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A Realistic Policy on International Carbon Offsets
Working Paper

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Program on Energy and Sustainable Development Working Paper #74

April 2008

As the United States designs its strategy for regulating emissions of greenhouse gases, two central issues have emerged. One is how to limit the cost of compliance while still maintaining environmental integrity. The other is how to "engage" developing countries in serious efforts to limit emissions. Industry and economists are rightly concerned about cost control yet have found it difficult to mobilize adequate political support for control mechanisms such as a "safety valve;" they also rightly caution that currently popular ideas such as a Fed-like Carbon Board are not sufficiently fleshed out to reliably play a role akin to a safety valve. Many environmental groups have understandably feared that a safety valve would undercut the environmental effectiveness of any program to limit emissions of greenhouse gases. These politics are, logically, drawing attention to the possibility of international offsets as a possible cost control mechanism. Indeed, the design of the emission trading system in the northeastern U.S. states (RGGI) and in California (the recommendations of California's AB32 Market Advisory Committee) point in this direction, and the debate in Congress is exploring designs for a cap and trade system that would allow a prominent role for international offsets.

This article reviews the actual experience in the world's largest offset market-the Kyoto Protocol Clean Development Mechanism (CDM)-and finds an urgent need for reform. Well-designed offsets markets can play a role in engaging developing countries and encouraging sound investment in low-cost strategies for controlling emissions. However, in practice, much of the current CDM market does not reflect actual reductions in emissions, and that trend is poised to get worse. Nor are CDM-like offsets likely to be effective cost control mechanisms. The demand for these credits in emission trading systems is likely to be out of phase with the CDM supply. Also, the rate at which CDM credits are being issued today-at a time when demand for such offsets from the European ETS is extremely high-is only one-twentieth to one-fortieth the rate needed just for the current CDM system to keep pace with the projects it has already registered. If the CDM system is reformed so that it does a much better job of ensuring that emission credits represent genuine reductions then its ability to dampen reliably the price of emission permits will be even further diminished.

We argue that the U.S., which is in the midst of designing a national regulatory system, should not to rely on offsets to provide a reliable ceiling on compliance costs. More explicit cost control mechanisms, such as "safety valves," would be much more effective. We also counsel against many of the popular "solutions" to problems with offsets such as imposing caps on their use. Offset caps as envisioned in the Lieberman-Warner draft legislation, for example, do little to fix the underlying problem of poor quality emission offsets because the cap will simply fill first with the lowest quality offsets and with offsets laundered through other trading systems such as the European scheme. Finally, we suggest that the actual experience under the CDM has had perverse effects in developing countries-rather than draw them into substantial limits on emissions it has, by contrast, rewarded them for avoiding exactly those commitments.

Offsets can play a role in engaging developing countries, but only as one small element in a portfolio of strategies. We lay out two additional elements that should be included in an overall strategy for engaging developing countries on the problem of climate change. First, the U.S., in collaboration with other developed countries, should invest in a Climate Fund intended to finance critical changes in developing country policies that will lead to near-term reductions. Second, the U.S. should actively pursue a series of infrastructure deals with key developing countries with the aim of shifting their longer-term development trajectories in directions that are both consistent with their own interests but also produce large greenhouse gas emissions reductions.

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