Carbon offsets, reversal risk and US climate policy

One controversial issue in the larger cap-and-trade debate is the proper use and certification of carbon offsets related to changes in land management. Advocates of an expanded offset supply claim that inclusion of such activities would expand the scope of the program and lower overall compliance costs, while opponents claim that it would weaken the environmental integrity of the program by crediting activities that yield either nonexistent or merely temporary carbon sequestration benefits. Our study starts from the premise that offsets are neither perfect mitigation instruments nor useless "hot air."

We show that offsets provide a useful cost containment function, even when there is some threat of reversal, by injecting additional "when-flexibility" into the system. This allows market participants to shift their reduction requirements to periods of lower cost, thereby facilitating attainment of the least-cost time path without jeopardizing the cumulative environmental integrity of the system. By accounting for market conditions in conjunction with reversal risk, we develop a simple offset valuation methodology, taking into account the two most important factors that typically lead offsets to be overvalued or undervalued.

The result of this paper is a quantitative "model rule" that could be included in future legislation or used as a basis for active management by a future "carbon fed" or other regulatory authority with jurisdiction over the US carbon market to actively manage allowance prices.