policies often include approaches for addressing issues of additionality, leakage, and impermanence. While greenhouse gas accounting is straightforward and easy to verify for some activities, for others it is much more complicated. Unfortunately, the complicated activities also tend to be the ones with the greatest mitigation potential, especially in the case of domestic offsets.
• Diverting attention from fossil fuel reductions. Offsets in a cap-and-trade system are intended to increase flexibility for compliance, thus reducing overall costs of compliance. One concern is that allowing capped entities to use offsets instead of forcing all reductions to come from their own facilities can shift or divert effort from the capped sectors. If this is done at a significant level for a long time, it could reduce the incentives for innovation and change in those sectors. However, including offsets need not cause diversion of effort from capped sectors or slow innovation. Instead, it can be used to achieve a higher level of climate protection for the same cost as a policy without offsets and/or can function as a short-term bridge strategy that buys time for capped sectors to develop enabling technologies and adjust their business plans. In this manner, the specific use of offsets is a political decision: offsets can help to achieve a more stringent cap or to lower costs to the capped sectors, or most likely, some combination of the two.
• Offsets become an entitlement. Paying the uncapped sector for emissions reductions can create a strong stakeholder group that prefers being paid for voluntary emissions reductions to being subject to reporting and emission compliance obligations in the future.
• Money sent overseas. Some are concerned that the likely low cost of many international offsets will result in wealth transfers to foreign nations. While this is true, such funding is expected to bring significant benefits to the U.S. It will achieve significant greenhouse gas reductions, providing capped entities in the U.S. flexibility in achieving their targets (therefore lowering costs), and resulting in the adoption of cleaner technology and reduced deforestation in other countries.
• Negative co-effects. While there are potential environmental benefits from offsets, there can also be negative environmental effects, such as tradeoffs in air pollutants, reduced water availability, and the replacement of native vegetation with nonnative but fast-growing and high-carbon species.

What types of activities could be included in a domestic offsets program?

A wide range of activities could be included in a domestic offsets program. For example:

• capture of landfill methane
• capture of coalbed methane
• reducing nitrous oxide and methane from wastewater treatment
• capturing natural gas and petroleum CO₂ and methane process losses
• afforestation/reforestation and forest management
• conversion of pasture or crop lands to grasslands
• conservation tillage or improved soil management
• improved rangeland management
• improved nitrogen fertilizer management
• avoided deforestation and forest degradation (avoided conversion)

Forest and agricultural offsets are expected to provide by far the largest stream of offsets from the U.S. At this time the most common types of farming and forestry activities in the U.S. that can be used to generate offsets are practices that (1) increase or avoid losses in the amount of carbon stored in biomass (e.g., trees), (2) increase the amount of carbon stored in soil, or (3) reduce methane emissions from manure processing and disposal.

What types of activities could be included in an international offsets program?

Developing countries do not yet regulate greenhouse gases, so offsets can be generated in the energy, manufacturing, and transportation sectors, in addition to agricultural and forestry sectors. Early offsets projects developed through the CDM have primarily been in renewable energy (65% of projects), methane reduction (14%), and supply-side energy efficiency (10%).[6] Within the renewables category, hydroelectric power generation accounts for 42% of projects, with wind power at 25% and biomass energy at 22%. To date, approximately 4% of CDM projects are in agriculture and only 1% in afforestation/reforestation. Although projects reducing HFC, PFC, and N₂O emissions only comprise about 2% of all projects, they represent 27% of the Certified Emissions Reductions (CERs) to be generated by 2012, the close of the first crediting period.

How do biofuels fit into an offsets program?

The production and use of some types of biofuels may release fewer greenhouse gas emissions than traditional fossil fuels, placing these biofuels at a competitive advantage in meeting emission reduction targets. That said, the particular treatment of biofuels in an offsets program depends on the scope of the cap-and-trade system as well as whether fuels are regulated upstream (e.g., refineries), downstream (e.g., power plants or vehicles), or by a low-carbon fuel standard. Any greenhouse gas emissions reductions achieved via biofuels as compared to fossil fuels should not be “double-counted” (credited for the same emission reductions more than once). If fossil fuels are regulated under a cap,[7]then there will be an incentive to use lower-emission biofuels, an incentive that will translate into increased demand for biofuel feedstocks. In such a scenario, it is unlikely that biofuels would qualify as an offset.

How much greenhouse gas mitigation can be expected from a domestic offsets program?

The greenhouse gas mitigation potential of a domestic offsets program depends on the price of carbon. The type of offset activities undertaken, as well as the location of these activities, will also change depending on the carbon price.

For example, a 2005 report by the U.S. Environmental Protection Agency (EPA) found mitigation potential in 2015 from agriculture and forestry at a carbon price of $1 per metric ton of carbon dioxide equivalent (tCO₂e) to be 121 teragrams (Tg)[8] CO₂e/year; at a price of $50/tCO₂e, mitigation potential jumps to approximately 1,500 TgCO₂e/year.[9] These mitigation potentials translate to roughly 2% and 22%, respectively, of total U.S. greenhouse gas emissions in 2003. The EPA report further notes that, at the lower end of the price spectrum, soil carbon sequestration and forest management are expected to dominate the offsets market, while afforestation is expected to dominate at higher prices. Regionally, the midwestern and south central portions of the U.S. display high mitigation potential at all carbon prices. The relative potential of Great Lake states declines at higher carbon prices.

An additional consideration is the timing of potential activities and offsets. In the early years of a domestic offsets program, agricultural soil sequestration and forest management practices are expected to dominate, with afforestation contributing more relatively up to 2050. Given the experience gained and comfort with certain types of activities, such as methane capture from waste management facilities, they are likely to be an important component in the early years while regulators are setting up the program even though they may be more expensive and make up a small amount of the total potential pool of domestic offsets over the longer term.

How much greenhouse gas mitigation can be expected from an international offsets program?

Given the scale of international uncapped greenhouse gas emissions (energy, manufacturing, transportation, deforestation) and sequestration potential (forest and agricultural management), it is not surprising that the potential pool of international offsets is substantially larger than of those generated within the U.S. However, proposed climate policies cap the use of offsets by domestic firms, which means the full potential of international offsets will not be exhausted. The availability of offsets will depend on the policies and regulations that are developed. If the policies are more constraining, or if transaction costs are higher than expected, the supply of offsets could be lower than depicted above.

How can offset projects be measured and monitored?

The best and most accurate way to measure and monitor greenhouse gas reductions or carbon sequestration in offset projects is through carefully designed and orchestrated field sampling.[10] That said, minimizing the cost and difficulty of participating in an offsets market will be important to encourage participation. Landowners and project developers can use existing standard models, equations, lookup tables, and Internet tools for measurement and monitoring to reduce the difficulty and expense of measurement that might otherwise discourage them from participating in an offsets program.[11] A number of such tools already exist, and efforts are under way to continue their improvement.

How can we be assured that an offset is real or valid?

The environmental, economic, and legal integrity of the offsets program requires that an offset represent a reduction in emissions or increase in sequestration equivalent to the amount emitted by the purchasing entity. Therefore, factors with the potential to reduce or misrepresent the actual amount of emission reductions or carbon sequestration achieved by an offset project must be accounted for when determining the total number of offsets to be awarded. Mechanisms must first be established for measuring and verifying offsets. Clear standards must be established for which types of projects are eligible for participation in an offsets program, how to ensure that the reductions made are additional to those that would have been made anyway, how to account for any induced impacts (leakage) that may occur outside of a particular project, and how to account for any release of stored carbon or reversal. The latter is a problem unique to sequestration projects that store greenhouse gases in plant biomass or soil.[12]

Additionality: How can we ensure that offsets result in an overall reduction in greenhouse gas emissions?

Because a capped entity can purchase an offset allowing it to emit greenhouse gases above its cap, the offset must represent a true reduction in emissions or increase in sequestration comparable to the entity’s increase in emissions. Thus an offset must be a reduction that would not have otherwise occurred, which is known as additionality. There are a number of additionality tests that have been proposed and are being used in current markets to determine if an offset results in an overall reduction in greenhouse gases that would not have occurred without the offset activity.[13] Additionality tests include, but are not limited to, the following:

• Legal, regulatory, or institutional test. Offset project must reduce greenhouse gases emissions or increase sequestration beyond levels required by laws, regulations, industry standards, or guidance.
• Technology test. Offset projects must use new or “additional” technologies, those not used under business-as-usual circumstances.
• Barriers test. An offset project is additional if it faces a significant implementation barrier, such as local or institutional resistance to new technologies.
• Common practice test. An offset project must implement a practice better than the common or business-as-usual practice.
• Initiation date test. An offset project must be initiated before a set date.
• Performance benchmark test. An offset project must demonstrate emissions reduction (or sequestration) better than a predetermined benchmark of emission (or sequestration).
• Proportional additionality. An offset project is discounted to reflect the additionality of the mitigation activity relative to its peer activities.

Baseline: How do we establish a point of reference to gauge the net benefits of an offset project?

A baseline is the net greenhouse gas emissions or carbon sequestration on a project’s lands or facilities that would have occurred in the absence of the project. Under many accounting protocols, the reduction in greenhouse gas emissions below the baseline or the increase in sequestration above the baseline count as credited allowances.

Leakage: What happens if an offsets project inadvertently leads to an increase in greenhouse gas emissions elsewhere in the economy?

Leakage is the shifting of emitting activities to locations not included in the measured area of an offsets project or program. This can result in a smaller net reduction in overall emissions than expected. Accounting for leakage in an offsets program helps maintain the environmental integrity of the program and the market value of the offset.[14]

Leakage usually occurs when an offset project reduces the supply of a good, displacing its production—and its associated greenhouse gas emissions—to another location. Leakage is likely to be a problem where an offset project reduces the land available for producing another market commodity, such as crops or timber. For example, when a landowner decides to generate offsets by switching to longer timber rotations, one possible effect is that the supply of timber could be reduced, leading to new timber harvest outside of the project area to satisfy unmet demand. This leakage would diminish or even eliminate any net gains in sequestration achieved through the project.

The inclusiveness of an offsets program will impact the susceptibility of individual projects to leakage—the more inclusive the offsets program is, the less leakage there is likely to be. In situations where leakage is expected, it is possible to discount an offset for the induced emissions or lost sequestration. Leakage cannot, however, be measured at a project level—it can only be assessed or modeled at the regional or national level, leading to estimates of leakage rates for specific project types in specific regions.

How can we address the fact that carbon sequestration may not be permanent?

Carbon sequestration offset projects create value by removing CO₂ from the atmosphere and storing it in terrestrial carbon stocks, such as soils or vegetation. If the stored carbon is returned to the atmosphere as a result of natural disturbance events (e.g., fires and floods) [15] or human actions (e.g., a farmer switching back to conventional tillage practices from no-till), the greenhouse gas benefits from the offset project have been lost. Mechanisms must be in place to manage the risk of reversal.

There are different ways to address environmental certainty while managing financial risk for the project owner. Several approaches could be considered, defined by who bears the risk.[16]

1. Project developer. Projects could be conservatively discounted based on risk. In other words, the project landowner would receive less than a one-to-one crediting from the developer for each ton sequestered or reduced, but then the risk and liability are transferred to the project developer. This approach to risk management works better when projects are aggregated in a diverse portfolio, because it allows the developer or aggregator to pool risk across projects more efficiently. Project aggregation will likely be the norm for agricultural sequestration, due to the relatively small amounts of carbon at stake on a per-acre or per-project basis.
2. Private third-party. Risk pooling could be extended further by involving third parties who manage risks through insurance contracts, financial instruments, reserve requirements, or other well-established vehicles used to manage risks from other commodities. These mechanisms will ultimately impose some sort of premium or discount as described above which will reduce the net payment to the landowner, but sustain the expectation that full losses will be covered.
3. Public shared-liability plan. A shared liability system where every allowance at risk of reversal pays a small percentage (at a level related to expected risk) into a national or regional shared liability buffer or reserve that will be available to all project developers when they are subject to a reversal caused by an act of nature.
4. Temporary credits. It is also possible to establish a mechanism through which offsets generate only temporary credits. The credits expire and must be replaced at the end of their contract term. This is the model pursued for afforestation/?reforestation sequestration projects in the Kyoto Protocol’s Clean Development Mechanism. Creating a temporary credit removes any need to protect or monitor long-term carbon sequestration, but in exchange commands a much lower price per metric ton than permanent offsets because of the purchaser’s need to replace the credit once it expires.

How can uncertainty in measurements and methods be addressed?

For some project types there will be uncertainty associated with the field-collected data or models used, as well as with the methods used to determine baseline and additionality. Methods and tools must include estimates of uncertainty.

To be conservative in maintaining environmental and economic integrity for offsets, a project’s offsets could be discounted by the uncertainty inherent in the methods used and the input data provided. One way to discount would be to use the most conservative estimate within an accepted statistical confidence interval, if such data are available.

A number of methods for measurement and accounting exist. Discounting that is scaled to increase with uncertainty will allow the market to settle on the ideal mix of effort and certainty. In this fashion, a landowner may consider measurement and accounting practices of increasing stringency up to the point where the increased costs and effort become greater than the benefit gained from a reduced discount.

How can existing projects or offset-eligible activities (i.e., early actors) be included in U.S. offset policy?

A critical question facing climate policymakers is how early actors—those already engaged in activities that reduce greenhouse gas emissions—will be credited in a federal cap-and-trade policy. Two issues stand out: (1) whether early actor projects will be credited in a future federal program and (2) whether they will receive any credit for their activities before the start of the federal program (backward crediting).

It is possible that activities already taking place (pre-compliance reductions) would be considered non-additional in a new federal program and thus would not be eligible to acquire credits for continued sequestration on their property. Thus exceptions in additionality rules are being considered to allow certain activities or actors (e.g., those who have registered their actions as a carbon project in a registry) to be eligible for crediting in the future federal market.

Given the desire to promote early activity and to prevent people from reversing the benefits realized by their actions, some suggest backward crediting early actor projects. There are two policy mechanisms for inclusion of pre-compliance reductions currently under discussion:

• setting aside proceeds from the sale of allowances, through auction or allocation, to compensate early actors for their pre-compliance emissions reductions
• permitting unsold credits produced by uncapped early actors to be incorporated into the federal offset market

The inclusion of existing projects or offset-eligible activities (i.e., early actors) is a critical issue that policymakers are sorting out.[17]