Whence the offsets?

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One of the significant critiques of the American Clean Energy and Security Act of 2009 (ACES)—indeed of any effort to price carbon—relates to the cost that the bill will impose on the US economy. In its analysis of the ACES bill, the Congressional Budget Office estimates that by 2020 the net cost per household would be $175 annually. Whereas this may not seem like a lot, we have to consider a potentially significant wild card in this equation: offsets. Architects of the bill readily point to offsets’ ability to reduce dramatically the cost of the cap-and-trade regime. This assumes, however, a ready supply of offsets. We urge caution in making such an assumption.

People often speak of allowances and offsets in the same sentence. Indeed, once they are created, they are fungible. ACES allows up to 1 billion tons of domestic offsets and 1 billion tons of international offsets into the system annually. Covered entities can use a combination of allowances and offsets to meet their compliance liabilities. Generally, an offset will always trade at a discount of an allowance and therefore would represent a more cost-effective option to comply with the law, without putting at risk the environmental integrity of the system – “a ton is a ton”. In the first year, for example, an entity can use a volume of offsets equal to 30% of their emissions. Nevertheless, the processes by which allowances and offsets are created could not be more different. The easiest way to differentiate is as follows: Allowances are created ex-ante by the government and given away freely or auctioned to allow business as usual emissions to occur; therefore its creation is immediate. Offsets, on the other hand, are created ex-post to reward voluntary actions that succeeded in reducing greenhouse gas emissions beyond what would have happened under normal circumstances; therefore, its creation requires a certification process which certainly takes a lot longer.

An example may help to clarify: in 2012 ACES directs the government to create 4,627 million allowances, which equates to the total level of emissions from capped sectors that the US government wants to see in 2012. The trick is that the number of allowances created by the government will decrease over time, prompting regulated companies to reduce emissions given the price signal attached to an allowance. In other words, a covered entity, such as a power plant, has to hold one allowance for each metric ton of carbon dioxide it emits in a given year. Those emissions would occur whether or not the government created allowances. Now, however, the power plant has a clear financial signal with those emissions.

An offset, however, is created ex-post by the action of an individual company or entity that made a voluntary investment in a project or activity that successfully reduced one metric ton of a greenhouse gas. Importantly, offsets can only be generated by voluntary investments in sectors that do not receive allowances. For example, a farmer decides to prevent methane emissions from a waste water lagoon by installing an anaerobic digester that captures the methane from the waste; that methane can be used by the farmer to generate heat or electricity. That methane is not included under the cap; in other words, there is no law or other compelling reason for the farmer to invest in such a system, other than the financial reward the farmer will receive from claiming and selling emission reduction credits.

Let us remember that offsets and allowances are only fungible once they have been created (up to the limit set by legislation), but the processes to create allowances and offsets differ substantially. It is much easier to create 4,627 million allowances if all it takes is a stroke of a pen. Companies can start trading the commodity immediately. Whereas offsets can be created from a variety of activities, all necessarily involve investing—on a voluntary basis—in equipment, changing production patterns and/or dedicating significant time and resources to implementing and tracking an emission monitoring system. All of these activities involve money,

time, expertise, and a certain degree of risk. Offsets also require third-party verification against established protocols. These protocols have to be created and approved by a standards body

before one can receive credit for a particular activity. The protocols ensure that the emission reductions, or offsets, meet certain stringent environmental criteria: the emission reductions must be permanent, achieve emission reductions that wouldn’t occur under normal circumstances and not result in an increase in emissions elsewhere. Analysts often boil these issues down to “transaction costs”. Indeed, people would not develop offsets unless the rewards were sufficient enough to make the time and effort worthwhile. Thus, as the cost of an allowance increases, the value of an offset does too and more and more projects become feasible. Yet, based on our experience developing offsets under the Kyoto Protocol’s Clean Development Mechanism, price is not necessarily sufficient to get the credits to the market place because of the time differential between a price signal and when an offset is issued, which can easily lapse for one or two years in the cumbersome international scheme. Therefore, what is even more important than price at a certain time is political certainty over an extended period of time and an expectation of a certain traded price.

Although ACES provides for a significant volume of offsets to be used in the cap-and-trade regime, it is not at all clear what volume will be available or how soon. By EPA’s own estimates, if international offsets are not forthcoming, allowance prices would increase by 96 percent. We can identify a number of issues that may constrain supply:

* Domestically, there are very few sectors that will be available for offsets. The majority of offsets will come from agriculture and forestry.

* Forestry projects will take a long time to develop an appreciable volume of credits, given the time trees need to grow.

* Although a significant volume of offsets may be created from agricultural practices, no protocols have been developed yet to measure and verify such emission reductions, so an early start of this sector is undermined.

* Scientific understanding of the efficacy of agricultural offset projects at sequestering carbon and reducing N2O emissions is limited.

Monitoring equipment is expensive, or unavailable, meaning practices may need to be used as a proxy for measuring reductions, which can undermine the environmental integrity of these activities.

* Importantly, international offset projects will need to be vetted and approved by EPA, which may limit eligibility by project type and country of origin of an already constrained supply.

It is clear that offset projects are easier spoken about than implemented in practice. It will be important for the US to design a system that upholds the environmental integrity of cap-and-trade, while ensuring a usable and streamlined system that does not artificially constrain supply. At the very least it will take a while for the system to mature and take shape. How long that process takes is anybody’s guess. In the meantime, we can draw one conclusion: competition for offsets will be high and companies that wish to lower compliance costs by using offsets will need to move quickly to lock up supply.

Article written by Toby A. Tiktinsky, Senior Client Manager at EcoSecurities

Tagged as: America carbon, Carbon Offsets, Emissions Reductions

Posted on September 26, 2009 · in USA