On Offsets, New Waxman-Markey Bill is a Mixed Bag

by Victor Flatt

May 19, 2009

On Friday, the House Energy and Commerce Committee released its anticipated Beta version of its comprehensive GHG and energy bill. Among other goals, the new discussion draft attempts to address concerns from moderate and conservative Democrats concerning the proposed cap and trade system and how it would work. The most notable change involves the free allocation of allowances to certain economic sectors to assist in the transition to the new system, and this is the part that seems to most directly respond to actual political pressures regarding the cost of controlling greenhouse gases.

With respect to offsets, the most problematic change is allowing the offsets, which are more uncertain than emission reductions, to be treated as equal in value to emissions allowances. The original Waxman-Markey discussion draft discounted all offsets by 20% with respect to equivalent greenhouse gas allowances, so that it took 1.25 offsets to be equal to one emission allowance credit. Though a rather blunt instrument, this was designed to account for the relative uncertainty of offset reductions, to provide an incentive to encourage actual reductions from regulated sources, and to even increase real reductions if the offsets proved 100% valid. The new draft retreats from this broad provision by allowing domestic offsets to count as equal to emission allowances on a one to one basis, though international offset credits are still subject to the 1.25 equivalency ratio. This disparity could be justified because of greater uncertainty in evaluating and accounting for international offsets, though other provisions of the bill seem to provide that foreign offsets are already as stringently regulated as domestic ones.

While a set ratio of offset to allowances is quite arbitrary, there is no other mechanism in the new draft to account for offset failures, except in the case of sequestration offsets. Moreover, with respect to sequestration offsets, the new bill backtracks on responsibility and offset integrity. In both drafts, the EPA is required to determine the risk of failure for sequestration project offsets and require the offset developer to deposit an amount in a “reserve” account to compensate for any losses. Though the EPA is given discretion to “assign liability and responsibility for mitigating and fully compensating for reversals,” the construction of the reserve account seemed to indicate that the risk of loss would be placed on the project developer since these persons were the ones who were to make the failed offsets whole. However, in the new draft, rather than requiring developers of failed sequestration offsets to replenish the offset reserve entirely, they are only required to replenish half of the lost offset potential if the failure was “unintentional.” This means that with respect to sequestration offsets, it is very possible that with offset failures, actual reductions could be less than what was guaranteed by the offset instrument.

This is not only problematic from an environmental point of view, but also from a financial point of view. It's expected that a secondary market in carbon trading securities is likely to develop with the passage of a cap and trade bill. The biggest threat to a market composed of GHG securities would be if the underlying value of the securities were to fail or be too volatile. By requiring sequestration offset project developers to make any failure of offsets completely whole, the discussion draft seemed to put the risk of loss entirely on the developer. That ensures that the market instrument derived from the sequestration offset will maintain its value in the secondary market. By explicitly requiring that sequestration developers only make failed offsets partially whole, the new bill calls into question the stability of the financial instrument based on that offset, which is not good for the GHG market or the financial sector as a whole.

Indeed, even though the bill assumes that no non-sequestration offsets will be approved until such time as the offset has actually occurred, even these non-sequestration offsets could be subject to failure (if it turned out for instance that there was fraud, or the leakage or additionality calculation was not correct). A GHG bill should be clear that it is the project developer that will always be responsible for any offset failure, and should explicitly require that offsets that fail to work be compensated by the developers in other ways, ensuring the stability of the market instruments based on these offsets.

One change that will be good for the secondary market is that the second draft accelerates when the EPA is to approve the first round of offset categories. The requirement has been moved up to one year from two years. In general, since most offset types are relatively well understood, this change will better allow the offset market to start developing. As long as there is uncertainty about what offset types the EPA will allow, or how many offset types might suddenly come on the market in the future, investors will be reluctant to buy these offsets because it will be difficult to calculate their value, both intrinsic and with respect to the total market. By requiring the EPA to establish categories quickly, the bill encourages a stable, predictable market, which allows for quick rollout of offset projects, which in turn allows for earlier and greater GHG reductions.

All in all, the new bill addresses some of the concerns over offsets in the system, but still has no mechanism to account for offset failures (except for the limited process for sequestration offsets). Any bill should still include a mechanism for the EPA to address environmental concerns with offsets on an individual basis beyond the limited analysis of environmental harms in large offset groups and should be very clear that offset failure should fall on and be compensated fully by the offset developer. This will ensure more robust environmental protection and more stability in offset financial instruments that are sure to develop

One last point: as I wrote last month regarding the first draft of Waxman-Markey, the U.S. market for offsets will dwarf anything that we have seen in the international arena, and lawmakers need to be aware of the significant load that will be placed on the EPA, and consider this in funding and staffing. That hasn't yet been addressed.
 

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Also from Victor Flatt

Victor B. Flatt is the Taft Distinguished Professor of Environmental Law at the University of North Carolina, Chapel Hill School of Law, and the Distinguished Scholar of Carbon Trading and Carbon Markets, Global Energy Management Institute, University of Houston, Bauer College of Business.

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