Realistic Policy on International Carbon Offsets

The following is a summary of an article by Wara and Victor (2008) in which they explore different facets of carbon offsets. A carbon offset is a reduction in greenhouse gas (GHG) in one place that compensate for GHG emissions elsewhere. There are six types of primary GHGs: carbon dioxide, methane, nitrous oxide, hydroflourocarbons, perfluorocarbon, and sulfur hexafluoride (Options for Addressing Carbon Offset Quality). Two major issues emerge for the U.S. as it designs its strategy for regulating emissions of greenhouse gases (GHG): (1) How to limit the cost of compliance; (2) How to “engage” developing countries in serious efforts to limit emissions. The U.S. should engage developing countries by: (1) investing in a climate fund that is meant to finance critical changes in developing country policies that will lead desired reductions; and (2) U.S. should pursue infrastructure deals in developing nations with the aim of shifting their longer-term development trajectories in directions that are consistent with their own interests and produce large GHG emissions reductions.

Cost-control and engaging developing nations have been addressed using a carbon offsets scheme. This is a preferred strategy for many countries and firms because it is seen as a “win-win” solution - a low-cost means for obtaining credits for emission reductions in developed nations and it offers developing nations a source of funding to alter their paths to a “greener,” more environmentally friendly approach to development. Developing nations and development banks are generally unopposed to carbon offsets plans because the offsets provide funds for operations at home.

It is argued that the theoretical the benefits of extensive use of carbon offsets are an illusion. An offsets system is thought to reward only real reductions, which is only partially true. The UNFCCC’s Clean Development Mechanism (CDM) and other offset schemes are unable to determine reliability as to whether credits are issued for activities that were going to happen anyway. Moreover, CDM cannot respond quickly enough to a price shock in cap-and-trade markets because of the need for strict regulatory oversight.

Theory and Practice

The core deal of the Kyoto Protocol involved economies in transition, or “joint implementation” (JI), and the developing world (“clean development mechanism, CDM”). The CDM is the largest emissions offset market in history, roughly ten times larger in volumes produced and financial values from 2008-2012 compared to JI. Furthermore, JI is confined to Russian and Ukrainian economies because of their special economic circumstances, making CDM the standard by which carbon offsets are studied on a global level. Certified Emission Reductions (CERs) are the CDM’s currency – a measure of the quantity of emissions that has been avoided (offset) by CDM projects.

The three stories point the need for reform within the CDM and for new tools for engagement with developing nations in both U.S. climate policy and post-Kyoto international architecture. They also point to the need to limit dependence of a U.S. cap-and-trade scheme on cost control derived from the CDM or other offsets program.

Problems with HFC-23

Trifluoroethane, or simply HFC-23, is 11,700 times more portent than CO2, another GHG. As such, projects that cut HFC-23 are extremely valuable because they generate large amounts of carbon offsets, or CERs using CDM terminology, at low costs. Early on, these projects comprised the bulk of emissions reductions, which sparked early excitement about carbon offsets as an investment opportunity.

Before CDM became standard protocol, HFC-23 was only vented into the atmosphere of developing countries, in contrast to the low-cost disposal techniques utilized in the U.S. and in Europe. It was previously thought that projects associated with HFC-23 would be ideal for the CDM. However, the sale of carbon credits from capturing HFC-23 is more valuable than the production of the refrigerant precursor that leads to its creation to begin with. Refrigerant manufacturers became concerned mainly with projects aimed at creating HFC-23 for the capture of it to sell credits. This inspired the development of restrictions by the CDM Executive Board. Despite these restrictions, incentives to produce more CERs through HFC-23 remained. Refrigerant manufacturers, the Chinese government, and carbon market investors will be paid a total of 4.7 billion euros, whereas the lessening of emissions will cost roughly 100 million euros. This disparity calls for more cost-effective mechanisms to lower emissions. One possible template to fund a project could be learned from the successful Montreal Protocol on Substances to Deplete the Ozone Layer.

Beyond HFCs: the new CDM market

HFC-23 investments have become an antiquated approach to reducing emissions through the CDM. They now make up less than half of all CDM projects and that number is projected to lower even more. Other types of projects have taken its place but they have exposed more problems within the CDM the previously thought. To fully understand the problem with the CDM, it is imperative to discuss the developing China because trends indicate that more than half of all emission credits will originate from project endeavors to reduce emissions there.

Considering energy sources is key to finding a way to reducing emissions. Coal-fired power plants generate roughly 80% of electric power in China. These plants have been around for a long time but the newer plants are being built and designed to be top of the line. In two years, China built 100 GW of electric generating capacity, equivalent to building the sum of power plants in U.S. in a fraction of the time. Rates of air pollution have risen as a result.

Now China is more focused on creating alternative sources of energy to claim CERs and reduce their own pollution, including wind, hydro, and natural gas. They are applying to claim at least the difference between emissions and the energy displaced on their electricity grid. A strict criterion to adhere to is to show that construction of each new alternative source—dam, natural gas plant, or wind farm—would not have been constructed were it not for the financial incentives set forth by selling carbon offsets. Additionally, they have created a 4000 km long pipeline stretching across the country from the western gas field to larger cities such as Shanghai. Success of this pipeline has prompted the building of an even more massive one. China shows no signs of slowing down, having signed a Renewable Energy Law that entails financial incentive for creating such wind farms and to encourage further expansion. And for the past 10 years, China has completed an average of 10 GW of hydro power per year with all the dams they have been building.

Despite its efforts to create new infrastructure centered around renewable energy, 80% of the electricity is still powered through coal. Claims made to gain credits hint towards a need for the CDM because competing against coal is no easy task. There would be no growth at all in these new ventures without help from the CDM. The high number of applicants likely indicates systemic issues with the CDM, and now new coal-driven power plants are also applying for credits while they are already being built and even though they have the capacity to be cost-effect on their own.

This problem has been seen across the board, although none such has a bigger impact than China with growing industrialization and a population that comprises approximately a billion people. The problem with the CDM Executive Board boils down to not having enough employees to give each case a thorough review before approving it. Consequently, facing pressure from governments in developing and developed countries, the CDM is prone to approve projects (Wara and David, p. 14). Such a reputation guarantees that countries will apply for credits whether that project was prompted by the CDM or not because they know they have a strong chance at getting approved. Compounding pressure from the sheer number of projects makes the CDM work environment hectic as they average one project per day. The CDM is working to change their project-by-project approach to something that acknowledges a series of activities, or “programmatic” initiatives in which credits are given for policy reforms and other activities aimed at reducing emissions.

The Credit Issuance Bottleneck

Final issuance of CERs are determined only when it is determined an actual reduction in emissions has been achieved. Containing the cost of compliance is important for firms and companies who are trying to supply CERs to the European Union Emission Trading System (EU ETS), which is the largest source of demand for CERs in the world. There is already a hurdle with the claims being backed up, and even in the final stage there is no difference. (Wara and David) assert that the CDM needs to respond 20 to 40 times quicker in verifying and issuing CERs to keep up with cost compliance needs. Third-party verifiers are said to be difficult to train, so this is a contributing factor. Moreover, the CDM itself does not have the manpower it needs to complete reviews in a timely manner. The CDM cannot be lax in their approval system because such behavior could run the risk of issuing credits to for projects that did not actually result in emission reduction, although it is suspected that this is already the case.For these reasons, offsets have been thought to be a poor mechanism for cost control.

Cost control

Offsets do not hold the same cost control characteristics as they do in theory. The reality is that credits are being issued for projects that do not represent actual reductions in emission. One system that is aimed at the same goal would be more effective at cost control than an offsets program. The CDM is blamed for the unpredictable prices in the EU, and the long process from claim to approval does not help to create cost control.

Engagement with Developing Countries

The CDM does not engage developing countries effectively because its system is inefficient and it sways them away from broader commitments. Moreover, the U.S. faces difficulty in implementing worldwide responsibility for reducing GHG because many of the biggest emitters are in competition with the U.S. – namely China and the EU. Two solutions to this problem have been propose by Wara and David: (1) The CDM needs to focus on activities where it will likely be effective, which the U.S. can mediate since they are the largest buyer of credits; and (2) Western nations, including the U.S., should develop better ways of engaging developing countries. As to the latter, western nations should invest in funding mechanisms that help the environment, without the project applying for emission credits. Also, investing in infrastructure and technology that is more environmentally aware will help developing nations in the long run. The benefits of having a better CDM and engagement strategy will include credits being issued to the right places and give developing nations the chance to build anew, towards adopting binding limits on emissions that they would eventually implement once they are on a suitable environmental trajectory.

Wara and Victor (2008) propose some solutions. Third-party verifiers, or their role in the CDM, have been known to cause problems. Wara and David believe that there is dysfunction among verification services, mis-aligned incentives, and confusion about the role of verifiers. Competition for these services is intense while retention is scarce because of their lower wages. It is suggested that the CDM raise their salaries and align their incentives with verifiers to ensure they perform up to their standards. Another suggestion set forth is that the CDM should concentrate on a smaller number of large projects at a time; and/or, invest in programmatic projects, which are meant to involve many smaller projects that add up to a large number of emissions reductions. This too has not seen much implementation because it is difficult to ascertain the reduction of the sum of many smaller projects, spread throughout the world. Also, the CDM should welcome all types of carbon reductions, given that the offsets program is based on adding the sum of reductions, it would not be representative, nor would it get credit for reductions in emissions if it is not an acceptable CER.

The importance of recognizing the ineffectuality of a common reform – limiting the use of carbon offsets within cap-and-trade systems, a strategy used by the EU. This is a problematic approach because it does not address the issue of quality, but favors projects with lower costs, which would have probably occurred without the CDM anyway. The U.S. can play a major role if it becomes a major purchaser of CERs. However, the Lieberman-Warner bill blocks the U.S. from achieving this because it allows for importation of large volumes of international credits from cap-and-trade systems without taking any from the CDM directly. The EU ETS treats CERs as goods contracted without an individual specimen being specified. This allows for laundering of CDM credits through foreign emissions trading markets and it blocks the U.S. from having any influence on the quality of these credits. This so called fungibility will only bring in more CERs with lower quality. Some kind of cooperation should exist between the top two CDM markets.

Beyond Offsets

A climate fund would focus on situations where offsets are inappropriate, but where investment is all that a developing nation needs to promote change in its activities. A prime example of this is the Multilateral Fund of the Montreal Protocol, designed to pay for changing developing countries’ trajectory to a more environmentally sound strategy aimed at reducing ozone depletion. This treats global warming directly, something that the CDM has not directly addressed and is probably beyond fixing within their scheme. Additionally, an infrastructure deals program will go beyond money as the solution to helping developing nations reduce carbon emissions.

Combining the positive qualities of the CDM with a Climate Fund would reduce emissions on a wider level than either could without the other. Furthermore, combining the powers of U.S. and China in an infrastructure deal to help build more gas pipelines would likely produce a large amount of GHG emissions by shifting away from coal towards healthier alternatives. The same could be said of a nuclear energy deal between the U.S. and India. “All U.S. efforts towards reducing developing country GHG emissions should be made with a focus on eventual inclusion of these emerging markets in a system of binding limits.”

Analysis of Wara and Victor (2008)

Wara and Victor (2008) identified multiple issues with the CDM. The many interlinking facets of carbon offsets leaves some firms confused about what it entails, leaving some ventures misguided and based on false assumptions. The current system faces problems on both ends. The CDM has a tendency to approve projects quickly due to an undermanned workforce and verifications from third-parties that cannot keep up with the demand of project approval. An alarming thought is the fact that little is known about carbon offsets in the general population, and there is no standard protocol by which companies are expected to seek offsets. Little is known about how individual companies actually decide which offsets to pursue, or who does the choosing. Polonsky, Grau, and Garma (2010) studied marketing problems associated with carbon offsets. They highlighted a study in which 356 Australian and 352 U.S. consumers were given an 8-item questionnaire about environmental issues. Seventy-seven percent of the consumers from Australia were found to have high knowledge about the environment, while 72% of respondents from the U.S. also demonstrated high knowledge. A significant disparity was found when the same respondents were asked about carbon offsets, where only 37% of Australian consumers and 40% of U.S. consumers reached the same level of high knowledge. Lower rates of knowledge about carbon offsets were found among those considered to be environmentally aware in the general sense. This is a stark statistic because carbon offsets is an important part of environmental issues, with carbon comprising most of the GHG emissions in the world. One cannot have a realistic discussion about climate change, the ozone-layer, or even “going green” without having knowledge about carbon offsets. There are many issues with how it is handled globally.

Perceived Issues

Lack of a global standard has lead to uncertainty with about the efficacy of the offsets scheme. If there is no governing body that regulates it, who is to say that companies would not break or bend rules to keep business going? The current governing body has its own set of problems that have denounced its credibility in some circles. Polonsky et al. (2010) realized the fact that there is no uniform standard for carbon offsets. They identified closest thing to a standard is the CDM, which has its many defects. Differences in standards can be defended by law since there is no actual standard and scientific opinions and definitions do not match from country to country or project to project. Another misleading factor can be illustrated when considering the case of an airline company, where an offset was sold for carbon produced from fuel used in flight averaged over the number of people on the plane. This excludes logistics that could nullify the validity of this offset if consumers were told explicitly that it does not include carbon emitted from the operation and manufacture of the airline itself. Plus the idea of replacing an entire fleet of planes to more fuel efficient ones is difficult to discern when considering the offset value – is it purely additive? Would it have happened anyway? This is an example of how credits are sometimes erroneously given. By this standard, anything that is additive does not qualify to be a carbon offset, therefore upgrading a fleet of vehicles and counting it as a carbon offset does nothing to control costs. It only makes matters worse.

More questions as to the validity of GHG reducing projects arise when considering whether the project will lead to reduction in carbon today or in the future, and taking a look at specific examples of how it can go wrong. For instance, a new plantation of trees has the potential to reduce emissions if and only if it matures. If it does not mature, is the plantation insured against loss? Would the consumers be informed and would they even care given the unclear and minimal options for solutions given by the ones who initially marketed the idea. And all forests eventually die, no matter the reason. Will ideas such as this one still hold weight in the future, or do these deals only matter for the foreseeable lifetimes of their investors and marketers? Someone will have to deal with it eventually and what more if it only served to create a wider disparity between credits and actual GHG reductions.

Options for Ascertaining Quality of Reductions

The authority that steps forward--be it the CDM or some other source—to put an end to the uncertainty of the current system has some guidelines to follow. The U.S. Government Accountability Office (GAO) identified five challenges as part of their February 2011 report to assessing the quality of offsets: (1) Assessing whether a project causes additional emission; (2) Emission can be difficult to measure, particularly those associated with soil and forestry; (3) Carbon in soil may not be permanent; (4) It is difficult to verify that a project followed the rules; and (5) most U.S. GHG-reducing programs are focused on soil, making it difficult to design rules and regulations around it.

GAO has reason to believe that non-additional offsets have been awarded credits but have had difficulty in verifying it. Setting a baseline would help but it requires a bit of fortune-telling, which no one has the ability to do. Still, comparing a project’s expected reductions against a projected baseline of what would have occurred without the offset is would yield many answers. It does not help that program administrators sometimes hide or manipulate data to support their claims. Renewable energy can also be a profitable business, making it difficult to measure the impact of emission reducing projects as the sole motivator behind such an investment.

There are measurement issues with certain types of programs, specifically those concerned with land-use, dispersed projects, and those prone to leakage. Land-use affect natural processes, such as forestation in which trees absorb carbon dioxide but the measuring the amounts of carbon reduced is not fully understood. Dispersed projects include giving out energy-efficient light bulbs, but the use of these bulbs is not monitored or assessed. Projects prone to leakage entails an increase in emissions elsewhere as a result of a project close to home. Permanence also plays a role in that sequestering carbon carries the risk of re-releasing carbon into the atmosphere. As mentioned earlier, forestation will eventually lead in the death of the forest either by natural means or the by the needs of building. Therefore, the nature of the benefits are only temporary.

More options used alone or in conjunction with others for assuring offset quality are discussed in the GAO. One option is to limit the quantity of allowable offsets so as to not overwhelm reviewers. Another is to limit the types of projects to those that are likely to have less problems with quality, such as those with just a single source of emissions and those that do not generate revenue independent of the offsets scheme. Furthermore, it is recommended that the value of offset credits be discounted, along with certain project types by percentage of offsets that do not meet the criteria set forth by specific quality standards, and subtracting offset quality by that percentage to compensate for quality issues.

Application: Uganda Stove Manufacturers

The Center for Entrepreneurship in International Health and Development (CEIHD) designed a program aimed to help reduce poverty, improve health, and prevent pollution in the local environments of Uganda by reducing carbon emission and verifying carbon offsets. They acknowledge that Europe implemented a cap and trade system, companies and countries that emit more than allowed by the Kyoto Protocol (reduce carbon emission to 5% below 1990 levels) must buy CERs, and that the CDM allows developing nations with no caps to create CERs at home and sell them.

In Uganda there are 1.6 million premature deaths per year due to pneumonia, lung disease, and low birth weights – all results of the contributing factors of indoor and outdoor air pollution from open fire cooking. Containing fire against the pot can save 30%-50% of fuel and more efficient combustion chambers save 50%-90% of emissions. All in all, it is a cost-effective way to improve health and reduce carbon emissions. However, the CDM saw no “marketable” voluntary standard by which there was a way to quantify carbon reductions from cookstoves.

The CEIHD suggested using the Kitchen Performance Test (KPT) to determine fuel savings from improved stove use and utilized this approach to conduct a study to determine the efficacy of improved stoves versus traditional stoves. This involves a 3-day monitoring of traditional stoves, followed by a one-month adjustment/training period with improved stoves, and finishing with another 3-day monitoring with the improved stoves. Improved stoves were either wooden or charcoal-based and improvements were tallied for both after adjusting for materials used to build or improve the old stoves. Total emissions reductions for each stove per day are calculated by multiplying the mean fuel consumption, emissions factor, non-renewability of biomass baseline, and the adjustment factor of project baseline and subtracting that from the project’s emissions. It was found that at the one-year follow-up, charcoal stoves yielded 21.9% savings and wood stoves yielded 43.7% savings. GHG emission reductions for wood were 4.49kg per day; charcoal reductions were found to be 0.85kg per day.

Safety Valve

Still, the safety valve approach would be “much superior” option in some circles. The safety valve is a possible addition to a cap-and-trade system that allows the selling of permits in unlimited amount at a pre-set price, thereby limiting the cost of meeting the cap. Jacoby and Ellerman proclaim the central idea of the safety valve is “that the cost of capping emissions at some target level can be limited by an offer from the regulatory authority to sell permits in whatever quantity is demanded at a predetermined price,” if factors such as economic growth were the cause prices to skyrocket, the cost of emission reduction would be limited to the price set forth by the safety valve. This begs another question: Should the GHG reduction goals be measured by a price or quantity instrument? Utilizing a cap and permit trading system for emissions deals with quantity, while an emission tax would serve as a price instrument. Pollution permits vary in price, and supply and demand for the future will always be uncertain. However, controlling agencies can alter caps, setting the stage for plausible corruption which is thought to already exist. The other option is an emission tax that serves to fix the price independent of varying economic conditions. Still, this holds a degree of uncertainty because there is no telling if there will be a limit on the amount of emissions. Amongst the political and economical jargon, what is the final goal?

Conclusion

Do businesses really care about emissions and what it does to the environment? It is difficult to imagine a scenario where developing countries will become involved in changing their infrastructure and technology in the name of furthering business ventures in developed nations. The idea is to reduce their carbon footprint, correct? Offsets appear to be noble and may reduce pollution in other countries but at the cost of becoming indebted to the United States, as they are assuming leadership of this issue, as is the case with many world affairs. The very existence of a project such as forestation is not in and of itself a useless thing; it does reduce emissions, but for how long? It is well known that trees die – some before they even have a chance to mature because of the environment or whatever else. If this is a known fact about the world, what why would a business invest in such a project? To earn CERs and save face as a “green” and environmentally responsible business. Admirable though it may be to the general observer, it is unfortunate that some enter such projects knowing that the public is misinformed about the subject and are applauding efforts that may not result in real reductions. Corruption in the name of financial gain seems to be the norm, and while the CDM works to reform its rules, they are unable to keep up with the claims demands, resulting in more negligent and permissive approvals of unworthy claims.

Wara and Victor see the need for cap-and trade systems that sufficiently predict costs of compliance, so that investments can be planned without costs rising to unsustainable levels. The current scheme of the CDM is inefficient and may actually be doing more damage. Bottlenecks in speed and quality of approvals need to be fixed on an administrative level. Theories also suggest that as more of the CDM weaknesses become apparent, it will become a smaller market with even fewer steady supplies of CERs. They suggest positive aspects of the CDM be combined with a climate fund to compensate reductions that are not applicable to an offsets program. Engaging foreign emerging markets such as India and China are also emphasized throughout the article. Wara and Victor’s assertion that the U.S. should include emerging markets with the idea that they will all be in a system of binding limits may speak to the U.S. tendency to be involved in international affairs and diplomacy. It is unclear as to what the political and economical ramifications will be for the countries funded by the U.S. and other developed nations they are in “competition” with.

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