A private sector view of offsets under a cap-and-trade program 4

Medina co-authored this post with Toby Tiktinsky, Senior Client Manager, at EcoSecurities.

Amid the fallout from the near collapse of the global financial system and revelations of significant fraud by financiers like Bernie Madoff and R. Allen Stanford, an intense debate has emerged over the role of business in society. The increased scrutiny of Wall Street—and by extension, corporate America—has focused on profits, bonuses, and how compensation schemes can encourage excessive risk-taking. The fact that institutions deemed “too big to fail” were bailed out by the government and are now earning incredible profits only serves to entrench the feeling that something isn’t right in corporate America.

These issues deserve the added attention and should be subject to a healthy debate, but the underlying tone of the debate has begun to worry us, as it seems to question the role of business in society. You may be wondering what this has to do with the climate change debate in general, or the debate on the role of offsets in a U.S. cap-and-trade scheme in particular. Believe us, it matters a great deal.

The American Clean Energy and Security Act of 2009 (HR 2454, aka the Waxman-Markey bill) would prompt a major paradigm shift in the way private companies operate in the United States and would require tremendous deployment of capital, entrepreneurship and ingenuity, tasks for which the private sector is aptly suited. Yet given the prevailing distrust of the private sector, especially when it involves any form of “trading,” we have seen Congress adopt some command-and-control style measures.

For example, nongovernmental organizations succeeded in lobbying to have the Environmental Protection Agency (EPA) regulate methane emissions from landfills and coal mines, making them unavailable as offset projects. The rationale is that the emission reductions can be achieved quickly, meaning the emission reductions don’t need to benefit from innovation and the profit motive.

Supporters of the command-and-control approach, however, do not realize that not only are they delaying the emission reductions, but they are also undermining investment in renewable energy. Project developers have already started pulling back on plans to invest in methane capture and flaring systems due to the Waxman-Markey bill. Without carbon revenue, projects that would cap landfills and use the gas to produce green electricity are not viable. For second-tier landfills in particular, a project developer needs both the electricity and carbon revenues to make projects financially acceptable. The private sector can only thrive under political certainty; this means that methane that would have been destroyed in the near term will continue being freely released into the atmosphere until EPA mandates its destruction, with an uncertain timeframe that may take years.

Furthermore, the growing distrust of the private sector has only amplified the concerns that the environmental community already voices about offsets (quoting credible and not so credible sources). Critics believe it’s too easy to “game” the system, which undermines the environmental integrity of cap-and-trade. On the other hand, practitioners who have experienced the difficulty of getting through the current Clean Development Mechanism (CDM) firsthand would laugh at the suggestion that you can “game” the system.

However, if designed and executed properly, offsets play a critical role for the environment and the economy. Offsets not only provide financial incentives to invest in emission reductions that occur outside of the cap, but they also serve as a critical cost-control function for the system as a whole.

EPA has conducted an analysis of Waxman-Markey that predicts allowance prices given a certain supply of offsets in the market. EPA forecasts that the allowance price will be about $13 by 2015, $27 by 2030 and $70 by 2050, based on the assumption that the offset supply will reach 1.2 billion, 1.35 billion and 1.8 billion respectively in those years. The bill allows up to two billion tons of offsets every year, but EPA does not foresee the supply of offsets ever reaching the limit set by the bill.

Even so, EPA’s expectation of offset supply will be massive compared to what we have seen in the market so far. The Kyoto Protocol’s CDM, for example, has only issued about 315 million tons of offsets in total; 81 million of these were retired in the European Union in 2008. This is a far cry from what the United States will need to keep allowance prices at the levels predicted by the EPA.

To be clear, the implications for the economy are immense if the supply of offsets falls short of EPA’s expectations. EPA estimates that the cost of allowances will increase by 96 percent if offsets are not available. Offset generation will thrive under political certainty that puts together a scheme that is clear, easy to navigate and ensures environmental integrity. Furthermore, for offset generation to thrive, there needs to be a clear link between investment and reward for private participants.

For example, as argued by Sonia in a previous post, having a scheme that bypasses or undermines the role of the private sector, such as a government-to-government sectoral scheme, would be extremely ineffective. This underlines how the growing distrust of the private sector directly belies the intent of the system to reduce costs by relying on the private sector to find the lowest cost reductions in the market place.

The debate, thus, should not focus on whether or not the private sector should play a role, but how do we design a system that includes the proper checks and balances to protect environmental integrity, while ensuring it is sufficiently streamlined to allow it to generate the volume of offsets needed to keep costs low.

Time and again the private sector has demonstrated its remarkable ability to mobilize tremendous skill and resources to accomplish great feats. Sadly more recently we have experienced its other great potential: economic destruction. Yet it would be a shame to focus on the latter, as surely we can—and must—harness this power to steer the world’s economy down a low carbon path.

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