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THE POLITICS AND ECONOMICS OF INTERNATIONAL CARBON OFFSETS

David G. Victor77

May 17, 2010


Offsets are the “sleeper” issue in climate policy. Most public attention concentrates on headlines such as the exact level of emission cuts promised in legislative proposals such as the 2009 Waxman-Markey bill (H.R. 2454) or the bill taking shape in the Senate. In reality, the rules that govern the use of offsets are likely to be much more important in determining the cost and efficacy of a U.S. climate policy. A wide array of studies suggest that offsets are the single largest factor in determining the overall cost of climate legislation such as the Waxman-Markey bill of 2009.78 The studies presented at this conference point in similar directions. The analysis by Fawcett (2010) reinforces EPA’s earlier results showing the important role for offsets in determining compliance costs. Using a different model, Blanford (2010) also shows the total compliance costs will be especially sensitive to offset rules, notably the rules that govern which types of offsets will be allowed into the market. Forestry is proving to be one of the largest wildcards in the supply of offsets. Sohngen (2010) shows that there are, in theory, large supplies of low-cost forestry offsets, but they are difficult to monitor and verify; high transaction costs and poor policy design could make it hard to utilize forestry offsets. Indeed, numerous studies have suggested that poorly designed offsets schemes could undercut the efficacy of emission limits while also creating perverse incentives that make it harder to engage developing countries in meaningful emission controls.79

Over the last 1-2 years the community of economic modelers that study climate change have begun to focus on offsets. Their studies are rightly looking at an array of important technical questions, such as quantifying supply curves for offsets, potential demand for offsets in different compliance markets, and transaction costs. This paper offers a complement: politics. I look at the origins of the world’s largest carbon offset market: the Kyoto Protocol’s Clean Development Mechanism (CDM).80 Then I explain the political forces that have shaped the design and administration of the CDM. I concentrate on the question that looms over most offsets schemes: whether offset credits are truly “additional” in the emission reductions they supposedly represent. Finally I explore how offsets might influence the dynamics of carbon markets. In each part of the analysis I suggest some implications for the community of modelers that are looking at the economics of climate change, along with implications for the emerging U.S. strategy in this area.

Throughout this analysis, I will make four arguments. First, there is much to be learned from the CDM because its history reveals the political forces that will shape offsets in the real world. Too much of the debate over offsets has imagined ideal schemes that function perfectly; the CDM illustrates how politics and administration can yield outcomes that are radically different from the ideal vision.

The CDM finds its political origins in a “second best” policy strategy. Economically, the first best policy strategy would have seen developing countries adopt meaningful commitments to control their emissions; in the absence of that approach, the CDM offered a market-like mechanism for engaging developing countries. While most of the U.S. policy debate about offsets today is focused on offsets as a means of lowering compliance costs, the CDM experience is a reminder that perhaps the most important role for offsets is as part of a strategy for engaging developing countries. Engaging developing countries may require massive transfers of resources, and the only politically feasible way to mobilize and channel those resources is through mechanisms such as offsets that keep the full cost hidden and away from public budgets. Within such constraints, the CDM was an expedient choice. But it has created perverse incentives that are making it harder to engage credibly with developing countries

77

Professor, School of International Relations and Pacific Studies, UC San Diego; Director, Laboratory on International Law and Regulation, 9500 Gilman Drive #0519, La Jolla, CA 92093.

78

For example, without international offsets, the allowance price would be 89% higher than the base scenario in the EPA study (EPA, 2009). Studies by Paltsev et al (2009) and CBO (2009) point to similar conclusions.

79

For example, Wara (2007); Schneider (2007); Wara and Victor (2008); Victor (2009).

80

I use the term “carbon” as a shorthand for all the warming gases, including carbon dioxide (CO2), that are typically considered under international offsets schemes. And I use the term “offsets” with a focus on international offsets, but most of the analysis here probably applies equally to domestic offsets.



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132 MODELING THE ECONOMICS OF GREENHOUSE GAS MITIGATION The PoliTics and economics of inTernaTional carbon offseTs David G. Victor77 May 17, 2010 Offsets are the “sleeper” issue in climate policy. Most public attention concentrates on headlines such as the exact level of emission cuts promised in legislative proposals such as the 2009 Waxman-Markey bill (H.R. 2454) or the bill taking shape in the Senate. In reality, the rules that govern the use of offsets are likely to be much more important in determining the cost and efficacy of a U.S. climate policy. A wide array of studies suggest that offsets are the single largest factor in determining the overall cost of climate legislation such as the Waxman-Markey bill of 2009.78 The studies presented at this conference point in similar directions. The analysis by Fawcett (2010) reinforces EPA’s earlier results showing the important role for offsets in determining compliance costs. Using a different model, Blanford (2010) also shows the total compliance costs will be especially sensitive to offset rules, notably the rules that govern which types of offsets will be allowed into the market. Forestry is proving to be one of the largest wildcards in the supply of offsets. Sohngen (2010) shows that there are, in theory, large supplies of low-cost forestry offsets, but they are difficult to monitor and verify; high transaction costs and poor policy design could make it hard to utilize forestry offsets. Indeed, numerous studies have suggested that poorly designed offsets schemes could undercut the efficacy of emission limits while also creating perverse incentives that make it harder to engage developing countries in meaningful emission controls.79 Over the last 1-2 years the community of economic modelers that study climate change have begun to focus on offsets. Their studies are rightly looking at an array of important technical questions, such as quantifying supply curves for offsets, potential demand for offsets in different compliance markets, and transaction costs. This paper offers a complement: politics. I look at the origins of the world’s largest carbon offset market: the Kyoto Protocol’s Clean Development Mechanism (CDM).80 Then I explain the political forces that have shaped the design and administration of the CDM. I concentrate on the question that looms over most offsets schemes: whether offset credits are truly “additional” in the emission reductions they supposedly represent. Finally I explore how offsets might influence the dynamics of carbon markets. In each part of the analysis I suggest some implications for the community of modelers that are looking at the economics of climate change, along with implications for the emerging U.S. strategy in this area. Throughout this analysis, I will make four arguments. First, there is much to be learned from the CDM because its history reveals the political forces that will shape offsets in the real world. Too much of the debate over offsets has imagined ideal schemes that function perfectly; the CDM illustrates how politics and administration can yield outcomes that are radically different from the ideal vision. The CDM finds its political origins in a “second best” policy strategy. Economically, the first best policy strategy would have seen developing countries adopt meaningful commitments to control their emissions; in the absence of that approach, the CDM offered a market-like mechanism for engaging developing countries. While most of the U.S. policy debate about offsets today is focused on offsets as a means of lowering compliance costs, the CDM experience is a reminder that perhaps the most important role for offsets is as part of a strategy for engaging developing countries. Engaging developing countries may require massive transfers of resources, and the only politically feasible way to mobilize and channel those resources is through mechanisms such as offsets that keep the full cost hidden and away from public budgets. Within such constraints, the CDM was an expedient choice. But it has created perverse incentives that are making it harder to engage credibly with developing countries 77 Professor, School of International Relations and Pacific Studies, UC San Diego; Director, Laboratory on International Law and Regulation, 9500 Gilman Drive #0519, La Jolla, CA 92093. 78 For example, without international offsets, the allowance price would be 89% higher than the base scenario in the EPA study (EPA, 2009). Studies by Paltsev et al (2009) and CBO (2009) point to similar conclusions. 79 For example, Wara (2007); Schneider (2007); Wara and Victor (2008); Victor (2009). 80 I use the term “carbon” as a shorthand for all the warming gases, including carbon dioxide (CO ), that are typically considered under 2 international offsets schemes. And I use the term “offsets” with a focus on international offsets, but most of the analysis here probably applies equally to domestic offsets.

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 DAVID G. VICTOR because it pays those countries to avoid strict emission control policies. Future studies of the economics of climate change should look at offsets not just for their impact on compliance costs but also for their influence on strategic interaction between industrialized and developing countries. The analytical questions are not just whether offsets are “additional” but whether they produce positive (or even negative) leverage on the emissions from developing countries. Over the long term the largest leverage that the industrialized countries have on the global warming problem will come from their strategy to engage developing countries. Because of perverse incentives embedded in any offsets scheme, one element of that strategy must be a credible sunset for offsets. Second, the design of CDM rules has been highly political, which is hardly surprising since it is mobilizing and allocating large amounts of capital and the other benefits that flow alongside investment. At present, the CDM pipeline is probably worth several tens of billions of dollars. By 2020, the Copenhagen Accord envisions that the CDM and other offsets markets might annually channel $100 billion to developing countries, which would exceed total current annual spending on official development assistance from all sources for all purposes. Politically organized interest groups have favored some technologies (e.g., small hydropower) while abhorring others (e.g., nuclear power). Those forces are evident in the current and prospective flow of CDM credits. The most important effect of politics on the design of the CDM has been the strong political pressure to gen - erate high volumes of offset credits at the expense of quality. Firms and governments in industrialized countries seek offset credits to assure that they will be able to comply with strict emission targets. Developing countries that host projects want to maximize the revenues that are linked to the flow of credits. By contrast, the interest groups that would press for higher quality and strict administration, which would lead to much lower and more uncertain flows of emission credits, are much less well organized and influential. A similar constellation of political forces is now mobilizing around U.S. policy on offsets. There are well-organized industrial forces that favor generous offsets rules. (Those forces are not wrong—indeed, if well administered, an unfettered offsets system would be a good policy.) But the crucial administrative questions have been left vague and are most deferred until the future. Interest groups that would favor strict administration are much less coherently organized. One remedy for these pressures is to set a credible safety valve on emission prices, which would remove the incentive for purchasers of offsets to seek high offset volumes as their only means of managing compliance costs. Third, many of the troubles in the CDM arise because it was designed by committee with very little attention to political economy. A much more strategic approach to the design of offsets is feasible and badly needed. In theory, most of the power in the creation of an offsets market originates with the largest purchasers of offset credits—today the EU and Japan (via the CDM) and eventually the United States, once a U.S. emissions policy is reliably in place. So far the EU and Japan have ceded much of their potential power to the Executive Board created under the Kyoto Protocol to manage the CDM. That Board is a cumbersome and largely ineffective system for administration. This is not news to the governments of the EU and Japan, but these countries have not pressed harder for such reforms nor created their own, better parallel system because they had no other alternative means of meeting the Kyoto targets. The United States has the luxury of starting over. The United States should use its market power more wisely by setting rules for price offsets according to quality, creating a system of buyer liability, and adopting other rules that will create stronger private incentives to identify and reward (with higher prices and better delivery terms) high quality projects. As such, U.S. rules could create a competition for quality rather than a race to the bottom. This is a hypothesis that merits some modeling effort since it suggests that the United States could have inordinate leverage on the quality of worldwide efforts to engage developing countries through the rules it sets in its home market. Fourth, the studies presented at this conference suggest that the offsets supply market will not be competi - tive. A few activities—forestry in Brazil and possibly Indonesia as well as the electric power sector in China—are likely to be the largest suppliers of offsets.81 All are dominated by government-owned corporations or government 81 The actual supply of forestry credits will depend on the combination of available forestry projects as well as the systems for administering those projects. Brazil combines large potential supply of such projects with decent public administration and could be the dominant supplier in forestry. In energy-related offsets, see Blanford (2010) for a striking set of supply curves suggesting that perhaps half of the supply of offset credits from developing countries would come from the Chinese electric sector. See also Victor (2009) for an argument why most of the non-electric activities in developing countries are much more difficult to include in crediting schemes—because monitoring of emissions and government control over the electric sector is usually much more decisive than in most other segments of the economy.

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 MODELING THE ECONOMICS OF GREENHOUSE GAS MITIGATION administrative bodies. The market is ripe for collusion, especially if demand for offset credits is strong and inelas - tic. Large purchasers of emission credits, notably the United States, can strengthen their hand by setting rules that encourage a diversity of supplies as well as safety valves that avoid the need to negotiate for offsets supplies from a position of weakness. Contingent offers of access to the U.S. offsets market could also create more elasticity and make it easier to negotiate with offset oligopolies. The Political Origins of International Offsets At its core, international climate diplomacy suffers from a problem of incompatible incentives. Some coun - tries, mainly in the industrialized world, are deeply worried about global warming and willing to spend their own resources (such as money, jobs, and political effort) to address the problem. Emissions from the enthusiastic nations are roughly flat; emissions from the more reluctant nations are growing like a weed. How can the enthusiastic nations convince the reluctant to change their behavior? Such problems are not new to international environmental diplomacy, and historically they have been solved by using carrots to realign incentives. In the Montreal Protocol on the Ozone Layer, notably, a large (about $5 billion to date) multilateral fund pays developing countries the “agreed incremental cost” of controlling their emissions. That big fund thus transformed a problem of incompatible incentives into one of compensation. And where com - pensation didn’t work the threat of coercion sat in the shadows. For developing countries that refused despite the generous offer, the Montreal Protocol threatened trade sanctions against ozone-depleting—a threat never carried out because the carrots were so effective.82 In global warming the stakes are a lot larger, and thus bigger carrots would be needed. That posed a huge problem for the diplomatic talks leading to the Kyoto Protocol; three solutions were explored. One solution would just pay the extra cost from a huge fund akin to the Montreal Protocol’s Multilateral Fund. A second would set emission targets for all nations and leave “headroom” for developing nations to sell extra credits and earn cash. These solutions were interesting to analysts but politically and practically impossible for real governments to adopt. A big government-to-government fund raised questions about whether governments really knew how to spend such resources, for cutting warming emissions was quite unlike the discrete technological projects involved in shifting away from ozone-depleting substances.83 Moreover, the sums would be huge—perhaps on the scale of $10 billion to $100 billion per year—which made theorists of international justice happy but politicians wince. 84 Much of that money would have gone to China, and even in the boom times of the late 1990s finding tens of bil - lions of public dollars for subsidizing economic competitors was an invitation to political suicide back at home. The “headroom” idea was equally impractical since all the developing countries abhorred targets. 85 And even if that toxic political problem could have been overcome there remained the practical difficulty of setting headroom targets for developing countries. Developing countries were averse to the economic costs of honoring strict targets and thus they would demand caps far above their highest emission scenario—thus assuring that under any scenario they would not be harmed by the cap. The resulting negotiations would have been “negative sum”—for every new country added to the negotiation the share of emissions left for industrialized countries would shrink faster than 82 See Parson (2003) and Benedick (1998) for histories of the ozone talks and the crucial role (among other factors) of the ozone layer fund. 83 The ozone fund was remarkably well administered, probably for two reasons. One is that administrative decisions were deferred to teams of experts (with modest political oversight), which would be hard to assure when much bigger amounts of money were at stake. The other is that projects were relatively easy to identify and technologies relatively easy to cost, and thus in practice it was not too onerous to agree on the meaning of “agreed incremental cost.” See de Sombre and Kaufman (1996). 84 It is hard to pin down exactly what scale of international transfer would be required, in part because that depends on the overall level of abatement. The scale of $10 billion annually is at the upper end of what was discussed in Kyoto and the $100 billion annual spend is written into the Copenhagen accord for the sum of public and private resource transfers by 2020. 85 In 1998 Argentina suggested setting a voluntary target for itself, in part because it was hosting the Conference of the Parties that year and wanted the event to be a success. Its action was pilloried by all other developing countries for breaking ranks and violating the maxim that developing countries don’t agree to targets. In the years since that maxim has thankfully eroded, but the wariness to setting binding targets—which is what would be required for a full blown emission trading scheme to operate—remains acute.

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 DAVID G. VICTOR the benefit of having a new negotiating partner.86 The Kyoto talks offered an instructive test of the negative sum theory. Russia was formally an industrialized nation and urged to accept a cap in Kyoto, but the nation was little worried about warming. The result was a cap identical to the highest emission scenario that Russian diplomats could imagine. Actual emissions from Russia, of course, were much lower, which gave the nation a huge surplus of “hot air” credits. If the Kyoto talks had had many more Russia’s sitting around the table the negative sum bargaining would have produced even more hot air. The NGOs called this “tropical hot air,” and they were right to oppose it. Analysts invented many clever schemes to solve the problem of tropical hot air, but none of them would work reliably in the real world and this strategy for engaging the reluctant developing countries would never work. With those other two options dead, the CDM emerged as a third option. It was a way to achieve (in theory) the economic advantages of global emission trading while avoiding the toxic problem of setting emission targets for developing countries. It was a way to encourage those countries to join on a volunteer basis—project by project—while avoiding the need for large government-to-government funds. The emergence of offsets in the U.S. policy debate has taken a very different track. It has originated through pressure from firms concerned about compliance costs and about the impact of U.S. regulations on economic competitiveness. Those are worthy concerns, but the U.S. debate has given strikingly little attention to how a large system of offsets will influence the willingness of developing countries to engage in mitigation of climate change. An offsets scheme such as the CDM isn’t the only way to engage developing countries. I have suggested some alternative answers that are based on the model of accession to the WTO—where complex accession deals engage reluctant countries rather than just payments of cash or credits (Victor, 2009). Over the last two administrations the U.S. government has pursued an approach that relies on bilateral deals with key developing countries—such as the U.S.-India nuclear partnership or the various U.S.-China deals on clean energy that are taking shape. The relationship between such ventures and the U.S. offsets market has remained strikingly vague. The conventional wisdom is that an offsets scheme will make it easier to engage developing countries because it will put more money on the table. The experience with the CDM suggests that exactly the opposite outcome may be unfolding. More money is available, but many of the offsets projects do not represent real reductions. Worse, the existence of an offsets scheme such as CDM creates perverse incentives. The problem in any such scheme is determination of the baseline against which offsets will be offered, and the experience with most offsets schemes— including the CDM—is that once the scheme is in place the baseline is endogenous. In gaming the baseline, host countries have strong incentives to avoid clear policies that would result in a lower emissions baseline. 87 A full-blown solution to this problem is beyond the scope of this essay, but such a solution is likely to involve at least two elements. One is a credible sunset for offsets. With a sunset provision—written into national law in the United States and other large purchasing countries, which will make it more difficult to roll back and thus more credible—it will be easier to avoid endogenous baselines because developing countries will know that they face the need to reduce emissions at their own expense over the long haul. Some preliminary modeling work that I have done with Valentina Bosetti suggests, in fact, that in a world where such policy signals have high credibility the result will be large efforts of self-financed emission reductions by developing countries (Bosetti and Victor, 2009). In tandem with the sunset is the need for a sunrise on credible sticks—ultimately, trade sanctions. So far, most of the U.S. debate about trade sanctions has focused only on the sticks, which has made such proposals particularly unwelcome overseas. (The lack of a credible U.S. policy to control its own emissions has also played a role.) But it is hard to see how a full-blown system of emission controls that includes all major economies and makes a serious dent in total world emissions will function without a complementary system for enforcement. 86 The ways that negative sum logic would unfold and why this spelled doom for global emission trading are detailed in Victor (2001). 87 There are ideas for solving such problems—such as negotiated baselines, standard international baselines, and such—but those approaches rarely work in practice because each host country’s situation is so different. It is hard to avoid the need to tailor baselines to each country—or even individual projects or sectors within countries. And it is hard to avoid the problem that plagues most systems based on complex counter- factuals, which is that administrators rarely have enough accurate information to set the baseline.

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 MODELING THE ECONOMICS OF GREENHOUSE GAS MITIGATION Design of Offsets In the ideal world, an offset scheme—like any performance-based instrument—should be designed to allow firms maximum flexibility to achieve the objective. A carbon offsets scheme should allow credit for any source of carbon reductions, leaving market participants to find the least costly way to meet that goal. The real political world is different. Markets channel resources that affect interests, and thus the design of offset rules is prone to become highly politicized. The most glaring example of political control over design in the CDM is the exclusion of nuclear power. That decision reflects that the best organized advocates for climate policy in the late 1990s when the CDM was taking shape also generally abhorred nuclear power. The nuclear industry was concentrated on other policies, less well organized and faced the particularly debilitating problem that the EU (which had emerged as the largest market for CDM credits once it was clear the United States would not join the Kyoto protocol) had decided it would not purchase any CDM credits from nuclear power projects. Such choices are hardly limited to nuclear power. Large hydro projects are all but banned from the CDM, although small hydro is a favored technology. Carbon capture and storage has struggled to gain approval even as renewable energy projects that are more costly, yield a lesser impact on emissions, and are probably not truly additional have readily earned CDM credits. From its formation, the CDM has been steeped in a particular vision of decarbonization based on small projects involving renewable energy and efficiency. Those projects are often the most costly way to decarbonize an energy system and they are particularly difficult to administer—a topic to which we turn in the next section. One sign that the political forces are wired in favor of such projects is the cur- rent effort to adopt special administrative rules to lower the administrative burdens for small projects and to allow “sectoral CDM” that would allow clusters of projects and policies to earn credits. None of these rules would be needed for crediting of large projects such as nuclear power, carbon storage, or efficiency upgrades at coal-fired power plants. It is hardly surprising that a scheme generating rents will be steered to the advantage of politically powerful groups. Analysts lament this because a more pure policy would give every comer an equal opportunity to earn credit for emission reductions. But in the real world that won’t happen—not just because some technologies have better organized interest groups but also because once the rents start flowing there are strong incentives for beneficiaries to remain well-organized and to block new types of emission projects from earning credit. My expectation is that the forestry community will soon learn this lesson. One of the few bright spots from the Copenhagen meeting was the adoption of the “REDD+” scheme. But if that scheme ultimately works by generating carbon credits that are fungible with emission credits earned under the CDM (so-called “CERs”) then success of REDD + will mean failure for other rent-seeking technologies. We should expect that CDM incumbents will soon be raising questions about the integrity of REDD+ investments and lobbying for rules that will lower the credits available from such activities. When creating new offsets systems, as in the United States, policy makers can fix these problems in two ways. First, they can create offsets schemes that allow all viable technologies to compete from the outset, which will reduce (but not eliminate) the flow of rents to hallowed projects and raise the odds that the offsets scheme will work like a real market. This seems like an obvious point, but it was a difficult point to apply when creating the CDM. U.S. policy makers should expect similar difficulties when they create a U.S. offsets scheme. U.S. policy makers should not underestimate the power of political interests that will try to control the rents that will flood into an attempt to torque the administration of an offsets system. Second, policy makers should not assume that offsets work best through monopoly. The Kyoto vision was for a single offsets market—the CDM—in part because that would yield the largest and most credible market. That choice has concentrated political fervor on the CDM and made it harder for the system to evolve because it faces no legitimate competition. A series of parallel markets could be better because that would allow for more experimentation and learning. Obviously some common floor standards would be needed to avoid the plague of Gresham’s Law. This kind of thinking has been abhorred in the diplomatic talks on global warming because the UN system does not welcome competition and because firms rightly fear the chaos of multiple standards. At this stage, however, a multiplicity of offsets schemes would be much more useful than a single system that is prone

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 DAVID G. VICTOR to gridlock. The United States has an opportunity, when it creates its own offsets scheme, to put this insight to work. For economic modelers, one implication is the need to look at scenarios where only certain technologies are eligible for offsets and where transaction costs vary with technology type. Looking beyond the exclusion of nuclear power in the CDM, the exclusion of certain options will play a large role in the use of CDM credits for advanced coal projects. Studies such as Blanford (2010) show the huge potential for reducing emissions from the power sector—notably through improved efficiency in the coal fleet. So far, however, no coal efficiency upgrades have ever gained CDM approval; some of the CDM’s most ardent supporters are also in the midst of a global campaign against coal. Despite compelling economics, the politics of awarding emission credits to coal upgrades (and the administrative challenge of determining which efficiency upgrades are truly additional) suggest that the CDM and other offsets schemes will find it difficult to include whole swaths of coal-related projects. As the economic model - ing community looks at possible designs for a U.S. offsets scheme it should look more closely at political economy scenarios that exclude coal, nuclear and other such projects. My guess is that the economics of offsets are a lot less attractive in those worlds, and that would be an important message to the designers of U.S. offsets systems. Administration and Additionality By far the biggest debates around offsets have concerned the question of additionality. Do offsets projects represent “genuine” reductions or are they just a shell game? I have worked on this question for a long time and am convinced that there are some offsets projects that are genuine but that the market is awash in bogus credits. 88 This is not simply a matter of fraud but is probably unavoidable once a decision has been made to deploy offsets as a policy instrument. Policy makers select offsets as a policy instrument when they are unable to regulate all pollution sources because such regulation would be politically or administratively impractical. 89 In this second- best setting, the task for administrators is never easy. They must obtain information about the hypothetical “true” investment patterns in the offset host and compare that counterfactual with actual investments. Offset credit is awarded for the difference. Analysts have known long ago—such as by studying the offset schemes under the 1977 Amendments to the Clean Air Act—that such schemes often sink under the weight and uncertainty of their administrative burdens.90 The administration of the CDM program has faced a nearly unsolvable problem: the counterfactual. Adminis - trators—which in the case of the CDM is a function divided between a central administrator (the CDM Executive Board) and supposedly independent verification agencies—must gather information that is essentially unobtain - able. The counterfactual can’t be measured, and for many projects it is nearly impossible even to estimate the counterfactual credibly. One standard approach for solving this problem is to calculate the financial return on a project in the absence of CDM credits and then compare that with the value of the credits. Other approaches have been tried as well— such as assigning standard baselines, which is attractive in theory yet nearly impossible to implement in the real world—but for most of the investments that are relevant to global warming it is hard to avoid an approach that relies on some form of financial counterfactual. And that approach suffers two fundamental flaws. First, an offsets system creates strong incentives for host governments to keep irrational policies in place. Put differently, a financial counterfactual makes policies in the host country endogenous to the CDM. If a host country behaves strategically it will pretend not to adopt policies that might otherwise make sense—for example, adopting incentives like local pollution mandates that encourage firms to switch away from high carbon fuels that also cause local pollution—because with offsets there is a large financial advantage to keeping old policies in place. When administrators of the offsets scheme don’t have perfect information on unobservable local prefer- 88 Wara and Victor (2008). Michael Wara and I are hardly the only people to work on this question. For others see, notably, Schneider (2007). 89 I will discuss this decision as a “second best” outcome, but there are some circumstances when case-by-case opt-in approaches are more efficient than attempting to include all emission sources. So far, international global warming diplomacy has not been dominated by those situations. Instead, the political forces for avoiding developing country caps have been the main factor at work. 90 Hahn and Hester (1989).

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 MODELING THE ECONOMICS OF GREENHOUSE GAS MITIGATION ences then the host country can get paid for the switch. Consider China, which has been particularly strategic in its policy behavior and not surprisingly is the largest world supplier of CDM offset credits. Late last year the CDM Executive Board rejected 10 Chinese wind projects (after a string of similar projects had earned approval) in part on the logic that Chinese wind policy had become endogenous to the CDM. 91 Some see the crackdown on these projects as evidence that the CDM administration can identify situations where local policy has become overly endogenous. If that were true then we should be encouraged that better administration is feasible such that only genuine projects are rewarded. In reality, the cats and the mice are both learning. The CDM Executive Board is in no better position today to identify such troubles than it was when it opened its doors for business. Over the long term local hosts will always have the advantage because policy endogeneity is nearly impossible to detect, and in countries where local policy is shrouded in opacity—which is often true when state enterprises with soft budget constraints play a large role in investment decisions, as is true in most developing country energy systems—it is particularly difficult for outsiders to determine the counterfactual. Second, financial additionality encourages investors and host countries to conspire in an effort to find invest - ments that look as irrational as possible. In many settings irrationality is just a fiction, for policies are endogenous. But often the real outcome includes a tinge (or more) of irrationality, which means that projects that earn support under the CDM do not scale or sustain themselves. Rather that offering a nudge down a different, lower-carbon development trajectory the CDM instead creates a dependency relationship that is hard to shake. These fundamental flaws suggest that any offsets system will include large numbers of bogus permits. My guess is that somewhere between one-third to two-thirds of the CDM pipeline fails the additionality test, although I must underscore that nobody knows the answer to this question and no amount of research probably will produce a robust answer since counterfactuals are impossible to observe.92 Put differently, linking a cap and trade system to a poorly administered offsets scheme is the carbon equivalent of Gresham’s law. It lets the players in the offsets market print money. Another implication is that the presence of an offsets scheme will create deeply perverse incentives for host countries and investors. Such troubles might be reduced with better administration, but what is striking in the U.S. policy debate is how little attention has been given to exactly how to administer a large offsets system (as envisioned in essentially all draft legislation working through Congress). This fact reflects that there isn’t much of a political constituency for strict administration. Firms that are worried about compliance with a national cap and trade system comprise an understandably strong constituency for generous offsets rules. Their keen interest in offsets might be dampened if, for example, a U.S. trading scheme included a price cap, which would dampen fears that compliance will be onerous and reduce the need to rely on international offsets as a cost control mechanism. (I favor such a price cap—for that reason and because a price-like instrument is a better way to slow global warming.) One of the puzzles in the CDM debate is why environmental groups have not been better organized to press for stricter administration. On this I can only speculate. One reason is that the gains from better administration are diffuse and abstract, and the cost of mobilizing to press for better administration are probably high. Moreover, a poorly administered CDM has channeled benefits to favored technologies—notably renewables and energy efficiency. Now that new industrial gas projects are coming to an end the next largest source of CDM credits is from renewable power projects. For U.S. policy makers this logic suggests that administration of an offsets scheme should be a bigger part of the policy debate. At present, all the main legislative proposals would vaguely delegate these functions to admin - istrative agencies, notably the EPA. Yet many of the administrative problems, such as the problem of baselines, are essentially unsolvable. Delegating them won’t fix that. I am particularly worried about two things. One is the inevitable fact that large numbers of bogus permits will be emerge and that will reduce confidence in the system. A second is the fact that EPA will be performing delegated functions—such as negotiating baselines—with near- monopoly suppliers, such as the Chinese electric sector. 91 Morse and He, 2010, “Making Carbon Offsets Work in the Developing World: Lessons from the Chinese Wind Controversy,” Program on Energy and Sustainable Development, Working Paper #90. 92 A big part of the answer depends on the accounting for industrial gas projects, which are an oddball feature of the CDM that I will ad - dress in the next section.

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 DAVID G. VICTOR There is no magical strategy for solving these problems. One starting point is clearer statutory guidance to EPA—including the power to adjust the size of the U.S. market that is linked to offsets, which would diminish the leverage of potential monopoly suppliers. Another, as mentioned above, is an explicit price cap so there are fewer pressures on the offsets scheme to provide a de facto price cap. The experience with the EU, where there is no meaningful price cap, suggests that international offsets, in practice, are an unreliable price cap because the exact timing of the crediting mechanism has been hard to predict; there is some evidence that the CDM may actually make prices more volatile. So far, my impression is that we have not had a serious debate about how an offsets scheme would be admin - istered. Draft legislation working through Congress sees a large role for offsets and defers administrative ques - tions until later and imagines that they can be solved. The few ideas for improving the quality of offsets, such as negotiated baselines, are unlikely to work. For example, one idea is to cap the quantity of offsets allowed inside the U.S. market. That approach, in theory, would limit exposure to poorly conceived offsets policy. In reality, it almost guarantees that the worst quality offsets will be used. 93 For modelers I suggest efforts on three fronts. First, more work is needed to look at compliance costs and efficacy when offsets schemes yield large numbers of bogus permits. Second, more work is needed to model transaction costs. I have already suggested that transaction costs probably vary by project type; other formulations, rooted in political economy, could be useful to explore as well. The transaction costs for first-of-a-kind projects are dramatically higher than successors, for example, and it might be useful to explore whether that is a strong deterrent to investors for certain types of projects. Overall, transaction costs could have high absolute values and in the early stages of international offset trading could be a large fraction of the total cost of securing offset credits. Third, there would be utility in looking at the bogus factor and transaction costs in tandem, for there may be a relationship akin to the Laffer curve that could be a useful guide for policy. With no administration and with highly aggressive administration the supply of genuine offsets is probably zero. In between is an interesting space that is prone to optimization, with the optimal choices depending probably on the prevailing value of credits. Market Dynamics In the middle 1990s as nations were crafting what became the Kyoto Protocol the prevailing view was that a global system of emission trading would be desirable. A single market with a single price would prevail. I have never subscribed to that view because I never understood why all countries would adopt policies that produced the same marginal effort (price). Moreover, the political and financial consequences of allowing carbon markets to equilibrate would be unmanageable. I also doubted that countries keen to spend large resources controlling emissions would tolerate unfettered links to countries whose willingness to pay was zero or negative. How would countries that had costly and well administered regulatory systems in place respond when a country with lax regulations flooded the global market? How would countries that adopted hybrid policies—for example, emission trading schemes connected to direct regulation or to price caps—integrate their national trading systems with nations that had different kinds of hybrids? As governments got serious about controlling emissions there was no reason to think that every nation would adopt the same national regulatory approach. Yet a global emission trad - ing market would require a large degree of commonality as well as exceptionally high confidence that all players were honoring the rules. One hiccup and the whole system could quickly crash. 94 93 Under the CDM nearly the entire pipeline for several years was filled with projects to reduce emissions from industrial gases. Such projects generated massive quantities of credits at very low cost and with dubious additionality—especially since the prospect of credits encouraged investors in industrial gas facilities to avoid using the latest technology so they could get paid with credits. More complex projects that would have represented more genuine additional efforts were squeezed from the market because they could not compete with the industrial projects that had tiny investment and transaction costs. Capping the use of offsets doesn’t fix administrative problems. 94 My skepticism was outlined in some detail in Victor (2001) and Victor et al. (2005). The former explained why global trading would never work as envisioned and the latter predicted the emergence of bottom-up fragmented trading systems due to the huge variation in national willingness to spend resources on climate change and ability to administer what is, in effect, a new form of money. Anyone who needed more evidence that common currencies only work when there is a massive alignment of interests and administration need look no further than the travails of the European Monetary Union and now the European common currency.

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0 MODELING THE ECONOMICS OF GREENHOUSE GAS MITIGATION The imagined ideal world of the Kyoto Protocol has not happened for more or less those reasons. Instead, the real world has evolved to produce highly fragmented carbon markets. Different rules govern different markets, and international trading is evolving very slowly and “bottom up.” That real world is a lot less efficient economically, but it exists because political and administrative decision-making rests mainly at the national level and nations differ wildly in their interests and capabilities. The fact of fragmented markets has important implications for international offsets because these credits could, in effect, become the trading hubs that integrate different national markets. 95 For policy makers this point suggests that offsets policy could become a central element of international strategy. At present, most of the discus - sion around international strategy focuses on diplomacy. But diplomacy, especially global diplomacy in the wake of the debacle at Copenhagen, is over-rated. Much more influential are facts on the ground, the draw of market forces, and real patterns of finance and investment. For the United States this creates a tremendous opportunity. If a U.S. offsets program sets the standard for quality then, through arbitrage, it can also set prices and quality for the global market. And if the United States avoids one of the central errors in the UN system—which has been to regulate offsets as a gatekeeper rather than creating price-based signals about offset quality—then it can also generate market forces that will use prices as a way to signal quality. 96 In effect, the United States can unilater- ally use its market power to set rules that will spread more widely. That would have the benefit of encouraging international offsets to “trade up” towards higher quality rather than “race to the bottom.” And it would put efforts to engage developing countries with payments—which was the original goal in crafting the CDM—on a footing that links those payments to real actions. For analysts, this line of thinking suggests two clusters of work that will be needed. One is to start modeling how offsets affect price formation in global carbon markets. That offsets would become pricing hubs is a likely outcome but hardly assured, and the capacity to model this would help guide U.S. policy on offsets. For example, policy makers might ask us how large an offsets pool is needed and what kinds of pricing rules would allow the United States to encourage a flight to quality driven by the U.S. market rules. These will be hard questions of immediate practical importance that can’t be answered without simulation. Carbon legislation in the United States that included offsets might include explicit instructions to administrators to perform such analyses so that the huge U.S. market is used as part of an explicit international strategy to encourage higher quality international regulation through offsets worldwide. A second area for analytical efforts concerns hybrid national regulations. For too long we have analyzed poli - cies that are convenient for models—such as global emission taxes or simple globally-integrated emission trading schemes—rather than policies that are convenient for politicians. Yet political convenience usually dominates in policy market. So far, the conventional wisdom is that political convenience favors emission trading. But upon close inspection the real outcome is likely to be what I have called “Potemkin trading,” which is emission trading that looks like your economics textbook on the surface yet behind the façade isn’t anything like a pure market. It is trading coupled to direct regulation, in part because many interest groups favor regulation as a way to diffuse and hide costs while channeling benefits to well-organized groups. Much of the regulation around renewable energy and energy efficiency in the United States takes this form, for example. Even in the EU, which has the world’s largest emission trading system, much of the real leverage on industrial emissions has come from regulatory standards rather than price incentives. And more than half of European emissions are excluded from the trading scheme in favor of direct regulation. As more countries look to auctioning emission credits even the presumption that emis - 95 There is a small but growing literature on this important question—variously called “docking,” “linkages” and “hubs.” See for example, Wagner et al (2009) and Jaffe and Stavins (2008). 96 I do not have space here to delve into the details on the errors of CDM administration, but the central point is that a rule of seller liability prevails. Thus once a methodology for generating CDM credits is approved then risk plummets. The result is that project brokers spend most of their efforts on gaining approval, which is what I am calling here the “gatekeeper” approach to administration, and ex post there is very little attention to project quality except in verifying that the project actually proceeds as approved in the methodology. And once credits are issued (which requires another gatekeeper step) buyers are essentially not liable for project performance. The enthusiasm for seller liability reflects a view, widely held especially as the CDM was taking shape, that buyers would avoid the market if they faced buyer risks. That view, I am suggesting here, is completely wrongheaded because it is buyers who have most of the power in the relationship and thus they need to face a price incentive to favor quality. Of course, there are risks to buyers and some of them are related to quality—for example, delivery risk—but the CDM administration has generally not aligned those risks and pricing mechanisms in a coherent manner.

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 DAVID G. VICTOR sion trading is politically favored will come under scrutiny as more firms look to taxes (or tax-regulation hybrids) because they offer easier ways to control regulatory exposure and channel rents. 97 Modelers probably should build the ability to analyze these real world policy outcomes—at least in a stylized fashion—because they suggest that emission caps and prices may not always be the binding constraint. When other constraints are more binding—for example, a strict renewable power standard coupled with emission trad - ing in the power sector—then emission markets will generate scarcity and surplus that bears no relationship to the underlying costs of abatement. If those markets are coupled internationally then the coupling mechanisms between markets—that is, international offsets—could come under severe stress. It may be useful to anticipate that stress so that governments that want to preserve high quality efforts to regulate emissions have a sense of when and how to intervene. Conclusions For too long we have looked at international offsets as a technical matter. This essay suggests that they lie at the center of global warming politics. Moreover, the political forces, although complicated, are amenable to some simple analysis and prediction. Those predictions can help policy makers design better international offsets markets, and demand for those designs may be acute in the next few years as the United States devises its green - house gas regulatory program. They can also help analysts develop models and scenarios that allow scrutiny of politically realistic outcomes. The largest international offsets market, the CDM, has not worked well. Yet it survives and has proven difficult to reform because the CDM rests on two political choices. One was the need to engage developing countries with a scheme that generates reliable income flows. The other was the need to dampen fears in the countries and firms that undertake the most aggressive regulatory efforts at home that costs will not spiral out of control. The political pressures that inspired the CDM also help explain the resistance to reform. There are powerful and well-organized constituencies that thrive on the rents that flow from the CDM. The constituency that would have been most likely to press for a better administered system has also found reform inconvenient because the CDM channels resources to a particular cluster of technologies and excludes technologies, such as nuclear power, that these groups abhor. The U.S. international offsets rules are still virgin territory, but it is hard to believe that they will not come under similar pressures. Some careful analytical work on those political pressures and attention to mitigating them will be essential lest the U.S. scheme follow the similar, tortured path of the CDM. References Benedick, Richard E. (1998) Ozone Diplomacy: New Directions in Safeguarding the Planet. 2nd edition. Cambridge, MA: Harvard Univ. Press. Blanford, Geoffrey (2010). “International Offsets: The Potential Role of the Energy Sector,” Presentation at the National Academy of Science Workshop on Assessing the Economic Impacts of Climate Change. April 15-16, 2010. Washington, DC. Congressional Budget Office (2009). “Congressional Budget Office Cost Estimate: H.R. 2454 American Clean Energy and Security Act of 2009, As ordered reported by the House Committee on Energy and Commerce on May, 21, 2009.” DeSombre, Elizabeth R. and Joanne Kauffman (1996) “The Montreal Protocol Multilateral Fund: Partial Success Story.” In Institutions for Environmental Aid. Eds. Robert O. Keohane and Marc A. Levy. (Cambridge, MA: MIT Press). Environmental Protection Agency (2009). “EPA Analysis of the American Clean Energy and Security Act of 2009 H.R. 2454 in the 111th Congress.” (Washington: EPA). Fawcett, Allen A. (2010). “International Offsets Usage in Proposed U.S. Climate Change Legislation,” Paper prepared for the National Academy of Science Workshop on Assessing the Economic Impacts of Climate Change. April 15-16, 2010. Washington, DC. Hahn, Robert and Gordon Hester (1989). “Where did All the Markets Go? An Analysis of EPA’s Emissions Trading Program,” Yale Journal of Regulation vol. 6, 109-153. Jaffe, Judson, and Robert N. Stavins. (2008). “Linkage of Tradable Permit Systems in International Climate Policy Architecture.” Discussion Paper 08-07. Belfer Center for Science and International Affairs. Harvard Kennedy School of Government. Sept. 2008. Paltsev, S., J.M. Reilly, H.D. Jacoby and J.F. Morris. 2009. “The Cost of Climate Policy in the United States,” MIT Joint Program on the Sci - ence and Policy of Global Change, Report 173. 97 For more on Potemkin markets see Victor (2009b).

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