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

Paper Number: 2012-04

Document Date: 07/2012

Author(s): Heather Klemick

Subject Area(s): Climate Change; Environmental Policy; Pollution Control Options and Economics Incentives

JEL Classification: Welfare Economics: Externalities; Taxation; Subsidies; and Revenue: Externalities; Redistributive Effects; Environmental Taxes and Subsidies; Environmental Economics: Climate; Natural Disasters and Their Management; Global Warming; Government Policy

Keywords: offsets; additionality; leakage; baseline; cap and trade; second-best theory

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.

This paper is part of the Environmental Economics Working Paper Series.

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