How to tell a good climate bill from a bad one? This series will guide you through the main issues that are likely to arise in the coming weeks as the Senate takes on climate change. In previous posts, we looked at the crucial and the merely important issues that factor in the climate debate. In this post we highlight issues that matter for climate policy, but will not necessarily make or break it. (To read the other posts in the series, click here.)

So far, we’ve established the absolutely critical aspects needed to make credible climate policy and identified the important features that would make that policy effective. Now we will focus on issues that aren’t quite on the same level, negotiable elements that could still have a meaningful role in determining the long-term viability and effectiveness of a domestic emissions mitigation program. These issues — specifically, price controls and the international implications of U.S. legislation — could become a big part of the political discussion.

Category III Issues: Negotiable Elements of Climate Policy

#1: Price controls: offsets and collars

An uncontrollably rising carbon price is a nightmare scenario for regulated firms and consumers, so industry groups have made a priority of getting robust price controls into climate legislation. Price controls generally take three different forms: banking and borrowing, offsets and price collars. Because banking and borrowing has such a strong effect on the emissions reduction path, we included them in our last post. Here we’ll focus on the two other strong cost containment mechanisms.

a) Offsets

If you’ve been paying attention to the debate over the past two years, you’ve likely heard something about offsets. They are one of the most controversial aspects of climate legislation. Environmentalists are suspicious of them and industry can’t live without them.

What exactly are offsets? As we mentioned in a previous post, carbon is a stock pollutant, meaning that we only care about its total accumulation in the atmosphere. If you keep adding carbon to the system, but remove an equal amount at the same time, it is just as good as no longer adding carbon at all. This is the underlying principle of offsets — firms that pay to remove greenhouse gases from the atmosphere (or keep them from entering in the first place) can receive the same credit they would get if they reduced their own emissions.

For example, with offsets in a cap-and-trade system, a utility that needs to reduce its carbon emissions by 20 million tons need not do so only through emissions cuts from its operations. It could reduce its own emissions by 15 million tons, then receive offset credits through financing a reforestation project and an agricultural methane reduction project that combined would lead to emissions reductions of five million tons, allowing the company to meet its target.

Here is a quick list of different kinds of offsets that might count under climate legislation:

Forestry: Forests absorb CO₂ through natural respiration processes and store it in plant tissue and soil. When deforestation occurs, that stored carbon is released into the atmosphere, contributing to emissions. Deforestation and forest degradation count for around 15 percent of global CO₂ emissions. Projects that reforest — increasing carbon sequestration — or reduce deforestation and forest degradation are growing increasingly popular in voluntary carbon markets and may facilitate significant savings. Some models have speculated that international forest offsets can account for 25 percent of emissions mitigation by 2020.

Agriculture: The agricultural sector accounts for six percent of U.S. emissions, but agricultural emissions will probably not be covered by a carbon price due to the complexity of measuring emissions from agricultural practices and the power of the farm lobby in Washington. The important gases from agriculture are methane emissions from large-scale cattle operations and manure management, and nitrous oxide emissions from fertilizer applications and soil management. Offset projects that capture renegade methane emissions or reduce nitrous oxide releases through better soil management will likely be the most widespread offsets available from the agriculture sector.

Renewable energy/energy efficiency: Projects that supplant dirty energy sources with cleaner sources or improve efficiency in energy production or end-use can also be eligible for offset credit. For example, a firm looking for cheap reductions could finance the development of a renewable energy project and receive credit for the emissions reduced when the renewable energy displaces conventional dirty energy. Additionally, projects that increase the efficiency of energy usage in buildings or facilities can count as offsets. These projects are a major component of the Clean Development Mechanism (CDM), which was established by the Kyoto Protocol. Using the CDM, developed countries can sponsor projects in developing countries and receive emissions reduction credit.

Waste management: The decay of garbage in the nation’s thousands of landfills represents the second largest source of U.S. methane emissions behind cattle operations. Methane flaring, a process that captures and burns these emissions, converting methane into CO₂, is considered an offset, as CO₂ has a lower global warming potential than methane. Combusting methane for energy generation may also generate offset credits.

Fugitive mine emissions: As with landfills, capturing fugitive methane emissions from coal mines presents an opportunity for offsets and may also have benefits in terms of miner safety.

While all of these offsets options are currently available in voluntary offset markets and allowed by regional cap-and-trade schemes like RGGI, they may not all be eligible for credit under federal regulation. Waxman-Markey does not count renewable energy, energy efficiency, waste management and coal emissions as offsets. Cantwell-Collins does not allow offsets in its trading system, but it does permit such projects to be paid for from its Clean Energy Reinvestment Trust.

Many offsets will be cheaper than actual emissions reductions, making them an important means of price control. This is especially true for international forest offsets — the EPA analysis of Waxman-Markey contended that allowance prices would be 96 percent higher without them. That said, Greenpeace and other environmental groups have firmly planted their flag in the anti-offset camp, and there are a number of issues that would need some serious policy attention in order to make forest offsets credible in the U.S. market.

There are four major requirements to making offsets a robust tool. First, they must be additional — that is, projects should only be considered offsets if the specific practice would not have happened anyway. Second, offsets should have permanence — projects are only useful if they are not quickly undone (an offset for planting a tree is of little value if it is rapidly cut down). Third, offsets should be verifiable — there must be some way to confirm that projects are doing what they claim (for forests, this can be very difficult). Finally, offset programs should address leakage — they should not simply shift emission-generating activities somewhere else. These are all valid concerns, and all four will have to be addressed for offsets to be a credible part of climate policy.

Potential hang-ups for offsets will likely involve politicians’ hesitations to send large sums of money overseas, the reliability and veracity of offset credits, the number of offsets allowed for use by regulated firms and the type of offsets available from domestic sources. Despite the misgivings of some policymakers and commentators, offsets will figure prominently in domestic legislation. Waxman-Markey included two billion tons worth of offsets annually, a significant proportion of overall U.S. emissions, the same amount as in the Kerry-Boxer bill introduced in the Senate last fall. Instead of spending time and energy railing against them, policy discussions should instead focus on setting up institutions to fix the problems listed above.

b) Price collars

More than anything else, firms want some certainty when it comes to climate regulations. Planning capital investments over the long-term will be significantly affected by carbon prices, and the more predictable the changes over time, the better firms can plan ahead. Moreover, sudden system shocks in the form of extreme drops or increases in prices can be very expensive and detract from the efficacy of cap-and-trade markets.

To protect the system and reduce price uncertainty, policy-makers are looking to use a price collar in the allowance market. A price collar is a way to define a general price path by restricting how much the price can rise or fall. Price collars work by establishing a price floor — under which the allowance price can never drop — and a price ceiling — above which the price will not rise. It is a simple mechanism in concept, and can provide a lot of certainty for regulated parties and market participants. The price floor and ceiling should be spaced far enough apart to accommodate market dynamics and rise at some rate to match the general rise in allowance prices.

When allowance prices hit the floor, they simply remain at that price until trading forces the price to rise again. Things get more complicated when they hit the ceiling, however. There are two options to bring down the price, depending on if you employ a hard collar or a soft collar. A hard collar releases additional allowances into the system until the price drops, regardless of how many it takes to do so. By contrast, a soft collar uses a strategic reserve of set-aside allowances to reduce the price below the ceiling. The difference between the two is a matter of emissions certainty. A soft collar maintains the overall emissions cap by taking some out of the system at the beginning, much like a rainy day fund, whereas a hard collar just dumps allowances into the market until the price changes. Firms may favor a hard collar because it provides more price certainty, but people concerned about overall emissions will prefer a soft collar.

#2: International aspects

If and when Congress does pass climate legislation, its impact will reach far beyond our borders. The international implications of domestic climate policy are extensive, and while they do not play a huge role in the political discourse, they have sway over some notable policy choices.

a) International negotiations

The Conference of Parties (COP) 15 in Copenhagen in December 2009 was advertised as a chance for the U.S. to reclaim its place at the world leader and innovator on environmental issues. The U.S. was able to do that only partially, and that was due largely to the extraordinary personal diplomacy of President Obama. U.S. negotiators had little to work with, bringing with them no official legislation to show other nations while trying to broker a deal that could pass Senate muster. Without a signed bill, the 2010 COP in Cancun this coming November will probably turn out similarly; nations will bicker and haggle and eventually end up not making any kind of serious commitment sans U.S. leadership. The EU does not have the sway to move a global climate deal forward, while other major emitters like China and India don’t have the incentive to act.

That’s not to say international negotiations will not have some influence on the shape of U.S. legislation. At Copenhagen, the U.S. committed to provide $30 billion from 2010 to 2012 to developing countries for mitigation, adaptation, technology transfer and other assistance. Additionally, the conference agreed to establish an annual $100 billion fund — of which the U.S. is expected to give roughly $20 billion — for developing countries for the same uses. Some of this funding will likely be partitioned from current programs, but it will certainly not be enough. Revenues from carbon markets established by climate legislation — as well as allowance allocations — will likely provide the most reliable source of international funds. The tradeoff is that every dollar spent on helping other nations adjust to climate change is one that can’t be used domestically. Though it won’t dominate the debate over any climate bill, the use of carbon revenues for international financing could end up having a real impact.

b) Competitiveness and leakage

Certain industries with intrinsically large carbon footprints, such as cement, steel and paper pulp, are particularly sensitive to carbon prices. These industries are concerned that paying for their sizable emissions will reduce their overall output, leading to job cuts and smaller profit margins. Moreover, they worry that a U.S. carbon price will lead to a shift in production to other countries that do not have similar regulatory burdens. When firms leave for other countries that don’t have a climate policy, it could lead to higher overall global emissions, a phenomenon known as leakage.

There are a couple of solutions to these problems. First, to help protect industries at home, climate policy can include rebates to industries — either in the form of cash or extra tradeable allowances — based on their output to help them adjust to the new reality of a price on carbon. Second (and more controversial), the federal government can establish border adjustments, slapping taxes on imports competing with vulnerable domestic industries. Essentially tariffs, such levies would put goods from countries without a climate policy on the same level as those from the U.S. Border adjustments can make for tricky politics, though. When the Waxman-Markey bill passed the House in 2009, President Obama openly criticized the inclusion of such measures. When the debate picked up in the Senate, however, 10 Midwestern senators stated they would not back any climate legislation that did not support manufacturing interests with some kind of border provision. Even if some compromise allows border adjustment to find its way into climate legislation, there’s a chance it would not be allowed under WTO agreements.

The Bottom Line

Last post, we reviewed important aspects of climate policy. In this post, we surveyed two areas that have value in generating good policy, but are negotiable in terms of their importance:

1. Is there a price collar? Are offsets allowed?
2. What is the effect of the proposal on international climate issues? How will it affect negotiations and commitments? How does it attempt to protect trade-vulnerable industries?

In our next and final post, we will focus on the issues that make little contribution to good climate policy — or might even be counterproductive.