Reforming carbon offsets, first in a series
Posted by Daniel Hall on April 23, 2008
How well is the carbon offset market working? Not as well as might be hoped; the Wall Street Journal has done much recent reporting on how the architects of the Clean Development Mechanism (CDM) — by far the largest carbon offset program in the world, and a key part of many countries’ strategy to achieve compliance with the Kyoto Protocol — are struggling to determine which offset projects should be eligible, to keep pace with demand for new offsets, and to clamp down on questionable projects.
Now Michael Wara and David Victor have a new working paper with some recommendations for reforming the system:
We argue that the U.S., which is in the midst of designing a national regulatory system, should not to rely on offsets to provide a reliable ceiling on compliance costs. … We suggest that the actual experience under the CDM has had perverse effects in developing countries — rather than draw them into substantial limits on emissions it has, by contrast, rewarded them for avoiding exactly those commitments.
Offsets can play a role in engaging developing countries, but only as one small element in a portfolio of strategies. We lay out two additional elements that should be included in an overall strategy for engaging developing countries on the problem of climate change. First, the U.S., in collaboration with other developed countries, should invest in a Climate Fund intended to finance critical changes in developing country policies that will lead to near-term reductions. Second, the U.S. should actively pursue a series of infrastructure deals with key developing countries with the aim of shifting their longer-term development trajectories in directions that are both consistent with their own interests but also produce large greenhouse gas emissions reductions.
There are many interesting aspects to the paper, and to this topic more broadly. I am going to try to write several posts about it over the next week or two. For this post I’m going to discuss one of the fundamental problems in offset markets that the authors identify.
Everyone knows that China is building lots of new electricity generating capacity — more than 100 GW per year, or more than the entire capacity of France — and that most of this is coal. But other resources are being built as well:
China’s current five-year plan, in fact, calls for major investments in hydro, wind, nuclear, and natural gas-fired power in order to diversify away from excessive reliance on coal. … Since 2004, China has been on a dam building spree, with 10 GW of new hydro power plant capacity being completed each year.
In addition to their “dam building spree” the paper reports almost 4 GW of new wind capacity in China in 2007. Ok, so how does this impact carbon offsets?
Today, as illustrated in figure 2, essentially all new hydro, wind, and natural gas fired capacity is applying to claim credit for emissions reductions under the CDM. These power plants are at least potentially eligible for the difference between their emissions and the electricity they “displace” on the Chinese electricity grid. Under the rules of the CDM, each new dam, wind farm, or natural gas power plant applies individually and makes the argument that it would not have been constructed but for the financial incentives produced by the sale of carbon offsets.
Taken individually, these claims may make sense — because, individually, any particular power plant utilizing non-coal sources of energy probably faces greater hurdles than new coal-fired generation or may be financially marginal, and the ability to sell CERs [offsets] offers the prospect of being able to compete toe-to-toe with coal. Taken collectively however, these individual applications for credit amount to a claim that the hydro, wind, and natural gas elements of the power sector in China would not be growing at all without help from CDM. This broader implication is simply implausible in light of the state policies described above.
This is essentially a fundamental problem with the type of “baseline-and-credit” schemes that are employed for offsets — the value of the offset encourages more of the activity being subsidized, and it quickly gets difficult to determine what the baseline is.
A comparison with cap-and-trade systems may be helpful. In a cap-and-trade program emissions are capped and regulated entities are allowed to trade permits. Provided the cap is binding — it is lower than emissions would be if an unlimited number of permits was handed out — then those entities that can reduce emissions most cheaply do so and sell extra permits to those who can’t. Since permits are scarce and valuable all firms face a cost (real or opportunity) for emissions. The incentive is to reduce emissions. And they can do this by adjusting either the extensive or intensive margin (i.e., the amount (extent) they produce or the emissions intensity of their production). But the important point is that the incentive is present at both margins.
In a “baseline-and-credit” system emissions are uncapped but all entities are offered a credit for reducing their emissions below a defined baseline. In many respects this is similar to the cap-and-trade system — the incentive for a firm to reduce emissions is the same if the credit has the same value in either system, right? Well, yes, potentially — if baselines are clearly defined and easy to measure. The problem is that frequently it is very difficult in the real world to determine what the baseline should be. What is the “baseline” amount of hydro or wind or natural gas generation in China (in the absence of the credit incentive)? We don’t know. In the real world we can’t observe the counterfactual. Because of this problem “baseline-and-credit” schemes often lose some of their efficiency because they act as a subsidy on output. Although they provide a clear incentive for reductions on the intensive margin — it is relatively easy to establish if a process has become less emissions intensive — they actually encourage more activity on the extensive margin. China will build more hydro and wind power if there is an extra subsidy (the offset credits) for doing so.
What’s the big deal, isn’t China building wind and hydro a good thing? The problem is that if China would have built many of these projects anyway, but they are able to collect and sell the credits for all of them, then whoever buys these credits (say, Europe) does so to avoid making emissions cuts of their own. The world actually ends up with more emissions than if we had never had the offset system in the first place. (Although the Europeans are probably happy to not have to make as many very expensive cuts domestically and China is very happy getting paid to do something it was going to (partly) do anyway.)
So what do the authors recommend?
We propose two broad classes of activities to effectively address and reduce these sources of emissions. One, a climate fund, focuses on those situations where offsets are an inappropriate tool but where investment is basically all that is needed drive a change in developing country activities. The other, an infrastructure deals program, takes aim at cases where more than just money will be required to assist developing countries in achieving low-carbon development. This engagement strategy, with its two elements, is an essential compliment to a reformed, tightened, and more limited future CDM.
In particular for the Chinese example that I highlighted above the authors focus on the infrastructure deals:
A wider array of financial, diplomatic, and political efforts are often needed to allow fundamental changes in the activities that give rise to emissions. To help mobilize these efforts, we suggest an array of “deals” that focus on large-scale shifts in infrastructure needed to gain significant leverage on GHG emissions in critical developing countries. These deals would, in effect, change these countries’ baselines — leading to lower emissions in ways that are particularly difficult to calculate in the normal offset calculus, which relies on measuring changes in emissions against a largely static baseline. By their very nature, major infrastructure deals would be few in number, thus limiting their scope to interventions in key sectors of the largest developing countries.
I tend to agree that these infrastructure deals might be a better way to go than the current offset system but I worry that the authors are overly sanguine about their political feasibility. And even if you can negotiate with China, and then with India, it doesn’t end — there will just be the next (Brazil), and the next (Southeast Asia), and the next (Middle East and Africa anyone?). In the long-run we are talking about fundamentally transforming how the energy sector works and this means putting everyone on a different development path not just the Chinese.
I will come back to this problem and others raised by offsets in several of my coming posts. Regular readers are encouraged to read the working paper — it’s not technical — and perhaps also the WSJ articles linked at top as background for upcoming posts.