Offsets and Copenhagen . . .

As this year unfolds, most industry groups are turning their mind towards Copenhagen and the position they should take and they are running seminars for their members to help them understand what is happening. In addition, as the US starts to draw up the final (!!??) design of its cap-and-trade system, it cannot be oblivious to the shape of a future international agreement.

I was involved directly and indirectly in all such aspects this week. On Thursday I presented the Shell view of the key elements of the design required from Copenhagen to VNO-NCW (The Confederation of Netherlands Industry and Employers), on Friday I was at a meeting of the European Round Table of Industrialists in which the position that organisation should adopt for Copenhagen was discussed. Again on Friday a colleague in Shell Trading presented our position on cap-and-trade offsets at a Pew Center organised seminar on Capitol Hill.

The common link here that warrants further discussion (in this and future postings) is the role of international offsets in domestic cap-and-trade systems. This might seem somewhat arcane, but the implementation of this is pivotal to a successful international agreement. So first of all, a paragraph of background (some may wish to skip this bit in italics).

An offset in a cap-and-trade system is carbon instrument that can be obtained outside the capped sectors and used for compliance under the cap. These are typically generated by executing, outside the cap, a project that reduces emissions and having that reduction certified as valid. The best example of this practice is the Clean Development Mechanism (CDM) of the Kyoto Protocol. The CDM allows emission-reduction (or emission removal) projects in developing countries to earn certified emission reduction (CER) credits, each equivalent to one tonne of CO2. These CERs can be traded and sold, and used by industrialized countries to meet a part of their emission reduction targets under the protocol.

There are two reasons that I can see for having offsets;

  1. As a mechanism to contain costs within the cap-and-trade system by offering an additional supply of compliance instruments (“credits“) over and above those issued by the government.
  2. As a mechanism to project the cost of carbon that exists within the cap-and-trade system to sectors outside the cap, such that they see it as an opportunity on which to act. The offset is effectively a proxy for the price of carbon that would exist had that sector also been covered –  possibly as a pre-cursor to real cap-and-trade being implemented.

Whilst I find that most people agree on this, divergence of opinion then occurs. Some see offsets as a route to low-cost reductions that aren’t available within the cap-and-trade system. At the same time, others complain about the ease with which reductions can be generated through CDM projects and then imported to Europe (into the EU-ETS) at higher prevailing prices, effectively arbitraging the system. So why should we have international offsets and how should the international offset system be designed?

First of all, let’s not forget that cap-and-trade is designed to put a market price on CO2 emissions and to therefore incentivise projects that reduce emissions. If we look at this from the perspecive of an abatement curve, the cap-and-trade system is designed to operate on the left hand side where a price for CO2 is actually needed – such as for carbon capture and storage, which would never be implemented without a price for CO2. Looking at the image below, cap-and-trade is designed for Zone B. 


Whilst energy needs (and hence emissions) can be reduced through Zone A type projects, they shouldn’t need a cap-and-trade system to encourage them to happen. Other policies might be needed to tease them out, but not cap-and-trade. Yet many projects being considered as potential for future offsets exist in this region of the abatement curve. It isn’t in the interests of a solid international agreement on climate change to simply encourage projects in non-capped sectors / countries to generate credits in Zone A for compliance in Zone B.

Rather, the international agreement should encourage all countries to act on Zone A of their own accord, since this is in the national interest anyway as it typically means energy savings. In addition, those countries without absolute reduction targets are also incentivised to operate in Zone B through an offset or project mechanism. This then generates an additional supply of compliance units for countries with absolute targets and begins the process of introducing specific low emission technologies into economies without targets in preparation for a future with targets.

Although this is generally the idea behind the CDM, it hasn’t quite functioned like this in practice, but I would argue that just having it has generated much experience and useful learning about offsets. The next generation of CDM will have to operate on a much larger scale, but also sit squarely in Zone B of the abatement curve.