Common Tragedies

Thoughts on Environmental Economics

Reforming carbon offsets, a continuing series

Posted by Daniel Hall on May 8, 2008

The World Bank Carbon Finance Unit has released its annual report on the state of the carbon market. The report summarizes the broader carbon market, with primary focus on two areas: the allowance market in Europe (the EU Emission Trading Scheme, or ETS) and the Clean Development Mechanism (CDM), the primary global offset market. As part of their discussion the authors note some of the criticisms and problems the CDM has faced, and recommend improvements. I’m going to focus on two of their critiques and one of their suggestions. I’m then going to synthesize these to argue that for some types of projects — particularly energy sector projects — we should move from an offset model to a straight subsidy payment model.

I’ve written previously about the problems with the CDM, including the idea that it is often tricky to measure when offsets are ‘additional’ since we can’t observe the counterfactual — a world without any carbon offsets.

The concept of additionality also becomes problematic when the baseline is unacceptable, or even perhaps immoral. The report authors write:

As clean energy projects begin to dominate the CDM, their developmental benefits are a lot more direct and visible than in the case of so-called “industrial gas” projects. Energy efficiency and renewable energy projects are now emerging as the most common type of CDM projects and this development should be encouraged. Many projects in Africa, likewise, have finally been transacted and this momentum too should be encouraged…

This has been a chief criticism of the CDM up until now. Most projects have been done in the more-developed poor countries — Brazil, China, India — while almost none were conducted in Africa in the first few years. And how could they be? If the ‘baseline’ is the absence of any grid-based electricity, how many emissions do you save installing a wind farm? An Africa with a renewable energy project is better than one without electricity at all, but it is hard to get support for it through the offsets market since there isn’t anything to offset. This is the first critique.

The authors of the World Bank report also offer their own practical, finance-based criticism of additionality requirements in the CDM:

The CDM Executive Board makes its assessment of whether a project activity is additional by relying increasingly on financial data or investment analysis in addition to barrier analysis. This information, when publicly available, is of limited value because requirements for return vary for projects from country-to-country and even within countries, based on the cost of capital and other inputs available to a project company. Appropriate rates of return for projects rest on various assumptions about inputs, and are difficult for a DOE to assess. Given these difficulties, the EB should ask what the added value of relying on such analysis really is. Intelligent and considered risk taking can and should be rewarded handsomely by markets, and the authors applaud those innovators that have created and harvested value in this manner.

This critique sounds fair to me. Project developers may well need different rates of return in various countries to justify investment. On one level this would argue for a more careful, case-by-case analysis of project validity, with less emphasis on trying to define a uniform ‘acceptable’ return rate. But the problem with such a solution is that case-by-case analysis increases transaction costs.

The World Bank authors do encourage a class of activities that could reduce transaction costs for some emissions reductions: a ‘programmatic’ CDM where credits are rewarded for changes in policy or programs that produce widely spread — but collectively large — benefits:

The move toward programmatic CDM is an extremely positive development and the authors commend the CDM Executive Board for its progress in this regard. It has the potential to help scale up transformative initiatives, while also reducing transaction costs, which is of particular importance for smaller countries, which may have several, smaller dispersed opportunities in important sectors.

I think the programmatic CDM is a good idea but I think you could take it even further. Given the difficulties I highlighted above why not adopt the mindset of the programmatic CDM to a broader class of activities that we want to encourage?

My recommendation would be to move to a straight subsidy system for many categories of activities such as renewable energy, energy efficiency, industrial efficiency, etc. These are the types of activities where: 1) baselines are difficult to measure; 2) additionality is rarely clear cut (whether on the basis of some output measurement or by financial return); and 3) comprehensive monitoring and verification of exact emissions reductions is very costly (e.g. efficiency projects). I think it would be preferable to have a system that encourages more of the activities we want — more (relatively) clean electricity for Africa, more efficiency in China and India — but doesn’t have large transaction costs. Why not just scrap the offset model for these classes of projects and start offering direct subsidies? “If you build 1 MW of wind power, we pay you $X. Reduce end-use energy demand by 1 MWh and we pay $X.” This will mean fewer offsets reaching European and (eventually) American offset markets, but in exchange I think these countries could be taking on less aggressive but more realistic reduction schedules that are achieved mainly domestically, and then diverting some funding towards subsidizing projects in the developing world.

I think the biggest argument against such a system is a political economy argument — states won’t agree to direct state-to-state subsidies. But if the offset market continues to have major problems with transaction costs — long delays in approving projects, costly monitoring and verification procedures — I wonder if they won’t reconsider.

I’ll note that in my view a major advantage of this proposal is that it would encourage large-scale development of renewable infrastructure and efficiency programs, rather than narrow project-by-project changes as currently.

The first post in this series is here.

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3 Responses to “Reforming carbon offsets, a continuing series”

  1. [...] water it down. Or is it because legislators want someone else to feel the pain?, asks Planet Gore. Common Tragedies takes a close look at the latest World Bank carbon-markets report, and offers some ideas for [...]

  2. [...] good. Some individual projects, like the New Jersey landfill profiled in the WSJ, might not provide additional emissions reductions. But if the carbon-offsets lucre encourages smaller, unregulated players to [...]

  3. [...] good. Some individual projects, like the New Jersey landfill profiled in the WSJ, might not provide “additional” emissions reductions. But if the carbon-offsets lucre encourages smaller, unregulated players to [...]

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