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

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  • Klemick, Heather

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.

Suggested Citation

  • Klemick, Heather, 2012. "What is the Optimal Offsets Discount under a Second-Best Cap & Trade Policy?," National Center for Environmental Economics-NCEE Working Papers 280907, United States Environmental Protection Agency (EPA).
    • Handle: RePEc:ags:nceewp:280907
    DOI: 10.22004/ag.econ.280907
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    Cited by:

    1. Strand,Jon, 2016. "Assessment of net mitigation in the context of international greenhouse gas emissions control mechanisms," Policy Research Working Paper Series 7594, The World Bank.
    2. Knut Rosendahl & Jon Strand, 2015. "Emissions Trading with Offset Markets and Free Quota Allocations," Environmental & Resource Economics, Springer;European Association of Environmental and Resource Economists, vol. 61(2), pages 243-271, June.
    3. Sabine Aresin, 2015. "Reduced Allowability and the Allocation of Emission Abatement," Working Papers tax-mpg-rps-2015-12, Max Planck Institute for Tax Law and Public Finance.
    4. Strand, Jon, 2016. "Mitigation incentives with climate finance and treaty options," Energy Economics, Elsevier, vol. 57(C), pages 166-174.

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    More about this item

    Keywords

    Environmental Economics and Policy; International Relations/Trade;

    JEL classification:

    • D62 - Microeconomics - - Welfare Economics - - - Externalities
    • H23 - Public Economics - - Taxation, Subsidies, and Revenue - - - Externalities; Redistributive Effects; Environmental Taxes and Subsidies
    • Q54 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Environmental Economics - - - Climate; Natural Disasters and their Management; Global Warming
    • Q58 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Environmental Economics - - - Environmental Economics: Government Policy

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