Tontitown: the financial test

One of the most intuitively appealing additionality tests is also among the most controversial with environmental policy types. The financial test asks whether the revenue from carbon offsets are enough to tip the budgetary scales so that a money-losing project becomes breakeven or profitable.

Deep down, this is what most of us believe additionality is all about. If wind energy were cheaper than coal-fired energy, offsets wouldn’t serve any purpose. Everyone would just build wind farms and sell their cheap, clean electricity into the grid. Or so the logic goes.

In reality, financial additionality tests are controversial in the policy community for at least two reasons.

The first, and major, reason is that financial additionality tests establish perverse incentives for developers to favor projects with borderline finances. If additionality criteria are set up to reward only those projects that are hovering on the edge of profitability, you can be certain that developers will gravitate toward those projects. Perhaps this makes technical sense — projects on firmer financial footing presumably don’t need the revenue from offsets, and shouldn’t be competing for this pool of money. But in practice, such a system can discourage developers from seeking innovations that would improve the finances of renewable energy.

The second, more prosaic problem with a financial additionality test is that it can be darned hard to establish financial additionality. Projects often have multiple revenue streams with an inherent element of uncertainty built in. Wind farms, for example, have huge up-front capital expenditures, low operating expenses, heavy tax subsidies, and revenue from the sale of electricity (which literally depends on which way the wind blows). On top of that, they have a revenue stream from offsets (or, more properly, RECs).

It’s certainly possible to establish that RECs are the factor that tips a wind farm to profitability by, for example, examining internal rates of return and other financial metrics. But the analysis is not trivial, and not nearly the open-and-shut case that we might naively wish for.

The difficulty of establishing financial additionality for many project types is actually one reason why landfill gas flaring projects like Tontitown are generally considered to be highly additional. Unlike, say, wind farms, landfill projects only have one source of revenue: carbon offsets. There is literally no other income stream to these projects, so it becomes trivially easy to establish financial additionality. And when financial additionality is assumed, the perverse incentive problem also disappears.

With Tontitown, the case becomes more complex. The confounding factor is that the project developer may have two motivations to develop the methane flaring system: revenue from offsets and the groundwater contamination problem. Such confounds are quite common in carbon reduction projects.

So the financial additionality question becomes slightly different. Rather than assuming that any investment in the flaring system indicates financial additionality, we have to look for investments over and above what was needed to address the groundwater contamination problem. In other words, if Waste Management put in the bare minimum amount of money needed to address the groundwater problem, it will be harder to argue that offsets motivated the investment. On the other hand, if Waste Management’s investment clearly and materially exceeds what they needed to do to fix the groundwater problem, then the project should pass a financial additionality test.

The BusinessWeek article alludes to this issue by acknowledging that last year, Tontitown made an $800,000 upgrade to the methane flaring system. But a true analysis needs to go quite a bit deeper than that. We’ve been learning a lot about methane flaring systems over the past few days. There are all sorts of ways to achieve the basic goal of fixing the groundwater problem: active wells, passive wells, subsurface wells, etc. These systems have dramatically different cost profiles and dramatically different greenhouse gas reduction profiles. Teasing apart these issues constitute a key part of assessing a financial additionality claim.

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  1. Joe Madden - March 21, 2007

    Offsets will not save the earth’s climate. “Additionality” and any other intellectual debate won’t either.

    However, if implemented with prudence and integrity, offsets can, among many other serious measures, be a one channel for direct action at the individual level.

    While I appreciate the discussion around GHG offsets, the questions around RECs are not new in this burgeoning industry. I am surprised that the Business Week author failed to cite the only offset provider that purchases 100% of its offsets directly from the Climate Exchange (CCX)

    Credits (Carbon Financial Instruments or CFIs) on the CCX are verified GHG reductions measured against an established benchmark from participating CCX members (like IBM, Ford, DuPont, City of Oakland, etc).

    The provider then purchases these verified reductions on behalf of its customers and retires them so that another entity on the exchange cannot. The net result is a reduction, not simply an offset, of carbon.

    Recently, Transgroup Worldwide Logistics launched TransNeutral which gives its clients the option to purchase CFI’s off of the CCX equal to the amount of CO2 generated from shipping cargo. Likewise, the Better World Club offers it clients the option to offset their driving and travel through purchases of CFI’s off of the CCX.

    Members of the CCX and organizations that source credits there should not be discredited by the “offset” debate. Rather, we need to reframe the debate in order to better define the role of REC’s in the GHG Offset Industry.

  2. Adam Stein - March 21, 2007

    Hi Joe,
    I appreciate your thoughts, but a few clarifications. I’m pretty sure that there are several organizations that purchase all of their offsets from the CCX. TerraPass is among them (although one third of our portfolio consists of RECs, not offsets).
    Also, the general scenario you describe — buying offsets and retiring them — is what all offset retailers do, TerraPass included.
    However, the specific CFIs you are talking about appear to be allowances, not offsets. When IBM reduces emissions, the reduction creates an allowance. These are similar to offsets, but they come from corporate members of the CCX who pledge to reduce emissions.
    The problem with purchasing allowances is that it can be very difficult to establish additionality. It’s not impossible — the Tontitown project is actually a source of allowances — but it can be tough. For example, it’s really hard to say whether IBM would have reduced its emissions anyway.
    So while the general scenario you describe is absolutely what TerraPass and other offset providers are all about, the additionality issue is still central.

  3. Matt - March 28, 2007

    Adam -
    Here you admit that often companies balance multiple reasons when deciding whether to go forward with a project or not. This seems to contradict the idea that businesses always make the most rational, “measurable” decision.
    I propose two more reasons why businesses don’t always make the most “rational” decision.
    1) lack of info. If businesses had perfect info, then their energy efficiency would be much higher. Amory Lovins in Natural Capitalism showed that many companies aren’t energy efficient simply because they are not aware of upgrades, or because the engineers who are can’t communicate in financial terms (I.e. money invested in efficient lighting could be said to have a return on investment of 25%+, but an engineer might describe it in terms of a payback period)
    2) PR, advertisement purposes. I know that this is tricky. But people choose to purchase offsets or RECs just because it gives them the warm fuzzies. Companies might be willing to suffer a loss on a project if it generates “goodwill” or the corporate equivalent of the warm fuzzies. Any thoughts on how to measure this or ideas about how important it is? I think it has to be mentioned.
    And, on a different tack: In light of all that you’ve learned about methane capture systems, what would it take to transform the methane flaring system into on that could harness the methane for useful energy, as part of the plant’s energy needs?

  4. Adam Stein - March 28, 2007

    Hi Matt –
    I would never suggest that business always make the most rational decision, but I must admit that I don’t see the connection with having multiple reasons for choosing a course of action. Pretty much any sufficiently important decision will have multiple factors impinging on it. That doesn’t preclude rationality. But again, I don’t really disagree with your larger point.
    The appropriate way to measure PR value is to ignore it. As the market builds, there will be thousands of projects coming online. The PR value will quickly drop to zero, if it’s not there already. What does a dairy farmer do with PR value anyway?
    Regarding your final question: I have no idea what it would take to transform the methane flaring system into one that generates electricity. Waste Management has developed many such electricity generation systems, and presumably they had reasons for not doing so at Tontitown. But this issue is out of scope of the review, and I have no expertise in the matter.