What is the Optimal Offsets Discount under a Second-Best Cap & Trade Policy?

Heather Klemick

No 201204, NCEE Working Paper Series from National Center for Environmental Economics, U.S. Environmental Protection Agency

Abstract: Despite concerns about additionality, leakage, permanence, and verification, carbon offsets have been proposed as a core component of recent cap-and-trade proposals in order to contain costs, involve uncapped sectors in GHG reduction goals, and build mitigation capacity in developing countries. Discounting the value of offsets relative to GHG allowances (i.e., setting a trading ratio less than one) has been suggested as one approach to protect the integrity of the cap. This paper presents a simple theoretical model to derive the optimal trading ratio between offsets and allowances when coverage of emissions by the cap-and-trade and offsets programs is incomplete. I discuss the relationship between the trading ratio and the GHG cap and offsets baseline, which jointly determine the stringency of the policy. While a discount for leakage is always optimal, one notable result is that if “hot air” is introduced by setting either the baseline cap or the cap too leniently, an extra discount is warranted.

Keywords: offsets; additionality; leakage; baseline; cap and trade; second-best theory (search for similar items in EconPapers)
JEL-codes: D62 H23 Q54 Q58 (search for similar items in EconPapers)
Pages: 27 pages
Date: 2012-07, Revised 2012-07
New Economics Papers: this item is included in nep-ene and nep-env
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Citations: View citations in EconPapers (7)

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Persistent link: https://EconPapers.repec.org/RePEc:nev:wpaper:wp201204

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