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Volatility in the price of emissions allowances is one of the biggest concerns surrounding U.S. greenhouse gas cap-and-trade proposals. To counter this problem, a number of provisions are being considered to increase flexibility and stabilize costs.
One option under consideration is offsets, which allow regulated firms to meet emissions requirements by paying unregulated sources to abate (cut emissions). Recently introduced U.S. cap-and-trade legislation allows regulated entities to cover as much as one-third of their emissions with offsets. However, the behavior of such markets is largely unstudied.
In a new discussion paper (DP 10-01), “Climate Policy Design with Correlated Uncertainties in Offset Supply and Abatement Cost,” RFF researchers Harrison Fell, Dallas Burtraw, Richard D. Morgenstern, and Karen L. Palmer assess the effects of heavy reliance on offsets and how best to control costs, in particular with a price collar (a floor and ceiling for allowance prices).
This paper builds on previous work by Fell and Morgenstern in “Alternative Approaches to Cost Containment in a Cap-and-Trade System.” They found that the inclusion of borrowing provisions and a price collar could greatly reduce cost uncertainty.
Although intended as a low-cost emissions reduction mechanism, uncertainty surrounding offset markets is high. For example it’s possible that the price for offsets will increase during the times they are most needed. This is because when the economy is good, the opportunity cost for exempted firms to reduce their emissions is higher.
Interestingly, the authors find that without price limitations, the uncertainty in allowance prices in a trading system could be greater with the inclusion of offsets than without them. This suggests that offsets and price collars shouldn’t be considered as interchangeable parts, but as complementary.
Further, the paper finds that a price collar can significantly reduce uncertainty, while only slightly increasing expected emissions over a no-collar policy. The authors suggest that future research could examine more realistic offset purchasing scenarios and the effects of international competition.