Streetwise Professor

February 8, 2010

Measure for Measure

Filed under: Climate Change,Commodities,Derivatives,Economics,Politics — The Professor @ 5:55 pm

The FT has an interesting article about the difficulties and uncertainties facing cap & trade schemes, even in Europe where they’ve been implemented.  A good part of the article focuses on the loss of intellectual coherence in climate policy in Europe, as regulations and taxes are being mooted to reduce CO2 emissions.  Such command and control bolt-ons are inconsistent with the basic concept of cap & trade, which is that by determining a price of carbon the market will induce efficient responses to reduce emissions on all relevant dimensions:

And the more the carbon market shrinks in its ambitions, the more it faces a broader threat: that of losing touch with its original objective. Credits could continue being traded in the old way. But if the main thrust of carbon reduction is tackled by other means, the market could face questions about its social utility.

But to me, the most interesting part of the article relates to the arcane area of offsets:

Nibble, nibble. Then we come to the aforesaid vexed question of offsets.

That is the system whereby EU companies build projects in developing countries – which are not subject to carbon caps – and thereby earn the right to emit more back home. The premise is that each project emits less than the existing version – or less than some notional alternative, which is not the same thing.

There is scope for abuse here. And, some claim, there is growing protest among locals who might not be too keen on a pulp mill or dam at all, let alone one built with foreign capital. Hence the curious sight reported by one environmentalist of thousands of Thais last year waving placards reading “Stop selling carbon credits”.

Since offset-based credits account for only a fifth of the total, the simplest solution might be to abandon offsets altogether. But that would be resisted by EU industry, since the whole job of meeting carbon targets would thereby fall on EU plants. It would also be a further reduction in the scope of the scheme.

For those not familiar with offsets, these are basically projects that absorb greenhouse gases or lead to reduced production of said gases by substituting low emissions technologies for high emissions ones.  Planting a forest that absorbs CO2 is an example of an offset.  The party planting the forest would receive CO2 credits based on the amount of carbon absorbed by the forest which could be sold.  The income from the sale of the permits can be used to recoup the costs of creating the offset, and earning a return on the capital committed.

As the article notes, Europe relies on offsets for about 20 percent of its CO2 reductions; the US ACES bill passed by the house depends even more heavily on offsets.

I teach (along with colleagues Victor Flatt and Praveen Kumar) what is likely the first university course in carbon trading offered in the US (and perhaps globally).  While teaching the course, prepping for it, and listening to my colleagues and student preparations, I have become convinced that although there is a strong conceptual case to be made for offsets (if it is cheaper to capture carbon somehow rather than reduce carbon output on other margins), the practical difficulties make it highly problematic to rely heavily on them.

The practical objection relates to transactions costs, notably what is sometimes called the measurement branch of transactions cost economics.

Every transaction involves some measurement.  Measurement is costly, and like all costs, it is desirable to economize on these expenses.  Measurement costs can be so large as to make some transactions prohibitively expensive.  Economizing on measurement costs can also affect the nature of transactions.  (As a prosaic example, to prevent excessive, wasteful measurement, it may be economical to package several pieces of fruit in sealed packages, rather than allowing consumers to pick over individual pieces.)

In my lectures in the carbon trading class, I discuss how commodity measurement issues have posed challenges in commodity markets, and how market participants have developed mechanisms to address these challenges.  Based on this history, and and an understanding of the unique issues associated with carbon and especially carbon offsets, I conclude that measurement problems are likely to be extremely knotty in this context.

The root problem is that incentives to monitor quality differ between transactions for “bads” like carbon, and transactions for goods, like wheat or oil. In transactions for private goods, the buyer has an incentive to monitor the quality of the good provided by the seller.  Moreover, the parties to the transaction have an incentive to develop ways to balance the costs and benefits of improved measurement.

In contrast, in a market for pollution, almost by definition the “consumer” in the transaction has no incentive to monitor.  Since the effects of the bad are extremely diffuse, the willingness and ability of those “consuming” it to monitor it are minimal.  Indeed, this is  one of the sources of transaction cost that must be invoked to justify the public regulation of CO2 emissions in the first place (in lieu of private Coasean bargaining, or reliance on torts).

So third parties must do the monitoring.  But this is likely to be very burdensome, for a variety of reasons.  At any point in time, it is a non-trivial problem to monitor the amount of carbon absorbed by any offset project.  Think of the challenges of measuring the amount of carbon absorbed by a forestation offset project.

Moreover, offset projects are supposed to be permanent.  Think of the forest example again.  If the forest burns down, the carbon captured–which has resulted in the distribution of valuable CO2 permits to the developer–is released.  Conceptually, you could provide the appropriate incentives by requiring the developer to acquire and retire an amount of carbon emission permits equal to the amount of CO2 released by the fire.  But here we face a stock-flow problem: the developer may be on the hook for say, 50 years worth of permits.  The developer has every incentive to retain very little capital, and just declare bankruptcy in the event.  So, to give the appropriate incentives to trade-off the benefits and costs of risk of loss of permanence, it may be necessary to require the purchase of insurance; or bonding requirements; or capital requirements.  But how do you price the insurance?  How do you determine the bond or capital that gives the right incentive?  Offset projects differ in permanence loss risks; who measures that risk (which will vary by project and by the efforts of the operator of the offset to control the risk of release) and prices it so that developers have the incentive to create the right mix of offsets?

Presumably we will see the creation of offset rating agencies to address some of these issues.  In light of the financial crisis, enough said?

And here’s another thought apropos the financial crisis.  I predict that if offset projects are created, financial instruments will be created to distribute (“slice and dice”) the risks of loss of permanence, and the risks of underperformance.  Specifically, I predict the creation of CDOs–carbon derivative obligations–that will create offset tranches from portfolios of offset projects.  The lower rated tranches will bear the first risk of loss of performance, the mezzanine tranches the second risk of loss, and the AAA pieces will only fail to pay out completely if the offset portfolio’s performance is so poor that the less senior tranches are wiped out.

After all, failure to produce the anticipated/promised amount of carbon offset is almost exactly analogous to a default, which is just the failure to produce a promised cash flow.  It is therefore to be expected that the risks will be managed, sliced, and diced in very similar ways.

But permanence isn’t the only issue.  Offsets are also supposed to be “additional,” meaning that a particular offset project wouldn’t have been created even without the prospect of receiving valuable carbon credits.  For instance, if the ability to sell natural gas or power makes a project to capture methane viable even absent the inducement of carbon credits, providing such credits provides an excessive incentive to create such projects.

And just how does one measure additionality, exactly?  It requires a detailed understanding of the economics of a particular project.  (The issues here are very complex.  Think of a wind power project.  Wind power is erratic, and typically requires backup from fossil fuel units to maintain reliability.  It’s not trivial to model what the actual amount of fossil fuel consumption that is eliminated by a wind project.)   Moreover, and even more problematically, since these projects are durable, it requires an understanding of the but for equilibrium; what does the equilibrium long term supply curve for these projects look like in the absence of a subsidy (via the provision of credits)?; what alternative technologies are being displaced?  Any measurement of these quantities is highly, highly subjective, and built on layer after layer of assumptions.

These problems would be pretty daunting even if enforcers/measurers had good incentives, and were not subject to influence.  But how does one incentivize those making the evaluations?  How does one economize on influence costs, which are likely to be quite substantial?  Again, all of the problems with rating agencies that culminated during the financial crisis occur in spades here.  And when one considers that offsets are to be created internationally, corruption and enforcement problems may be particularly acute in some jurisdictions.

In other words, offsets sound great in theory, but are likely to be extremely expensive in reality, especially if they are introduced on large scale.  These expenses need to be taken into consideration when evaluating the costs and benefits of cap & trade generally, or of specific cap & trade plans.  Moreover, these costs may prove so prohibitive that it would be better to eschew offsets altogether, or sharply circumscribe their use.  But this will mean that the cost of carbon will be that much higher as the burden of adjustment to caps will be forced onto other margins subject to diminishing returns.

From my perusal of various sources, it doesn’t seem that the measurement issue has been adequately analyzed, or measurement costs adequately quantified.  As a result, it is likely that the costs of a cap & trade system will be far greater than have been estimated.  That is a sobering thought.

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