Contents

• Introduction
• Offsets: An Overview
• Offset Types and Examples
• Biological Sequestration
• Renewable Energy Projects
• Energy Efficiency
• Non-CO₂ Emissions Reduction
• Potential Benefits of Offsets
• Cost-Effectiveness
• Potential Co-Benefits
• Potential Benefits to Developing Nations
• Other Potential Domestic Benefits
• Potential Concerns
• Integrity Concerns
• Additionality
• Measurement
• Double-Counting
• Permanence
• Leakage
• Delay of Technology Development
• Transaction Costs
• Concerns in Developing Nations
• Considerations for Congress

Summary

If Congress establishes a greenhouse gas (GHG) emissions reduction program (e.g., cap-and-trade system), the treatment of GHG emission offsets would likely be a critical design element. If allowed as part of an emissions program, offsets could provide cost savings and other benefits. However, offsets have generated concern.

An offset is a measurable reduction, avoidance, or sequestration of GHG emissions from a source not covered by an emission reduction program. If allowed, offset projects could generate "emission credits," which could be used by a regulated entity (e.g., power plant) to comply with its reduction requirement. Offsets could include various activities:

• agriculture or forestry projects: e.g., conservation tillage or planting trees on previously non-forested lands;
• renewable energy projects: e.g., wind farms;
• energy efficiency projects: e.g., equipment upgrades;
• non-CO₂ emissions reduction projects: e.g., methane from landfills.

Including offsets would likely make an emissions program more cost-effective by (1) providing an incentive for non-regulated sources to generate emission reductions and (2) expanding emission compliance opportunities for regulated entities. Some offset projects may provide other benefits, such as improvements in air or water quality. In addition, the offset market may create new economic opportunities and spur innovation as parties seek new methods of generating offsets.

The main concern with offset projects is whether or not they represent real emission reductions. For offsets to be credible, a ton of CO₂-equivalent emissions from an offset project should equate to a ton reduced from a covered emission source, such as a smokestack or exhaust pipe. This objective presents challenges because many offsets are difficult to measure. If illegitimate offset credits flow into an emissions trading program, the program would fail to reduce GHG emissions. Another concern is whether the inclusion of offsets would send the appropriate price signal to encourage the development of long-term mitigation technologies. Policymakers may consider a balance between price signal and program costs.

If eligible in a U.S. program, international offsets are expected to dominate in early decades because they would likely offer the lowest-cost options. Domestic sectors, such as agriculture and forestry, might benefit if international offsets are excluded. Some object to the use of international offsets due to concerns of fairness: the low-cost options would be unavailable to developing nations if and when they establish GHG emission targets. However, some offset projects may promote sustainable development. On the other hand, international offsets may serve as a disincentive for developing nations to enact laws or regulations controlling GHG emissions because many projects would no longer qualify as offsets.

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The Role of Offsets in a Greenhouse Gas Emissions Cap-and-Trade Program: Potential Benefits and Concerns

Introduction

A variety of efforts to address climate change are currently underway or being developed on the international, national, and sub-national levels (e.g., individual state actions or regional partnerships).¹ These efforts cover a wide spectrum, from climate change research to mandatory greenhouse gas (GHG) emissions reduction programs.² In the 110^th Congress, Members have introduced a number of proposals that would establish a national GHG emissions reduction regime.

GHG emissions reduction programs, both ongoing and proposed, vary considerably. The primary variables are scope and stringency: which emission sources are covered by the program and how much emission reduction is required.³ These factors largely determine the impacts of an emissions reduction program, but other design details can have substantive effects.

One such design element is the treatment of offsets. An offset is a measurable reduction, avoidance, or sequestration of GHG emissions from a source not covered by an emission reduction program. If a cap-and-trade program includes offsets, regulated entities have the opportunity to purchase them to help meet compliance obligations.⁴

Offsets have generated debate and controversy in climate change policy. If Congress establishes a federal program to manage or reduce GHG emissions, whether and how to address offsets would likely be an important issue. Because most current and proposed programs allow offsets (see tables at the end of the report), offset projects will probably play some part in an emissions reduction program.

The first section of this report provides an overview of offsets by discussing different types of offset projects and describing how the offsets would likely be used in an emission reduction program. The next section discusses the supply of offsets that might be available in an emission trading program. The subsequent sections examine the potential offset benefits and the potential concerns associated with offsets. The final section offers considerations for Congress. In addition, the report includes a table comparing the role of offsets in selected emission reduction programs: proposals in the 111^th and 110^th Congresses, U.S. state initiatives, and international programs.

Offsets: An Overview

Offsets are sometimes described as project-based because they typically involve specific projects or activities whose primary objective is to reduce, avoid, or sequester emissions. Because offset projects can involve different GHGs, they are quantified and described with a standard form of measure: either metric tons of carbon-equivalents (mtC-e) or metric tons of CO₂-equivalents (mtCO₂-e).⁵

To be credible as offsets, the emissions reduced, avoided, or sequestered must be additional to business-as-usual (i.e., what would have happened anyway). This concept is often called "additionality." If Congress establishes a GHG emission cap-and-trade program, only sources not covered by the cap could generate offsets.⁶ Emission reductions from regulated sources (e.g., coal-fired power plants) would either be required or spurred by the emissions cap.⁷ In contrast, if agricultural operations were not covered under an emissions cap, a project that collects methane emissions from a manure digester would likely be an additional GHG emission reduction.

If offsets are allowed as a compliance option in an emissions trading program, eligible offset projects could generate "emission credits," which could be sold and then used by a regulated entity to comply with its reduction requirement.⁸ This approach is part of the European Union's (EU) Emission Trading Scheme (ETS), which EU members use to help meet their Kyoto Protocol commitments.⁹ Under the EU ETS, regulated entities can purchase emission credits that are created from approved offset projects.¹⁰ Regulated entities can then apply the credits towards their individual emission allowance obligations.¹¹ For example, a regulated entity may consider purchasing offsets if the offsets are less expensive than making direct, onsite emission reductions. Assuming the offset is legitimate—i.e., a ton of carbon reduced, avoided, or sequestered through an offset project equates to a ton reduced at a regulated source—the objective to reduce GHG emissions is met. From a global climate change perspective, it does not matter where or from what source the reduction occurs: the effect on the atmospheric concentration of GHGs would be the same.

Offsets increase emission reduction opportunities. When offsets are not allowed, incentives to reduce emissions or sequester carbon are limited to the covered sources, and there is little motivation to improve mitigation technologies for non-covered sources. Including offsets in a cap-and-trade program would expand these incentives

Offset Types and Examples

Offsets could potentially be generated from an activity that emits GHGs or that would remove or sequester GHGs from the atmosphere. This section discusses offsets in four categories. Each category is discussed below with project examples for each group.

Some of the categories and examples listed below may be limited by location. If a U.S. law or regulation (other than an emissions cap) governs a specific emission source (e.g., methane from coal mines), that source's emission reductions would not qualify as domestic offsets, unless the reductions made went further than the regulations required.¹² For example, if the source is required by law or regulation to reduce methane emissions by 50%, reductions up to this threshold would not qualify as offsets, but reductions in excess of 50% might qualify as offsets. As more nations establish mandatory caps or require specific technological controls or practices at emission sources, the universe of potential offsets would shrink.

Biological Sequestration

Trees, plants, and soils sequester carbon, removing it from the earth's atmosphere. Biological sequestration projects generally involve activities that either increase existing sequestration; or maintain the existing sequestration on land that might otherwise be disturbed and release some or all of the sequestered carbon. This offset category includes sequestration that results from agriculture and forestry activities, and is sometimes referred to as land use, land use change and forestry (LULUCF) projects. Examples of these projects include

• planting trees on previously non-forested land (i.e., afforestation);
• planting trees on formerly forested land (i.e., reforestation);
• limiting deforestation by purchasing forested property and preserving the forests with legal and enforcement mechanisms;
• setting aside croplands from agricultural production to rebuild carbon in the soil and vegetation; and
• promoting practices that reduce soil disruption: e.g., conservation tillage and erosion control.¹³

Compared to the other offset categories discussed here, biological sequestration projects, particularly forestry projects, offer the most potential in terms of volume. However, this category is arguably the most controversial because several integrity issues are typically (or perceived to be) associated with biological sequestration projects.¹⁴ These issues are discussed in more detail in later sections of this report.

Renewable Energy Projects

Historically, renewable energy—e.g., wind, solar, biomass—has been a more expensive source of energy than fossil fuels.¹⁵ A renewable energy offset project could provide the financial support to make renewable energy sources more economically competitive with fossil fuels. Renewable energy sources generate fewer GHG emissions than fossil fuels, particularly coal. Wind and solar energy produce zero direct emissions. Use of renewable sources would avoid emissions that would have been generated by fossil fuel combustion. These avoided emissions could be sold as offsets. Potential renewable energy offset projects may include¹⁶

• constructing wind farms to generate electricity;
• adding solar panels;
• retrofitting boilers to accommodate biomass fuels; and
• installing methane digesters at livestock operations.¹⁷

Domestic renewable energy projects are not likely to qualify as offsets in a national emissions reduction program. In a carbon-constrained context, project developers would be hard-pressed to demonstrate that a renewable energy project would not have happened anyway. In an "economy-wide" cap-and-trade emissions program, energy sector emissions would likely be capped. The cap would make fossil fuels more expensive and renewable energy sources more attractive. However, renewable energy projects may still create credible offsets in nations without GHG emission controls on their energy sectors.

Energy Efficiency

A more energy efficient product or system requires less energy to generate the same output. Improvements in energy efficiency generally require a financial investment in a new product or system. These capital investments likely pay off in the long run, but the payback period may be too long or capital financing may be constrained, particularly for small businesses or in developing nations. Examples of possible energy efficiency offset projects include

• upgrading to more efficient machines or appliances;
• supporting construction of more energy efficient buildings;
• replacing incandescent light bulbs with fluorescent bulbs.

Similar to renewable energy offsets, domestic energy efficiency offset projects would likely face substantial hurdles in proving their additionality in a carbon-constrained regime. As the price of carbon increases and raises energy prices—both outcomes expected with an emissions cap—the incentive to reduce energy use through energy efficiency improvements will increase.

Offset ownership is another potential challenge regarding some energy efficiency offsets. Energy efficiency improvements may occur at a different location than the actual reduction in emissions. For example, a business that runs its operations with purchased electricity will use less electricity if energy efficiency improvements are made, but the actual emission reductions will be seen at a power plant. Thus, the reductions may be counted twice: first as an energy efficiency offset and second as a direct reduction at the power plant. One way to address this potential dilemma is to restrict energy efficiency projects to only those that reduce or avoid on-site combustion of fossil fuels. This approach is used in the few congressional proposals that specifically allow energy efficiency offsets.

As with renewable energy projects, there could be energy efficiency projects in nations that do not limit GHG emissions.

Non-CO₂ Emissions Reduction

Multiple sources emit non-CO₂ greenhouse gases. These emissions are often not controlled through law or regulation. These sources—primarily, agricultural, industrial, and waste management facilities—emit GHGs as by-products during normal operations. In many cases, the individual sources emit relatively small volumes of gases. However, there are a large number of individual sources worldwide, and many of the gases emitted have greater global warming potential (GWP) than carbon dioxide.¹⁸ Offset projects in this category would generally provide funding for emission control technology to reduce these GHG emissions. Examples of emission reduction opportunities include the following:

• methane (CH₄) emissions from landfills, livestock operations, or coal mines (GWP = 25)
• nitrous oxide (N₂O) emissions from agricultural operations or specific industrial processes (GWP = 298)
• hydrofluorocarbon (HFC) emissions from specific industrial processes, such as HFC-23 emissions from production of a refrigerant gas (GWP of = 14,800)
• sulfur hexafluoride (SF₆) from specific industrial activities, such as manufacturing of semiconductors (GWP = 22,800)

This offset category is broad, as it involves many different industrial activities. As such, some offset types in this category are generally considered high quality, and others that have generated controversy. For example, methane reduction from landfills or coal mines has a reputation as a high quality offset. These projects are relatively easy to measure and verify, and in many cases would likely not occur if not for the financing provided by an offset market. Therefore, the challenge of proving additionality is easier to overcome.

Offsets involving abatement of HFC-23 emissions from production of a common refrigerant¹⁹ have spurred controversy. Of the offset types certified through the Kyoto Protocol's Clean Development Mechanism (CDM), HFC-23 offsets represent the greatest percentage: 50% of the certified emission reductions (CERs) have come from HFC-23 abatement projects.²⁰ Controversy has arisen because the production facilities can potentially earn more money from the offsets (destroying HFC-23 emissions) than from selling the primary material.²¹ This creates a perverse incentive to produce artificially high amounts of product to generate a more lucrative by-product.

Potential Benefits of Offsets

The inclusion of offsets in a cap-and-trade program could potentially provide multiple benefits. Perhaps the primary benefit would be improved cost-effectiveness. The ability to generate offsets, which could be sold as emission credits, would provide an incentive for non-regulated sources to reduce, avoid, or sequester emissions. The inclusion of offsets could expand emission mitigation opportunities, likely reducing compliance costs for regulated entities. Many offset projects have the potential to offer environmental benefits, as well. Developing countries, in particular, may gain if the United States includes international offsets in a GHG emission program. In addition, the offset market may create new economic opportunities and spur innovation as parties seek new methods of generating offsets. These issues are discussed below in greater detail.

Cost-Effectiveness

A central argument in support of offsets is that their use makes an emissions reduction program more cost-effective. A wide range of activities could be undertaken that would generate offsets. Many of these individual activities would likely generate a relatively small quantity of offsets (in terms of tons), but in the aggregate, their climate change mitigation potential is substantial. Arguably, direct regulation of these sources—either through a cap-and-trade program or regulatory command-and-control provisions²²—may not be cost-effective because of the administrative burden.

By allowing these sources to generate offsets and sell the offsets (as emission credits) to regulated entities, several benefits are achieved. First, emissions are reduced, avoided, and/or sequestered at sources that may not have otherwise occurred.²³ Second, the offsets generated increase the compliance options for regulated entities: covered facilities can either make direct, onsite reductions or purchase emission credits generated from offsets. The increased reduction opportunities provided by offsets are expected to lower the cost of compliance. This impact ultimately affects consumers because they are expected to bear the majority of an emission program's costs.

A 2008 EPA study analyzed the economic impacts of the Lieberman-Warner Climate Security Act of 2008 (S. 2191), a cap-and-trade proposal that would allow covered sources to use domestic and international credits to each satisfy 15% allotments of their allowance submission.²⁴ As with other economic models of climate change regulation, the modelers necessarily make many assumptions. Thus, the relative differences between different scenarios are perhaps more useful than the absolute estimates. EPA's study demonstrated a dramatic difference between the offset scenarios. The study found that if offsets are not allowed, the price of carbon would be substantially higher (e.g., 192% higher in 2015) than if offsets could be used as prescribed by the bill (Figure 1).

Figure 1. Emission Allowance Price at Three Offset Scenarios Under Framework of S. 2191

Source: Prepared by CRS with data from EPA, EPA Analysis of the Lieberman-Warner Climate Security Act of 2008 (2008).

The study also found that international offsets would play a large role, especially in the beginning decades of the program, because there are generally more low-cost offset opportunities in other nations. In later years (as the carbon price rises), domestic offset types, particularly forestry-related offsets, play a larger role.

Potential Co-Benefits

Offset projects may produce benefits that are not directly related to climate change. For example, many of the offset projects that promote carbon sequestration in soil (e.g., conservation tillage) improve soil structure and help prevent erosion.²⁵ Erosion control may reduce water pollution from nonpoint sources,²⁶ a leading source of water pollution in U.S. waterbodies.²⁷

Depending on a project's specific design and how it is implemented, other agriculture and forestry offset projects could potentially yield positive environmental benefits. However, there is some concern that certain projects may produce undesirable impacts, such as depleted soil quality, increased water use, or loss of biodiversity.²⁸ Many agriculture and forestry offset projects would likely involve land use changes, such as converting farmlands to forests or biofuel production.²⁹ Determining whether the change imparts net benefits may be a complex evaluation, depending upon, among other things, the current and proposed species of plants and/or trees. Policymakers would likely encounter projects that offer trade-offs: for example, they offset GHG emissions, while imposing an unwanted outcome, such as increased water use, reducing availability downstream.³⁰ EPA found that the more aggressive offset opportunities—afforestation and biofuels production—are more likely to present the most distinct trade-offs.³¹

Potential Benefits to Developing Nations

Most observers would agree that developing nations are unlikely to limit and reduce GHG emissions on a schedule on par with developed nations. With less-regulated emission sources, the universe of eligible offset opportunities would be much larger in developing nations. Offset types, such as renewable energy and/or energy efficiency projects, which could face substantial hurdles to qualify as offsets in the United States, would be eligible offsets from developing nations. These types of projects would likely provide environmental benefits beyond GHG emission reduction—improvements in local air quality—by displacing or avoiding combustion of fossil fuels.

Offset projects in developing nations have the potential to promote sustainable development, such as creation of an energy infrastructure that is less carbon-intensive and more energy efficient. In fact, this was one of the objectives in establishing the Clean Development Mechanism (CDM). Whether this objective is being met is a subject of debate. However, recent projections suggest that offset activities that promote sustainable development will account for a larger percentage of emissions credits in the coming years.

As a comparison between Figure 2 and Figure 3 indicates, the proportion of renewable energy and energy efficiency projects in the CDM is expected to more than double by 2012. This projected shift would likely improve support for sustainable development objectives. However, offset projects—primarily, HFC and N₂O reduction from industrial activities—that provide few sustainable development benefits are still expected to account for a considerable proportion of emission credits issued.

Figure 2. CERs Issued to Data by Project Type (as of May 1, 2009)

Figure 3. 2012 Projections for CERs by Project Type (as of May 1, 2009)

Source for Figure 2 and Figure 3: Prepared by CRS with data from United Nations Environment Programme, Capacity Development for the Clean Development Mechanism ("CDM Pipeline"), at http://cd4cdm.org/index.htm.

Other Potential Domestic Benefits

A federal cap-and-trade emission program that allows offsets as a compliance option may provide economic benefits to particular sectors of the U.S. economy. However, there may be trade-offs, depending on which types of offsets are eligible and whether or not international offsets are allowed. If international offset projects are included in the program, some U.S. business sectors may benefit from the transfer of technology and/or services to support projects in other nations. If international offsets, generally the lowest-cost options, are excluded, the offset projects from the domestic agriculture and forestry sectors would likely gain a greater share of the offsets market, thus generating business opportunities in these sectors.³²

Another potential benefit that is often highlighted is the ability of an offset market to encourage innovation. As the carbon price provides an incentive for regulated entities to find onsite emission reductions (e.g., through efficiency improvements or development of new technologies), the offset market may spur parties to find new ways to reduce, avoid, or sequester emissions from non-regulated sources. However, there is some concern that the drive to find creative offset methods may encourage offset projects that yield unknown, unintended, and possibly harmful, environmental effects. A frequently cited example in this regard is ocean fertilization, which seeks to stimulate phytoplankton growth (and ultimately improve CO₂ sequestration) by releasing iron into certain parts of the surface ocean. ³³

Potential Concerns

Although offsets have the potential to provide benefits under an emissions trading program, several issues associated with offsets have generated concern and some controversy. Perhaps the primary concern regarding offsets is their integrity. To be credible, an offset should equate to an emission reduction from a direct emission source, such as a smokestack or exhaust pipe. This issue is critical, if offsets are to be used in an emissions trading program. However, implementing this objective would likely present challenges. This and other concerns are discussed below.

Integrity Concerns

If offsets are to be included in an emissions trading program, offset integrity—i.e., whether or not the offsets represent real emission reductions—is critical. Several issues need to be addressed when evaluating offsets. Some of these issues may present implementation challenges, which if not overcome, could damage the integrity of the offset. These issues are discussed below.

Additionality

Additionality means that the offset project represents an activity that is beyond what would have occurred under a business-as-usual scenario. In other words, would the emission reductions or sequestration have happened anyway? Additionality is generally considered to be the most significant factor that determines the integrity of the offset. In the context of an emissions control program, a test of additionality would examine whether the offset project would have gone forward in the absence of the program. An additionality determination would likely consider the following questions:

• Does the activity represent a common practice or conforms to an industry standard?
• Is the offset project required under other federal, state, or local laws?
• Would the project generate financial gain (e.g., be profitable) due to revenues from outside the offset market?³⁴

Offset credits allow regulated entities to generate GHG emissions above individual compliance obligations. If project developers are able to generate emission credits for projects that would have occurred regardless (i.e., in the absence of the trading program), the influx of these credits into the program would undermine the emissions cap and the value of other, legitimate offset projects.

Additionality is at the crux of an offset's integrity, but applying the additionality criterion may present practical challenges. For instance, it may be impossible to accurately determine "what would have happened anyway" for some projects. Assessing a project's additionality may involve some degree of subjectivity, which may lead to inconsistent additionality determinations.

Measurement

Reliable GHG emissions data are a keystone component of any climate change program. If Congress allows offsets as a compliance option, offset data (emissions reduced, avoided, or sequestered) should arguably be as reliable as data from regulated sources. From a practical standpoint, however, achieving this objective may be difficult.

It is generally much simpler to measure and quantify an emission reduction from a direct source than from an offset project. Indeed, the more difficult measurement may be the main reason such reductions are not required by a control program. Regulated sources determine their compliance by comparing actual GHG emissions data against their allowed emissions.³⁵ In contrast, project developers determine offset emission data by comparing the expected reduced, avoided, or sequestered GHG emissions against a projected, business-as-usual scenario (sometimes referred to as a counter-factual scenario).

To accomplish this task, offset project managers must establish an emissions baseline: an estimate of the "business-as-usual" scenario or the emissions that would have occurred without the project. If project managers inaccurately estimate the baseline, the offsets sold may not match the actual reductions achieved. For example, an overestimated baseline would generate an artificially high amount of offsets. Baseline estimation may present technical challenges. In addition, project developers have a financial incentive to err on the high side of the baseline determination because the higher the projected baseline, the more offsets generated. Requiring third-party verification (as some proposals do) would potentially address this specific concern.

Biological sequestration offset projects may present particular challenges in terms of measurement. The carbon cycle in trees and soils is only partially understood.³⁶ Variations exist across tree species, ages, soil conditions, geographic locations, and management practices.³⁷ Estimates of carbon uptake and storage are frequently considered imprecise or unreliable. Further, changes in vegetation cover may have non-emission effects on climate, such as how much of the Sun's energy is reflected or absorbed by the Earth. A recent study in the Proceedings of the National Academy of Sciences stated, "Latitude-specific deforestation experiments indicate that afforestation projects in the tropics would be clearly beneficial in mitigating global-scale warming, but would be counterproductive if implemented at high latitudes and would offer only marginal benefits in temperate regions."³⁸

Double-Counting

To be credible, when an offset is sold, it should be retired and not sold again or counted in other contexts. However, opportunities for double-counting exist. For example, a regulated entity may purchase offsets generated through the development of a wind farm in a nation that has not established GHG emissions targets. The U.S. buyer would count the offsets, which may have been purchased to negate increased, onsite emissions at the regulated source. In addition, the nation, in which the wind farm is located, would likely see an emissions reduction due to the wind farm. If this decrease is reflected in the nation's GHG emissions inventory, the offset project (wind farm) might replace other reduction activities that the nation might have taken to meet its target.

Some may argue that double-counting is less of a problem if the offset project occurs in a nation with only a voluntary target (as opposed to a nation subject the Kyoto Protocol). However, the impact would be the same if the nation eventually establishes a mandatory target and takes credit for the earlier reductions associated with the offset project. By taking credit for an earlier reduction, the nation might need to make fewer reductions to be in compliance with the new mandatory program.

A tracking system could help avoid such double-counting.³⁹ Most would agree that a domestic tracking system would be simpler to establish and monitor than a system that follows international offset trading. The latter would require, at a minimum, cooperation with the nations hosting the offset projects.

Permanence

With some offset projects there may be a concern that the emission offsets will be subsequently negated by human activity (e.g., change in land use) or a natural occurrence (e.g., forest fire, disease, or pestilence). This issue is most pertinent to biological sequestration projects, specifically forestry activities. Although many observers expected forestry offsets to play a large role in the CDM, this has not been observed in practice. This result is partially due to concerns of offset permanence in developing nations.⁴⁰

Offset buyers need some assurance that the land set aside for forests (and carbon sequestration) will not be used for a conflicting purpose (e.g., logging or urban development) in the future. Although natural events (fires or pests) are hard to control, human activity can be constrained through legal documents, such as land easements. In addition, an offset could come with a guarantee that it would be replaced if the initial reduction is temporary. Permanence may be more difficult to monitor at international projects.

Leakage

In the context of climate change policy, GHG emissions leakage generally refers to a situation in which an emissions decrease from a regulated (i.e., capped) source leads to an emissions increase from an unregulated source. EPA states that leakage "occurs when economic activity is shifted as a result of the emission control regulation and, as a result, emission abatement achieved in one location that is subject to emission control regulation is [diminished] by increased emissions in unregulated locations."⁴¹

Leakage scenarios may involve emission sources from the same economic sector, but located in different countries. Many voice concern that if the United States were to cap emissions from specific domestic industries (e.g., cement, paper), these industries would relocate to nations without emission caps and increase activity (and thus emissions) to compensate for the decreased productivity in the United States. Thus, global net emissions would not decrease, and affected domestic industries would likely see employment losses.

In the context of offsets, leakage may occur in an analogous fashion. The opportunity for leakage exists when an offset project decreases the supply of a good in one location, leading to greater production of the good somewhere else. Compared to other offset types, forestry projects, particularly those that sequester carbon by curbing logging, likely present the greatest risk of leakage.⁴² For example, an offset project that restricts timber harvesting at a specific site may boost logging at an alternative location, thus reducing the effectiveness of the offset project.⁴³ Preventing or accounting for leakage from these projects poses a challenge.

Delay of Technology Development

As discussed above, the inclusion of offsets would likely lower the overall cost of compliance. Although many consider this a desired outcome, some contend that the price of carbon needs to reach levels high enough to promote the long-term technological changes needed to mitigate climate change.

Offsets also can delay key industries' investments in transformative technologies that are necessary to meet the declining cap. For instance, unlimited availability of offsets could lead utilities to build high-emitting coal plants instead of investing in efficiency, renewables, or plants equipped with carbon capture and storage.⁴⁴

Transaction Costs

Transaction costs generally refer to the costs associated with an exchange of goods or services. In an offset market, transaction costs may encompass the following:

• searching for offset opportunities;
• studying and/or measuring offset projects;
• negotiating contracts;
• monitoring and verifying reduced, avoided, or sequestered emissions;
• seeking regulatory approval;
• obtaining insurance to cover risk of reversal (i.e., non-permanence).⁴⁵

Depending on the price of carbon in the offset market, transaction costs may represent a substantial percentage of the value of the offset. Several studies have examined offset projects in an effort to estimate transaction costs. Generally, the studies' results include a transaction cost range that varies by offset type and project size. For example, a study by the Lawrence Berkeley National Laboratory (LBL) found a transaction cost range of $0.03/mtCO₂-e to $4.05/mtCO₂ -e.⁴⁶ Overall, the various studies found that smaller offset projects (measured by tons of CO₂-e) may be at a disadvantage because they would likely face proportionately higher transaction costs: the LBL study found that the mean transaction cost for small projects was $2.00/mtCO₂-e, but only $0.35/mtCO₂-e for the largest projects.

The transaction costs may hinder innovation by serving as an obstacle to small, but promising offset projects. However, transaction costs are inherent in an emissions program that requires project developments to meet certain provisions—additionality, measurement, verification, monitoring—to maintain the integrity of the offset allowed as compliance alternatives.

Concerns in Developing Nations

Some argue that offset use, particularly unlimited access to international offset opportunities, raises questions of fairness. Most of the world's GHG emissions (especially on a per capita basis) are generated in the developed nations, while most of the lower-cost offset opportunities are in developing nations. Many observers expect the developing nations to establish mandatory GHG reduction programs several years (if not decades) after developed nations' emission programs are underway. The developed nations are likely to initiate the lower-cost projects and retire the offsets, thus removing the "low-hanging fruit." If and when the developing nations subsequently establish GHG emission caps, the lower-cost compliance alternatives would not be available to them.⁴⁷ Some have described this as a form of environmental colonialism.⁴⁸

Another concern is that international offsets may serve as a disincentive for developing nations to enact laws or regulations limiting GHG emissions. For instance, if a developing nation established emission caps or crafted regulations for particular emissions sources, reductions from these sources would no longer qualify as offsets. Developing nations may be hesitant to forego the funding provided by offset projects.

Considerations for Congress

From a climate change perspective, the location of an emission activity does not matter: a ton of CO₂ (or its equivalent in another GHG) reduced in the United States and a ton sequestered in another nation would have the same result on the atmospheric concentration of GHGs. Moreover, unlike many air pollutants—e.g., acid rain precursors sulfur dioxide and nitrogen oxide, particulate matter, and mercury—a localized increase or decrease of CO₂ emissions does not directly impart corresponding local or regional consequences. This attribute of CO₂ emissions, the primary GHG, allows for offset opportunities.⁴⁹

If allowed as part of an emissions reduction program, offsets have the potential to provide various benefits. The ability to generate offsets may

• provide an incentive for non-regulated sources to reduce, avoid, or sequester emissions (where these actions would not have occurred if not for the offset program);
• expand emission mitigation opportunities, thus reducing compliance costs for regulated entities;
• offer environmental co-benefits for certain projects;
• support sustainable development in developing nations; and
• create new economic opportunities and spur parties to seek new methods of generating offsets.

The main concern with offset projects is whether or not they produce their stated emission reductions. To be credible, an offset ton should equate to a ton reduced from a direct emission source, such as a smokestack or exhaust pipe. If offset projects generate emission credits for activities that would have occurred anyway (i.e., in the absence of the emission trading program), these credits would not satisfy the principle of additionality. For many offset projects, determining additionality will likely pose a challenge. Other offset implementation issues—baseline estimation, permanence, accounting, monitoring—may present difficulties as well. If illegitimate offset credits flow into the trading program, the cap would effectively expand and credible emissions reductions would be undermined. The program would fail to meets its ultimate objective: overall GHG emissions reductions.

Offset projects vary by the quantity of emission credits they could generate and the implementation complexity they present. For instance, domestic landfill methane projects are comparatively simple to measure and verify, but offer a relatively small quantity of offsets. In contrast, biological sequestration activities, particularly forestry projects, offer the most offset-generating potential, but many of these projects pose multiple implementation challenges. This may create a tension for policymakers, who might want to include the offset projects that provide the most emission reduction opportunities, while minimizing the use of offset projects that pose more implementation complications.⁵⁰ Addressing these challenges may require independent auditing and/or an appreciable level of oversight and administrative support from government agencies. A report from the National Commission on Energy Policy stated, "Proposals that expect to achieve significant (> 10 percent) compliance through offsets in the near term will be obligated to create a substantial enforcement bureaucracy or risk an influx of illegitimate credits."⁵¹

If concerns of legitimacy can be resolved, the next question for policymakers may be whether the potential benefits provided by offsets would outweigh any potential harm. One debate may involve whether including offsets would send the appropriate price signal to encourage the development and deployment of new technologies, such as carbon capture and storage. Policymakers may consider striking a balance between sending a strong price signal and reducing the costs of the emissions reduction program.

Another debate may focus on the possible effects of offsets in the developing world (assuming international offsets are allowed in a federal program). On one hand, many of the offset projects may offer significant benefits—more efficient energy infrastructure, improved air quality—to local communities. On the other hand, some maintain that if developed nations use all of the low-cost offsets in developing nations, the developing nations will face higher compliance costs if and when they establish GHG emission reduction requirements. Moreover, there is some concern that international offsets may serve as a disincentive for developing nations to enact laws or regulations limiting GHG emissions because they would lose funding from the offset market.

Whether to include international offsets in a federal program raises other considerations as well. The ability to use international offsets for compliance purposes would substantially expand emission reduction opportunities, compared to only allowing domestic offsets. The more emission mitigation opportunities available, the lower the carbon price. This highlights the debate over the balance between overall program costs and price signal for technological development.

If eligible in a U.S. program, international offsets from countries without binding reduction targets are likely to dominate in early decades because of their comparatively lower costs. Certain domestic economic sectors, primarily agriculture and forestry (if eligible as offsets), would benefit if international offsets are excluded. However, the inclusion of international offsets may benefit other U.S. economic sectors through the transfer of technology and services to support the projects. Moreover, as noted above, the more offset opportunities, the lower the overall costs of the cap-and-trade program.

Footnotes

1.	In 1992, the United States ratified the United Nations Framework Convention on Climate Change (UNFCCC), which called on industrialized countries to initiate GHG reduction. The UNFCCC defines GHGs to include carbon dioxide (CO2), methane (CH4), nitrous oxide (N2O), sulfur hexafluoride (SF6), hydrofluorocarbons (HFC), and perfluorocarbons (PFC).
2.	See CRS Report RL33826, Climate Change: The Kyoto Protocol, Bali "Action Plan," and International Actions, by [author name scrubbed] and [author name scrubbed]; CRS Report RL31931, Climate Change: Federal Laws and Policies Related to Greenhouse Gas Reductions, by [author name scrubbed] and [author name scrubbed]; CRS Report RL33812, Climate Change: Action by States to Address Greenhouse Gas Emissions, by [author name scrubbed].
3.	See CRS Report RL30024, U.S. Global Climate Change Policy: Evolving Views on Cost, Competitiveness, and Comprehensiveness, by [author name scrubbed] and [author name scrubbed].
4.	In this way, offsets would complement the more traditional emissions trading that can occur between two covered sources. For example, a covered source (e.g., power plant) can make reductions beyond its compliance obligations and then sell these reductions as credits to other covered sources. This type of transaction represents the "trade" component of a cap-and-trade program.
5.	An emissions cap might require only CO2 emission reductions, but still allow CO2-e offsets from projects that involve non-CO2 GHGs.
6.	Although Congress could address GHG emissions with alternative policies—e.g., by enacting a carbon tax or setting emission limits for each source type ("command-and-control)—the option to use offsets is generally discussed in the context of a cap-and-trade regime. Offsets could be a component of a carbon tax framework (e.g., as tax credits), but that discussion is beyond the scope of this report.
7.	For instance, if a covered source reduced its emissions beyond its compliance obligation, the source could sell the reductions as "credits" to other sources subject to the cap. This financial opportunity would create the incentive for sources to find and make reductions beyond their compliance obligations. These type of exchanges represent the foundation of the cap-and-trade system.
8.	For comparison purposes—e.g., estimating the quantity of offsets and potential offset benefits—this report generally assumes that emission sources and sequestration activities will either not be regulated in any fashion or they will qualify as offsets. However, there are alternative means of addressing emission sources and sinks that are often considered good candidates for offsets. See the Text Box on p. 8: Policy Alternatives to Offsets.
9.	For more information, see CRS Report RL34150, Climate Change and the EU Emissions Trading Scheme (ETS): Kyoto and Beyond, by [author name scrubbed].
10.	The credits are called "certified emission reductions" (CERs) or "emission reduction units" (ERUs), depending on whether they originate from the Clean Development Mechanism (CDM) or from Joint Implementation projects, respectively. The CDM is the Kyoto Protocol compliance mechanism, which has been used widely in the EU-ETS, that allows for developing nations to generate offsets and sell them to regulated sources in developed nations. The CDM was established by Article 12 of the Kyoto Protocol. For more information on the Kyoto Protocol's "flexible mechanisms," see http://unfccc.int/kyoto_protocol/mechanisms/items/1673.php.
11.	Although the credits are equivalent to allowances in environmental and economic terms, they are not interchangeable. For more on the EU ETS, see CRS Report RL33581, Climate Change: The European Union's Emissions Trading System (EU-ETS), by [author name scrubbed].
12.	If the source was subject to an emissions cap, reductions beyond compliance obligations would be sold directly as emission credits.
13.	For more information on agricultural activities, see CRS Report RL33898, Climate Change: The Role of the U.S. Agriculture Sector, by [author name scrubbed].
14.	See CRS Report RL34560, Forest Carbon Markets: Potential and Drawbacks, by [author name scrubbed] and [author name scrubbed].
15.	This comparison does not account for the externalities associated with fossil fuel combustion: air pollution, environmental degradation, health problems linked to emissions, etc.
16.	In addition, some may argue that nuclear energy could be considered a renewable energy. This debate is beyond the scope of this report.
17.	The digesters capture the methane, which can be used for energy purposes.
18.	GWP is an index of how much a GHG may contribute to global warming over a period of time, typically 100 years. GWPs are used to compare gases to carbon dioxide, which has a GWP of 1. For example, methane's GWP is 25, and is thus 25 times more potent a GHG than CO2. The GWPs listed in this report are from: Intergovernmental Panel on Climate Change, Climate Change 2007: The Physical Science Basis (2007), p. 212.
19.	Chlorodifluoromethane, referred to as HCFC-22.
20.	Of the CERs expected to be issued by 2012, the percentage drops to 22% (still the highest percentage by offset type). See the United Nations Environment Programme (UNEP), CDM Pipeline data, at http://cdmpipeline.org/index.htm.
21.	This calculus depends on the market price for offsets. See Michael Wara, Measuring the Clean Development Mechanism's Performance and Potential, Working Paper #56, Stanford Center for Environmental Science and Policy (2006).
22.	A command-and-control program may require, for example, that certain technologies be installed to control emissions from landfills or animal waste, or that specific practices (e.g., conservation tillage) be performed in agricultural operations.
23.	If they would have occurred, they would not be additional (to business-as-usual), and thus, not qualify as offsets.
24.	EPA, EPA Analysis of the Lieberman-Warner Climate Security Act of 2008 (2008).
25.	Intergovernmental Panel on Climate Change, Climate Change 2007: Mitigation. Contribution of Working Group III to the Fourth Assessment Report (2007), p. 526.
26.	Nonpoint source pollution is caused by rainfall or snowmelt moving over and through the ground. As the runoff moves, it picks up and carries away natural and human-made pollutants, finally depositing them into lakes, rivers, wetlands, coastal waters, and even underground sources of drinking water. See EPA's Nonpoint Source Pollution website, at http://www.epa.gov/owow/nps/qa.html.
27.	See CRS Report RL33800, Water Quality Issues in the 110th Congress: Oversight and Implementation, by [author name scrubbed].
28.	Intergovernmental Panel on Climate Change, Climate Change 2007: Mitigation. Contribution of Working Group III to the Fourth Assessment Report (2007), pp. 529-530.
29.	In fact, these activities are often categorized, particularly in international contexts, as land use, land use changes, and forestry (LULUCF) projects.
30.	For example, certain evergreen plantations (tree farms) generally have higher water use than the land they replace. Intergovernmental Panel on Climate Change, Climate Change 2007: Mitigation. Contribution of Working Group III to the Fourth Assessment Report (2007), p. 530.
31.	EPA, Greenhouse Gas Mitigation Potential in U.S. Forestry and Agriculture (2005), p. 8-8.
32.	As discussed above, the inclusion of international offsets would lower the emission allowance price, which would benefit regulated entities and ultimately consumers.
33.	See Ken O. Buesseler, et al., "Ocean Iron Fertilization—Moving Forward in a Sea of Uncertainty," Science Vol. 319 (2008), 162.
34.	See, World Resources Institute, The Greenhouse Gas Protocol for Project Accounting (2005), at http://www.ghgprotocol.org.
35.	The emissions data may not be a direct measurement, but an estimate calculated by using related data, such as fuel consumption.
36.	See CRS Report RL34059, The Carbon Cycle: Implications for Climate Change and Congress, by [author name scrubbed].
37.	See CRS Report RL34560, Forest Carbon Markets: Potential and Drawbacks, by [author name scrubbed] and [author name scrubbed].
38.	Govindasamy Bala, et al., "Combined climate and carbon-cycle effects of large-scale deforestation," Proceedings of the National Academy of Sciences, Vol. 104 (2007): 6550-6555.
39.	See Anja Kollmuss, "Carbon Offsets 101," World Watch (2007).
40.	Frank Lecocq and Philippe Ambrosi, "The Clean Development Mechanism: History, Status, and Prospects," Review of Environmental Economics and Policy (Winter 2007), pp. 134-151.
41.	See Environmental Protection Agency (EPA), Office of Air and Radiation, Tools of the Trade: A Guide To Designing and Operating a Cap and Trade Program For Pollution Control (2003), Glossary.
42.	Nicholas Institute for Environmental Policy Solutions, Harnessing Farms and Forests in the Low-Carbon Economy: How to Create, Measure, and Verify Greenhouse Gas Offsets, Zach Wiley and Bill Chameides, eds. (2007), pp. 18-19.
43.	Similarly, forest sequestration projects could shift demand to substitute products (e.g., steel or aluminum studs to replace wood studs in homebuilding) whose production requires more energy, and thus releases more carbon. See CRS Report RL31432, Carbon Sequestration in Forests, by [author name scrubbed].
44.	Testimony of David Hawkins, Climate Center, Natural Resources Defense Council, before the Senate Committee on Environment and Public Works, November 13, 2007, at http://docs.nrdc.org/globalwarming/glo_07111301A.pdf.
45.	These are the costs assessed in the following study: Camille Antinori and Jayant Sathaye, Assessing Transaction Costs of Project-Based Greenhouse Gas Emissions Trading (2007), Ernest Orlando Lawrence Berkeley Laboratory.
46.	Ibid.
47.	See e.g., David M. Driesen, 1998, "Free Lunch or Cheap Fix?: The Emissions Trading Idea and the Climate Change Convention," Boston College Environmental Affairs Law Review 26:1-87; see also Emily Richman, 2003, "Emissions Trading and the Development Critique: Exposing the Threat to Developing Countries," New York University School of Law Journal of International Law and Politics 36:133-176.
48.	See e.g., Ross Gelbspan, "Toward A Global Energy Transition," Foreign Policy In Focus (2004).
49.	This attribute also creates critical challenges for policymakers. For instance, if one nation invests in emission reductions, any resulting benefits (e.g., decreased atmospheric GHG concentration) would be shared by all nations, including those that continue to increase their emissions. This dynamic has led some to refer to climate change as the "ultimate global commons pollution problem" because it discourages unilateral emission reduction. See Henry Lee, 2001, "U.S. Climate Policy: Factors and Constraints," in Climate Change: Science, Strategies, & Solutions (Eileen Clausen, editor).
50.	For a discussion of the potential supply of offsets in a cap-and-trade program, see CRS Report RL34705, Potential Offset Supply in a Cap-and-Trade Program, by [author name scrubbed].
51.	National Commission on Energy Policy, 2007, Energy Policy Recommendations to the President and the 110th Congress.