Policy commentary

RFF Policy Commentary Series

Jul 27, 2012 | Daniel F. Morris, Harrison Fell
When the clock strikes midnight on December 31, 2012, California’s carbon cap-and-trade system, established under the state’s Global Warming Solutions Act (Assembly Bill 32, or AB 32), will be open for business. The start date is one of the few existing certainties for what will be the largest emissions allowance market in the western hemisphere.

The California Air Resources Board (ARB) has worked to design the carbon market to operate as smoothly and efficiently as possible, taking lessons learned from existing carbon trading programs such as the European Union Emissions Trading System (EU ETS) and the Regional Greenhouse Gas Initiative (RGGI), as well as from offset-supply programs such as the Clean Development Mechanism (CDM). The result is a market that attempts to balance the uncertainty of compliance costs and allowance price fluctuations with the assurance that emissions targets are met. Achieving this balance will be tricky, but California has a few notable tools, including an allowance price collar, emissions credit banking, linkages with other GHG reduction programs, and, in particular, the inclusion of approved carbon offsets.

Offsets (emissions reductions made in order to compensate for emissions elsewhere) are a critical cost-containment component of the California cap-and-trade program as they effectively increase the supply of compliance options. They will play a prominent role in the California market—regulated parties can use offsets for up to eight percent of their compliance burden. And yet, offsets continue to generate controversy among stakeholders.

Opponents claim offsets will not create actual emissions reductions. To ease this concern, ARB will review each offset project to verify the emissions reductions. If the offset project did not create meaningful emissions reductions, those credited reductions must be replaced.

This has raised another point of contention: Who is responsible for making up the emissions reductions from invalidated offsets? ARB has put this responsibility on firms purchasing offsets—a buyer liability rule. Firms holding an invalidated credit must replace that credit to remain in compliance. This approach contrasts with methods adopted elsewhere. Quebec, for example, will instead maintain a state-run buffer pool of offsets to replace those invalidated.

Industry and offset advocates are unsurprisingly opposed to the state’s rule. They argue that buyer liability will put costly burdens on them and reduce the liquidity of the entire market. Emitters, the argument goes, are not offset developers, so they lack the resources and expertise to evaluate offset quality. If the state is confident in its certification process for offsets, industry argues, it should stand by that process by assuming liability for bad offsets. Indeed, the protocols approved by ARB for initial offset certification are among the strictest requirements in any current carbon market, and such stringency likely will drive up the cost of developing offsets. State officials counter that opponents of buyer liability are just trying to shift costs onto the state.

Regardless of where liability lies, the possibility of invalidations should force marginal (low quality or high uncertainty) offsets out of the market. Limiting offset supply reduces cost-saving opportunities and increases overall program costs. The fundamental question underlying this debate is whether offset buyers or the state are better equipped to evaluate offset quality and deal with potential invalidation at least cost.

Buyer Liability

If buyers are liable for bad offsets, they can protect themselves. Below are several possible options.

Risk Discount: Offsets are riskier than standard emissions allowances because they can be invalidated. Therefore, we would expect offsets to trade at a discount to emissions allowances. The discount on offsets passes some of cost associated with the invalidation risk on to offset sellers.

Self-Maintained Buffer (Physical or Financial): Offset buyers could protect themselves against invalidation by building and keeping a pool of verified offsets for insurance rather than compliance. Similarly, buyers could require collateral against offset invalidation—at least one likely offset buyer, Pacific Gas and Electric, has indicated it will do so.

Banking: AB 32 allows regulated firms to exceed their compliance burden by achieving additional emissions reductions now, then “banking” allowances for use in the future. Firms typically bank allowances to minimize their costs over the total life of the regulation and insure against unanticipated high abatement costs in the future. (The invalidation of a firm’s offsets is essentially an abatement cost shock.) Therefore, we might expect firms to bank more allowances if they are liable for invalidated offsets.

Insurance: Offset buyers could obtain private insurance to protect against losses from invalidated offsets. Opponents of buyer liability argue that offset insurance would likely be very expensive, especially given regulatory uncertainty around offset provisions, the unknown permanence of a given cap-and-trade program, and the lack of an existing market. Advocates counter that the market will develop along with the cap-and-trade market due to demand. It’s unclear who is right.

State Liability

If, instead, the state were liable for invalid offsets, it could presumably deal with offset risk in some of the same ways as firms could under buyer liability, with some additional options.

Maintained Buffer: Just like buyers, the state could set aside a portion of offsets to be used in case of reversals or invalidations. Such regulator buffers are common: they will be part of Quebec’s cap-and-trade system, and California included a Forest Buffer Account in AB 32 to protect against unintentional reversals of forestry offsets (for example, losses from fires, disease, or pests). This buffer account could be expanded to non-forest offsets.

Emissions Cap Haircut: When the annual emissions cap is set, the state could claim some portion of allowances and hold them in case of invalidation, an approach known in wonky parlance as a “haircut” for the cap. The haircut would force all actors in the market to cover the liability indirectly, regardless of their use of offsets, because the reduced supply of allowances will drive credit prices up. This approach would therefore reduce some of the cost savings provided by offsets.

Insurance: Also like regulated firms, California could buy private insurance against losses. The same challenges remain for developing a functional insurance market, with some potential benefits and complications. As the only purchaser of insurance, California would have some bargaining power for getting beneficial rates. But, if insurance companies are reticent to enter the market for private firms, they may feel even less protected when the state is the only player in the game.

The Reality of Costs

Although many of the actions available to deal with liability may be the same for the state and for offset purchasers, overall costs might be different.

Buyer liability provides incentives for private industry to innovate, creating contract structures and financial instruments to deal with invalidation risk. Although firms claim that the state is in a better position to assess the quality of a given offset project, it may not always be—the market may eventually be better able to determine the acceptable level of uncertainty than the state.

The state may have an advantage, however, in dealing with liability because of economies of scale and investments that the state will have to make regardless of the liability regime. For instance, as the party that issues offset protocols and judges offsets before they enter the market, the state will already have invested in determining offset quality, and may have true informational advantages over purchasing firms. If buffer stocks or third-party insurance are used to insure against possible offset invalidations, the state may be able to take advantage of economies of scale and/or monopsony power to keep costs down. Also, by taking on the liability itself, California might improve the liquidity of the secondary offset market, which would, in turn, lower the cost associated with holding an offset.

Despite complaints, the AB 32 buyer-liability ship appears to have sailed. ARB has reiterated that it is sticking with its decision to place liability on the buyers. Although California might be able to address offset risk more cheaply than industry, the state’s fiscal situation is likely a key factor in its decision. Were it to take on the liability itself, it would incur the additional costs of developing, administrating, and sustaining the liability mechanism in whatever form it selected. Rather than take on the burden of offset insurance options, California is putting the onus on the carbon market to develop the best way to account for invalidated offsets. How the market responds will help determine the future and robustness of offsets as an effective cost-containment mechanism for California’s efforts to reduce greenhouse gas emissions and also will shed light on the costs of dealing with the inherently uncertain nature of offsets.

Daniel Morris is a center fellow at Resources for the Future’s Center for Climate and Electricity Policy. Harrison Fell is an assistant professor at the Colorado School of Mines.

Further Reading

Mignone, B.K., M.D. Hurteau, Y. Chen, and B. Sohngen. 2009. Carbon Offsets, Reversal Risk and US Climate Policy. Carbon Balance and Management 4:3. http://www.cbmjournal.com/content/4/1/3.

Halbritter, K.S., and M. Ohndorf. 2012. Optimal Liability Apportionment in Programmatic Credit-Based Emissions Trading. Climate Policy 12: 440–452.