About The Author:
ROGER FELDMAN, Co-Chair of Andrews Kurth LLP Climate Change and Carbon
Markets Group has practiced law related to the finance of environmental and
energy projects and companies for 40 years. In particular, he has analyzed
and executed a wide variety and substantial value of project financings. He
chairs the American Bar Association’s Committee on Carbon Trading and
Finance, serves on the Board of the American Council for Renewable Energy,
and has been a senior official in the Federal Energy Administration. He is
a graduate of Brown University, Yale Law School and Harvard Business School.
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July 2009
Offsetting The Invisible Hand
by Roger Feldman --
Andrews Kurth, LLP
(originally published by PMA OnLine
Magazine: 2009/08/03)
Introduction
The proposed creation and treatment of GHG Offsets represents a
microcosm of some of the more problematic issues presented by the
overall cap and trade program envisioned by Waxman-Markey. Given the
likelihood that these provisions will at least receive some modification
in any legislation that is enacted, it is useful to consider these
issues generically.
Offsets
are essential to the workability of the GHG trading system. It has been
estimated that they could account for up to 2 billion tons of total
emissions reductions under the entire cap. In 2012, that could mean
that up to 15% of the emissions cut could be made into offsets. It is
estimated that the figure could rise by 2050 to 33%. Offsets are thus
one of the key expansion joints to preserve what could otherwise be a
very strained, and hence a more potentially costly, cap and trade
system.
The
business of offsets manufacture and trade is also one of the two major
emergent financial industries based solely on environmental legal
property rights. Its roots are first in the CDM process of Kyoto, whose
policy goals were as much international policy as the inherent
requirements for the operation of a cap and trade system, and second, in
the current pale American cousin to Kyoto--the voluntary market--whose
motivations were both societal betterment, on the one hand, and shrewd
commercial cap and trade pre-compliance anticipation, on the other. All
of these motivations are bundled in the proposed new legislative
treatment of offsets. Fortunately, from a management execution
viewpoint, its implementation will have benefited from experiences in
product design and financial application which have already occurred.
The functional success of an offset program ultimately is based on the
otherwise-effective operation of the trading markets: the valuation of
the offset “currency” by these markets is meant to be compared by
statutorily covered parties with the price of buying auctioned
allowances or undertaking other mitigation activities. Offsets thereby
constitute a “thermostat” to control the overall costs of reducing
greenhouse gases.
The
farsighted have made bets on the shape of this market and therefore of
the offsets market. They are scrambling to assure through the
legislative process the vlidity of the bets already made. The players
in this transition are imminently faced with the potentially lucrative
challenge of moving from the self defining world of the US voluntary
markets to the more highly structured Federal systemic one and, on its
heels, the international successor to Kyoto. There could be important
secondary ramifications arising from the success of the emergent offset
market, notably credit support for the structured project finance of
offset producing projects.
Another
ramification is likely to be the development of innovative transactional
risk management instruments and possibly the introduction of new
approaches to risk aggregation. The overall, therefore asset-backed,
structured finance could enhance the significance of offsets in a new
statutory system. These results could be compounded if, as
Waxman-Markey contemplates, offset credits nearly doubles to 60% in the
next 40 years.
The
question is: will these potential benefits be thwarted by potential
flaws of the offset regime or in the cap and trade regime to which it is
tied? What may be commercially and financially done can still be
hindered by what remains to be administratively and politically worked
out.
Possible
Flaws
These
flaws fall into four generic important categories:
(1)
Dispersal of Administrative
Responsibility
The detailed
rules defining the eligible offset opportunities to facilitate statutory
compliance remain yet to be written in great detail. It is important to
recognize that responsibility for the overall rules are bifurcated
between two bureaucracies with parallel responsibilities but different
constituencies, US EPA (Waxman-Markey Title III) and USDA (Title V). A
newly created entity, the Offsets Integrity Advisory Board, is to be
established by EPA to provide supplementary advice.
Also
bifurcated is the oversight of the trading respectively of
allowance/offsets on the one hand, over which the FERC will have
jurisdiction and the trading of the derivatives of them, based on
which will be the CFTC’s bailiwick. Combined with the other factors
discussed below, the uncertainty and implementation delay resulting
from administrative dispersion (and in some cases, lack of
administrative experience) certainly are not likely to result
readily in the operation of markets which give useful price signals
to the emitters’ decision makers.
(2)
Fragmentation of Green
Programs
This
problem could be exacerbated by the fact that the cap and trade
system must operate in a non-parallel universe, with the new
national “Combined Efficiency and Renewable Energy System” (Title V)
which is designed to incentivize the utility industry to modify its
generation mix, by requiring compliance by each state with minimum
targets for renewable energy and energy efficiency savings. The
full interplay of relative renewables and efficiency savings
requirements is still at issue. Resident electric generators have
to contribute to meeting these requirements by purchasing Renewable
Energy Credits (and energy efficiency savings credits), and/or by
development of their own generation, or by making
statutorily-defined Alternative Compliance Payments. There is only
one administrative agency slated for defining REC regulations and
providing trading oversight, the FERC (with some state interactions
in tighter requirements setting).
But
the issues of dispersal of administrative responsibility is
present. Waxman-Markey offers relatively few cross-overs between
the operation of FERC jurisdiction over RECs and EPA’s
responsibilities with respect to offsets. There may be overlaps
between the list of project types eligible to produce offsets and
that for renewable generation sources which can produce RECs. This
overlap is illustrated by one of the few examples of tortuous
line-drawing which actually exists in the statute. Qualified
waste-to-energy is to be deemed eligible to earn RECs credits to the
extent of the biogenic (non-fossil fuel) component of municipal
solid waste and certain other waste streams. However, this may only
be the case if the FERC and the EPA determine that the life cycle
GHG emissions from use of waste-to-energy facilities is lower than
the emissions from the likely alternative disposal scenario.
For
parties subject to compliance requirements by two sets of statutory
mandates, there is a decision-making tension between the need to
invest in “direct” offset sources to comply with Title III, or
essentially to RECs for Title I purposes, which have limited Title
III value because the carbon benefits are only indirect. Simply
put--and renewables proponents should mark this well--buying green
power doesn’t necessarily provide GHG offsets. The ambiguity in
this area may distort the orderly development of the energy markets;
it may even have the unintended result of not doing as much for
climate change as is desirable.
Intellectual confusion and disputes exist in some quarters as to the
mutually exclusive nature of the availability of offsets on the one
hand and RECs on the other. The statutory Renewable Electricity
Credit definition, “one megawatt hour of renewable electricity,”
leaves open the question of whether there exist “environmental
attributes,” i.e., carbon reduction characteristics
attributes of RECs, which some voluntary accreditation systems would
purport to make a separately tradable source of green mitigation
benefits. Most utility standard contracts are emphatic about
appropriating to the buyer of RECs all of the environmental benefits
which may accompany RECs production. Most commentators have drawn a
bright line: RECs cannot be double counted and neither can carbon
credits. The same act of renewable electricity production or of
efficiency cannot both add carbon credits because of its “indirect”
carbon reduction, and provide REC credits as well. Grey areas may
be left, for example: what if a renewable energy project owner would
rather sell carbon offsets and market to non-utilities the power
stripped of its environmental attributes? Does that strategy comply
with applicable regulatory schemes?
While, in the general public’s eye, renewable energy production and
carbon credits creation are conflated, this may well not be the case
in long term market decision-making, and even the operation of
trading markets would not appear to be enhanced by this situation.
(3)
Importation of Global
Uncertainties
Uncertainty
as to the rules of the climate change game may be further exacerbated
when the shape and operation of the applicable rules is also keyed to
achieving larger international linkage policy goals. In the larger
policy sense it certainly may be desirable to link the world’s
regulatory systems, and for the United States to be a leader in the
process. Short of that, however, there may be legal complexity whose
market impacts may be sub-optimal. The pool of offset credits is
envisioned as half domestic offsets and half from international
sources. Then translation sets in: beginning in 2018, 1.25
international offset credits must be submitted for each ton of
emissions. Detailed provisions for qualification and award of
international offset credits are slated to be developed by EPA in
conjunction with the Department of State and AID. The focus is on
encouragement of GHG mitigation in those sectors in developing countries
with which bilateral treaties are reached and where several criteria
designed to assure credit quality are met, thereby facilitating the
fungibility of international and domestic credits. The proposed law
does not, however, stop there. Social engineering is also built into
the required findings by U.S. agencies, e.g., that in the sector,
the host nation has done enough to “encourage equitable sharing of
profits and benefits derived from international offset credits with
local communities, indigenous peoples and forest dependent communities.”
The introduction of the
international complexity in the availability, value weighting, and
eligibility of offsets begins as an effort at globalization and
interface with the regimes of international bodies. There is the
danger that it is susceptible of morphing into a tool for some
super-national stewardship and/or de facto domestic protectionism.
It introduces another agency actor on the stage, with another set of
policy motivations. It introduces another source of change over
time.
Trading markets can superficially adapt to (and profit from) the
speculative opportunities which are thereby created. However, to
the extent offset rules are further encouraged to become a seedbed
of ongoing uncertainty and distortions triggered by policy
variables, private decision makers will find it harder to make
environmentally and economically sound decisions which manage risk
well.
(4)
Risk Management Issues
Waxman-Markey does provide opportunities to deal with the risks
associated with defects or performance slippage in the operation of
the offset system. A notable example is in the agricultural sector
where opportunities may be generated from sustainable practices, but
remain subject to issues of permanence and reversal. Consequently,
the concept of “term offsets” has been statutorily introduced,
i.e., temporary offsets which expire after a maximum of five
years, because farmers cannot commit to assure creation of offsets
beyond that period. Term offsets therefore expire, but they are
subject to revalidation. However, a covered entity seeking to gain
the benefits of the use of term offsets may not use them to
demonstrate compliance unless it simultaneously makes a showing to
EPA that it will have sufficient enough resources to obtain the
necessary quantity of allowances or credits necessary from other
sources, if need be, to demonstrate final compliance.
The adequacy of the
statutory provisions to address risk management issues has been
questioned. One important context has been biological
sequestration, which represents the largest source of potential farm
and forestry offsets. Among the concerns voiced has been the need
for assurance that domestic offsets are fully fungible with each
other and with allowances. It has also been suggested that offsets
should be made available at the program, rather than the project
level, so that pooled risks for multiple projects can be addressed
through what has been dubbed “risk management behind the registry.”
Otherwise, it may not be feasible for adequate risk protection to be
made available for smaller projects.
Conclusions
Why are
these overlapping flaws in the proposed offset system--dispersal of
administrative responsibilities, fragmentation of green programs,
importation of global uncertainties, deficiencies in risk management--of
such practical significance? The answer is because collectively they
obscure the clarity of GHG mitigation cost option comparisons by GHG
generators. Collectively they increase market volatility which, in
turn, leads to a damper on decision maker actions.
This
possibility of clarity in decision-making facilitated by markets is the
basis for what is ultimately postulated as the motivating force for
technical innovation. It is the modern adaptation of the “invisible
hand” dictum of Adam Smith, only now the magic of the market proclaimed
is not just to aggregate wealth but to lead self-interested pollution
reduction as well. It is a premier justification of a cap and trade
system, as opposed to a command and control system. If regulatory
uncertainties impair market operation on an ongoing basis, this updated
neo-classical rationale for the creation of the cap and trade system
will be more suspect. While there may be offset projects and there will
be trading volume, based on available information, the “invisible hand”
of the market, on which policy makers are counting, will be paralyzed by
the ongoing complexity and uncertainty which the system presents to
actual decision makers who are not confident of the price signals they
are receiving. As the renewable energy industry has recently
demonstrated, innovation only thrives where price signals are within a
predictable band on which investors can rely. There is no reason to
assume that confusing offset price signals will have a different effect.
In their
haste to achieve passage of the cap and trade climate change
principle--to “just do it,” as one noted columnist recently
prescribed--there should not be created a new “funny money” which can be
proliferated in volume without producing the sorely needed investment in
new innovation in green technology necessary to ultimately reverse the
precipitous slide into global warming. In short, let’s hope Congress is
wise enough not to inadvertently offset the potential of the invisible
hand.
ROGER FELDMAN, Co-Chair of Andrews
Kurth LLP Climate Change and Carbon Markets Group has practiced law related
to the finance of environmental and energy projects and companies for 40
years. In particular, he has analyzed and executed a wide variety and
substantial value of project financings. He chairs the American Bar
Association’s Committee on Carbon Trading and Finance, serves on the Board
of the American Council for Renewable Energy, and has been a senior official
in the Federal Energy Administration. He is a graduate of Brown University,
Yale Law School and Harvard Business School.
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