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05.09.2023

Carbon Permits and Offsets

We should all be familiar with climate change and its catastrophic effects. We can already feel its consequences in rising sea levels, desertification, increased frequency of extreme weather events, and many others [1]. The main driver behind climate change is the large increase in greenhouse gas (GHG) emissions that started with the industrial revolution [2].

Because of increased public awareness, corporations are taking steps to reduce their carbon footprints. In some cases, the reduction is entirely voluntary, driven by internal Environmental, Social and Governance goals. In some others, emission reductions are the consequence of the financial penalties imposed on heavy polluters [3].

In this article, we will first look at the cap-and-trade system, which is one example of such financial penalties [4]. We will then introduce carbon offsets as a tool companies can use to reduce the cost of their emissions. This will then lead us to the voluntary offset market and the issues that have been raised with it. Finally, we will have a quick overview of some other instruments that are being considered as possible ways to address these issues.

The Compulsory Market: Carbon Permits

Under a cap-and-trade system (or Emission Trading System, ETS), governments issue permits that allow companies to emit greenhouse gases. Typically, each permit allows a company to emit one tonne of CO2e (CO2 equivalent, an amount of GHG which would contribute as much as one tonne of CO2 to global warming).

These permits may be auctioned, with their price set according to the bids received. This method of allocation creates an extra expense for the regulated emitters while raising revenue for the government. This is intended to encourage companies to reduce their emissions faster. Alternatively, permits may be allocated for free to different industries based on their requirements. Free allocation reduces the incentive to reduce emissions but is typically justified as a way to avoid carbon leakage, which means energy intensive companies offshoring their operations or being outcompeted by foreign firms outside the scope of the ETS [5].

Under this compulsory scheme there is a secondary market, meaning permits issued by the government can be bought or sold after their initial allocation. This opens the door for financial institutions to trade permits, and for regulated participants to sell permits they don’t need (because they reduced their emissions more than expected) to others who need more than anticipated.

The goal of any well-designed ETS would be reducing GHG emissions over time. Since the government can control the number of permits issued, they could theoretically cap the emissions at the level required to meet the country’s sustainability goals. A constant reduction in the number of permits in circulation would make it financially advantageous for polluters to invest in greener technology in order to reduce their costs.

The secondary market also helps companies that exceeded their GHG reduction goals generate extra profits by selling any extra permits, while penalising firms that failed to reduce their emissions and need to buy them.

If there is a clear path of future permit number reduction (with a corresponding increase in their price), then regulated companies would be strongly encouraged to invest in long-term projects that could help them meet more ambitious future GHG reduction goals. The development of carbon derivatives (futures and options on carbon permits) is meant to provide information on current market expectations of future emissions to companies and policymakers. This should help them make informed decisions when it comes to how to tackle the long-term transition to a greener economy [6].

However, current ETS implementations have been subject to heavy criticism. One of the issues with these programs is the difficulty of measuring the actual GHG emissions of regulated firms. There is also the problem of carbon leakage, resulting in firms complying with the scheme by changing the location of their emissions instead of reducing them. Using offsets to compensate emissions covered by the scheme also results in firms complying on paper without having to reduce their actual emissions. There is also a risk of governments choosing to “bail out” polluters by issuing more permits if their price became so high that they could cause any immediate economic damage; if the total number of permits in circulation is too high, or regulated industries do not believe the authorities would let prices rise above a certain level, then there is a cap on how much these firms will be willing to invest in their green transition projects [7].

Carbon Offsets

The basic idea behind carbon offsets (also called carbon credits) is very simple. If there is an activity that produces a single tonne of CO2e each time it is performed, then if we ensure that one tonne of CO2e is removed somewhere else each time this activity happens the net result on the atmosphere will be neutral.

Moreover, companies would only buy offsets if doing so is cheaper than reducing their own emissions. This means that instead of investing in an expensive project to reduce their carbon footprint, they would finance an external project with the same overall effect instead, reducing the total cost of meeting a GHG emission reduction goal.

Of course, things get a lot more complicated when looking at real world scenarios.

Types of Offsets

Credits can be generated from both removal and avoidance of emissions. For example, direct capture and storage of GHG gasses using air-filtering machines would directly reduce the amount of CO2 in the atmosphere. The technology needed for this is still in its very early stages and not scalable in size, which means credits from this type of project are expensive and hard to come by. While direct capture is expected to grow in the near future, there is still a long way to go before this is a viable strategy to reduce the concentration of atmospheric CO2 [8].

Forestry projects can also help capture CO2. Planting new trees or leaving forests to thrive undisturbed can result net carbon removal from the atmosphere and storing it in organic matter. Corporate marketing has forced this form of offset into the public consciousness (‘buy one gizmo, plant one tree’ probably sounds familiar) – but as we’ll see below, even something so widespread has serious downsides.

A more controversial type of offset can be generated by emission avoidance. These are created when greenhouse gasses are not emitted that would have been otherwise released. For example, financing efficient cooking stoves for communities where open fire cooking is still prevalent should result in reduced energy usage.

How much credit should be taken from avoidance projects is extremely difficult to quantify. For example, should the project generate offsets during the whole life of the new stoves, even if it is likely that the old ones would have been replaced in the near future anyway?

Even more controversial are credits generated when a project results in greenhouse gasses being emitted, but the sponsors claim that the emission was lower than it could have been. For example, logging of a forest covered by an offset scheme could be allowed, while generating credits because the rate of logging is lower than in other similar forests in the same area [9].

Quality Criteria

We can see that not all carbon offsets are made equal. In an effort to rate their quality several organisations have come up with methodologies to appraise emission reduction projects and determine how impactful they really are. In general, for a carbon offset to be high quality we would need the following:

Cotemporality – the emission reduction that generates the offset should happen at the same time as the GHG emissions that it is meant to compensate. Current emissions cannot by offset with promises of future reductions that, even if realised, would not undo the damage the extra emissions would have already caused.

Clear measurement of emissions – both the baseline emissions that would have occurred without the project taking place and the emissions after any mitigation need to be measured precisely so that the right number of offsets can be created.

Additionality – the reduction in emissions that can be transformed into offsets needs to be a consequence of the project being funded by the offset purchases. For example, credit should not be taken for undertaking a project that is financially profitable on its own merits. This is because otherwise the project and associated GHG reduction would have happened regardless of the finance raised by offset sales.

Lack of carbon leakage – the project generating offsets should not directly lead to higher emissions elsewhere. For example, protecting a specific area of a forest from logging should not generate offsets unless it leads to reduction of overall logging in the region. Increased logging in a nearby forest would just shift emissions instead.

Duration – the project should ensure that any carbon sequestration or emission avoidance will result in a long-term reduction in atmospheric CO2. For example, an offset should not be generated if a project protects an area of forest this year, but trees are chopped and burned the next one.

No double counting – this would happen if, for example, a regulated industry reduced its emissions and used that fact to both use less permits under an ETS system and sell offsets to other firms. Each tonne of CO2 emissions reduction would have been counted twice.

Any co-benefits from the project – for example, creating jobs in rural areas, protecting biodiversity, improving the life conditions of the local population, etc.

In the regulated market there are clear guidelines on what carbon offsets can be used. For example, carbon credits used to reduce a company’s emissions under the EU ETS must be generated under the Clean Development Mechanism or Join Implementation mechanism set up under the Kyoto protocol [10].

The situation is different in the voluntary market. Because voluntary offsets are not used in a compliance scheme, the source of credits may not be one recognised by the schemes above. There are different organisations that appraise carbon projects and approve the issuance of offsets, resulting in a somewhat chaotic market with offsets of varying quality being traded.

An example of such an organisation is Verra [11], which runs the VCS standard. This is one of the biggest agencies dedicated to certifying carbon credits. Others, such as the Gold Standard, are supported by NGOs like WWF or Fairtrade [12]. Typically, companies making net-zero pledges would use carbon offsets from reliable sources to compensate the emissions from their operations. Of course, as this is a completely voluntary pledge, it would be up to individual companies to decide the standard of quality their offsets must meet, with customers as the ultimate judges of their actions.

Controversies in the Carbon Offset Market

Despite the best attempts to separate wheat from chaff, even well-known organisation can back offsets of dubious quality [13]. This is making companies reluctant to invest in the carbon offset market [14]. Some of the biggest issues that have been raised in the past are:

The problem of carbon accounting. Measuring how much CO2 is being captured or not emitted thanks to a certain project is an almost impossible task. This gets compounded by the issue of additionality, where some changes would arguably happen over time anyway due to reduced costs of new technologies or regulatory pressures. Creative accounting practices may also put the quality of an offset in doubt, whether that is due to double counting, or taking credit for future emission reductions that may not end up materialising (related to the cotemporality defined above).

Colonial-like attitude towards developing countries and indigenous populations. Nature preservation projects are one of the largest generators of carbon offsets. Many are based in developing countries with plenty of tropical forests or grasslands. While selling carbon offsets can be a useful way for these countries to finance their development while preserving their natural capital, sometimes the offset market is criticised as a way for industrialised countries to protect their carbon-intensive lifestyles while placing the burden of offsetting in the developing world. This is particularly controversial when conservation projects clash with the traditional lifestyles of indigenous populations [15].

Offsets can be used as an excuse to delay proper GHG reduction action. After all, if a heavy polluter can buy their way out of reducing emissions, why would they engage in expensive and risky internal transformation projects? Cheap offsetting disincentivises decarbonisation and can defeat the whole purpose of a cap-and-trade system.

Focus on a single metric can lead to undesirable outcomes. For example, it is obvious that a forest burning and being replanted using a fast-growing invasive tree species will result in damage to the local ecosystem. However, from an emissions point of view, the planting of the foreign tree may lead to the carbon released in the forest fire being recaptured faster than if local trees were used. This is just an example of how the context of GHG emission and capture is as important as the raw amounts.

Not all carbon is made equal. It is dangerous to think that any carbon taken away from the atmosphere will be safely stored forever. While forests are a good way to remove carbon from the air, it may return to the atmosphere at any point either due human activity (logging trees for firewood) or natural causes (forest fires, trees dying due to illness and later decomposing). However, the fossil fuels that humanity burns for energy have been buried underground for millions of years. Clearly, storing carbon in trees for, at most, a few centuries, cannot compensate the release of vast amounts of carbon that was part of a much slower cycle measured in geological time.

Beyond Carbon Permits and Offsets

As we saw in the previous section there are issues with carbon offsets that have made some institutions look at alternative approaches to improve their climate credentials. While a thorough analysis of these is beyond the scope of this article, we will introduce here the concepts of carbon insetting and biodiversity credits as tools that have been proposed to combat ecosystem collapse. These are designed to address some of the issues with traditional carbon offsetting, either helping reduce gross emissions or ensuring that any necessary reductions come accompanied with verifiable action to protect vulnerable ecosystems.

One of the issues with traditional offsets is that a company using them is paying a third party to reduce their CO2 footprint on their behalf. Due to a complex web of certifying agencies, offset traders, and different project types, it may be difficult for the buyer of a credit to know if they are actually making a difference.

Insetting tries to address this problem by having a company look at how their activities impact emissions across their own value chain [16]. For example, if a chain of retail shops wants to reduce its impact on climate change, it would be sensible for them to ensure that their suppliers are taking steps towards decarbonisation as well. The company can work together with others across its supply chain to help everyone reduce their carbon footprint.

Unlike offsetting, companies practising insetting would have control over the specifics of the project they are financing. On the one hand, this means they can ensure the reduction is actually happening. However, the risk of double-counting would be increased (in our example, both the supplier and the retail chain may claim to have reduced their emissions by a certain amount, making it look like the reduction happened twice). The lack of oversight by any external verification agency also creates scope for firms to claim emission reductions through insetting projects of dubious quality.

Another different tool are biodiversity credits. This is a relatively new but growing market that tries to address the problem with the narrow focus of carbon offsets. As already discussed, recapturing carbon that has been emitted is not the same as not having emitted it in the first place.

Biodiversity credits share with carbon offsets the idea that an individual or corporation can help fight climate change by voluntarily buying a token to finance a project run by a third party. The difference is that, for biodiversity credits, the token is created by helping protect vulnerable ecosystems, rather than reducing atmospheric CO2 [17].

The goal of this new type of credit is to raise funds for projects that look at nature preservation as a holistic process, rather than optimising the single metric “reduction in atmospheric CO2e”. Of course, their biggest issue is how to objectively measure a concept as ill-defined as biodiversity value. It is hard to compare different projects or even come up with a standard measure for how much benefit must be created to generate each token.

Summary

The path to decarbonisation is a long and expensive one. Compulsory schemes such as the cap-and-trade systems implemented in many developed countries are potentially a useful tool in encouraging companies to reduce their emissions. The financial penalties incurred by regulated industries can act as a nudge to force them to act now to reduce future emissions. It is likely that these programs will only become more popular in the future.

Many other firms will also try to reduce their climate impact due to pressures from both customers and policymakers. However, if we want to ensure that the steps taken are actually effective, we need proper oversight of the voluntary carbon offset market. It is also important to understand that carbon offsetting, while useful to compensate for short-term emissions, cannot be a replacement for long-term emission reductions.

We also need to acknowledge the shortcomings of the current approaches in both the compulsory and voluntary carbon markets. New instruments, such as biodiversity credits, are being proposed that may address some of these issues. Which ones prove successful in the future, and how much impact they can actually make, will have a very real impact on the efforts to fight against the worst consequences of climate change.

 

References

1 – https://climate.nasa.gov/effects/

2 – https://www.climate.gov/news-features/understanding-climate/climate-change-atmospheric-carbon-dioxide

3 – https://aprllp.com/understanding-the-2022-world-bank-carbon-pricing-report/

4 – https://openknowledge.worldbank.org/handle/10986/37455

5 – https://www.gov.uk/government/publications/participating-in-the-uk-ets/participating-in-the-uk-ets#free-allocation-of-allowances

6 – https://www.isda.org/a/soigE/Role-of-Derivatives-in-Carbon-Markets.pdf

7 – https://www.fern.org/fileadmin/uploads/fern/Documents/FERN_designedtofail_internet_0.pdf

8 – https://www.iea.org/reports/direct-air-capture

9 – https://www.theguardian.com/environment/2021/may/04/what-is-carbon-offsetting-and-how-does-it-work

10 – https://climate.ec.europa.eu/eu-action/eu-emissions-trading-system-eu-ets/use-international-credits_en

11 – https://verra.org/

12 – https://www.goldstandard.org/about-us/ngo-supporters

13 – https://www.theguardian.com/environment/2023/jan/18/revealed-forest-carbon-offsets-biggest-provider-worthless-verra-aoe

14 – https://www.wsj.com/articles/many-companies-are-shying-away-from-carbon-credits-11673900838

15 – https://news.mongabay.com/2023/03/carbon-credits-from-award-winning-kenyan-offset-suspended-by-verra/

16 – https://files.worldwildlife.org/wwfcmsprod/files/Publication/file/773q5lvbf0_WWF_position_and_guidance_on_corporate_use_of_voluntary_carbon_credits_EXTERNAL_VERSION_11_October_2019_v1.2.pdf?_ga=2.138580730.891103504.1681989425-1684734785.1681989424

17 – https://e360.yale.edu/features/biodiversity-credits

 

Cristian Redondo Loures

July 2023