Economic Incentive Instruments & Carbon Offsets

Environmental EconomicsHarvard University Summer School

Jennifer Janisch Clifford

July 6,2011

Market Incentives to PolluteFirms are encouraged to pollute when

resources are free.Need to make it more profitable not to

pollute than to pollute.95% of current air & water pollution could be

eliminated by known & available technology.

Internalizing External CostsGoal is to close the gap between private &

social costs.2 General Approaches toward this goal:

1) Direct Government Regulations (Command & Control)

2) Economic Incentive Instruments

Economic Incentive Instruments (EIs) either:1) Put financial burdens on the polluters –

these costs provide an incentive to reduce pollution, or

2) Polluters are offered financial incentives, for example subsidies if they reduce pollution or their environmental impact.

EIs are considered desirable for:

Expected EfficiencyExpected to provide incentives for innovationPerceived as a more appropriate set of

instruments in the preventative phase of environmental policy

EIs have in common:The existence of financial stimuliThe possibility of voluntary actionThe involvement of government (or related)

authoritiesThe intention of directly or indirectly

maintaining or improving environmental quality by applying the instrument.

EIs can be:ChargesSubsidiesDeposit- Refund SystemsMarket CreationFinancial Enforcement Incentives

Market Creation: Cap & Trade

Parties may buy “rights” for actual or potential pollution & may sell pollution allowances when they exceed compliance.

Trading Systems “Cap & Trade”Advantages:

Each time a permit is sold the limit decreases Incentive to invest in pollution control equipment

(present economic value). Efficient: minimizes overall cost.

Carbon OffsetsA carbon offset is a financial instrument

representing a reduction in greenhouse gas emissions.

1 carbon offset = reduction of 1 metric ton of carbon dioxide or its equivalent.

2 Markets for Carbon Offsets1) Compliance Market: industry & government

need to buy carbon offsets to comply with caps on total carbon emissions. In 2006 $5.5 billion of carbon offsets were

purchased in the compliance market = 1.6 billion metric tons of CO2 reductions.

2) Voluntary Market: individuals, companies, & governments purchase carbon offsets to mitigate their own greenhouse gas emissions.In 2006 $91 million of carbon offsets were

purchased in the voluntary market = 24 million metric tons of CO2.

Kyoto ProtocolThe Kyoto Protocol sanctioned offsets as a

way for governments & industry to earn carbon credits.

Projects are validated and measured by the Clean Development Mechanism (CDM).

To comply with the Kyoto Protocol if emission levels are higher than the allowable standard they may offset their emissions by purchasing “CDM-approved Certified Emissions Reductions.”

30 industrialized countries, signatories to Kyoto, have been legally bound to meet quantitative targets for greenhouse gas reductions to below 1990 levels between 2008 & 2012.

EU implemented Cap & Trade system in 2005 to reach Kyoto targets.

Kyoto expires in 2012 (signed in 1997, became binding in 2008).

Climate ConferenceNext international climate conference will be

held in Durban, South Africa beginning on November 28th.

Necessary to secure concrete, legally binding, verifiable agreements on carbon reduction from industrialized & emerging economies.

High expectations for the Copenhagen conference but it ended in disappointment: No legal agreement reached, concluded with a political statement.

December 2009 Copenhagen Conference on International Climate Change Agreements & Standards to replace or extend the Kyoto Protocol.

American House & Senate was motivated to pass climate change legislation to cap greenhouse gas emissions before December conference but failed.

The House passed the Waxman-Markey Bill June 2009 Climate Legislation (Kerry-Lieberman) failed in the Senate (July 2010)

Read “As the World Burns” by Ryan Lizza New Yorker 10/11/10 Issues with Cap & Trade legislation:

Whether allowances will be given away or auctioned. President favors auctioning of permits; budget has projected $646 billion in

revenue generated between 2012 & 2019. Companies that have been polluting for free do not want to start paying for it. Utilities will pass on higher costs to consumers. Revenue generated from auctions will be used for clean energy projects and

assistance for low & middle income families.

Cap & Trade TimelineCap & Trade was designed & tested in the

United States in 1990 as part of the Clean Air Act Amendments.

In the 1990s the US acid rain cap & trade program achieved 100% compliance in reducing SO2 emissions (22% below mandated levels).

The $2 billion annual cost of the acid rain controls is a quarter the initial estimates.

Savings from Cap & Trade Acid Rain Reductions:17,000 deaths a year prevented in the

U.S.100’s of 1000’s of respiratory illnesses

lessoned.Acid Rain Program is saving $108 billion

annually in healthcare costs.

Benefits of Climate Change LegislationStrengthens energy securityImproves air qualityIncreases competitive advantage in trade and

technology innovationIncreases resource efficiency

It is in countries’ own self interest to enact climate legislation.

Projection is that Cap & Trade plan would reduce emissions 80% by 2050

European emissions decreased 3% in 2008 alone.

Australia has delayed Cap & Trade legislation to 2012.

Prime Minister has promised more ambitious targets.

ProgressU.S.: American Recovery & Reinvestment Act

included $80 billion for clean energy development & $16.8 billion for renewable energy programs.

China: 12th 5-Year plan (just released) includes significant targets for reducing carbon intensity (amount of carbon emitted per unit of economic output) 40-45% from 2005 levels by 2020.

India: Expert Group for Low Carbon Strategy for Inclusive Growth.

Mexico: Looking at energy laws and climate change legislation.

ProgressBrazil: Pledged to reduce deforestation in the Amazon by

80% by 2020. (still an annual loss of 3,250 sq. km a year)Brazil policymakers talk of ending deforestation by 2030.Brazil: Legislation on deforestation

Expansion of rainforest land designated as National Park or Indigenous Reserve.

Greater enforcement of laws against illegal logging, cattle ranching and slavery.

Government discouragement of sugarcane cultivation in the Amazon.

Land registry & formalization of land holdings.

REDD: Reducing Emissions from Deforestation & DegradationPayments for carbon sequestration in forests

and avoided deforestation.Idea: Rich countries should pay poor Not to

cut down trees.Goal: Cut deforestation in half by 2020.6 Wealthy Nations have pledged $4.5 billion

to launch REDD by 2012> 70 Developing Forest Countries could be

eligible for P.E.S.

REDD: Reducing Emissions from Deforestation & DegradationProposed at Kyoto in 1997: industrialized

countries be allowed to offset their own emissions by paying developing countries not to cut down their forests. European environmental groups opposed the idea – rainforests since have been disappearing at a rate of 20 – 30 million acres a year.

Concern is that credits will flood the market and drive allowance prices down, decreasing incentives to invest in clean technologies.

Benefits of REDD creditsAllowing REDD credits to be used for

compliance carbon in cap & trade:1) Would provide incentive for protection of

tropical forests2) Change the dynamics for forest protection3) Help to avert disastrous global warming.

Deforestation accounts for approximately 20% of anthropogenic greenhouse gas emissions.

4) Will put a value on standing trees. Trees may be worth more alive than dead.

• Environmental Defense Fund study

Value of RainforestMost of the values are public goods that are

not counted in national output.In the national accounts forest clearance is

recorded as progress.U.N. Millennium Ecosystem Assessment

identified 24 main ecosystem services, most of which are found in forests (almost none of which are priced on markets).

“Forests are disappearing because they are undervalued.”

ForestsAbout half the Earth’s original forest area has

been cleared. According to FAO approximately 10 billion

acres of forest remain worldwide (31% of Earth’s land surface). Only one third of which is primary & FAO counts as “forested” areas with as little as 10% forest cover.

Deforestation contributes 15 -17% of World’s total emissions (> all transportation combined).

Worldwide forests absorb one quarter of all carbon emissions.

The Economics of Ecosystems & BiodiversityThe Economics of Ecosystems & Biodiversity

(TEEB) found:Contribution to the livelihood of poor forest dwellers at

$500 mil to $1 billion a year (based on estimated market value of fish & thatch).

Rainforest’s role in avoiding siltation in hydro-power reservoirs valued at $60 mil to $600 mil annually.

Contribution to South America’s agricultural output (through regulating the water cycle): $1 - $3 billion (Head of research team thinks the real value may be 10 Xs higher).

Value of Bio-prospecting unknown but potentially tremendous.

The negative externalities from forest loss and degradation cost $2 – 4.5 trillion a year.

Local PES SchemesIn response to Yangzi River flooding, China

pays farmers $450 a year per reforested hectare.

Costa Rica has paid $45 – 163 per conserved hectare since 1997.

U.S. & Australia markets for “Habitat Banking” or biodiversity offsets.