Emissions Offsets in a Greenhouse Gas Cap-and-Trade Policy

Emissions offsets have received much attention, both positive and negative, as a policy option to mitigate climate change. Simply put, an offset is an agreement between two parties under which one party voluntarily agrees to reduce its emissions (or increase carbon storage in forests or agricultural soils) in exchange for a payment from another party. For this discussion, the paying party is mandated via regulation to reduce emissions, but the selling party is not. The underlying premise is that the offset seller can cut emissions less expensively than the offset buyer can and will do so if they are paid more than the action costs.   

The most well-known climate policy offset program is the Clean Development Mechanism (CDM). Under that arrangement, countries that have agreed to binding greenhouse gas (GHG) reduction commitments under the UN’s Kyoto Protocol can meet the commitment through: focusing on internal emissions reductions, trading emissions rights with other countries facing Kyoto emissions targets, or relying on the CDM itself, obtaining emissions reductions credits generated through offset projects in developing countries not bound by Kyoto targets.  

One of the newest programs is the Regional Greenhouse Gas Initiative, which recently launched a mandatory program to reduce GHGs from the electric power sector in 10 northeastern states with offsets from the uncapped sectors allowed as a compliance option. And earlier this year, U.S. Senators Lieberman and Warner introduced legislation to cut GHG emissions 70 percent by 2050, with domestic and international offsets as a significant component of the policy’s cost containment design.  The legislation did not pass, but it laid the foundation for future efforts that seem sure to include offset provisions.

Why Offsets?  

The economic argument in favor of offsets is straightforward to anyone familiar with emissions trading principles. Rather than designate which parties must undertake which reductions to achieve a collective target, it is more efficient to allow parties to contract among themselves to find who can achieve these reductions at the lowest cost. This is true for emissions trading in general and for offsets in particular. Empirical evidence bears this out. A recently published study by EPA of the Lieberman-Warner bill found that allowing offsets even subject to quantitative limits on their use reduces marginal compliance costs by about half. In addition to cost containment, offsets are seen as a potential source of economic stimulus, delivering much-needed resources and efficient technologies to sectors and countries outside the cap that are economically disadvantaged. They can also be a source of environmental co-benefits through the deployment of less polluting technologies and protecting forests and other ecosystems that sequester carbon.

Potential Problems

Two common criticisms of offsets are that they deflect effort from abatement in the capped sectors, and generate credit for reductions that may not be real. But the former criticism is misdirected. Deflecting abatement from the capped sectors is exactly how offsets work to reduce costs. It should be the overall reductions we are interested in, not where they occur. However, if offset credits are being given for reductions that do not actually occur, the transaction and the cap are illusory.

The validity of offset reductions is called into question because they are generated from sources that do not face an emissions mandate. This makes it difficult to determine how to give credits for emissions reductions—reductions compare to what?  The answer typically comes in the form of a baseline that captures what the emissions level would be under a “business as usual” scenario. Reducing emissions below this baseline can be considered additional to reductions that would have occurred anyway.

“Additionality” is a necessary condition for the reductions to be real. Additionality may be more readily apparent in some cases such as methane capture from livestock operations or afforestation of cropland because these are not prevalent practices for farmers under business as usual. But in practice it can be difficult to determine additionality because once a project starts, the baseline is a counterfactual event that is unobservable. This can become a matter of guesswork that varies in sophistication—from complex data analysis to simply asking the party to provide evidence the project is additional. If a party has too much freedom to set its own baseline, there is legitimate concern about its validity and whether the reductions are therefore truly additional.

Another potential problem with offset transactions is “leakage,” which occurs when emissions reductions generated by the project simply lead to emissions being shifted to some ungoverned source, such as another uncapped entity not engaged in an offset project, thereby counteracting the project’s reductions. A third problem, “permanence,” comes specifically from offsets generated by biological sequestration of carbon in forests and agricultural soils, which have the highest physical and economic potential in a domestic U.S. program. These projects create value by removing CO2 from the atmosphere and storing it in biomass and soils. The stored carbon, however, can be re-emitted by natural disturbances, such as fire, or intentional management actions.  If this occurs, the original benefits of the project have been negated and the offset accounting shortfall needs to be addressed.

Possible Solutions

Offset policy has focused on addressing additionality, leakage, and permanence issues in two ways.

Quality standards

Each of the problems identified here can be dealt with by imposing standards to protect offset quality. This follows the CDM approach, which restricts the activities eligible for offsets and requires an Executive Board to approve all projects.  All CDM projects must meet standards for additionality, address leakage, and require all biological sequestration projects to accept temporary payments rather than risk impermanence. This was deemed necessary to get political buy-in from parties who were skeptical of offset integrity. The results have been mixed. Indeed, it has been challenging to get many CDM projects approved, thereby restricting supply. But the logjam is loosening and some projects that have been approved have been criticized for generating dubious reductions despite quality standards.   

Quantitative restrictions

Policymakers have tended to couple quality standards with quantitative restrictions on the use of offsets for compliance. For example, the EU limits the share of compliance commitments that can be met with offset credits to approximately 10 percent (with some variation across countries within the EU). The Lieberman-Warner bill would have similarly placed compliance limits on offsets, as does the new House draft bill introduced by Reps. Dingell and Boucher. These restrictions implicitly suggest that policymakers are lured by the appeal of offsets, but they only trust them so far.

Summary

Offsets are neither a panacea nor a pox.  Done well, they expand emissions reduction opportunities and lower the cost of achieving the cap, but they create a number of accounting problems for a cap-and-trade program. Rigorous standards for their inclusion are essential if the system is to have integrity. Nonetheless, some flexibility is necessary to ensure that high-quality offsets are not left out of the system because of overly burdensome requirements. This tradeoff is as much art as science. Quantitatively limiting offsets for compliance is not an ideal solution, but it may be necessary, at least at first when offset quality is highly uncertain.  Even with quality standards and quantitative restrictions in place, the CDM has generated a substantial flow of potential credits (3.8 billion tons in the pipeline) redeemable in the Kyoto system. Clearly, the current system, warts and all, has at least passed the first test of viability. Whether or not offsets are a critical element of the post-2012 Kyoto framework and the U.S. compliance market remains for policymakers to decide.   

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Views expressed are those of the author. RFF does not take institutional positions on legislative or policy questions.

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