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4
Offsets—What’s Assumed, What Is Known/Not Known, and What Difference They Make

As Newell noted in the opening session, the existence of carbon offsets—whether from within the jurisdiction (domestic, non-covered sectors) or from outside the jurisdiction (international)—has a significant impact on estimations of the cost of reducing greenhouse gas emissions. In introducing the third session of the workshop, Karen Palmer of the planning committee noted that analysis of proposed climate legislation showed that the existence of international offsets lowers carbon allowance prices by 70 percent compared to the case where offsets are not allowed. Yet there is much confusion about how offsets are defined and, in particular, how international offsets should be treated as more countries participate in international agreements to reduce emissions. Many different models and sources of offsets have been proposed, including project-based offsets under the Clean Development Mechanism (CDM), broader-scale international programs of offsets for reducing emissions from deforestation and soil degradation (REDD), and sectoral offsets produced by reductions of emissions beyond agreed-upon target levels for a particular sector in a particular country. Each type of approach to offsets raises issues related to monitoring and verification of emissions reductions and estimation of costs. In addition, for certain types of offsets, institutional arrangements such as the existence of a centralized monopsonistic buyer of international offsets, as well as political risk in some countries, may affect the costs and the supply of offsets. There are also fundamental analytical issues as to how offsets can be represented in macroeconomic models. This session of the workshop was organized to discuss how offsets are defined, the different forms they can take, and how offsets might be used, in addition to institutional issues for both suppliers and demanders and how they affect costs, including what has been learned from the CDM experience.

Ray Kopp of Resources for the Future began the session by discussing definitions of offsets and taxonomy and some of the modeling issues associated with offsets, and by offering brief observations on the political economy of offsets. Compliance offsets allow a country that has entered a legal obligation to reduce emissions to achieve those reductions wherever doing so is least costly. For example, if the United States makes a commitment to reduce greenhouse gas emissions but finds it less costly to reduce emissions in another country, domestic or international policy might allow the United States to meet its obligation in the countries where the low-cost opportunities occur. Kopp noted that it is important to verify that such emissions reductions in the low-cost country would not have occurred in the business-as-usual case and so can be certified as additional reductions. Some of the critical modeling issues associated with offsets include the additionality issue mentioned above, transaction costs, and avoidance of double-counting so that an offset generated for one country is not also used by a second country to meet its obligations.



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4 Offsets—What’s Assumed, What Is Known/­Not Known, and What Difference They Make As Newell noted in the opening session, the existence of carbon offsets whether from within the jurisdiction (domestic, non-covered sectors) or from outside the jurisdiction (international) has a significant impact on esti- mations of the cost of reducing greenhouse gas emissions. In introducing the third session of the workshop, Karen Palmer of the planning committee noted that analysis of proposed climate legislation showed that the existence of international offsets lowers carbon allowance prices by 70 percent compared to the case where offsets are not allowed. Yet there is much confusion about how offsets are defined and, in particular, how international offsets should be treated as more countries participate in international agreements to reduce emissions. Many different models and sources of offsets have been proposed, including project-based offsets under the Clean Development Mechanism (CDM), broader-scale international programs of offsets for reducing emissions from deforestation and soil degradation (REDD), and sectoral offsets produced by reductions of emissions beyond agreed-upon target levels for a particular sector in a particular country. Each type of approach to offsets raises issues related to moni - toring and verification of emissions reductions and estimation of costs. In addition, for certain types of offsets, institutional arrangements such as the existence of a centralized monopsonistic buyer of international offsets, as well as political risk in some countries, may affect the costs and the supply of offsets. There are also fundamental analytical issues as to how offsets can be represented in macroeconomic models. This session of the workshop was organized to discuss how offsets are defined, the different forms they can take, and how offsets might be used, in addition to institutional issues for both suppliers and demanders and how they affect costs, including what has been learned from the CDM experience. Ray Kopp of Resources for the Future began the session by discussing definitions of offsets and taxonomy and some of the modeling issues associated with offsets, and by offering brief observations on the political economy of offsets. Compliance offsets allow a country that has entered a legal obligation to reduce emissions to achieve those reductions wherever doing so is least costly. For example, if the United States makes a commitment to reduce greenhouse gas emissions but finds it less costly to reduce emissions in another country, domestic or international policy might allow the United States to meet its obligation in the countries where the low-cost opportunities occur. Kopp noted that it is important to verify that such emissions reductions in the low-cost country would not have occurred in the business-as-usual case and so can be certified as additional reductions. Some of the critical modeling issues associated with offsets include the additionality issue mentioned above, transaction costs, and avoidance of double-counting so that an offset generated for one country is not also used by a second country to meet its obligations. 

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 MODELING THE ECONOMICS OF GREENHOUSE GAS MITIGATION Kopp noted that there is a movement from project-based offsets (which are like those under the CDM) to sectoral offsets, whereby a baseline and an emissions cap are established for a whole sector (such as the electricity generation sector) in a given country and offsets are generated by reducing emissions to a level below that cap. There are some problems with the sectoral credits as well, such as the fact that different countries might establish their own baselines using different criteria. If those baselines are liberal, a lot of emissions credits are generated. Another problem is whether large markets for carbon will develop. The largest would be in the United States, but if there were no U.S. market would the market in Europe and other developed nations be large enough to drive the creation of the massive amounts of credits necessary for offsets to play a major role? Kopp also pointed out that bilateral deals might pose complexities in terms of their political economy. For example, in choosing certain countries with which to make bilateral arrangements, the United States will take into consideration issues beyond simply the availability of sectoral offsets in that country. Kopp noted that concerns surrounding political economy may not favor cutting sectoral deals with China, whereas Mexico may be viewed as a more suitable partner. The second speaker, Geoff Blanford of the Electric Power Research Institute, focused on international offsets and their role in meeting U.S. targets for reduction of greenhouse gas emissions. Blanford began by noting that recent legislation (for example, H.R. 2454, the Waxman-Markey bill) proposed that several types of offsets be admissible with a high limit on international crediting. Blanford observed that emissions abatement opportunities internationally are abundant and cheap but that many institutional barriers exist in the near term. He observed that the high limit on international offsets is built in as a way to contain costs, especially for the Organisation for Economic Co-operation and Development (OECD) countries that would be the first countries with emissions caps. He also noted that if, over the long term, support for global stabilization efforts broadens and requires that the developing countries also reduce emissions, then the non-OECD countries will become less willing to export cheap abatement options. Such a situation would create a policy dilemma if offsets from non-OECD countries were desired for reducing OECD countries’ compliance costs at the same time that insistence grew for non-OECD countries to accept emissions reduction targets to help meet a global stabilization target. Blanford then outlined the potential size and cost of offsets available in a system in which emissions are capped for the United States and other OECD countries. For the United States there are domestic offsets, but only, under the Waxman-Markey bill, for forestry, agriculture, and some non-CO2 greenhouse-gas-emitting activities. Thus offsets available domestically are quite limited. As shown in Figure 4.1, the supply of offsets available from other FIGURE 4.1 Supply curves for offsets in 2030 for OECD countries. SOURCE: Based on data from EPA (2006) and Rose and Sohngen (2010). Figure 4.1 Bitmapped

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 OFFSETS—WHAT’S ASSUMED, WHAT IS KNOWN/NOT KNOWN, AND WHAT DIFFERENCE THEY MAKE $/person CO2 FIGURE 4.2 Supply curves for offsets in 2030 from forest carbon. Ch 4 - Fig 7.eps bitmap OECD countries for use by the United States in meeting its emissions cap is not forecast to be very large because these other OECD countries can be expected to have similarly stringent emissions caps subject to similar marginal abatement costs. The two largest categories of supply are global forestry, which although large, is associated with places that pose difficulties related to permanence of governance and verification of offsets, and energy-related offsets from non-OECD nations. However, Blanford reminded the audience that, despite the potentially large supply of energy-related offsets in non-OECD nations, this is precisely the category of emissions that should be capped if there is eventually to be a global effort to reduce greenhouse gas emissions. He went on to show that the largest portion of energy-related offsets generally comes from the electricity sector, particularly the electricity sector in China. Blanford indicated that negotiations with China or others must balance the host country’s political position on burden sharing with the potential financial benefits of trading in offsets. Brent Sohngen of Ohio State University followed with an assessment of forest- and other land-based offsets. He began by describing the land-based actions as forest management (afforestation, forest management, avoiding deforestation) and agricultural management (conservation tillage, methane management, control of nitrogen oxide emissions). Based on his analysis, options for offsets from forestry greatly exceed those from agriculture. Sohngen also noted that, as shown in Figure 4.2, most of the low-priced forestry offsets are in the tropical countries. His estimate for using forestry as well as energy-sector offsets to meet a global emissions target that stabilizes average global temperature change at 2 degrees Celsius indicates that these offsets could reduce carbon prices by about 40 percent. Further, Sohngen showed that including forestry offsets in a trading scheme could slow and eventually reverse deforestation. It could also result in a transfer to developing countries of about $44 billion per year with an average payment of $70 per hectare per year. However, using offsets on this scale would also cause enormous land-use changes and require projects on an enormous scale to implement such a program. For example, by 2025 100 million hectares of “new forest” would be required. Although markets can change land-use patterns in a time period that short—agricultural expansion has converted forested to cleared land on a scale of 100 million hectares worldwide over the past 15 years—there are currently no government programs that can produce this level of land-use change over such a short time period. The policy design issues that Sohngen mentioned for carbon offsets included baselines and additionality in essence, can it be shown that the action that generated an offset credit (e.g., planting trees) would not otherwise

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 MODELING THE ECONOMICS OF GREENHOUSE GAS MITIGATION TABLE 4.1 Categories for Mitigation as Sources of Greenhouse Gas Emissions Mitigation Category Data Source CH4 from landfills EPA (2006) CH4 from coal mines EPA (2006) CH4 from the natural gas sector EPA (2006) CH4 from the oil sector EPA (2006) N2O from adipic acid production EPA (2006) N2O from nitric acid production EPA (2006) CH4 and N2O from livestock manure management EPA (2006) CH4 from livestock enteric fermentation EPA (2006) CH4, N2O, and soil carbon from paddy rice EPA (2006) N2O and soil carbon from cropland EPA (2006) F-Gases (11 source categories) EPA (2006) International forest carbon sequestration Sohngen and Mendelsohn (2006) International energy-related CO2 Clarke et al. (2007) SOURCE: Allen A. Fawcett, Appendix C, this report. have been done? Another issue concerns permanence. Although many argue that carbon needs to be permanently sequestered to have any value in the mitigation of climate change, Sohngen argued that carbon that is only tempo - rarily stored can and should be valued. One of the biggest policy design issues may be leakage, whereby activities designed to cut greenhouse gas emissions and implemented in one jurisdiction or project lead to the shifting of the targeted emitting activities elsewhere, thus undermining the overall effort to reduce emissions. The final design issue discussed by Sohngen was measuring, monitoring, and verification (MMV) for land-based offsets, which can require significant costs to achieve. He concluded that leakage and MMV are the two most significant issues. The final speaker for the third workshop session, Allen Fawcett of the Environmental Protection Agency, discussed the use of offsets in policy modeling. Fawcett noted that all of the major legislative proposals allow a large amount of international offsetting (roughly 1.5 billion tons of international offsets of carbon dioxide equiva - lents per year) as a cost-containment feature. The costs and the availability of international offsets are among the most important factors in determining the estimated cost of legislation such as H.R. 2454. Table 4.1 shows the potential categories for mitigation that would serve as the primary sources for abatement of greenhouse gas emissions. Fawcett noted that the mitigation data for each category was adjusted to more accurately represent the amount of abatement that could actually be available to the market for offsets. These adjustments were meant to take into account the difficulties in measuring, monitoring, and verifying offset reductions in countries without a market-based greenhouse gas emissions policy, as well as the lack of a clear market signal for generating offsets. The largest sources of offsets are in the energy-related CO2 reductions and forestry options in Group 2 countries and regions (China, the former Soviet Union, Southeast Asia, Latin America, and Africa). Figure 4.3 shows the demand for greenhouse gas abatement under H.R. 2454, the Waxman-Markey bill, using the assumption that all Group 1 countries and regions (including the United States, Canada, Western Europe, and Japan) reduce emissions at a rate similar to those mandated for the United States under H.R. 2454 (about 80 per - cent from 2005 levels) and that Group 2 countries reduce emissions to about 25 percent below 2005 levels. Figure 4.1 indicates that the largest source of offsets in the early years is Group 2 forestry offsets, and in the later years, Group 2 energy-sector reductions. Fawcett then described various sensitivity cases to show how assumptions about available sources of greenhouse gas abatement, reference case greenhouse gas emissions, and climate policies in other countries can have major impacts on the estimated mitigation costs. He concluded by noting how these sensitivities highlight the importance of future research to update and improve estimates of marginal abatement cost curves for international sources of greenhouse gas abatement. This research would examine the difference

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 OFFSETS—WHAT’S ASSUMED, WHAT IS KNOWN/NOT KNOWN, AND WHAT DIFFERENCE THEY MAKE FIGURE 4.3 International supply and demand for greenhouse gas abatement by categories of abatement for analysis of recent Ch 4 - Fig 8.eps legislative proposals (HR 2454). bitmap in greenhouse gas abatement potential from countries with market-based climate policies versus abatement in the form of offsets or sectoral credits from countries without market-based climate policies. The first discussant in this session was David Victor of the University of California, San Diego, who used his analysis of the CDM, which is currently the world’s largest carbon offset market, to comment on political economy issues associated with offsets. He made four points. The first was that international offsets exist because of a political deal: the less-developed countries have interests different from those of the highly industrialized countries and are not going to spend their own resources in a major way on controlling emissions, and so offsets serve as a compensation mechanism to engage them in one form or another in reducing greenhouse gas emissions. His second point was that the debate about offsets is typically viewed completely through the lens of compliance costs. Many important interest groups, especially in the United States, are enthusiastic about generous offset rules because they think that offsets will contain compliance costs. However, the evidence from the CDM is that offsets are a horrendous safety valve, because the actual production of usable and bankable credits is highly erratic. The CDM is an enormously complicated administrative process that is constantly being torqued by one interest or another. Victor’s third point picked up on Geoff Blanford’s point about the Chinese electricity sector being a large source of offsets. Victor noted the need to be transparent about where the resources are actually going because a flow of tens of billions of dollars from U.S. firms to Chinese firms may not be politically viable. His final point concerned forestry and the politics of international offsets if forestry is added on a large scale. Although a carbon offset scheme should allow credit for any source of carbon reductions, leaving market participants to find the least costly way to meet that goal, the real political world, Victor pointed out, is different. Using the CDM as an example, he emphasized that the design of offset rules is subject to becoming highly politicized. He stated his belief that when sponsors of existing projects that attract the most CDM resources realize that forestry projects will become very low cost competitors, it is likely that they will create many procedural barriers that will make it difficult for the potential of forestry offsets to be realized in practice. Molly Macauley of Resources for the Future then provided comments on the data needed for verification of forestry offsets. She noted that previous verification estimates have been “good enough” and, when necessary, have been improved by extensive fieldwork for a project or for an individual country. However, the currently available data are inadequate for understanding global forests. For improved understanding of the global carbon cycle as well as modeling and policy design, Macauley argued that we need better information on global forest inventories

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 MODELING THE ECONOMICS OF GREENHOUSE GAS MITIGATION to meet verification protocols that have been proposed so far. She noted that technology is available to potentially provide the level of data needed to verify forestry offsets, but it is not deployed. She also noted that institutional and economic barriers are large because forestry resources represent both private (nationally sovereign resources) and public (carbon) goods. Macauley provided a back-of-the-envelope estimation of approximately $21 billion as the level of resources that would be necessary to make a one-time census of protocol-quality data for global forested area. There would also be the need to update the forest census periodically and perform field spot checks to ensure that leakage is not occurring. Macauley concluded by noting that countries might pay for gathering such data if their forest carbon is a valued asset and has some marketability. The marketability of forestry resources for offsets might provide the motivation for space agencies to raise the priority of monitoring land-use measures. The third session ended with comments and questions from the audience. Adele Morris from the Brookings Institution noted that the presentations and the modeling and policy challenges discussed in these talks pointed to some of the political problems for offsets. One, based on the EPA analysis presented by Allen Fawcett, is that the United States would be spending six times as much on imported allowances under H.R. 2454 as on domestic abatements. A second issue noted by Morris is that, considering the potential for transfers of funds from U.S. firms to, for example, Chinese firms, some of that investment provides for the purchase of new technologies and the implementation of more efficient processes. This could present a competitiveness issue as U.S. firms see foreign competitors’ investments in new equipment and processes being underwritten by the offset market. Clay Ogg with EPA’s Office of Policy noted that there were food, fuel, and forest tradeoffs, with the food issue potentially not being sufficiently emphasized in the workshop presentations. His opinion was that initiatives that have even a very modest impact on reducing greenhouse gas emissions could have a tremendous impact on food supply and food crises. William Nordhaus from Yale University raised the concern that the economic modeling of forestry offsets does not sufficiently take into account research that shows that reforestation or anti-deforestation efforts do not have the effects on climate that are being posited. Such research shows that, even though it is possible to remove a considerable amount of carbon from the atmosphere through reforestation or by stopping deforestation, there is little impact on temperature because these efforts are also changing Earth’s surface albedo and/­or water cycle.