Adverse Selection in an Opt-in Emissions Trading Program: The Case of Sectoral Crediting for Transportation

Sectoral crediting mechanisms such as sectoral no-lose targets have been proposed as a way to provide incentives for emission reductions in developing countries as part of an international climate agreement, and scale up carbon trading from the project-level Clean Development Mechanism to the sectoral level.

Countries would generate tradable emission credits (offsets) for reducing emissions in a sector below an agreed crediting baseline. However, large uncertainties in the regulator's predictions of the counterfactual business-as-usual baseline are likely to render sectoral no-lose targets an extremely unattractive mechanism in practice, at least for the transportation case study presented here. Given these uncertainties, the regulator faces a tradeoff between efficiency (setting generous crediting baselines to encourage more countries to opt in) and limiting transfer payments for non-additional offsets (which are generated if the crediting baseline is set above business-as-usual).

The first-best outcome is attainable through setting a generous crediting baseline. However, this comes at the cost of either increased environmental damage (if developed country targets are not adjusted to account for non-additional offsets), or transfers from developed to developing countries that are likely to be too high to be politically feasible (if developed country targets are made more stringent in recognition that many offsets are nonadditional). A more stringent crediting baseline still generates a large proportion of non-additional offsets, but renders sectoral no-lose targets virtually irrelevant as few countries opt in.