Chapter 2 Creating and Financing the Next-Generation Carbon
A. The Carbon Offset Value Proposition
The United States is effectively the birthplace of emissions trading for controlling pol- lution, especially air emissions. Trading programs have existed in the United States since 1979 for stationary sources regulated by the Clean Air Act. 9 Results from emis- sions trading programs have been regarded as largely positive. Economic studies rou- tinely find, on a theoretical or an empirical basis, that well-designed emissions trading programs achieve their pollution reduction and mitigation policy goals at the lowest cost to society. 10 Trading programs achieve these goals more quickly and with more positive spin-off effects than other regulatory mechanisms that rely on controlling behaviors or technological options. Not surprisingly, when global warming and cli- mate change became a policy priority in the United States and elsewhere, emissions trading was quickly identified as a key policy tool to reduce GHGs. Mandatory carbon trading programs have been met with greater enthusiasm outside the United States.
Carbon markets are basically emissions trading markets with various allowance and credit features. Allowances are generally associated with cap-and-trade programs, where a number of allowances or permits to emit a unit of the regulated emission are awarded up to an aggregate cap. Participants emitting beyond their allowances are sub- ject to sanctions set out in the trading program. With pure cap-and-trade programs, there is at least theoretical certainty that the level of polluting emissions will be capped.
Credit markets are generally associated with baseline-credit programs, where cred- its are issued for reductions in emissions beyond an established baseline. Similarly, credits for offsets can be issued for activities that capture, avoid, sequester, or remove emissions beyond an established baseline. Pure credit-based systems promote effi- ciency by meeting objectives for emission intensity or average performance, but noth- ing in the design of these programs ensures lower emissions on a programwide basis.
For example, programs designed to lower GHG emissions could nevertheless result in higher actual emissions in those regions with growing economies. To address these issues, some hybrid trading schemes rely on both allowances and credits to meet the emissions control requirements.
8 Mike Fowler, Clean Air Task Force, The Role of Carbon Capture and Storage Technology in Attaining Global Climate Stability Targets: A Literature Review (Feb. 2008), http://www.catf.
us/projects/power_sector/advanced_coal/CATF_CCS_Review.pdf .
9 Denny Ellerman and David Harrison, Jr., Pew Center on Global Climate Change, Emissions Trading in the U.S.: Experience, Lessons and Considerations for Greenhouse Gases (May 2003), http://www.pewclimate.org/docUploads/emissions_trading.pdf .
10 Id.
DUE DILIGENCE AND TRANSACTIONAL ISSUES
Allowances are essentially finite and controllable by the regulatory authorities.
Although credits are limited, in theory, by many factors, including nature, physics, available technology, and economics, their supply is not controlled directly by the regulatory authorities. With that theoretical point acknowledged, experience with the flexible mechanisms of the Kyoto Protocol discussed below has produced new insights and concerns about the potential international participation in these markets and the actual size of the credit supply. To meet their environmental objectives, trading pro- grams that combine allowances and credits must carefully set the rules governing how participants can substitute these currencies. In the extreme, a participant might be able to meet its emission requirements with credits only while never reducing its own emis- sions. More realistically, there is the potential for sources of credits to oversupply nascent trading markets and, as a result, to depress the price of the allowances.
Three fundamentals make emission trading markets work effectively. First, emission limits must be established that require binding emission reductions. Without a need for an explicit reduction of current and projected emissions, there is no demand to trade (beyond altruistic or public relations benefits). Second, there must be measurable vari- ability in the cost of reducing emissions for the regulated activities, because variability promotes trading between high- and low-cost sources of reductions. Third, the require- ments must be enforceable and enforced. If there is no penalty for failing to meet con- trol obligations, the first fundamental — to set binding reductions — will be negated.
Enforceability requires accurate accounting of emissions and verification that reduc- tion targets have, in fact, been met. In selecting sectors or activities that are likely to be most amenable to a cap-and-trade program, costs to administer emissions inventories and the existence of consistent accounting rules are important. Attempts to address all emission sources might render a cap-and-trade program unworkable. In some sec- tors — for example, transportation — there might be large number of sources that are difficult to monitor, which would make an end-use trading program expensive to administer and enforce.
Compliance with an emission trading program can be designed at the local, regional, or national level. Flexible compliance is provided by various schemes and mechanisms available to the parties that are compelled to meet the targets (Compliance Group) and typically include:
• Bubbles — where a group of trading parties aggregates their emissions allowance tar- gets (e.g., assigned amount units [AAUs]) and redistributes them internally. The European Union (EU) member states under the Kyoto Protocol, for example, have a collective 8 percent reduction target, but have redistributed AAUs among members, creating targets that range from –28 percent (Luxembourg) to + 27 percent (Portugal).
• Credits generated within the Compliance Group: such as Joint Implementation (JI) — projects in countries with emission targets that reduce, avoid, or sequester GHG emissions and create emission reduction units (ERUs).
• Credits outside of the Compliance Group: such as Clean Development Mechanism (CDM) — projects in countries without emission targets (non–Annex I countries) that reduce, avoid, or sequester GHG emissions and create certified emission reductions (CERs).
Each party with targets in the Compliance Group should be issued a number of allowances reflecting its reduction target. To reduce compliance costs to meet the tar- gets, trading programs might develop rules for trading and transferring compliance units. Each party can then meet its emission requirements through a combination of (1) allowances, initially acquired and transferred from trading; (2) credits from land- use activities, such as removal units (RMUs) that reflect approved land use, land-use change and forestry (LUCF) activities (that is, “sinks”); (3) internal credits, such as ERUs generated by JI projects; and (4) outside credits, such as CERs generated by CDM projects.
Different types of projects and activities can generate emission offsets and therefore are potential sources of internal and outside carbon credits. Typical offset activities include improvements in energy efficiency; fuel switching; methane avoidance or cap- ture; GHG recovery and avoided venting; afforestation, reforestation, and avoided deforestation; investments in renewable energy; and carbon capture and storage.
Offset projects have received various levels of encouragement across trading sys- tems. In the European Union Emission Trading Scheme (EU-ETS), the use of offset credits is determined by the national allocation plans. Regulated installations are gen- erally allowed to use JI and CDM credits to supplement their allowance allocations by 10 percent. 11
In the United States, the Regional Greenhouse Gas Initiative (RGGI) limits offset credits to 3.3 percent of a power plant’s total compliance obligation, but leaves open the possibility for a larger share when CO 2 allowance prices exceed threshold levels. 12 Moreover, RGGI’s compliance rules limit the type of projects that qualify as offset- based credits, as noted on its Web site:
RGGI has developed prescriptive standards for specific project categories, to ensure that offsets are real, additional, verifiable, enforceable, and permanent. At this time, five project categories for CO 2 offset allowances are eligible under the participating states’ regulations.
• Landfill methane capture and destruction
• Reduction in emissions of sulfur hexafluoride (SF6) in the electric power sector • Sequestration of carbon due to afforestation
• Reduction or avoidance of CO 2 emissions from natural gas, oil, or propane end-use combustion due to end-use energy efficiency in the building sector
• Avoided methane emissions from agricultural manure management operations RGGI also allows for emissions credit retirements from a mandatory program outside the United States (e.g., Clean Development Mechanism CERs) to be used as an offset under limited circumstances. 13
11 See National Allocation Plans: Second Phase (2008–2012), http://ec.europa.eu/environment/
climat/emission/2nd_phase_ep.htm (last visited on Feb. 8, 2009).
12 See http://www.rggi.org/offsets (last visited Feb. 8, 2009).
13 Id.
DUE DILIGENCE AND TRANSACTIONAL ISSUES
The carbon credit market is dominated by the CDM. Of the 2007 project-based activity in carbon credits, CDM project share was 87 percent of the volume and 91 percent of the value. Moreover, these investments are regionally concentrated in a small number of developing countries. In 2007, for example, China hosted 73 percent, India 6 percent, and Brazil 6 percent of the CDM projects. 14