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a realistic policy on international carbon offsets michael w wara and david g victor working paper #74 april 2008

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wara and victor pesd working paper #74 april 18 2008 the program on energy and sustainable development at stanford university is an interdisciplinary research program focused on the economic and environmental consequences of global energy consumption its studies examine the development of global natural gas markets the role of national oil companies reform of electric power markets international climate policy and how the availability of modern energy services such as electricity can affect the process of economic growth in the world s poorest regions the program established in september 2001 includes a global network of scholars based at centers of excellence on five continents in law political science economics and engineering it is based at the freeman spogli institute for international studies program on energy and sustainable development freeman spogli institute for international studies encina hall east room e415 stanford university stanford ca 94305-6055 http pesd.stanford.edu ii

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wara and victor pesd working paper #74 april 18 2008 about the authors michael w wara is currently a research fellow and lecturer at stanford law school where he teaches international environmental law his research focuses on the emerging global market for greenhouse gases and the post-kyoto regime for reducing their emissions wara s interests also include the interaction between climate water and endangered species management previously he was an associate at holland knight llp he holds a j.d from stanford law school and a ph.d in ocean sciences from the university of california santa cruz his doctoral research focused on the interaction between long term shifts in global climate and tropical ocean/atmosphere dynamics david g victor directs the program on energy and sustainable development at stanford university s freeman spogli institute for international studies the program has active research underway on international carbon markets and climate change policy the role of state-controlled oil companies in the world oil market energy services for the very poor and the geopolitical future of coal including both the internationalizing coal trade and the emerging business models for carbon storage dr victor is adjunct senior fellow at the council on foreign relations where he directed the council s task force on energy security and is senior advisor to the task force on climate change chaired by governors george pataki and tom vilsack he also leads a study group that is examining ways to improve management of the nation s $50b strategic oil reserve dr victor received his ph.d from the massachusetts institute of technology political science and international relations and his b.a from harvard university history and science iii

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wara and victor pesd working paper #74 april 18 2008 iv

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wara and victor pesd working paper #74 april 18 2008 a realistic policy on international carbon offsets michael w wara and david g victor1 summary 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 welldesigned 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 1 we thank kyle danish michael levi chris mottershead billy pizer and tauna szymanski for their valuable comments on early versions of this manuscript errors and opinions are fully our own 5

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wara and victor pesd working paper #74 april 18 2008 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 6

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wara and victor pesd working paper #74 april 18 2008 into thin air after years of indecision the united states is on the verge of adopting substantial limits on its emission of greenhouse gases federal legislation to cap u.s emissions is under consideration in both houses of congress many states are already far advanced on their own schemes all the presidential contenders promise vigorous action on the problem at the same time the u.s has been playing a more active and constructive role in international negotiations the bush administration signed the bali roadmap for international climate negotiations under the united nations framework convention on climate change unfccc while also attempting to build other complementary international systems to coordinate climate policies the g8 has the climate issue at the top of its agenda every year the central question in america s policy debate is no longer if the country will regulate greenhouse gases rather today s questions center on how two key political issues that drive features of any u.s market-based system are cost-control and engagement with the rest of the world especially developing countries a precondition for achieving both objectives is maintaining the environmental integrity of the system most debates over cost control focus on the designs for a cap-and-trade system and levy special attention on various schemes to put a ceiling on emission prices because such schemes make it possible to assure industry that the cost of buying needed emission credits won t be excessive and will be predictable the experience in the european carbon emission trading scheme ets where prices have been unpredictable has kindled interest in such devices since it will be hard to plan compliance when the cost of emission credits is unknown and highly variable.2 developing country engagement especially with key trading partners such as china and india is essential in order to insure that the u.s doesn t fix the problem at home only to find that free riders on u.s climate policy efforts in the developing world enjoy its benefits without actually changing their own behavior as well real climate policy must contend with many other factors such as setting the overall level of emissions and allocating the emission credits but cost control and engagement for developing countries lie at the center of any politically viable plan to control u.s emissions to date both have been addressed primarily using one tool ­ carbon offsets.3 international carbon offsets have been thought to be a win-win solution in that they offer developed countries a source of low-cost emission reductions and offer developing countries a source of funding to alter their development paths to a climate friendly orientation indeed the architects of the european union ets have embraced both those goals and allowed extensive use of offsets.4 economic modeling of proposed cap-and-trade bills in the united states has shown that theoretically offsets have the 2 3 david g victor and danny cullenward making carbon markets work scientific american sept 24 2007 the greatest experience to date is with the eu ets where cost control is accomplished via offsets the liebermannwarner bill accomplishes cost control via a mix of domestic offsets and international credits international credits are defined in the bill as allowances from other cap-and-trade schemes if such schemes allow for the use of offsets as in the eu then this provision amounts to laundering of offsets via prior conversion into another nation s carbon currency thus cost control in that bill is also via offsets both directly and indirectly see s 2191 110th cong § 2501 2008 4 although recently released draft guidance on the eu ets for the post-2012 period indicates that the european commission has grown substantially less enthusiastic about the use of offsets for cost control purposes mainly because of a desire to foster domestic abatement see proposal for a directive of the european parliament and of the council amending directive 2003/87/ec so as to improve and extend the greenhouse gas emission allowance trading system of the community 2008/0013 cod at 26 at http ec.europa.eu/environment/climat/emission/ets_post2012_en.htm 7

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wara and victor pesd working paper #74 april 18 2008 potential to allow sharp reductions in costs.5 at the same time there is nearly unanimous support from developing countries and development banks applauding the ways that offsets channel funds to developing countries.6 our argument is that the theoretical benefits of lower costs and broader engagement of developing countries through the extensive use of offsets are an illusion they are based on the assumption that it is possible to administer an offsets system so that it rewards only bona fide reductions this assumption is valid for only a fraction of the real offsets market we make the case by looking to the world s largest existing offset market the unfccc s clean development mechanism cdm many studies have shown that this market is far from perfect.7 we will document the fuller extent of its flaws at root the cdm and other offset schemes are unable to determine reliably whether credits are issued for activities that would have happened anyway while also keeping transaction costs under control and assuring investor certainty we will document some ways to tighten the cdm rules but we will also underscore that the cdm is structurally unable to engage developing countries in ways that would actually make a dent in emissions we will also show that the administration of cdm makes it a very poor cost control mechanism because credits are issued only after long delays and in unpredictable quantities the cost and response in generating cdm credits beats to drummers that are at best poorly attuned to what is needed for an effective cost control mechanism because of the need for stringent and complex regulatory oversight offset markets cannot respond quickly to a price shock in cap-and-trade markets they serve.8 as a consequence other simpler cost control schemes such as an explicit safety valve are likely to be much more effective nevertheless experience with the cdm suggests that international carbon offsets will have an important role to play in engaging developing nations in the project of climate change but close study of outcomes in the cdm strongly suggests that the role that project-level offsets plays should be more limited than at present and that a variety of other incentive programs will be required in order to both 5 recent epa analysis estimates that the inclusion of offsets and international credits in the liebermann-warner bill reduces the predicted allowance price for capped sectors from $77 to $40 in 2015 us environmental protection agency epa analysis of the liebermann-warner climate security act of 2008 s 2191 in 110th congress march 2008 us environmental protection agency epa analysis of the climate stewardship and innovation act of 2007 july 2007 us energy information administration energy market and economic impacts of s.280 the climate stewardship and innovation act of 2007 report sr-oiaf/2007-04 august 2007 s paltsev et al assessment of u.s cap-and-trade proposals mit global change joint program report 146 april 2007 updated february 2008 richard g richels et al managing the transition to climate stabilization aei-brooking joint center working paper no 07-01 january 2007 6 karen capoor and phillippe ambrosi world bank carbon finance unit state and trends of the carbon market 2007 may 2007 pointcarbon carbon 2007 ­ a new climate for carbon trading march 2007 7 lambert schneider oko-institut e.v is the cdm fulfilling its environmental and sustainable development objectives an evaluation of the cdm and options for improvement prepared for wwf november 2007 barbara haya international rivers network failed mechanism how the cdm is subsidizing hydro developers and harming the kyoto protocol november 2007 axel michaelova and pallav purohit additionality determination of indian cdm projects can indian cdm project developers outwit the cdm executive board 2007 michael wara is the global carbon market working 445 nature 595 2007 8 it is possible that offsets might have short-term stabilizing effects even if their supply can t respond to price volatility because in the presence of banking they will increase the willingness and lower the costs of borrowing allowances from future trading periods however borrowing against future offset delivery can only work if future deliveries are themselves predictable because future offset supplies themselves are likely to be uncertain borrowing costs would likely be extremely high 8

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wara and victor pesd working paper #74 april 18 2008 insure that u.s funds are used cost-effectively and to produce real change in developing nation emissions of greenhouse gases ghgs ultimately the experience from the global offset market points to a niche role for offsets both as a tool for cost control within cap-and-trade systems and as one of a portfolio of tools for engaging developing nations in the problem of climate change theory and practice stories from a real carbon offset market the kyoto protocol is one of the most complex multilateral environmental agreements ever negotiated at its core was a bargain between developing countries whose participation is essential to any long-term effort to control emissions and developed countries who accepted binding limits on emissions that core deal was cemented with flexible compliance mechanisms involving carbon offsets generated either in economies in transition so-called joint implementation ji or in the developing world so-called clean development mechanism cdm of these alternative compliance mechanisms the cdm has become by far the largest emissions offset market ever created the ji market involving emission credits from russia ukraine and the other economies in transition will play a role in compliance for some nations but current estimates are that the cdm will be nearly ten times larger in both volumes produced and financial values during the kyoto protocol s compliance period 2008 to 2012 9 at the same time the enormous diversity of projects participating in the cdm when compared to ji and the special circumstances of the russian and ukrainian economies makes cdm a more representative offset market for considering the likely impacts of u.s participation in a post-kyoto global carbon market finally many of the rules for ji implementation have been copied wholesale from the cdm if one wants to study offsets in the real world one studies cdm the growth of the cdm has been truly extraordinary in 2007 the value of the cdm market totaled 12 billion more than triple the previous year s figure.10 the cdm project pipeline has grown in four years from essentially nothing to more than 3000 projects either registered or in the process of achieving the necessary regulatory approvals the project design documents for these projects together project that the cdm market will deliver more than 2.2 billion cers to the end of the kyoto protocol s compliance period see figure 1 certified emission reductions cers are the cdm s currency they are the measure of the quantity of emissions that has been avoided offset by cdm projects if all of those cers bubbling through the pipeline actually come to fruition and if they represent real emissions reductions then the cdm would be the largest source of ghg reductions produced by the kyoto protocol it is instructive to look at the role of cers in the european union s emision trading scheme for that system is the largest source of global demand for cers while it is difficult to make a precise assessment on current trajectories import of cers could account for up to ten times the actual reductions of emission reductions from within the eu cap-and-trade total required reductions to meet the limits under the eu s ets during the 2008-2012 period are expected to be about 700 million metric tons tonnes of co2-equivalents of which perhaps only a small percentage would be accounted for through actual reductions within eu borders the eu to be sure is making a serious effort to control emissions at home but those emission controls are proving much more costly than importing cers the eu member states have adopted allocation plans that could in theory allow all their reductions under the 9 cdm projects now registered or in the process of becoming registered are projected to supply 2.6 billion cers to 2012 while ji projects are projected to supply less than 0.2 billion erus see jørgen fenhann unep-risø centre cdm-ji pipeline database at http www.cdmpipeline.org pointcarbon cdm-ji monitor 23 january 2008 pg 6 10 9

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wara and victor pesd working paper #74 april 18 2008 ets to be met with cers although we do not expect that extreme outcome to occur for reasons we will discuss below 11 a b figure 1 participation in the clean development has grown explosively over the past four years shown in a is the projected volume of certified emissions reductions cers delivered to the end of the kyoto protocol as a function of time different colors indicated different project types shown in b the same data but expressed in percentage terms early on industrial gas capture projects most notable hfc-23 capture projects dominated the supply of credits more recently renewable power and natural gas-fired power projects have been growing in importance.12 in the next section we will illustrate that many of these reductions could have been accomplished at a far lower price that many credits are probably not backed by real reductions and that the promise of such a massive supply of credits is extremely unlikely if even the current poor level of environmental quality of the program is to be maintained our three stories point to the need for reform within the cdm but also for the inclusion of multiple new tools for engagement with the developing world in both u.s climate policy and any post-kyoto international architecture they also 11 the rules set for the national allocation plans for individual european nations allow substantial imports of cers potentially in excess of required cuts below business as usual emissions verified emissions in 2005 and 2006 averaged about 2.2 billion tonnes required reductions from this level to meet the cap in the 2008-2012 period will average 133 million tonnes per year but allowed imports of cdm and ji credits total 278 million tonnes per year allowing for a net increase of emissions within the eu ets compensated by reductions in developing countries at the same time early indications are that greenhouse gas emissions within the eu ets actually increased in 2007 by approximately 1 see lambert schneider is the cdm fulfilling its environmental and sustainable development objectives Öko-institut e.v report prepared for wwf nov 5 2007 eu ets emissions likely to have increased in 2007 citl data pointcarbon april 2 2008 12 data courtesy of jørgen fenhann unep-risø centre cdm-ji pipeline database at http www.cdmpipeline.org 10

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wara and victor pesd working paper #74 april 18 2008 point to the need to limit the dependence of a u.s cap-and-trade scheme on cost control derived from the cdm or other offsets program a hfc-23 end of pipe activities perverse incentives and overpayment the early history of the cdm is primarily the story of an obscure gas called trifluoromethane or hfc-23 this gas is a potent ghg and is produced mainly as a waste product during the manufacture of another gas hcfc-22 the hcfc-22 is used in some air conditioners and as a feedstock for high performance plastics it is a partial replacement for other gases that are being phased out because they harm the ozone layer hfc-23 is 11,700 times more potent a greenhouse gas than co2 projects that cut hfc-23 emissions are extremely valuable because they generate enormous volumes of carbon offsets or in the cdm s terminology certified emissions reductions cers at very low cost in the early development of the carbon market these projects made up the bulk of emissions reductions see figure 1 they also accounted for the vast majority of financial value in the nascent rapidly growing cdm market in 2004-2006 that sparked early excitement about carbon offsets as an investment opportunity the costs of capturing and destroying hfc-23 at refrigerant plants are non-zero but extremely low in the u.s and europe many factories producing this waste gas have since the 1990 s voluntarily eliminated their emissions of hfc-23.13 in the developing world by contrast until the cdm refrigerant factories simply vented this potent ghg because of the low costs of destroying the gas and its high potency initially it was thought these projects would be ideal offset projects for the cdm scheme at the same time our work along with the highly successful fund within the montreal protocol on the ozone layer which funded an analogous phaseout of industrial chemicals suggested that these types of emissions should be handled outside of the kyoto market system via a dedicated fund.14 unfortunately close scrutiny of the economics of hfc-23 projects revealed that they were in many senses too good to be true our work15 and the work of others16 showed that the sale of carbon credits generated from hfc-23 capture is far more valuable than production of the refrigerant gas that leads to its creation in the first place thus refrigerant manufacturers were transformed overnight by the cdm into ventures that generated large volumes of cers with a sideline in the manufacture of industrial gases in response to these perverse incentives the cdm executive board implemented a number of restrictions that limited but failed to eliminate the perverse incentive to produce refrigerant in order to produce waste hfc-23 capture this waste and so create enormous quantities of cers in the case of hfc-23 abatement the cdm was also a startlingly inefficient means for 13 indeed technologies developed and deployed voluntarily in u.s plants are the same as those that have been adopted in the cdm a mcculloch incineration of hfc-23 waste streams for abatement of emissions from hcfc-22 production a review of scientific technical and economic aspects 18 2005 at http cdm.unfccc.int/methodologies/background_240305.pdf last visited april 14 2008 14 david g victor and gordon j macdonald how to make kyoto a success 389 nature 777 1997 david g victor and gordon j macdonald a model for estimating future emissions of sulfur hexalfuoride and perfluorocarbons 42 climatic change 633 1999 15 michael wara the performance and potential of the clean development mechanism pesd working paper #56 2006 available at http pesd.stanford.edu/cdm 16 unep technical and economic assessment panel response to decisiion xviii/12 report on the task force on hcfc issues with particular focus on the impact of the clean development mechanism and emissions reduction benefits arising from earlier hcfc phase-out and other practical measures august 2007 11

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wara and victor pesd working paper #74 april 18 2008 achieving emissions reductions in the developing world payments to refrigerant manufacturers the chinese government which heavily taxes these cdm projects and to carbon market investors by governments and compliance buyers will in the end total approximately 4.7 billion while estimated costs of abatement are likely less than 100 million given limited funds to invest in developing world climate abatement we conclude that there is a need for mechanisms to access extremely low-cost emissions reductions via more cost-effective mechanisms elsewhere we have outlined such systems which could include a project fund such as was done in the highly successful multilateral fund under the montreal protocol on substances to deplete the ozone layer.17 b beyond hfcs the new cdm market over the last two years awareness of the hfc-23 problem has grown and governments have tried to clamp down on these projects by stemming the flow of hfc-23 credits while encouraging growth in other types of offset projects it was thought the cdm would at last encourage investment in activities that would deliver more fundamental changes in technology leading to reductions in emissions for example it was thought that countries would invest in new energy systems that had much lower carbon emissions indeed the cdm market has shifted as shown in figure 1 today hfc-23 projects account for less than half of projected project deliveries and that fraction is declining the good news in theory is that most of the growth in cdm has been outside the hfc-23 sector and projects involving other industrial gases with similar drawbacks the bad news is that these new projects reveal even deeper problems with the cdm mechanism problems that for projects that could theoretically deliver the largest reductions in emissions can t be fixed we focus our discussion on china because it is the most important developing nation in terms of ghg emissions and because current market trends indicate that more than half of all emission credits will likely originate in reduction projects based there.18 we focus on the energy sector because it is fundamental to making a dent in ghg emissions and because it is where the fastest growth in the chinese cdm pipeline is occurring energy projects are crucially important and under the current rules such projects offer the greatest potential for future growth in the cdm in china coal-fired power plants generate approximately 80 of all electric power most of the existing plants are older inefficient designs but most new plants being built are state of the art and china is building new power plants at a truly astonishing rate during each of the past two years approximately 100 gw of new electric generating capacity was constructed in china rapid buildout of coal plants is expected for the foreseeable future in the country.19 the astonishing rate of growth is equivalent to building the entire u.s power plant fleet in less than a decade.20 this new demand has put enormous strain on china s coal supply system including its mines and railroads as evident in the spate of blackouts in january after many years as a coal exporter china is now a net importer of coal 17 michael wara is the global carbon market working 445 nature 595 2007 richard elliot benedick ozone diplomacy new directions in safeguarding the planet 2nd ed harvard university press 1998 18 as of january 1 2008 53 of cers issued to 2012 will be created in china assuming that all projects currently undergoing validation are registered jørgen fenhann unep-risø centre cdm-ji pipeline database at http www.cdmpipeline.org 19 on the rate of power plant construction in recent years see keith bradsher china s green energy gap new york times october 24 2007 for projections see international energy agency 2007 world energy outlook 2007 paris iea 20 the u.s power plant fleet had a total nameplate generating capacity of 955 gw in 2006 see energy information administration annual energy outlook 2008 revised early release 12

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wara and victor pesd working paper #74 april 18 2008 in addition to unreliable power combustion of coal with dirty technologies contributes to the country s soaring rates of childhood asthma and the other ills of air pollution in response to these problems the chinese government has implemented a series of policies to both reduce the country s dependence on coal and to reduce the environmental impacts of electricity generation china s current five-year plan in fact calls for major investments in hydro wind nuclear21 and natural gas-fired power in order to diversify away from excessive reliance on coal a 4,000 km long pipeline from the country s western gas fields to the booming cities in the east has been completed a second even larger pipeline is now under construction in 2006 a renewable energy law entered into force that provides strong financial incentives for development of new wind farms in china and sets explicit capacity expansion goals for the wind sector since 2004 china has been on a dam building spree with 10 gw of new hydro power plant capacity being completed each year these changes in china s goals are evident not only in energy policy but also in china s cdm projects today as illustrated in figure 2 essentially all new hydro wind and natural gas fired capacity is applying to claim credit for emissions reductions under the cdm these power plants are at least potentially eligible for the difference between their emissions and the electricity they displace on the chinese electricity grid under the rules of the cdm each new dam wind farm or natural gas power plant applies individually and makes the argument that it would not have been constructed but for the financial incentives produced by the sale of carbon offsets figure 2 hydro wind and natural gas fired power plants built or under construction in china compared to applications for cdm crediting for these projects essentially all new capacity blue bars is applying for cdm offset credit red bars issued credits are based on the difference between these new energy sources and the chinese grid ghg emission intensity shown are new capacity and cdm applications for chinese hydro and wind power in 2007 and for natural gas-fired power in 20052008.22 21 22 nuclear power although a source of low-carbon energy is ineligible to participate in the cdm under the current rules hydro and wind cdm applications exceed new capacity additions in part because some plants applying for credit in 2007 13

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wara and victor pesd working paper #74 april 18 2008 taken individually these claims may make sense because individually any particular power plant utilizing non-coal sources of energy probably faces greater hurdles than new coal-fired generation or may be financially marginal and the ability to sell cers offers the prospect of being able to compete toe-to-toe with coal.23 taken collectively however these individual applications for credit amount to a claim that the hydro wind and natural gas elements of the power sector in china would not be growing at all without help from cdm this broader implication is simply implausible in light of the state policies described above that so many plants would come forward to claim credit as marginal indicates systemic problems with the cdm project evaluation and approval process these problems are probably just the beginning as efforts are under way to apply a methodology that would allow investors to gain credit for installing more efficient supercritical coal-fired power plants in china despite the fact that many such plants are already being built without cdm credits and such plants are probably cost-effective in many chinese power markets on their own.24 these problems are not peculiar to the chinese context they reflect a fundamental challenge in any offset system the host governments and investors that seek credit have a strong incentive to claim that their efforts are truly additional the regulator in this case the cdm executive board can t in many cases gather enough information to evaluate these claims these problems of asymmetrical information are compounded in the cdm to be sure because the cdm executive board is massively under-staffed and the cdm system relies on third-party verifiers to check the claims made by project proponents in practice these verifiers who are paid by the project developers have strong incentives to approve the projects they check further there is scant oversight on the integrity of the verification process and no record of punishing verifiers for misconduct lacking any other source of information about individual projects and facing pressure from both developing and developed country governments the cdm executive board is prone to approve projects asymmetries of information are rampant the incentives mostly align in favor of approval this challenge is made all the more formidable by the sheer number of projects upon which the board must decide the cdm eb on average registers about one project every day as eligible to generate cdm credits thus the board cannot afford to spend large amounts of time evaluating the complexities of financial data presented to justify a project s eligibility for cdm credits nor can it delve into a project s relationship to state energy policy furthermore the cdm eb faces a financial limit on the costs it can reasonably impose on individual offset projects in order to remain viable relatively small carbon offset projects cannot afford the cost and uncertainty that would accompany truly extensive scrutiny indeed there is strong pressure from cdm investors to limit such transaction costs and speed up approval were built earlier and in part because some plants that applying for credit experienced construction delays data sources national development and reform council international gas union international energy agency jørgen fenhann unep-risø centre cdm-ji pipeline database 23 additionality within the cdm is evaluated in a variety of ways projects show they are additional by comparing the proposed activity to what is required by regulation to what is the most financially attractive activity under the applicable circumstances and by assessing any other barriers to implementation of the project 24 in september 2007 the cdm eb approved a methodology for crediting supercritical and ultra-supercritical coal fired power plants see http cdm.unfccc.int/methodologies/db/c7o6iua9otnruk4x619vx2a6os4du7/view.html china has also been pushing construction of these plants as a response to the severe shortages of coal in southern china see information office of the state council of the people s republic of china china s energy conditions and policies december 2007 see also keith bradsher china s green energy gap new york times october 24 2007 14

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wara and victor pesd working paper #74 april 18 2008 it is hard to see how any offset system can dramatically reduce these problems of asymmetrical information distorted incentives and transaction costs one proposal now being embraced cautiously within the cdm system is to allow for so-called programmatic initiatives that is to offer credits for broad policy reforms or for clusters of activities within whole sectors rather than on a project-byproject basis this approach would cut transaction costs and in theory allow for greater scrutiny for many offset project types however information asymmetries are likely to be pervasive indeed if the current system is unable to assess whether the current large projects in gas hydro and renewable power in china are truly additional in their promised emission reductions it is hard to see how a programmatic approach would be much different for these types of projects such problems are likely to recur for any large-scale carbon offset regime domestic or international that operates at the relatively finegrained level of the individual emission reduction project at least in sectors where additionality determinations are particularly challenging our paper focuses on international offsets but we caution that these problems are unlikely to be substantially different for a domestic offsets program such as a scheme to allow offset credits through changes in land use a conventional wisdom has emerged that land use changes and other highly dispersed sources and sinks should be handled in a domestic climate policy through the use of offsets because these sources are too difficult to monitor or regulate with the precision needed for full-blown inclusion within the cap-and-trade however offsets carry enormous costs due to the difficulty of determining additionality which is a problem magnified by the asymmetrical incentives that are intrinsic to an offsets system the offsets approach encourages project hosts to gain credit when net emissions happen to be declining whether or not they are actually declining due to some additional effort but leaves the source unregulated when net emissions are rising for certain discrete projects such as changes in land use and some methane reduction projects an offsets system could play a useful transition role because the cost of certifying individual projects may be lower than tracking all emissions from the sector.25 however we are mindful that offsets systems create asymmetrical incentives that encourage only some activities to opt in to regulation while leaving other emissions unchecked a domestic regulatory system like an international system should move as rapidly as feasible towards including all sources and sinks under a cap c the credit issuance bottleneck so far we have outlined the early troubles with hfc-23 and today s more disturbing troubles in identifying whether important energy projects are yielding actual reductions in emissions below the level that a developing country would have experienced in the absence of the cdm project these are daunting problems but a third challenge is looming to date more than 950 individual carbon offset projects have achieved registration in the cdm the final step after which credits can be generated a further 2000 projects are at various stages of seeking registration but registration of large numbers of projects is not the last hurdle that a project must overcome registered projects must operate and produce actual reductions in emissions that are then verified leading finally to issuance of cers by the eb this final issuance process is the key to the cdm fulfilling its role as a mechanism for generating supplies of emission credits and thus containing the cost of compliance to date the cdm has not shown that it is up to this task early indications are that this final bottle-neck in the process 25 daniel s hall issue brief 15 offsets incentivizing reductions while managing uncertainty and ensuring integrity in assessing u.s climate policy options raymond kopp and william pizer eds resources for the future 2007 15

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