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The Evolving Role of Greenhouse Gas Emission Offsets in Combating Climate Change Joseph E. Aldy and Zachery M. Halem Working Paper 22-17 September 2022 Resources for the Future i About the Authors Joseph E. Aldy is a university fellow at Resources for the Future RFF and a Professor of the Practice of Public Policy at Harvard’s Kennedy School. His research focuses on climate change policy, energy policy, and mortality risk valuation. Aldy also currently serves as the faculty chair of the Regulatory Policy Program at the Harvard Kennedy School. In 2009–2010, he served as the special assistant to the president for energy and the environment, reporting through both the White House National Economic Council and the Office of Energy and Climate Change. Zachery M. Halem is director of the Lazard Climate Center. Acknowledgments This research has been supported by the Lazard Climate Center. We have benefitted from feedback from Patrick Bolton, Jae Edmonds, Carolyn Fischer, Nat Keohane, Billy Pizer, Tim Smith, and Rob Stavins. The Evolving Role of Greenhouse Gas Emission Offsets in Combatting Climate Change ii About RFF Resources for the Future RFF is an independent, nonprofit research institution in Washington, DC. Its mission is to improve environmental, energy, and natural resource decisions through impartial economic research and policy engagement. RFF is committed to being the most widely trusted source of research insights and policy solutions leading to a healthy environment and a thriving economy. Working papers are research materials circulated by their authors for purposes of information and discussion. They have not necessarily undergone formal peer review. The views expressed here are those of the individual authors and may differ from those of other RFF experts, its officers, or its directors. Sharing Our Work Our work is available for sharing and adaptation under an Attribution-NonCommercial- NoDerivatives 4.0 International CC BY-NC-ND 4.0 license. You can copy and redistribute our material in any medium or format; you must give appropriate credit, provide a link to the license, and indicate if changes were made, and you may not apply additional restrictions. You may do so in any reasonable manner, but not in any way that suggests the licensor endorses you or your use. You may not use the material for commercial purposes. If you remix, transform, or build upon the material, you may not distribute the modified material. For more information, visit https//creativecommons.org/licenses/by-nc-nd/4.0/. Resources for the Future iii Abstract As governments, firms, and universities advance ambitious greenhouse gas emission goals, the demand for emission offsetsprojects that reduce or remove emissions relative to a counterfactual scenariowill increase. Reservations about an offset’s additionality, permanence, double-counting, and leakage pose environmental, economic, and political challenges. We review the role of offsets in regulatory compliance, as an incentive for early action, and in implementing voluntary emission goals. The rules and institutions governing offsets drive large variations in prices and in the types of projects deployed to reduce or remove emissions across offset programs. A lack of carbon price convergence and potential information asymmetries may contribute to limited price discovery and market segmentation. Taking into account the financial properties of offsets, an array of financial and technological innovations could enhance offsets’ environmental integrity and promote liquid offset markets. Unresolved questions about the future of policy will influence the evolution of voluntary offsets markets. The Evolving Role of Greenhouse Gas Emission Offsets in Combatting Climate Change iv Contents 1. Introduction 1 2. Offsets as a Regulatory Compliance Strategy 3 3. Market Drivers for Voluntary Supply Schmalensee and Stavins 2019; Shapiro and Walker 2020. Such emission offset transactions typically require regulator certification and approval of “permanent” emission reductions, where the offset seller often meets the permanence standard by demonstrating the adoption of long-lived pollution control equipment. Such a compliance option has the potential to deliver environmental, economic, and political benefits. By requiring, in some non-attainment areas, firms to finance emission cuts at nearby facilities that are greater than the new facility’s expected emissions, such transactions could reduce net emissions in that area and facilitate progress toward attaining the air quality standard. Enabling a firm to seek out lower- cost emission reduction opportunities improves the cost-effectiveness of complying with the air quality regulations and most of these local offsets markets realized marginal benefits in excess of marginal costs Shapiro and Walker 2020. Permitting such implementation flexibility can facilitate the political durability of air quality policy Carlson and Burtraw 2019. The fundamental challenge with offsets lies in demonstrating that the emission- reduction project would not have happened otherwise Hahn 1989. The environmental benefits depend on the “additionality” of the activity; that is, evidence must be produced demonstrating that the investment and associated emission reductions are marginal and hence are the result of the offsets transaction. Failure to demonstrate “additional” emission reductions could produce “paper tons,” defined as emission reductions recorded in a transaction that do not reduce net emissions in practice Butler 1984, Dudek and Palmisano 1988. In an effort to address the potential for paper tons to undermine the environmental integrity of offsets and trading, environmental regulators developed project-specific review and verification methods, which have also increased the transaction costs associated with offset trading. Nonetheless, these early Clean Air Act experiences informed policy experimentation in various forms of emissions trading, including the development of offsets programs to address greenhouse gas emissions. The 1992 United Nations U.N. Framework Convention on Climate Change established non-binding emission goals for developed The Evolving Role of Greenhouse Gas Emission Offsets in Combatting Climate Change 4 countries and a voluntary offsets program, often referred to as “joint implementation.” Under joint implementation, one country could invest in an emission-reducing project in another country. Such project-based transactions could evolve into an informal emissions trading market, since neither party to these transactions were subject to emission caps. A decision at the 1995 U.N. climate talks prevented a national government from investing in a joint implementation project in another country and using the estimated emissions reductions as a means to show progress toward its voluntary goal to limit emissions to 1990 levels by 2000. As a result, only a few developed countries invested in pilot projects of joint implementation to prove the concept, but these efforts resulted in limited emission-reduction activities. These early, modest efforts set the stage for expanding the role of offsets in subsequent international negotiations Wiener 1998. The 1997 Kyoto Protocol established the first, legally-binding emission targets for industrialized nations and enabled these countries to employ an array of market- based approachesincluding emissions trading, joint implementation among industrialized nations with emission targets, and the Clean Development Mechanism CDM in developing countiesas a part of their implementation and compliance strategies. The CDM institutionalized a process where an emission-reduction project in a developing country could be registered, evaluated, and issued creditsoffsets, referred to as Certified Emission Reductions CERsthat could be sold to a developed country for its use in demonstrating compliance with its Kyoto targets Lecocq and Ambrosi 2007; Gillenwater and Seres 2011. Like the possibility of paper tons under Clean Air Act project-based trading, CDM projects raise questions of additionality. If a project in a developing country that would have happened anyway receives emission reduction credits that offset efforts to cut emissions elsewhere, then this could result in “tropical hot air”a net increase in emissions originating from developing countries Meyers 1999, Philibert 2000. The CDM Executive Board, created under the Kyoto Protocol, developed rules to govern this new offset market and attempt to minimize such tropical hot air. These market rules covered project eligibility criteria; processes and methods for estimating emission reductions and monitoring projects on emission-related outcomes; registration and evaluation of specific CDM projects; issuance of offsets that may be sold by registered projects; and certification of independent project auditors. With an objective of demonstrating environmental integrity, CDM offsets provided a low-cost way for developed countries to satisfy their Kyoto targets. A robust CDM offsets market with buyers spread among the developed world could also enable greater global cost-effectiveness by indirectly linking country-specific mitigation programs via the offsets market if developed country A bought CDM offsets and developed country B bought CDM offsets, then a liquid offsets market could result in carbon price convergence among countries A and B Jaffe et al. 2009. Since the CDM would require project-specific verification, the transaction costs were expected to result in less emission abatement than would be expected under a cap- and-trade program. Moreover, the CDM eligibility rules precluded some forms of Resources for the Future 5 emission abatement, such as building new nuclear power plants or sector- or economy-wide policies, such as a carbon tax or tradable performance standard. Early analyses of the Kyoto Protocol assumed that developing countries could reduce emissions under the CDM at 15-20 percent of what energy-economic models estimate under an efficient economy-wide carbon price The White House 1998; Weyant and Hill 1999. To put this “20 percent haircut” assumption in context, consider a thought experiment in which we take the average realized carbon price in the European Union Emissions Trading System EU ETS between 2008 and 2012the primary market destination for CDM offsets during the Kyoto Protocol’s first commitment periodand simulate what the U.S. government’s modeling analysis would have estimated for China’s emission reductions under the Clean Development Mechanism. With average EU ETS allowances of about €14/tCO 2 , China would have been expected to produce more than 300 MMTCO 2 of offsets per year via the CDM. In practice, China produced certified emission reduction offsets of a little less than half this amountabout 135 MMTCO 2 per yearduring the 2008 to 2012 period. 1 China’s CDM certified emission reductions represented a little less than 10 percent of the reductions that would have been expected from an economy-wide carbon price of €14/tCO 2 . While this gap between potential and realized reductions may reflect excessively optimistic assumptions about emissions abatement in China in late-1990s energy-economic models, the institutional details, selective eligibility of emission-reduction activities, and associated transaction costs of the CDM likely precluded emission reductions that would otherwise be economic under lower-transaction cost policies. While the Kyoto Protocol allowed national governments to buy and use CDM offsets to demonstrate compliance with their emission targets, the largest driver of demand for such offsets came from European firms covered under the EU’s cap-and-trade program. The EU ETS allowed firms to acquire and submit CDM credits in lieu of ETS emission allowances to demonstrate their compliance. Doing so effectively converted the offsets into a commodity on par with allowances, which enhanced demand among firms for offsets and improved market liquidity. Indeed, CERs traded at prices fairly consistent with, but at a modest discount to, ETS emission allowances through 2011 Ellerman et al. 2016. The resulting revenues for CDM projects in developing countries delivered on one of the promises of market-based approaches highlighted in the 1997 Kyoto negotiations by their advocates these projects could provide economic benefits to these countries with low costs of reducing emissions Aldy 2004. The resulting demand catalyzed substantial growth in the offsets market in 2012, developing countries’ projects generated 350 million metric tons of credits Figure 1. For the post-2012 period, the EU set qualitative and quantitative limits on the use of CDM credits, reflecting concerns about the environmental integrity of CDM projects. For example, the EU prohibited the use of CERs from projects that destroyed industrial gases, such as 1 The Subcommittee on Energy and Power 1998 includes several hundred pages – including spreadsheets of modeling results – on the Clinton Administration’s economic analysis of the Kyoto Protocol, which serves as the basis for this simulation. The Evolving Role of Greenhouse Gas Emission Offsets in Combatting Climate Change 6 HFC-23 and nitrous oxide, because of the likelihood that these did not deliver additional emission reductions. The EU also began to limit CDM credits from country of originallowing post-2012 credits only from projects registered in least developed countriesand set maximum limits on the use of CDM credits for compliance purposes by emission sources covered by the ETS European Commission n.d.. These restrictions depressed demand for CDM credits, and offsets issued through the CDM declined more than 80 percent between 2012 and 2020. Building on the experience with offsets under the CDM, several sub-national and sector-specific carbon pricing policies have integrated offsets into their design. For example, California and the Regional Greenhouse Gas Initiative RGGI cap-and-trade programs have included offsets as a compliance strategy for covered firms, although only businesses operating in the California market have taken advantage of this opportunity to date. The California system, like the EU ETS between 2008 and 2012, effectively treats offset credits as fully fungible with allowances for compliance purposes. In contrast, RGGI allows offsets to enter the market only if allowance prices exceed a pre-specified level. Thus, the RGGI program’s offset provision operates as a “safety valve” or cost containment mechanism to prevent unexpectedly high prices. Offsets in this program are available for compliance only in high-allowance price states of the world, whereas there are no such limitations on offsets used in the California market. In 2016, the member countries of the International Civil Aviation Organization agreed on the Ca