Carbon Offsetting - Market Overview

In order to understand the carbon markets, it is important to recognize the differences between two fundamentally different types of carbon commodities, allowances and offsets, and the systems that create them. The first, allowances, are created by cap-and-trade systems. The second, offsets or carbon credits, are created by baseline-and-credit systems (also sometimes called a project-based system).

Under a cap-and-trade system, an overall cap is set to achieve emissions reductions. Each of the participants within a cap-and-trade system (usually countries, regions or industries) is allocated a certain number of allowances based on an emissions reduction target. In a cap-and-trade system the cap constitutes a finite supply of allowances, set by regulation and political negotiation. These allowances are then neither created nor removed, but merely traded among participants. This finite supply creates a scarcity and drives the demand and price for allowances.

A cap-and-trade system aims to internalize (some of) the costs of emissions, and thus drives actors to seek cost-effective means to reduce their emissions. The challenge in a cap-and-trade programme is to determine the appropriate level at which to set the cap, which should be stringent enough to induce the desired level and rate of change, while minimizing overall economic costs. A baseline-and-credit system in contrast, does not entail a finite supply of allowances. It does not involve projects that are implemented under the umbrella of a cap-and-trade system. Rather, more credits are generated with each new project implemented. These credits can then be used by buyers to comply with a regulatory emission target, to “offset” an emitting activity (such as an airline flight), or to be a “carbon neutral” organisation with zero “net” emissions.

In a baseline-and-credit system a carbon offset buyer can only legitimately claim to offset his emissions if the emissions reductions come from a project that would not have happened anyway. This concept is called additionality in the carbon markets, and refers to the requirement that “[…] reductions in emissions […] are additional to any that would occur in the absence of the certified project activity” (Kyoto Protocol in Article 12.5). Under a cap-and-trade system it is the cap and the allocations rules that drives demand, and determines the level of emissions reduction. Activities that are undertaken in response to the pressure of the cap therefore do not need to prove that they are additional. Additionality is discussed in detail in chapter 5.1.

Cap-and-trade systems often allow for a certain number of offsets to come from emissions reductions that are generated by projects that are not covered under the cap (i.e. from baseline and-credit systems)¹. Under a cap-and-trade system the covered sources (for example power producers) have an obligation to reduce their emissions. If these covered sources cannot buy offsets, they will have to reduce their emissions in some other way (e.g. by buying allowances or by increasing efficiency in their plants). If they can buy offsets and these come from projects that are fully additional, then the offsets replace reductions that the cap-and-trade participant would have had to otherwise achieve himself. In other words, under a cap-and-trade system, offsets do not lead to emissions reductions beyond the target set by the cap but only cause a geographical shift in where the emissions reduction occurs. Therefore, non-additional offsets sold into a cap-andtrade system will actually lead to an increase in emissions since the buyer will not have reduced his emissions and the seller will not have offset this increase in emissions.

In a voluntary system, on the other hand, individuals and companies are not required to reduce their emissions. We can therefore assume that they would only do so to a limited extent. The availability of offsets enables them to go beyond what they would have done anyway to reduce their own emissions. The availability of offsets in the voluntary market may therefore lead to additional emissions reduction that would not have happened without the availability of offsets. Buyers in the voluntary market can only claim a unique, incremental “offset“ reduction if the reduction is additional. Yet even without additionality tests, the offset market might induce reductions that would not have happened otherwise, because the market will bring investment to some projects at the margin. But without clearly established additionality, there is no one-to-one correspondence between each credit sold and an additional tonne of reductions.

Distinguishing Features of Cap-and-Trade and Baseline-and-Credit Systems

Cap-and-trade systems exist almost exclusively in the compliance market². Baseline-and-credit systems exist both in the compliance and in the voluntary market. All currently established cap-andtrade programs allow for a limited use of offsets and have an associated offset programme:

Except for the CCX Offset Programme, voluntary offset standards are independent of and function outside of a cap-and-trade system³. The following sections provide a brief overview of the compliance and the voluntary markets.

Compliance Market

Carbon markets exist both under compliance schemes and as voluntary programs. Compliance markets are created and regulated by mandatory national, regional or international carbon reduction regimes.

Cap-and-Trade Systems

Baseline-and-Credit Systems Used within Cap-and-Trade

Voluntary Carbon Markets

The voluntary carbon markets function outside of the compliance market. They enable businesses, governments, NGOs, and individuals to offset their emissions by purchasing offsets that were created either through CDM or in the voluntary market⁵. The latter are called VERs (Verified or Voluntary Emissions Reductions). It is noteworthy that about 17% of the offsets sold in the voluntary market in 2006 were sourced from CDM projects (Hamilton, 2007)

Carbon Offsets in the Compliance and in the Voluntary Market

Unlike under CDM, there are no established rules and regulations for the voluntary carbon market. On the positive side, voluntary markets can serve as a testing field for new procedures, methodologies and technologies that may later be included in regulatory schemes. Voluntary markets allow for experimentation and innovation because projects can be implemented with fewer transaction costs than CDM or other compliance market projects. Voluntary markets also serve as a niche for micro projects that are too small to warrant the administrative burden of CDM⁶ or for projects currently not covered under compliance schemes. On the negative side, the lack of quality control has led to the production of some low quality VERs, such as those generated from projects that appear likely to have happened anyway (see chapter 5.1 on additionality.)

Voluntary and Compliance Carbon Market Size

Compared to the compliance market, trading volumes in the voluntary market are much smaller because demand is created only by voluntary wish to buy offsets whereas in a compliance market, demand is created by a regulatory instrument. Because there is much lower demand, because quality standards are not widely established, and because they are not fungible in compliance markets, carbon offsets sold in the voluntary market tend to be cheaper than those sold in the compliance market

In 2006, 23 million tonnes of CO₂e were traded at a value of €62.6 million (Hamilton, 2007) in the voluntary market – the trading value of the compliance market, including allowances and credits was €23 billion in 2006. The value of CDM and JI credits was €3.8 billion in 2006. (Capoor and & Ambrosi, 2007.) Nevertheless, the voluntary carbon market has grown dramatically over the last couple of years. According to a recent report, the voluntary offset market grew 200% between 2005 and 2006 (Hamilton, 2007).