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Are offsets market based instruments? An information perspective

This week I participated in a series of interviews with the GAO on a new report they are preparing in implementing compliance grade offset programs (for those that are interested, the GAO has prepared excellent surveys of voluntary offset programs and of the international carbon market). Aside from wondering why they are spending (my and your) tax dollars on this issue given the political realities, the interviews sparked some new thoughts for me on offsets.

Analyses I have compiled for Congressional testimony indicate that scaling a Clean Development Mechanism-like structure to meet the demands of a US cap-and-trade system along the lines envisioned in the Waxman-Markey legislation would require at least ten times the generation rate of offsets and likely far more in terms of the regulatory effort involved. In other words, a very heavy lift for an agency and the likely the largest administrative cost of a cap-and-trade system.

This is true because the average size of offset projects in the CDM is biased by a small number of very large projects (HFC-23 and N2O) that tend to minimize the regulatory burden of issuing lots of credits. That market structure would be unlikely to exist within the US, because those projects are under the cap, or outside of it, because they are already offset projects and what is left is smaller scale. All that means a much greater regulatory burden for whoever is overseeing the supply of US offsets (EPA, the USDA, or the CDM EB).

Cap-and-trade programs appear to exhibit increasing returns to scale along the margin of regulatory effort or burden while offset programs do not. Ask yourself how many more FTEs at EPA would be needed to expand the acid rain trading program from the mid-west and eastern states to the nation as a whole. The answer is not very many at all – this cap-and-trade is administered mostly via computer networks and continuous emissions monitoring devices. But imagine a regional expansion of the same sort for an offsets program – a doubling of the emissions sources that could supply offsets would likely require an approximate doubling of administrative resources devoted to oversight on issues like baselines and additionality.

Cap-and-trade markets create strong incentives to disclose information and then utilizee a market to aggregate these disclosures into a marginal abatement cost, aka allowance price. What is increasingly clear about offset markets is that they create strong incentives for emitters to either misinform or withhold information from regulators – both in order to inflate the baseline emissions against which project performance is judged and credited. This “hide the ball” type of behavior observed in offset systems like the CDM is very similar to that engaged in by firms subject to more traditional “command-and-control” types of regulation.

Two points, one policy relevant, one conceptual emerge from this line of thinking:

Policy relevant: It isn’t obvious that an agency will realize cost-savings from a cap-and-trade if most compliance occurs via offsets. What may instead occur is a displacement of regulatory effort from capped sectors to uncapped ones. This may result in actual waste of agency resources because the system now requires monitoring of both capped and uncapped emissions.

Conceptual: Maybe the appropriate definition of a “market based” regulation is one that creates information disclosure and aggregation incentives rather than one that utilizes market-like structures to achieve compliance.

An important caveat: it remains to be seen how so-called “standardized baseline” approaches, akin to those adopted by the Climate Action Reserve, will perform as they scale. The proponents of these systems chief argument in they favor is that they minimize both agency resources and project developer transaction costs per ton of offset generated. The key question will be whether they can do so while insuring environmental quality in a diverse set of sectors and jurisdictional settings.

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