Building a Firm Foundation for GHG Regulation

The carbon credit origination business was established within the framework of the Kyoto Protocol and underpins the growing U.S. voluntary greenhouse gas (GHG) market. Carbon credits are also getting traction in the project finance arena, and some new investment funds have emerged to exploit these opportunities. Proposed U.S. legislation also appears likely to use carbon offsets or credits, although the details remain unclear. I wonder if these schemes adequately support the goal of global GHG emission reductions.

Stable Structure Needed

The four pillars that support the structure of GHG regulation—faith in market solutions, globalization, energy agnosticism, and green consumerism—are all under attack, not just in the U.S., but worldwide. I believe that improved carbon origination rules can reinforce the foundation of each of these pillars and protect them from future structural failure based on their current design. Let me explain.

The first pillar of carbon “cap and trade” is, of course, that effective markets will create innovative technological responses to the increased prices imposed on carbon emissions. In short, economically created necessity will be the mother of many inventions. The “offset” concept simply globalizes the thought: It salutes effective markets as providing the required “push” to develop the necessary technical fixes rather than technology “pulling” the markets. For example, almost all of the Environmental Defense Fund’s recommended carbon offset projects rely on variants of the same technology fix. That is too one-dimensional for my taste.
 
The “globalization” column may not be supporting its share of the load, as localized GHG rules may be expensive, yet useless. GHG reductions of, say, hydrofluorocarbon emissions in China may not be the path to systematic reduction of concentrated emissions in Germany. Globalization is an issue that has been raised with respect to other cap-and-trade programs. Obviously, it remains to be seen whether the whole world will adopt the same carbon standards so that there is some symmetry when ratcheting down emissions limits. From a long-term standpoint, a scheme may be rewarding the wrong technologies located in the wrong places.

The third pillar, energy agnosticism, effectively assumes that energy production that leads to carbon compliance is the best route, regardless of its energy security value or cost consequences. Indeed, many leading analysts don’t think that under a new cap-and-trade regime, new coal plants can play a significant role in meeting the future foreseeable growing power needs. That role is left to renewable (if possible) or, by default, to gas or nuclear generation, and the availability of fuels for those last two generation types is somewhat problematic.

The fourth pillar is also showing cracks. It assumes that green consumerism is a sustainable path forward and that consumers will voluntarily pay for the creation of the carbon-diminishing marketplace. Indeed, the price of offsets for carbon origination is predicated on the assumption that consumers will pay the passed-through “carbon tax” on energy and consumer goods. But will our current and future economic pressures prove that assumption valid? Already, leading market survey firms are reporting that consumers turn away from “green” when it costs more, even though they like the idea of “green” in principle. For example, the Florida Public Service Commission killed the Florida Power & Light green power program in August, citing high program costs and the state’s new renewable portfolio standard.

Flawed Structural Design

With a little imagination, an offsets scheme could be much more than one small element of a cap-and-trade scheme. Offsets are treated as a quirk of the Kyoto Protocol or perhaps a version of the soon-to-be-atavistic voluntary market, but they should instead be treated as a principal policy measure—a reinforcing of the foundation for the four pillars.

Return to first principles as you consider this line of thinking. Carbon emission reduction has economic value as “currency” only because a legal scheme makes it so. The difference between an allocated allowance and an offset emission reduction is defined and equilibrated only by the rules of the legal market framework in which they operate. Allowances are awarded or auctioned value currency, and offsets are another form of value currency to pay the price of pollution.

Consequently, if the columns are to keep standing, some carbon value currency must be awarded to the activities that bolster them. Absolute GHG reduction is the goal, but we need more than arithmetical addition and subtraction of value currency for carbon to influence, in a practical way, positive development sustaining innovation, globalization, energy security, and consumer acceptance.

New Offset Approach

In my opinion, consideration should be given to modifying the operative definition of “offsets” using the following guidelines:

• Offset possibilities should be maximized, regardless of the emitting source. Emissions generators should be permitted to obtain offset rewards (excess “allowances”) for further improving the management of their systems, whether by abatement, renewables, or efficiency. (This is essentially contrary to the approach taken by the recently failed Warner-Lieberman legislation.)
• Offset “dumping” should be precluded. Carbon reductions by different technologies qualifying as offsets are not necessarily all equal. There may be several technologies whose development deserves and requires differential support for a variety of possible policy reasons. A case can certainly be made, for example, that offsets should not be a permissible “export” product for countries that are otherwise net contributors to GHG pollution through their other activities. The globalization of GHG limitations will not just happen for the simple reason that cost avoidance creates competitive advantage. It’s a case of Gresham’s Law in action: Value currency that is the result of insufficiently rigorous rules will drive out better-quality value currency if permitted to do so.
• Offset technology development support should be targeted. Special offset support, analogous in purpose to special tax code incentives, should be given to certain technologies that promise to facilitate needed energy technology development. For example, carbon capture and sequestration (CCS) must be developed if clean coal development is to actually occur, which has extraordinary importance for long-term energy security. Either CCS use or the development of CCS infrastructure should be the beneficiary of special offset rights if it meets progressive performance tests.
• Regional consumer impacts of carbon regulation should not be ignored. Offsets should be available in some form to mitigate costs to consumers of the inevitable pass-through of carbon charges, at least on a transitional basis. In areas where there is concentrated location of generators’ emissions, local consumers should not have to effectively bear a disproportionate share of the economic burden of the “carbon tax” or the stranded costs of coal-fired generating assets.

In sum, the future of the carbon credit offset generation business depends on the abiding strength of a global GHG reduction scheme. If the availability of offsets is not viewed as supportive of any of the GHG reduction scheme’s four pillars, then the underpinnings for any global GHG program—and with it, the carbon credit origination business—may become another failed economic scheme that was not thought through pragmatically. Like power deregulation.

—Roger D. Feldman is cochair of the Clean and Renewable Energy Group at the law firm of Andrews Kurth LLP. He is also a director of the American Council on Renewable Energy and cochair of the Climate Change Committee of ACORE.