Carbon Offsets: Open House for Waste, Fraud and Corruption

The UK House of Commons Environmental Audit Committee wants to compel airlines and other “carbon-intensive” businesses to offer customers the means to offset their environmental impact.

Presumably they would do this by forcing these businesses to buy more offsets in the carbon offsetting market, which is predicted to be worth at least £4 bn a year by 2010.

Like politicians everywhere, the Environmental Audit Committee, when diagnosing the presence of a problem, look for a solution that will involve preferably no visible price tag at all, and in any case no price tag that can be traced to them.

If excessive CO2E (carbon dioxide equivalent greenhouse gas emissions) are a problem, there are but two solutions. The first is command-and-control methods: limit the scale of the activities creating excessive CO2E emissions by administrative or regulatory fiat. In the limit, ban them. This was done with chlorofluorocarbons (contributors to the ozone hole over the Antarctic) which were phased out by 1996. It can be effective if something is to be banned completely. That is not possible with CO2E emissions. Any conceivable future will have continued emissions of CO2E. Bureaucrats are not very good at deciding who can produce how much CO2E in hundreds of thousands of activities and firms. Last time something like that was tried we called it Central Planning.

The second way to reduce CO2E emissions is to make it more expensive at the margin to engage in the activities/processes that produce CO2E. By increasing their marginal cost to the producer using the CO2E-intensive process and to the consumer engaged in CO2E-intensive activities, an incentive to economise is created. This can either be done through, you guessed it, taxes on production processes and consumption activities that produce CO2E or through 'cap and trade'.

With explicit taxation, the authorities set the tax rate per quantum of CO2E emitted at the level expected to achieve the desired level of (and reduction in) CO2E emissions. With cap and trade, the authorities determine the upper limit or quota on the amount of C02E emissions that will be allowed in a given period. They create permits to issue that amount of CO2E and either give them away or auction them off. If they are given away, there has to be an efficient secondary market in CO2E emission permits for the scheme to have any effect.

In a world without uncertainty, the competitive price of a permit for a given quantity of CO2E emissions under cap and trade would be the same as the tax paid on that quantity of CO2E emissions under explicit taxation. In a world with uncertainty, they are similar but not equivalent; neither one obviously dominates the other under all circumstances. Politicians, including Gordon Brown, prefer cap and trade, because it hides/obscures the fact that for it to work, it must be equivalent to a tax; however, it does not look like a tax and will not show up in conventional tax burden calculations. Also, you can hand out the credits free of charge to your friends (including the heavy historical polluters).

A first-round give-away does not necessarily reduce their effectiveness of cap and trade in reducing CO2E emissions, as long as the permits can be resold on an efficient secondary market. With such a market, a heavy polluter (who will have to retain most or all of its free allocation rather than selling them at a profit to other polluters) remains confronted with a higher opportunity cost of CO2E emissions at the margin. However, compared to the government auctioning the permits off to the highest bidder, giving them away is a lovely device for making lump-sum wealth transfers to the government’s friends.

Command-and-control methods, taxation and cap and trade all have the same informational requirements: the authorities must be able to monitor the quantity of CO2E actually emitted. That is no small task in many instances, which is why taxes and cap and trade tend to focus on the biggest emitters only. Sometimes it’s easy. A CO2 tax can be added onto the regular fuel tax to encourage lower CO2E emissions in transportation using petrol or diesel fuel.

Offsets, the creation of credits that can be added to the (national, regional or global) CO2E quota under cap and trade schemes, require not only the (difficult) verification of how much CO2E is actually emitted in the real world, but also the impossible verification of how much CO2E would have been emitted in some counterfactual alternative universe. The quantity of offset credits earned by some activity is the net quantity of CO2E that has been saved as a result of this activity.

Just stating it makes one shout out: impossible! Fraud! Bribery! Corruption! Wasteful diversion of resources into pointless attempts at verification! And indeed this is what is happening before our eyes. Enterprises get paid for not cutting down trees and for installing filters and scrubbers they would have installed in any case. The new Verification of the Carbon Counterfactual industry is growing in leaps and bounds. The amounts of money involved are vast and the opportunities for graft, bribery and corruption limitless. The offset proposal has birthed a monster.

Who came up with this demented offset concept? It’s an attempt to placate the developing world for not having enough CO2E emitting activities historically to benefit from a significant free initial allocation of credits in proportion to a country’s historical track record of CO2E emissions. If we had a common worldwide tax (say a constant real amount per unit of CO2E emissions), nobody would have thought of offsets. If the UN were the only source of carbon credits, and if it were to auction the entire quota each period in a single, transparent global auction, no-one would have come up with this ludicrous offsets concept. It is because countries were awarded free CO2E quotas under the Kyoto Protocol and under subsequent EU schemes in proportion to their past CO2E emissions, that we found former heavy polluters like Russia with permits that were surplus to requirements, but poor newly industrialising countries like Vietnam with very little by way of free initial allocations. So we had to do something for the historically CO2E emissions-innocent developing world. What was chosen was the most real resource-wasting and corruption- and rent-seeking inducing scheme anyone could think of. Masses of jobs for engineering consultants, environmental auditors, lawyers etc. All verifying the unverifiable and getting paid handsomely for it.

If we want to help the developing world to install CO2E efficient technology and to discourage CO2E-inefficient production, transportation and consumption, we hould encourage these poor countries to tax these CO2E-intensive activities; we should then send them unconditional cash to take care of the distributional and poverty consequences of the higher CO2E taxes. That, however, would mean higher taxes in the rich countries, or lower public spending in rich countries. And God forbid that reducing CO2E emissions would have a visible price tag. Truth, courage and politics: three concepts almost never encountered in the same place.