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5.4 Domestic Offsets
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Offsetting provides participants in a cap-and-trade system, or payers of a carbon tax, with an alternative way of complying with the carbon pricing policy. Instead of buying emission permits or paying the tax, regulated firms can fund projects that reduce emissions outside the scope of the carbon pricing policy.65
For example, consider a company regulated under a cap-and-trade system. It must hold enough permits to cover its annual emissions, and the price of permits is determined by the emissions trading market. If market prices are high, the company could buy offsets to cover its remaining emissions, rather than buying regulated permits. Offsets might come from a farmer who has adopted new manure management approaches that reduce methane production, for example, or from any other project that reduces emissions from sources that are not covered by the carbon pricing policy.
In theory, offsets can enhance the effectiveness and efficiency of carbon pricing policy, by extending coverage to those sectors that are difficult to include within a broad policy. Examples of such sectors and emissions sources include high upstream oil and gas, agriculture and landfills. By providing an incentive for reductions from sources that would otherwise fall outside the reach of carbon pricing policy, offset programs can extend opportunities for more and/or lower-cost emission reductions.
In practice, the case for offsets may be overturned by uncertainties about the quality of offset programs.66 For offsets to provide true low-cost emission reductions, they must meet several criteria:
- Additionality. The emission reductions in an offset project would not have happened in the absence of offset payments. Additionality can be difficult to show, and it is likely that some projects that would have happened in the absence of the offset program still receive payments. This is known as ‘free-ridership’, and it undermines the environmental effectiveness of carbon pricing policy.
- Clear ownership. Offsets must have a clear owner. If the reductions represented by offset credits are attributed to more than one owner, overall emissions will rise. Effective offset programs require a clear and regulated registry system to track ownership.
- Permanence. Offsets arising from projects that involve the biological sequestration of carbon through afforestation or ecosystem restoration are not necessarily permanent, unlike offsets that arise from projects that prevent emissions. Biological sequestration projects are vulnerable to risks such as fire and storm damage that will result in the release of sequestered carbon back into the atmosphere. Mechanisms must be established to deal with these risks, and to ensure permanence in emission reductions.
Where these criteria are not met, the use of offsets will reduce the economic efficiency and environmental effectiveness of the carbon pricing policy. The difficulties of establishing additionality are significant. Ensuring the quality of offsets creates a burden on government agencies to establish and enforce offset rules. In the near-term regulators cannot escape the fact that offsets carry a trade-off between low-cost reductions and policy certainty. At their worst, poorly-functioning offset systems can create “hot air” credits that do not represent real and additional reductions. The presence of such offsets would reduce the effectiveness of a carbon trading policy by reducing the market price of emissions permits, and thus the market signal to cut emissions.
In terms of political acceptability, offsets can be a politically attractive way of keeping costs down in a cap-and-trade system with uncertain prices. On the other hand, they may be seen as a weakening of carbon pricing policy, especially in the long term, and as an inexpensive loophole in regulation for carbon-emitting industries.
5.4.1 Offset Policy Options
If offsets are included in carbon pricing policy, their use will be constrained, either implicitly through the quality-assurance process, or by explicit rules that limit the use of offsets to meet compliance targets. A variety of policy mechanisms can be used to control the number or type of offset projects allowed into a pricing program, including quantitative limits, set asides, trading ratios, and rental credits.67
A range of options is available for the design of an offset program, which balance the potential benefits of increased opportunities for the market to find least-cost reductions with the dangers of diminished environmental integrity and cumbersome administrative burden:
- Offsets not allowed. Policy-makers may determine that the difficulties of ensuring quality offsets are too great, and that offsets should not be allowed as a compliance mechanism. Where this is the case, other forms of regulation and policy should be used to deal with emissions sources outside the regulated scope, such as landfills and agriculture.
- Only certain types of offset allowed. By establishing a list of eligible offset project types, in which procedures for determining additionality are well developed, policy-makers can get some of the benefits of offsets while limiting the risks of low-quality offsets. The RGGI program has established a list of eligible project types.
- Offsets allowed, but their use limited. The EU ETS allows offsets but limits their use, allowing firms to meet only a portion of their compliance obligations through the use of offsets. This restriction ensures that at least a portion of emission reductions occur within the regulated sectors.
- Offsets allowed in the short term, phased out over time. Offsets can help contain costs during the initial stages of carbon pricing. As a result, they may be attractive in the short term, even if their long-term use makes it difficult to guarantee that targets will be met.
- All offset types allowed, rigorous process to ensure quality. Policy-makers can allow offsets from any project type, and establish a rigorous procedure for offset validation, verification and monitoring, to ensure that the offset program does not undermine environmental effectiveness. The Clean Development Mechanism of the Kyoto Protocol, an international offset mechanism, uses this approach, as does the Turning the Corner plan of the Government of Canada68.
A final choice in establishing an offset program involves the location of offset projects: domestic or international? Domestic offsets may be easier to monitor, and may provide higher confidence in environmental integrity. They also ensure that carbon pricing revenues stay within Canada. International offsets are likely to be cheaper, since lower-cost emission reductions are available outside Canada. The Clean Development Mechanism of the Kyoto Protocol is an example of an international offset mechanism for which the administrative architecture of validation, verification and monitoring of offset projects has already been established. The disadvantage of such a system is that large capital flows out of Canada may not be politically acceptable. This issue is further discussed in the broader context of international abatement opportunities.
5.4.2 Summary and Conclusions for Offsets
High-quality offsets can enhance the economic efficiency of carbon pricing policy by extending the reach of pricing beyond regulated sectors. However, achieving high-quality offsets is difficult, and policy-makers must weigh the risks of low-quality offsets in considering whether to allow their use, and how to design an offset program. In particular:
- Offset programs tend to diminish environmental effectiveness, because of free-ridership and the difficulties of ensuring additionality; and
- If they are to maintain environmental effectiveness, offset programs become cumbersome and administratively complex;
Given the existence of an offset market already in Canada, there may be a case for limited use of offsets in the short term. However, complementary regulations in many cases are a better approach than offsets to dealing with domestic emissions outside the scope of carbon pricing policies. International offsets may represent cost-effective emission reductions; however, the problems of additionality and free-ridership mean that their use should be limited.
