Carbon offsets can be an effective tool for lowering the costs of compliance in a cap-and-trade program, and are already being widely used internationally to comply with greenhouse gas emissions targets. To function well and maintain the integrity of a cap-and-trade system, carbon offsets must adhere to certain basic criteria and standards defining how they are quantified and certified. A number of programs around the world have begun developing such standards, but these standards would have to be carefully evaluated before being adopted under a U.S. regulatory program. Carbon offsets can come from many types of projects that reduce or sequester emissions. Some types of projects face higher quantification uncertainties than others, however, necessitating higher transaction costs in certifying the offsets they generate. These projects include certain types of forestry and agriculture carbon sequestration projects, which are subject to greater measurement and baseline uncertainties, reversibility, and leakage compared to other projects. It may be preferable in some cases fund these projects using direct payments rather than an offset market, in order to avoid costs of reducing uncertainties and lower the total cost of achieving emission reductions.
What are carbon offsets?
A “carbon offset” is a reduction in greenhouse gas (GHG) emissions that is achieved to compensate for, or “offset,” GHG emissions occurring at other sources.1 In a cap-and-trade system, carbon offsets allow emissions from regulated sources to increase above levels set by the cap, on the premise that those increases are compensated by reductions achieved at unregulated sources. Because reducing emissions at unregulated sources is often less costly, carbon offsets can lower the total cost of achieving an overall net emissions goal.
In an emissions market, carbon offsets can be traded in the form of certified “credits” or “offset allowances.” One credit usually denotes a reduction in GHG emissions equivalent to one metric ton of carbon dioxide (CO2). The terms “offset credit,” “offset allowance,” and “carbon offset” are often used interchangeably. In most cases, offset credits are issued for reductions achieved by specific projects, i.e., “offset projects”. In order to receive credits, the project owners must demonstrate that they have reduced emissions according to predefined rules and procedures. In principle, a wide variety of projects can generate carbon offsets. Examples include, but are not limited to:
- Capturing methane created by landfills and flaring it or using it to produce energy (thus displacing fossil fuel combustion);
- Installing equipment at chemical factories to capture and destroy industrial GHGs, such as HFCs or N2O.
- Switching from high carbon-intensity fuels (e.g., coal) to fuels with low or zero net carbon emissions (e.g., biofuels) for energy production or transportation.
- Improving the efficiency of energy production from fossil fuels, e.g., by upgrading commercial or industrial boilers, or exploiting opportunities to combine the production of heat and power.
- Deploying equipment or appliances that use less energy (e.g., high-efficiency air conditioners or fluorescent light bulbs) and reduce demand for fossil fuels.
- Planting trees or adopting forestry or land management practices that remove carbon dioxide from the atmosphere and sequester it.
Globally, markets for carbon offsets have grown rapidly over the last five years (Figure 1). The largest of these markets was created by the “Clean Development Mechanism” (CDM) established under the Kyoto Protocol. Through the CDM, emission reductions in developing countries can be used to offset emissions in industrialized countries, whose total emissions are capped by the Kyoto Protocol. The CDM effectively allows industrialized countries to achieve their emissions targets through a combination of domestic and foreign reductions. The CDM is also envisioned as a way to help less developed countries grow sustainably through the transfer and deployment of beneficial technologies and practices. A separate Kyoto Protocol mechanism, called “Joint Implementation” (JI) recognizes carbon offsets from projects in industrialized countries.
Figure 1. Annual Volumes of Carbon Offset Transactions in Millions of Tons of Carbon Dioxide Equivalent (See PDF)
A separate global market for carbon offsets has arisen to meet voluntary demand for GHG emission reductions. The voluntary offset market is driven by companies and individuals seeking to help avert climate change outside any regulatory obligation to do so.2 Although this market is growing rapidly, it has struggled with a proliferation of different standards and lack of consistent guidance on what constitutes a credible offset.
What are the basic requirements for carbon offsets?
To have a functioning market for carbon offsets, clear rules and procedures are required defining their creation and certification. Although these rules and procedures can differ from program to program, most of the literature on carbon offsets refers to a core set of basic criteria, derived from criteria established under the 1977 Clean Air Act. Specifically, offsets must be “real, surplus (or additional), verifiable, permanent, and enforceable” in order to maintain the integrity of an emissions trading system.4 Interpretations of these criteria vary, but their essence can be summed up as follows:
An offset credit must represent an actual net emission reduction, and should not be an artifact of incomplete or inaccurate emissions accounting. In practice, this means methods for quantifying emission reductions should be conservative to avoid overstating a project’s effects. It also means that the effects of a project on GHG emissions must be comprehensively accounted for.5 Some projects may reduce GHG emissions at one source, for example, only to cause emissions to increase at other sources. A frequently cited example would be a forest protection project that simply shifts logging activities to other forest land, causing little net decrease in carbon emissions. Unintended increases in GHG emissions caused by a project are often referred to as “leakage.” For carbon offsets to be real, they must be quantified in ways that account for leakage.
Only emission reductions that are a response to the incentives created a carbon offset market should be certified as offsets. Reductions that would occur regardless of an offset market (e.g., those that result from “business as usual” practices) should not be counted. The rationale for this is straightforward. The basic premise of carbon offsets is that they maintain net GHG emissions at a level set by a trading system’s cap. Total emissions should be the same with or without an offset program. Since offset credits allow regulated sources in a cap-and-trade system to increase their emissions, offset reductions must be “additional” in order to maintain net emission levels. Crediting reductions that would happen anyway will result in higher total emissions than a cap- and-trade program without offsets.
Although this general concept (called “additionality”) is straightforward, it is vexingly difficult to put into practice. Determining which projects (and therefore which reductions) would not have occurred in the absence of an offset market is frequently challenging and always subjective. Within existing carbon offset programs, there are two basic approaches to determining “additionality”: project-specific and standardized.
Project-specific approaches seek to assess, by weighing certain kinds of evidence, whether a project in fact differs from an imagined baseline scenario where there is no carbon offset market. Generally, a project and its possible alternatives are subjected to a comparative analysis of their implementation barriers and/or expected benefits (e.g., financial returns). If an option other than the project itself is identified as the most likely alternative for the baseline scenario, the project is considered additional. The Kyoto Protocol’s CDM requires project-specific additionality tests.
Standardized approaches evaluate projects against objective criteria designed to exclude non- additional projects and include additional ones. For example, a standardized test may count as “additional” any project that:
- Is not mandated by law
- Is not a “least-cost” option (objectively defined)
- Is not common practice (objectively defined)
- Involves a particular type of technology
- Is of a certain size
- Is initiated after a certain date
- Has an emission rate lower than most others in its class (e.g., relative to a performance standard)
Several U.S.-based carbon offset programs (including the California Climate Action Registry, the Chicago Climate Exchange, and the Regional Greenhouse Gas Initiative) have adopted standardized additionality tests. It is also possible to combine project-specific and standardized approaches.
Carbon offsets should result from projects whose performance and effects can be readily monitored and verified. Verification is necessary to demonstrate that emission reductions have actually occurred and can therefore be used to offset emission increases at regulated sources. Verification helps ensure that offset reductions are “real” and not overestimated. Because of the importance of maintaining net emissions levels within a trading system, projects whose effects are difficult to verify – or whose effects cannot be measured with reasonable precision – may not be suitable for generating carbon offsets.
Since emission increases are effectively permanent (e.g., fossil fuel emissions cannot be put back in the ground), offsetting emission reductions should be permanent as well. Permanence is only an issue where the effects of a project can be reversed, such as forestry projects where carbon stored in trees or soils can be released to the atmosphere due to fires, harvesting, or other disturbances. In these cases, a mechanism is required to make reversible reductions/removals functionally equivalent to permanent reductions for the purpose of issuing offset credits. There are at least three possible ways to do this:
- Issuing credits on a discounted basis. For example, only one credit is issued for every two tons of CO2 sequestered in trees or soils.7 Although this approach has been proposed in the literature,8 it has not been put into practice within existing offset programs.
- Issuing temporary or expiring credits. Credits for reversible reductions can be made to expire at a predefined date, or canceled if verification indicates that a reversal has occurred. In both cases, the holder of the credits would have to procure other credits or allowances in order to remain in compliance with the cap-and-trade system. This approach has been adopted by the CDM for reforestation and afforestation projects.
- Establishing an insurance or buffer system. Buyers or sellers of reversible reductions could be required to buy “insurance” in some form to compensate for reversals, or establish carbon sequestration buffers that serve the same function. There are many ways these mechanisms can be structured, and they may be combined with requirements for landowners to commit to maintaining carbon stocks over the long term (e.g., through easements). The U.S. Regional Greenhouse Gas Initiative has adopted this approach for reforestation projects.
It is worth noting that all of these mechanisms have the effect of either increasing costs for project developers or reducing the amount of compensation they receive per ton of emissions reduced or removed from the atmosphere.
Carbon offsets should be backed by regulations and tracking systems that define their creation and ownership, and provide for transparency. Clear definitions of ownership are essential for enforceability. For example, both the manufacturer and the installer of energy efficient light bulbs might want to claim the emission reductions caused by the light bulbs – as might the owners of the power plants where the reductions actually occur. Regulatory rules must establish who has claim to emission reductions, who is ultimately responsible for ensuring project performance, who is responsible for project verification, and who is liable in the case of reversals.
How can these requirements be realized?
To create a functioning market for carbon offsets, the criteria outlined above must be elaborated in set of standards and those standards administered by a regulatory body responsible for certifying and issuing offset credits. Standards are required to create a carbon offset “commodity” that is as uniform as possible, i.e., one offset credit equal to one ton of CO2- equivalent emission reductions regardless of where it is sourced. Three related sets of standards are necessary to fully define a carbon offset commodity:
- Procedural and technical standards. These are standards related to the validation, monitoring, and verification of offset projects, as well as the certification and crediting of GHG reductions. Procedural and technical standards ensure that offsets are verifiable.
- Contractual standards. These are standards for the establishment and transfer of property rights related to carbon offsets, for information disclosure, and for the assignment of liability. They can include terms for payment and delivery, allocation of risk, and compensation where emission reductions are reversed or not realized. Contractual standards are necessary to avoid double-counting of reductions and double- issuance of credits, and ensure that offsets are enforceable.
- Accounting standards. These are standards related to the actual quantification of carbon offsets. Accounting standards specify methods for defining quantification boundaries, estimating baseline emissions, and correcting for unintended changes in emissions (i.e., “leakage”). Accounting standards also cover methods for demonstrating “additionality.” Finally, they may specify methods for treating reversible GHG reductions on an equal footing with permanent reductions. Accounting standards are a first-order requirement for ensuring that “a ton is a ton” and ensure that offsets are real, surplus, and permanent.
Are there existing standards for carbon offsets?
Yes, in fact there are quite a number. The challenge is deciding which ones might be sufficiently stringent and credible for a U.S. regulatory offset program. Current offset programs (both mandatory and voluntary) are probably most diverse in terms of accounting standards.
Internationally, an extensive amount of work has been done to clarify the basic requirements of carbon offset accounting. Two salient examples of this work are the Greenhouse Gas Protocol for Project Accounting (“Project Protocol”), developed by the World Resources Institute (WRI) and World Business Council for Sustainable Development (WBCSD), and the ISO 14064 (Part 2) standard developed by the International Organization for Standardization – both of which provide a general framework for quantifying emission reductions from offset projects. To specify a truly standardized commodity for carbon offsets, however, requires elaborating these general requirements into “methodologies” or protocols aimed at specific types of projects. Such protocols streamline the quantification process, taking into account data requirements and analysis relevant to a particular project type.
WRI/WBCSD Project Protocol includes two sector-specific supplements, aimed at grid- connected electricity projects and land-use and forestry projects. Even these guidance documents, however, are too broadly specified to guarantee a true standard for carbon offsets. The task of developing standardized protocols has fallen to a number of individual programs that verify and certify offsets. The largest of these is the CDM. Table 1 summarizes the types of publicly available protocols and methodologies developed by the CDM and other programs around the world.
Table 1. Offset Protocols and Methodologies Developed Under Existing Programs (See PDF)
A thorough evaluation would be required to decide whether the protocols developed under these programs are suitable for a national U.S. regulatory offsets program. One of the challenges in designing offset protocols is that they require balancing tradeoffs. Protocols that are too stringent (e.g., with respect to additionality) may end up excluding good offset projects and raising overall compliance costs. Lenient protocols may allow too many reductions to be credited and therefore undermine the integrity of an emissions cap. Ideally, protocols should be developed and adopted according to how well they achieve desired policy outcomes for an emissions trading system, including objectives for environmental integrity, transaction costs, and administrative costs.13 Protocols developed under other programs may or may not fit the bill for a U.S. national GHG trading system.
What types of projects should be included in a carbon offset program?
Only emission reductions at sources not covered by an emissions cap can truly qualify as offsets. While it may be desirable to encourage reductions at covered sources, “crediting” such reductions must be done through some form of allowance allocation rather than the creation of offset credits.14 Only projects that affect sources (or sinks) of GHG emissions not covered by the cap should be included in an offset program. Under Senate Bill 2191 as currently drafted, for example, the following types of projects might be included in a domestic offset program:
- Agricultural and rangeland management
- Manure and livestock management
- Forest, agricultural, and rangeland land-use change
- Forest management practices
- Fossil fuel (oil, gas, and coal) production, processing, and delivery
- Landfill gas and waste management
In addition, it makes sense to exclude any projects that are likely to have adverse social, economic, or environmental effects. This is probably best accomplished through general eligibility criteria applied to projects, rather than the exclusion of project types.
Beyond these considerations, there is in theory no reason to limit the types of projects allowed in an offset program as long as they can meet the basic criteria outlined above (i.e., real, additional, verifiable, permanent, and enforceable). However, some types of projects will face greater risks and uncertainties relative to these criteria than others. The question becomes whether it makes sense to exclude some types of offsets on the basis of higher uncertainties and associated costs.
Are there differences in the credibility of offsets from different project types?
The “credibility” of a carbon offset largely depends on the level of confidence one has in its quantification, additionality, verification, permanence, and ownership. Broadly speaking, the risks and uncertainties for carbon offsets fall into four categories:
- Measurement uncertainty. Accurately quantifying emission reductions requires being able to accurately monitor and verify the performance of a project and its effect(s) on emissions or sequestration. Accurate measurement is easier for some types of projects than others.
- Baseline uncertainty. Accurately quantifying emission reductions also requires reasonable certainty about a project’s baseline emissions and its additionality.16 Baseline uncertainty will be higher for projects that have numerous possible alternatives, and for projects that provide significant compensation or revenue aside from their emission reductions.
- Leakage potential. Accurately quantifying emission reductions requires accounting for any unintended increases in emissions caused by a project. Leakage can add significant uncertainty to a project because it often difficult to monitor and quantify. Some types of projects are more prone to leakage than others.
- Reversibility risk. The potential for reversal of a project’s emission reductions creates uncertainty about its value as an offset. Reversibility is only a concern for projects whose emissions benefits result from sequestration.
In general, many types of forestry and agriculture carbon sequestration projects will face higher quantification uncertainty, because they are subject to greater relative measurement uncertainties, baseline uncertainties, reversibility, and leakage. Table 2 illustrates how some different types of offset project compare against these categories of uncertainty, based on qualitative analysis and a preliminary survey of carbon offset quantification literature. Further studies are needed to develop a full quantitative comparison for different project types, but there are generally clear differences between projects that avoid GHG emissions and those that sequester carbon.
Table 2. Illustrative Project Types and Their Associated Uncertainties (See PDF)
Can the risks and uncertainties for some project types be addressed?
In most cases, yes. There is no reason in principle why projects with relatively high quantification uncertainty cannot yield credible offsets. The only challenge is that methods to compensate for the uncertainty will tend to raise costs. For example:
- Compensating for measurement uncertainties may require more costly measurement and verification practices, or the use of conservative estimates or discounts for quantified reductions. Both methods will increase the cost per ton of creditable emission reductions.
- Compensating for baseline uncertainties may require more rigorous analysis and additionality tests (raising costs for project developers and/or program administrators), or similar application of conservative estimates that err on the side of under-counting emission reductions.
- Compensating for leakage generally requires the incorporation of project elements designed to mitigate it,25 or the application of conservative methods to estimate its impact, both of which may increase costs relative to other types of projects.
- Compensating for reversibility requires the adoption of one of the methods already described in this testimony (above), which will tend to either increase costs or reduce compensation to project owners.
The bottom line is project types with higher levels of quantification risk and uncertainty are likely to incur significantly higher costs for every ton of CO2 they reduce in order to have their reductions certified as offsets. Unfortunately, no studies have yet tried to quantify the likely size of this cost differential under a strict regulatory program.26 The added costs may have important consequences for how these types of projects fare in a broader market for GHG reductions. Furthermore, it may take time to develop protocols for some types of projects in ways that effectively mitigate uncertainty. This could lead to delays in how soon those projects can enter the market. Finally, even where the added costs amount to less than a dollar per ton of CO2, this could mean many millions of dollars of added investment burden across the entire market for carbon offsets.
Are there alternatives?
It may be worth asking whether some types of GHG emission reductions are best achieved through carbon offset markets or through other policy mechanisms. If the added costs associated with reducing uncertainties for sequestration projects could be avoided, for example, then greater reductions could in principle be achieved for the same total expenditure of resources.
One way to do this would be to fund these and other projects with high quantification uncertainties through a separate program of direct payments, or allowance set-asides.27 Unlike offsets, reductions achieved through direct payments would not be have to be used to compensate for increased emissions from capped sources, and therefore would not have to be subject to the same levels of scrutiny in terms of measurement, additionality, leakage, and reversibility. While it may still be desirable to fund reductions that are “real, additional, verifiable, permanent, and enforceable,” the application of these criteria would not have to be as stringent. For example:
- Measurement of the effects of funded activities would be primarily for information purposes, and would not have to meet the same degree of accuracy needed to ensure that quantified reductions are truly offsetting emissions on a ton-for-ton basis. Avoiding and mitigating leakage from funded activities would be desirable, but the extent of leakage would not have to be rigorously quantified.
- While it may be desirable to fund “additional” activities, demonstrating additionality on a project-by-project basis would not be necessary. Avoiding the need to develop and apply complicated additionality tests could reduce costs significantly.28
- Verification of funded activities would still be necessary, but could be limited to a simple confirmation that activities are being undertaken rather than checking their performance in ways that are necessary for precise quantification.
- Long-term carbon storage for sequestration projects would be desirable and could be encouraged, but designing complicated insurance mechanisms to put carbon sequestration on equal footing with permanent emission reductions would not be necessary.
- Enforcement of a direct payment program would consist of ensuring that project owners follow through on their commitments, and would not require tracking systems or legal rules for establishing ownership of emission reductions.
Whether or not a direct payment system would make sense as an alternative greatly depends on
how various other elements of a cap-and-trade system and offset program are designed. Total
demand for reductions (determined by cap levels), the types offset projects allowed, and limits
on the use of offsets will all play a role in determining price levels and whether “high transaction
cost” projects can succeed in the market. The stringency required of offset protocols (based on
policy objectives, as described above) will also play a role. Further study is needed to determine which types of projects might best be encouraged through an offset program and which might be better achieved through direct payments. In the meantime, it makes sense to design policies that keep both options open for a variety of project opportunities in “uncapped” sectors.
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