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Members of Congress this year can take an important step toward a U.S. cap-and-trade marketplace in greenhouse gas emission allowances. Legislation proposed by Sen. Joseph Lieberman (I-CT) and Sen. John Warner (R-VA) would establish a national cap on carbon emissions and then auction emission allowances to industries, which in turn could trade those allowances or use them to cover their emissions. An often overlooked but nonetheless controversial component of this proposed cap-and-trade system in the Lieberman-Warner bill is a provision that will allow emitters to meet their emissions targets, in part, by obtaining carbon “offset” credits from reductions in emissions that are not covered by cap-and-trade restrictions, including emissions from forestry and agricultural sources and from unregulated energy uses.
Making sure Congress crafts these carbon offset credits wisely as part of a mandatory cap-and-trade system is a difficult but important challenge. The reason: Carbon offsets have earned a bad name in many quarters, particularly here in the United States where the appetite for companies and individuals to demonstrate “carbon neutrality” by offsetting their carbon emissions in the absence of a cap-and-trade system has spawned an unregulated, voluntary offset market that many consider to be unreliable at best, and rife with fraud, at worst.
Even in the international arena, where “offsets” earned in the developing world are subject to regulation under the Kyoto Protocol, there are concerns that some offsets credited as new reductions under the Protocol’s Clean Development Mechanism would have occurred anyway. Critics also complain that polluting industries are obtaining offset credits on the cheap, enabling them to avoid making more expensive—but needed—investments in reducing their own emissions.
Proponents of carbon offsets, however, argue that bona-fide carbon reductions obtained through well-designed offset projects have important benefits, including incentivizing investment flow and market interest in steps to reduce carbon emissions in ways that might otherwise go unaddressed and, in the process, lowering the overall costs of meeting carbon reduction mandates. Both sides of the offset debate make persuasive arguments, but with Congress and the states now designing mandatory cap-and-trade programs, policy choices must be made.
The threshold question—as explored in a Carbon Offsets Workshop I hosted at Stanford University’s Woods Institute for the Environment—is whether a U.S.-based cap-and-trade program should bother with “offsets” at all. The answer is a qualified yes.
Offsets make sense in a cap-and-trade world because they provide a financial incentive for reducing greenhouse gas emissions that otherwise are beyond the reach of the cap-and-trade system. As such, they are a sensible component of a comprehensive legislative effort to control all greenhouse gas emissions.
Indeed, offsets should be viewed as one of several types of financial incentives that target emissions not covered under a mandatory carbon cap. Other financing mechanisms, such as tax credits, rebates, and grants, may be more appropriate ways to encourage reductions in some types of un-capped emissions sources. That’s why climate change legislation should include both a mandatory system for reducing emissions—via the “cap” part of cap-and-trade—and a suite of incentives—including offsets—that seek to reduce emissions from sources that are not restricted under the cap.
The Lieberman-Warner bill, S. 2191, takes a step in the right direction by including an offset program as part of its cap-and-trade system. The thrust of this program is to enable companies subject to emission caps to meet their obligations in part through emission reductions achieved by segments of the economy outside the cap-and-trade system. Lieberman-Warner would establish a program to quantify, certify, and verify emissions reductions from qualifying projects.
Lieberman-Warner’s carbon offsets program includes a number of sensible features. The legislation, for example, would only allow a company regulated under the carbon cap program to meet up to 15 percent of its allowance submission requirements through carbon compliance offsets. This limit would ensure that lower-cost offsets would not swamp the market and displace investments needed in the emissions profiles of regulated industries. Lieberman-Warner also would enable companies to meet up to 15 percent of their compliance obligations with allowances from a foreign greenhouse gas trading market approved by the Environmental Protection Agency. These allowances could include offsets accepted for compliance purposes in an approved foreign trading market.
By taking a few additional steps, however, Lieberman-Warner can nest its offsets program in a more comprehensive policy framework that includes a menu of incentives to reduce greenhouse gas emissions that otherwise are beyond the scope of the cap-and-trade program. The incentives program would pick up where the mandatory cap-and-trade program leaves off—filling gaps under the carbon cap and tailoring different types of incentives to different types of emissions reduction opportunities. Here are the three key principles for this program.
Measures to Include Carbon Offset Credits Where There Are Gaps Under a Cap-and-Trade System
Under any mandatory cap-and-trade program that is “economy-wide” in its coverage there will still be a significant number of greenhouse gas sources emitting significant quantities of carbon dioxide and other greenhouse gases that are not limited by a mandatory cap—at least in the initial years of a mandatory cap-and-trade program. Cases in point: Emissions from disaggregated, smaller industrial sources that burn their own fuel, the collection of methane from landfills or old coal mines or emissions from agricultural and forestry practices
In addition, because any cap-and-trade program would initially focus on mostly “upstream” polluters, such as power plants, additional opportunities for emissions reductions by “downstream” users in the chain of energy use are largely unaddressed. Examples include: energy-saving building retrofits and the purchase of fuel-efficient car or truck fleets. These downstream carbon offset opportunities are touched only indirectly—and sometimes not at all—by a cap-and-trade system, yet can yield real and cumulatively significant reductions of greenhouse gas emissions.
Encourage New Carbon Reduction Opportunities through a Climate Change Incentive Program
To provide a more comprehensive approach for reducing all significant emissions of greenhouse gases, Congress should enact an incentive system that encourages reductions from otherwise unregulated greenhouse gas emissions sources alongside a mandatory cap-and-trade program.
An offset program along the lines of the Lieberman-Warner approach should form Tier I of the Climate Change Incentive Program, with carbon offsets renamed “compliance credits” to more accurately describe validated emissions reductions used to meet mandated emissions levels. Nomenclature matters here. Once this system is in place we should retire the ambiguous and misleading term “offsets” because it has been used so loosely as to have virtually no meaning.
Because these compliance credits would be acquired and used by companies operating under a cap-and-trade system to meet their allowance requirements, these new credits will be in demand, and the carbon market will set their price. Building on some of the features included in the Lieberman–Warner offsets program, this new Compliance Credit Program should advance the twin goals of environmental integrity and compatibility with the mandatory cap-and-trade system by:
- Awarding compliance credits only for projects that meet stringent, measurement, verification, and permanence requirements via the application of rigorous methodologies and protocols that EPA approves for this purpose
- Restricting companies’ use of compliance credits to no more than 15 percent of their allowance submissions
Periodically revisiting the qualification of project types for compliance credits in light of the evolution of “business as usual” practices, new regulatory requirements, and other developments.
Tier I compliance credits would also be made available for purchase in the so called voluntary offset market, which currently serves individuals and businesses who are not required to reduce emissions under a carbon cap but who nonetheless want to invest in projects that will reduce greenhouse gas emissions. Because Tier I compliance credits will be certified by EPA to provide real and verifiable emission reductions, these individuals and businesses will, for the first time, have an opportunity to purchase and retire top-grade compliance credits to account for their greenhouse gas emissions.
Additional incentives should be included in the Compliance Change Incentive Program’s Tier II, Targeted Carbon Reduction Program. This Tier II program would include program- or project-based activities that reduce emissions that may not satisfy the stringent tests required to earn Tier I compliance credits. These activities would earn other financial rewards, including tax credits, rebates, grants, or other financial incentives.
A wide array of such rewards is now provided under a variety of federal laws and would be expanded under greenhouse gas reduction proposals such as Lieberman-Warner. Broad-based grant programs that encourage carbon-enhancing forestry or agriculture practices, for example, could be included in Tier II, with some practices in those sectors also likely qualifying for compliance credits under Tier I. Other Tier II activities might include program initiatives to encourage more efficient energy use via the use of existing or new subsidies or tax rebates.
Once Tier II programs develop a track record, some of them may qualify to move up into Tier I, where they can generate marketable compliance credits. In this way, Tier II may serve as an “incubator” of projects and programs that ultimately may qualify for compliance credit status under Tier I.
Under the Tier II Targeted Carbon Reduction Program, EPA would be charged with estimating emissions reductions that are generated from federally-supported financial incentive programs, and with maintaining a web-accessible inventory and database of the federal programs and their estimated emissions reductions. States and local governments would be encouraged to contribute data from their programs to this inventory and database. As emissions reductions outside the cap are documented under this program, reductions required under the cap may be recalibrated to account for reductions achieved under the Targeted Carbon Reduction Program.
In contrast, when Tier I compliance credits are used by companies regulated under the carbon cap, they would be counted under the existing cap—not as additional reductions outside the cap. EPA would issue periodic reports to Congress regarding the relative cost-effectiveness of initiatives that are part of the Targeted Carbon Reduction Program, based on an evaluation of the estimated per-ton cost for emissions reductions achieved through the financial investments made under each initiative.
By melding together these two complementary types of financial incentives—Tier I compliance credits and Tier II carbon reduction programs—into a Climate Change Incentive Program, many emissions sources that would otherwise be ignored under a mandatory cap-and-trade system will receive special attention and be incentivized to reduce their emissions. In addition to this benefit, the Climate Change Incentive Program also will more comprehensively identify and measure carbon emissions from unregulated sources and evaluate the relative cost-effectiveness of the financial incentives included in this new carbon offset program.
This rich data set will provide important information about the nature and scope of emissions that are otherwise beyond the reach of the cap-and-trade program. It will also inform policymakers about which types of incentives provide the most bang for the buck. Over time, these data may provide the basis for expanding the cap to include some of these currently unregulated emissions sources.
By adopting these measures, the Climate Change Incentive Program will also avoid the “winner- takes-all” situation in which investments in reducing emissions from unregulated sources either qualify for valuable financial incentives through an “offsets” program or are left out in the cold. Where there is no alternative financial incentive mechanism to support good projects that cannot satisfy all of a compliance credit’s requirements, the pressure builds to weaken the standards for offsets. The two-tiered structure reduces those pressures while, at the same time, enables policymakers to more systematically review and augment financial incentives that seek to reduce emissions from unregulated sources.
Building Toward an International Carbon Market
Because all greenhouse gas emissions and any greenhouse gas reductions affect the entire planet, regardless where they occur, Congress should require EPA to explore whether and, if so, how the Climate Change Incentive Program might interact with offset programs established under the Kyoto Protocol. The Lieberman-Warner approach of allowing EPA to review proposed carbon allowances and offset credits that are generated overseas and are routed through nations that have caps under the Kyoto Protocol deserves careful consideration.
Carbon allowances, for example, which have been produced by companies in the European Union and which have secured greater-than-required emissions reductions under the E.U. cap should be considered highly credible. EPA’s review needs to be meaningful, however, given potential differences between the U.S.-based Compliance Credit Program and Kyoto’s Clean Development Mechanism and Joint Implementation program (a carbon-reduction cousin of CDM which generates offset credits in Russia and Eastern Europe). In particular, there are serious concerns that some CDM-qualifying projects are not “additional,” meaning they would have occurred without regard to the CDM program and, as a result, they should not be credited as reductions under the cap.
The type of financial incentives included in the Tier II Targeted Carbon Reduction Program should also be actively explored in international settings, where program financial support may be effective, at least at the outset, in reducing overall emissions from some types of emission sources such as, for example, tropical deforestation. Likewise, Lieberman-Warner’s diversion of some allocations in order to help finance international efforts to reduce tropical deforestation is appropriate, and should be accompanied by a concerted effort to formulate an approach to avoid deforestation in tropical countries including, in particular, some type of “crediting”-type mechanism to preserve tropical rain forests, as called for in Section 3805 of Lieberman-Warner.
Creativity and discipline will be needed in this regard, however, because it may be difficult to demonstrate that project-based investments to avoid tropical deforestation actually generate net emissions reductions. The serious measurement and “leakage” challenges, for example, of making sure deforestation activities don’t simply move to another area of the country, must be closely policed. The Lieberman-Warner bill’s focus on the importance of establishing country-wide baselines against which to test progress in reducing tropical deforestation is an appropriate response to this real-life concern.
All of these steps to craft an effective carbon compliance program will be examined in detail in the following pages of this paper. Congress boasts a unique opportunity to include carbon offsets in any forthcoming carbon cap-and-trade legislation, and then create a new set of carbon compliance offsets to further reduce greenhouse gases alongside the cost of reducing those gases as the United States shifts to a low-carbon economy. The steps outlined below detail how new compliance credits and other financial incentives that target unregulated emissions sources can help us get there.
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David J. Hayes