Analyzing How Carbon Offsets in Compliance Pricing Schemes Impact Market Carbon Price

Abstract

Key Objectives & Results The value of carbon offsets as a tool for reducing greenhouse gas emissions has been the subject of many recent debates. With an increasing number of governments instituting compliance carbon pricing schemes to economically motivate emissions reductions, it is imperative for policymakers to understand the implications of allowing for offset use within these schemes. However, few studies have investigated the impact that offset use allowance within compliance schemes has on scheme ambition and emissions reduction potential. Our paper seeks to fill this gap by quantitatively researching the impact of offset use on the carbon price within compliance schemes. Through a panel data regression model analyzing data across 68 national and sub-national compliance schemes from 2010 to 2021, we have determined that schemes that allow for offset use have higher carbon prices than those that do not. These results indicate that allowing for carbon offset use can help governments increase their emissions reductions potential in compliance pricing schemes. Summary In an effort to curb greenhouse gas (GHG) emissions to avoid the worst impacts of climate change, carbon pricing mechanisms have become a popular tool for countries to incorporate into their emissions reductions plans (Caciagli, 2018; Jernnäs et al., 2019). The most common pricing mechanisms are carbon taxes and emissions trading systems (ETS) (World Bank, 2022). A carbon tax is a policy that places a fee on each unit of GHG emissions emitted, while an ETS sets a cap on emissions through tradable emission permits (World Bank, 2022). There are currently 47 national and 36 subnational jurisdictions across the globe implementing compliance carbon pricing schemes, which collectively cover about 23% of global annual GHG emissions (World Bank, n.d.). Compliance schemes can differ in a variety of design factors, such as the emissions cap or sector coverage. Each of these features can impact the carbon price level of the scheme, which in turn impacts the scheme ambition, or its potential for reducing GHG emissions. Our project focuses on one particular carbon pricing scheme feature: the use of offsets. A carbon offset “is a reduction [or removal] in emissions of carbon dioxide or greenhouse gasses made in order to compensate for or to offset an emission made elsewhere” (Tsai et al, 2020). Carbon pricing schemes can include carbon offset mechanisms by allowing regulated entities to buy up to a certain number of carbon offsets as an alternative to tax payments or carbon allowance purchases. It is currently a subject of debate if allowing for offset use affects the ambition of compliance schemes. Advocates for offset use argue that it incentivises emissions reductions beyond what is achievable within the regulated sectors and provides a cost-effective, flexible way for regulated entities to meet compliance targets (La Hoz Theuer et al., 2023). Meanwhile, critics argue that offset programs do not have sufficiently stringent protocols to ensure actual or additional GHG reductions (Badgley et al. 2021). However, no studies have quantitatively investigated the impact that offset use has on the emissions reduction potential of compliance schemes. As carbon pricing mechanisms continue to increase their coverage of global emissions, and as offsets continue to become more prominent, it is imperative that decision makers have the knowledge and tools to understand how offset inclusion may impact the carbon price and the ambition of schemes. Our research aims to fill the research gap by answering the question: Does allowing for carbon offset use within compliance pricing schemes impact the carbon price signal? To answer our research question, we used a clustered standard errors random effects panel data regression model to analyze the impact carbon offset use has on our continuous dependent variable, carbon price. We analyzed 68 schemes across national and subnational jurisdictions from 2010 to 2021 and collected approximately 50 variables for the model. The variables include scheme characteristic and design, offset use properties, and external socio-economic variables that have been shown to impact carbon price (Best & Zhang, 2020; Levi et al., 2020; Lin & Jia, 2019; Batten et al., 2020). Our final statistical model included carbon price as the dependent variable and a binary variable for allowing offset use. Additional explanatory variables include a binary variable determining if the scheme is a tax or an ETS, an interaction binary variable describing if the scheme is a tax that allows for offsets, GDP per capita, GHG emissions per unit of GDP, the government effectiveness index, the renewable energy consumption in the country, the jurisdictional emissions covered by the pricing scheme, the globalization index, the climate awareness index, and maximum temperature. Our model results demonstrate that offset use within carbon compliance pricing schemes has a positive significant (p<0.05) impact on carbon price, meaning that the carbon price is higher for schemes that allow offset use. Higher carbon prices motivate greater emissions reductions, thus increasing the GHG reduction potential of the compliance scheme. We believe that these results potentially indicate that governments allowing for offset use in compliance schemes are leveraging the flexibility of offset mechanisms to further reduce their GHG emissions. Our research only scratches the surface of the potential impacts of offsets and ambition of carbon compliance pricing schemes. Future research should delve into the impact of offsets on other proxies for ambition, such as the size of an emissions cap within an ETS or the emissions coverage of a scheme. In addition, in-depth attention should be paid to equity concerns caused by increased carbon prices. Lastly, we believe future research focusing on how offsets can impact corporate climate ambition would be very valuable to governments and NGOs designing the increasingly growing voluntary carbon market.