Can offsets pave the way for ambitious compliance carbon schemes?

Five years after world leaders agreed on the landmark Paris Agreement, national policies and financing remain off-track from averting disastrous climate change. Signatories are now expected to update their nationally determined contributions (NDCs) with more ambitious emission reduction targets. These targets will be met by climate policies such as carbon pricing.

However, introducing, maintaining and increasing the ambition of carbon pricing is contentious due to the perceived increase of personal and economy-wide costs. To address these issues, policymakers incorporate different types of cost containment measures, such as offsets. Currently, 34 national and subnational jurisdictions allow offsets to be used as a cost containment measure in domestic carbon markets. Mexico, Chile and Indonesia have confirmed they will incorporate offsets to proposed emissions trading schemes (ETS).

As the urgency to implement more stringent national climate targets grows, can offsets play a role in introducing and raising the ambition of carbon pricing schemes?

To answer this question, South Pole and Wuppertal Institute analysed five national and regional carbon pricing schemes to draw insights on offset design in:

1. European Union Emissions Trading Scheme (EU ETS)

2. Alberta’s different ETS from 2007 to now

3. Australia Emission Reduction Scheme and Safeguard Mechanism

4. Colombia’s carbon tax

5. Japan’s Joint Crediting Mechanism (JCM)

This analysis is part of the ongoing research project “Analysis of Advantages and Disadvantages of Offset Approaches in Selected Sectors”, facilitated and funded by the German Environment Agency. One finding is that offsets can be a viable and environmentally sound cost containment measure when introduced as part of an ambitious compliance scheme. Here’s how:

Offsets assisted countries in introducing a carbon pricing instrument

When compliance actors anticipate that future carbon prices will be much higher than the offset price, offsets are an attractive cost containment measure. This was the case in the EU, where the pilot phase revealed that the forward carbon price could reach over EUR 25 per tonne of carbon dioxide equivalent (tCO2e) in future periods.

Offsets were attractive in comparison to other cost containment measures because they permitted flexible design options to achieve emission reductions within and outside of the geographical, jurisdictional and sectoral scope of the compliance scheme, potentially contributing to sustainable development, like in the case of CDM. This garnered political support of and for offset supply sectors and beyond.

In the case of Alberta, Australia, and Colombia, domestic voters supported the use of offsets to finance emission reductions in politically powerful sectors within the respective jurisdiction. The JCM provides Japanese firms with financial support to undertake carbon project development in foreign countries.

More clear evidence is needed on whether offsets raise the ambition of carbon pricing instruments

From the case studies analysed, there was no clear evidence on offsets increasing the ambition level of carbon pricing schemes. This was also due to the fact that the majority of the carbon pricing schemes themselves did not raise their ambition as it was the case in Columbia, Japan and Australia.

In Canada, the provincial government of Alberta was forced to adopt a higher carbon price that was aligned to federal legislation, as set under the Greenhouse Gas Pollution Price Act. As a response, the Albertan government doubled the total percentage of flexible measures, such as offsets, that Albertan compliance facilities could use to reduce their overall carbon costs. Given these political circumstances, it cannot be argued that offsets were a key factor in enabling the compliance scheme to raise its ambition, as this was due to the level of climate ambition of the successive parties in the province, and policy alignment to the ambition level set by the Federal Government.

In contrast, the EU ETS reduced the amount of offsets that could be used in subsequent phases. The main reason was because the EU carbon price was persistently low as a consequence to the 2008 economic recession. Offsets were not needed as a cost containment measure even as the EU ETS mitigation target increased in future phases. In fact, EU policymakers were working on ETS reforms to boost the carbon price signal.

Looking ahead: the future role of offsets as cost containment measures in compliance schemes

The conclusions from the analysis suggest that offsets can pave the way for introducing a carbon pricing scheme when:

1. policymakers are willing to introduce and maintain a strong carbon price signal that justifies the inclusion of cost containment measures;

2. offsets can garner additional political support from potential offset suppliers and voters;

3. institutions certifying offsets have the capacity to reduce transaction costs and delivery risk of offsets.

Since the findings provide no clear evidence for offsets having led to an increase of ambition of carbon pricing schemes in the past, the introduction of an offset component should include a phase-out / sunset clause with the continuation of the offsets being tied to the continuous increase of the ambition level of the compliance instrument. Furthermore, offsets must be certified according to the principles of environmental integrity to not undermine the environmental integrity of the compliance scheme itself. With this, offsets could deliver on their role as a driver of ambition.

That way, offsets that are part of ambitious compliance schemes could contribute to achieving broader post-2020 objectives. These include the ambition raising impacts offsets can have on the supply side, their broader integration into sectoral transformation strategies and their role in achieving net-zero in the second half of the century. These aspects will be touched upon in future blog posts of this series.

Blog series: Can offsets be a solution to global climate inaction?

This blog is the first of a 3 part series that highlights key research findings from a research project that is funded by the German Environment Agency and jointly conducted by Wuppertal Institute and South Pole. The reports on which these blogs are based are soon to be published on the UBA website and the findings will be further discussed in an I4C webinar on "How to raise ambition through carbon offsetting? Lessons learned and post-2020 prospects" at the end of September 2020.