Waxman-Markey Cap and Trade: The Trouble with Offsets

This is a joint post with Matt Hoffman.Carbon offsets -- granting rights to emit greenhouse gases beyond a stated ceiling in exchange for contributions to cutting emissions elsewhere -- are an important part of the Waxman-Markey cap and trade bill now making its way through the U.S. Congress. Offsets have plenty of appeal, but in practice they have a poor track record. And there are less risky, lower cost ways to achieve similar goals. Offsets make sense in theory. Because emissions cuts in developing countries can be cheaper than equivalent reductions at home, developing country offsets could reduce the cost of a cap and trade bill. As recent negotiations in the U.S. House have demonstrated, cap and trade is unlikely to pass unless the price of emissions permits is held in check. Moreover, helping developing countries to cut their own greenhouse gases is in everybody’s interest. As CGD research has shown, disastrous climate change is inevitable unless developing countries substantially cut emissions.Waxman-Markey allows for two billion tons in offsets, one billion tons for international allocation and one billion tons in the U.S. itself. One billion tons would be a significant reduction of developing country emissions, but the experience with offsets so far is not encouraging.Stanford’s Michael Wara and David Victor recently studied the Kyoto Protocol’s Clean Development Mechanism (CDM) -- the largest international offset system--and found “an urgent need for reform.” They determined that between a third and two-thirds of CDM offsets do not achieve actual cuts in emissions. The U.S. Government Accountability Office (GAO) has also analyzed the CDM and reached three critical conclusions:

1. The CDM may be less cost-effective than a program of direct investments in emissions reduction.
2. Ineffective offsets may undermine the integrity of the U.S. cap and trade system by giving polluters an “easy out.”
3. Although proposed reforms may improve the CDM, it will remain hobbled by its requirement that offsets be measured against counterfactual, business-as-usual scenarios that can never be verified. As Harvard’s Robert Stavins put it in Tuesday’s Washington Post: "Who knows what you would have done?"

Real money is at stake. At the bill’s minimum auction price of $10 per ton of CO2-equivalent greenhouse emissions, two billion tons of U.S. and international offsets would create at least $20 billion of offset value annually -- a huge sum subject to all the risks identified by Wara, Victor, Stavins and the GAO. Although offsets will relieve some upward pressure on permit prices, they offer no guarantee that prices will not spike unacceptably.Given these evident risks, Congress may want to consider replacing offsets with a more direct approach to cost containment and developing-country emissions reduction. Cost containment can be achieved by Waxman-Markey’s Strategic Reserve of emissions permits (Section 726, p. 434), which allows for an expansion of the permit supply to counter excessive upward pressure on the price.Waxman-Markey also offers other ways to promote developing-country emissions reduction. At present, the bill pursues this goal through four channels: 1 billion tons of international emissions offsets; 1% of permits auction proceeds earmarked for clean technology deployment; 1% of auction proceeds earmarked for forest conservation; and additional forest conservation funds from the Strategic Reserve fund when it auctions permits to dampen price pressure.In our view, this is all too complicated; Waxman-Markey should be simplified in a way that reflects three key principles:

• First, the bill’s international component should focus on the overriding objective: driving clean technologies toward cost-competitiveness with carbon-intensive technologies in developing countries, thereby empowering private investors to lead a rapid transition to low-carbon development.
• Second, offsets are simply too risky to play a prominent role in cap and trade legislation.
• Third, the bill can expand political support by providing further insurance against unacceptable price spikes for emissions permits.

We suggest that Congress drop or drastically reduce the international offsets; compensate for the loss of those offsets by expanding the 1% allocation of permit auction proceeds to international clean technology deployment; adjust the Strategic Reserve (SR) auction rules to ensure rapid relief from unanticipated price spikes; and broaden the SR’s international component to include clean technology as well as forest conservation.This will simultaneously simplify the bill, strengthen its political base by limiting price risks, and ensure direct, reliable, large-scale support for low-carbon development.