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Offsets We Can Trust

An Interview With David Hayes on How to Get Carbon Offsets Right

Coal plant smoke stack SOURCE: NREL Provisions in the Lieberman-Warner bill would allow companies to meet some of their emissions targets by purchasing “offset” credits from reductions in emissions not covered under cap-and-trade. But current offsets markets are unregulated and unreliable. Hayes explains how to regulate offsets that will enable verifiable emissions cuts.
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Despite the good intentions of companies and individuals who want to reduce their carbon footprints, carbon offsets have earned a bad reputation. The current voluntary market for offsets is unregulated; consumers have few ways of verifying the promised reductions of the projects in which they invest; and some offsets simply channel funds into projects that are ineffective or would have happened without the money from offsets. But under cap-and-trade, argues David Hayes in a new paper, “Getting Credit for Going Green: Making Sense of Carbon ‘Offsets’ in a Carbon-Constrained World,” the federal government has the opportunity to regulate the offset market in order to create a program that quantifies, certifies, and verifies emissions reductions from qualified projects.

A Two-Tiered Approach to Carbon Offsets

(Excerpted from “Getting Credit for Going Green”)
Compliance credits and carbon reduction programs together would expand the range of tools to reduce greenhouse gases under a Climate Change Incentives Program

Tier I: the Compliance Credit Program
The first tier of the Climate Change Incentives Program would establish a market-based incentive program to invest in high-quality emissions reductions projects from otherwise non-regulated sources of greenhouse gases pollution. Reductions that meet stringent requirements—including additionality, measurement, verification, and permanence requirements—would count as compliance credits that could be bought and sold in the carbon market and used like carbon allowances under a mandatory cap-and-trade system to satisfy companies’ emissions reductions requirements.

Because companies required to operate under a mandatory carbon cap-and-trade system could use these compliance credits to demonstrate compliance with emissions reduction requirements, the credits would have a market value that provides a strong financial incentive for investment in projects that generate such credits. Compliance credits will function as carbon offsets, but because they include these special features, they should not be tagged with the ambiguous moniker “offsets.” Instead, they should be called compliance credits, a more accurate and descriptive term.

Tier II: Targeted Carbon Reduction Program

Currently, a number of federal and state programs provide financial incentives that have the intent, or the effect, of reducing carbon emissions from unregulated sources. Many more are under active consideration at all levels of government. Tier II of the Climate Change Incentive Program would direct the Environmental Protection Agency to identify and catalogue all existing carbon reduction financial incentive programs at the federal level and refer collectively to these initiatives as part of the Targeted Carbon Reduction Program that reduces carbon emissions. Tier II programs would include a wide variety of initiatives, many of which are programmatic in nature, such as tax incentives for the purchase of high-mileage automobiles, direct financial assistance for home-based energy efficiency projects, and tax credits for installing solar panels.

Under the Targeted Carbon Reduction Program, EPA would be charged with estimating emissions reductions that are generated from federally supported financial incentive programs and 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. Some Tier II programs may qualify, over time, for Tier I Compliance Credits. Thus, Tier II may help to “incubate,” and provide a track record for, projects or programs that ultimately qualify for Tier I compliance credits.

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.

Hayes is careful to warn that the primary “motor” in an effective emissions reductions framework is cap-and-trade; offsets are just the “grease” on the fringes of the system. In his proposal, companies regulated under cap-and-trade would only be allowed to meet up to 15 percent of their emissions allowance with “offsets.” These strictly regulated “compliance credits” would form Tier I of Hayes’s proposed system. Funds used to purchase “compliance credits” would support verifiable emissions reductions projects that would not have otherwise happened. The program would also include incentives for Tier II projects that do not meet the strict rules for “compliance credits.” These Tier II projects could, for example, encourage energy efficiency or improved forestry and agricultural projects. While these secondary programs would not be eligible for support from purchases of “compliance credits,” Tier II could serve as an incubator for projects that might eventually meet the strict regulations to qualify for Tier I status. Voluntary markets for offsets could continue to exist alongside this regulated framework, as they do in the European Union, he says.

Science Progress spoke with Hayes about the possibilities for rethinking offsets and ensuring that they both reduce emissions and fund new technologies that will support a low-carbon economy. This interview has been edited and condensed.

Andrew Plemmons Pratt, Science Progress: You see a problem with the word “offset” itself and you argue in your paper that the term has been used so loosely, “as to have virtually no meaning.” Instead you suggest that the term “compliance credit” would be better. What would “compliance credit” provide that the current conception of “offsets” does not?

David Hayes: Right now, the concept of offsets in the United States is completely unregulated. There are many organizations that will sell you, as an individual, something they call a carbon offset. That’s very attractive to many individuals and businesses because they are interested in counterbalancing their carbon footprint and they need help. There are obviously things individuals can do to reduce their carbon footprint in terms of buying more efficient automobiles and reducing energy use at home, etc. But there is no getting around the fact that individuals and business typically cannot get to zero without investing in an outside project that will remove carbon that would otherwise go into the atmosphere.

Entrepreneurs and many well-meaning organizations have responded by selling carbon “offsets” that purportedly have been created through investments in unrequired reductions of carbon emissions, but the offset market is unregulated and there are significant questions about whether many of the offsets that are being sold in the marketplace have environmental integrity and are in fact reducing carbon in a way that otherwise would not occur without the purchase of offsets. So “offsets” is a slippery and almost meaningless term.

“Compliance credits” are a special type of offset, if you will, that would come into play in connection with adoption of a mandatory cap-and-trade program. It would be fundamentally different from today’s offsets because unlike today’s unregulated environment, a compliance offset would only be approved if it met stringent standards established and policed by the EPA.

SP: How would compliance credits work for an individual company under cap and trade?

Hayes: Let me provide you with a little more context first. The idea of a cap-and-trade system is that most greenhouse gas emissions would be capped and regulated. There would be a limit on most sources of greenhouse gases. Over time that cap would be shrunk and the limits would become tighter and that’s how we would reduce, over time, our carbon emissions. But as a practical matter, we are not going to be able to capture all emission sources under a cap-and-trade system. There will remain a significant number of emission sources—maybe 20 percent of the total—that are unregulated under cap-and-trade. The concept of an “offset,” in this new system, is that we provide an incentive to reduce emissions from these otherwise unregulated sources. Some projects that reduce these unregulated sources may be of a high enough quality, and enforceable with enough assurance, that they can be used to demonstrate an emissions reduction by the regulated entities that have responsibilities to reduce their emissions. That’s what a compliance credit is all about. Offsets are a fundamentally different construct when you have a mandatory cap-and-trade system. Instead of just opening up a bazaar for the sale of unregulated offsets, there is a policy goal of seeing if we can incentivize reductions in those emissions sources that are not covered by the cap.

SP: Some of the industries that would fall under the cap-and-trade regulation might be power plants. If, for instance, I was operating a power plant, could you walk through the process of how I would be able to function under a cap-and-trade system, account for some of those emissions using compliance credits, and what kind of projects those compliance credits might support?

Hayes: If you operate a power plant you are going to need to obtain allowances that will match your emissions. The allowances will be in the form of a right to emit carbon dioxide in the amount at which you are emitting it. And there will be a number of mechanisms that you can use to obtain these allowances. You will likely need to purchase some allowances, probably through an auction. (In fact, most of the allowances will likely be purchased in this way.) Also, if you make investments and reduce your emissions more than you are required to under the cap, you may generate excess allowances. And if you don’t need them, you’re going to be able to sell them to another power plant. That’s the “trade” part of cap-and-trade.

Another source of some allowances will be, under my scheme, compliance credits–that is, proven reductions of carbon obtained from unregulated sources. Those credits can be purchased by the power plant to help meet a part of its budget for allowances. Under my proposal and the Lieberman-Warner proposal, there is a limit of 15 percent on how much of the budget can be met through these compliance credits. That limitation is intended to ensure that compliance credits are the “tail” and not the “dog.” The primary focus of cap-and-trade has to be on major emission sources making investments in their own reductions.

SP: The compliance credits emitters invest in might be going to projects of different sorts, and you’re very careful to explain in your paper that not all emission-reducing projects are created equal. This is why some would fall under the strict rules of your compliance credits. You point out that measuring emissions from different projects—particularly in forestry and agriculture—can be difficult, making it hard to verify their impact. Could you talk a little bit more about the importance of splitting credits between Tier I compliance credits and Tier II projects?

Hayes: This is a very important concept. We should be interested in capping major emission sources and reducing those emissions in a regulated way. But we should also give attention to unregulated emission sources, and that’s where the compliance credit idea fits. We should provide a range of incentives to reduce those emission sources that are otherwise unregulated. Compliance credits are sort of the “gold standard”; they are going to be the surefire, verifiable projects that everyone is so confident are providing new emissions reductions that we are comfortable using them for regulated compliance purposes. But there are lots of other incentives we can provide to reduce emissions from unregulated sources.

We have a lot of those incentives in place already. There are incentives for you and me to buy a Prius. There are lots of programs at the state and local level to encourage folks to reduce electricity use or weatherize their homes. I think it’s important that we recognize—and this is what I call Tier II—that there are a basket of incentives already in place to reduce emissions that are otherwise unregulated. We should identify those incentives; we should have a disciplined way to see how they are working; to see how cost effective they are; and doing so will provide a number of benefits. It will help us decide which of these incentives is working best. It will give us more information about emissions from these sources that are otherwise unregulated, and in some cases, it may identify real opportunities for major emission reductions that should qualify for a Tier I compliance credit. The other advantage of thinking about Tier I and Tier II together is that it takes some of the pressure off of forcing projects into Tier I—the gold standard compliance credit. If you don’t have a suite of incentives, then there is enormous pressure for projects that shouldn’t qualify for compliance credits to get pushed into qualifying. Either you get the pot of gold and you create a project that reduces carbon in a way that meets these tests and has real value on the carbon market, or you are left with nothing. That sort of stark, on/off switch can lead to a lack of discipline in how compliance credits are awarded.

In agriculture and forestry in particular, there are special challenges just in terms of the science, with regard to how you measure reductions of carbon. I do not think that all agriculture and forestry projects have to be in Tier II and can only be incentivized through means other than compliance credits. Some projects should qualify for compliance credits. The challenges in measurement and other issues (additionality and “leakage”) are going to have to be confronted and addressed, however. It’s just going to be harder for agriculture and forestry to meet the compliance credit test. For agriculture and forestry and other unregulated sectors, we should look at the whole suite of incentives and apply those that make the most sense.

SP: How would a well-regulated program change the current voluntary retail market for carbon offsets that consumers buy to counterbalance emissions from plane travel, commuting, or home energy use? You suggest in your paper that this voluntary market for offsets could still exist even under a cap-and-trade regime but that a retail market might also need to fall under the Federal Trade Commission. Can you talk a little bit about how that voluntary market for offsets could still exist with more regulation for these compliance credits?

Hayes: One might think that the voluntary market would evaporate once you have a comprehensive cap-and-trade system in place because much of the voluntary market is taken up by companies that recognize they are going to have compliance obligations and are putting their toe in the water and trying to hedge their carbon risk. Once you have a full cap-and-trade system, those companies will be covered by the system and their path will be clear in terms of what their obligations are, so there will be less impetus for their participation in the voluntary offset market. But I’m persuaded—from my work at Stanford and also the experience in Europe where a voluntary market continues to thrive along side the mandatory Kyoto market—that there is enough interest in making investments in projects that may produce carbon reductions that the voluntary market will continue in the shadow of a mandatory cap-and-trade program. And, in my view, the voluntary market should be allowed to continue to operate as long as there are willing buyers and sellers that are experimenting and developing ideas for additional carbon reduction projects that later might mature into something that has regulatory significance. All the power to them! What we don’t want is for the ordinary citizen to be left to the vagaries of an unregulated, voluntary offset market. There are two ways to address this.

The first way is to provide access so that you and I can buy these compliance credits that are the gold standard—regulated, proven reductions—that a regulated entity can purchase and use for compliance purposes. Individuals and businesses should also be able to purchase those credits and retire them. Given that opportunity, individuals who buy these credits will know that they are investing in a project that has real carbon benefits. These credits will be more expensive than what they would buy on the unregulated voluntary market, but they will know that they’re getting what they are paying for. The other point is that if there is a voluntary market that continues—and I think there should be—there needs to be more regulatory oversight by the Federal Trade Commission so that there is no fraud or misrepresentation in connection with the sale of offsets in the voluntary market. Responsible individuals and businesses that are interested in purchasing carbon “offsets” should be sure they are getting what they pay for.

SP: What about the Lieberman-Warner bill itself? What are the prospects for a system like this getting incorporated into the final version of that legislation and why precisely should offsets, and this new thinking about offsets, take regulatory priority upon the eventual enactment of a successful bill?

Hayes: I don’t think that offsets should take regulatory priority. Offsets are grease; they are not the motor. The motor is the cap and the mandated reductions under the cap, the auction of allowances. The offset concept kicks in at the margin. That doesn’t mean that it’s not important, however. Compliance credits and other incentive programs under Tier II can provide an important complement to the mandatory cap-and-trade program by focusing on, and helping to reduce, otherwise-unregulated emissions sources.

I do think it’s important that when legislation is passed that we get on with the task of identifying standards and protocols for projects that meet compliance credit standards because investors are interested in investing in projects that qualify. The EPA needs to get on it. It’s very unfortunate that the current EPA isn’t well down the road in terms of doing this. They have been held back by the policy decisions of the Bush administration.

The Lieberman-Warner bill that was introduced in the fall has an offset title in it that has some features of the program that I am laying out in more detail. As for the prospects of Lieberman-Warner this year, that’s a bigger question that is certainly is not going to turn on the question of how offsets are addressed. I certainly hope that legislation moves. Even if it doesn’t, I think the debate in the next few months is extremely important because it will establish the base line of sensible legislation that I hope will move very quickly when a new president is elected.

SP: It’s obviously a complex issue. What should we be sure to take away?

Hayes: The primary point that I would like to get across is that it’s difficult but very important to change the negative perception that many have about offsets. The bias against offsets is understandable, given the unregulated way that they are now dealt with. It’s tough to do that 180 turn and to look at the world in a different way. But the world is going to be very different when we have a mandatory cap-and-trade system. In that context there is a place for compliance credits and for a broader incentive structure to deal with these unregulated emission sources. So I’m proselytizing and looking for converts, asking folks to be nimble in their thinking and to be willing to shed their understandable bias against offsets because we are talking about a very different context and a very different regulatory world.

David Hayes served as Consulting Professor at Stanford University’s Woods Institute for the Environment. He is a partner at Latham & Watkins, a Senior Fellow at the World Wildlife Fund, and a Senior Fellow at the Progressive Policy Institute.

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