When does additionality matter? (Part 3)

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In two previous posts, I’ve attempted to establish that additionality is neither some strange concept relevant only to carbon offsets, nor an awkward patch used to fix a defect in the design of carbon markets. Rather, the concept of additionality is applicable to any incentive system, whether subsidy, tax, or whatever. The real question is what degree of additionality is actually necessary or desirable in any given system. Put another way, when should we care enough about additionality to incur the costs of measuring and enforcing it?

Those costs can be quite high, and the benefits sometimes uncertain. Let’s return to one of my previous examples: the grocery store owner who offers coupons to lure new customers, even though most coupons will probably fall into the hands of old, non-additional customers. In this case, additionality is difficult to enforce, and the benefits of enforcement are low (because coupon programs don’t cost much to run). High cost, low benefit: additionality isn’t a concern.

Now the carbon offset market. Here the cost of measuring additionality is high, but the need is even higher. There are (at least) two reasons for this. The first is the obvious one: carbon offsets can be used to satisfy emission limits under a cap-and-trade program. Non-additional offsets undermine the cap. Good offset projects help to reduce the strain of carbon caps on the economy by lowering the cost of reductions. But too many bad offset projects threaten the whole system by allowing emissions to keep growing.

The second reason is more subtle, but equally important: a large proportion of potential projects are non-additional. For example, a recent McKinsey analysis suggested that 40% of the greenhouse gas reductions available to us are revenue-positive. And, of course, a lot of possible projects are just flatly unhelpful — I routinely field questions from well-meaning people wondering if they can get offset revenue for leaving some tract of land undeveloped. If we don’t test carefully, non-additional projects will soak up all the available offset financing, undermining a carbon cap and stranding the projects we want to support.

It’s these two facts together that make additionality a critical component of any offset market. If the pool of possible non-additional projects were fairly small, we might not want to incur the cost of measuring additionality. Unfortunately, that pool is large, so we need to be discriminating.

Sean is right to raise questions about perverse incentives in the carbon market, but abandoning additionality is no solution. In my final post on this topic, I’ll talk about the specific issue of Sean’s co-gen projects, and why I think additionality isn’t really the problem here at all.

Photo available under Creative Commons license from Flickr user Schwarzerkater.

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  1. Jeremy - April 3, 2008

    Thanks for the post Adam. I just read Casten’s piece and think you should speak to the difference between the voluntary market and the international and upcoming domestic regulated market. Especially the difference between emissions allowances and offsets which not many people seem to understand.
    As a buyer of carbon offsets, I don’t have to do anything. I don’t have to “reward” a company for reducing CO2 emissions. I don’t have to hand over free money to Dupont just because they reduce HFC 23 at 20 cents and try to charge me $5 on the CCX. I certainly don’t have to give money to a company like RED for reducing CO2 when they’re making money doing it already.
    I understand markets are important, and the voluntary carbon market is a great market signal for project developers and future cap and trade/offset proponents. I don’t, however, want my money to go to a project that would have happened without it. I don’t see voluntary carbon as a commodity. I want to know where my money goes and, most of all, that my money is making a difference. A direct difference, not as an incentive for driving a market by making a company 15% ROI instead of 10% ROI.
    I want real reductions as a direct result of my money. I want to know my money makes a difference and that but for my contribution, the project wouldn’t have happened anyway. And honestly, I don’t really care if I have to pay $20 per ton of CO2 to make this happen. I don’t mind Terrapass making a profit and I don’t mind a project developer making a profit, nor do I mind the excessive cost of monitoring and verification. Heck, I don’t mind if a project costs $5 per ton and I’m paying $30. I just want to know that my money is making a very, very clear difference.
    I do NOT want to give Casten money to increase his bottom line by the smallest fraction. He can make money now installing his equipment, and even more money in the future in the regulated market. In the voluntary market, however, where my money goes, I will continue supporting Terrapass and other offset companies that rely heavily on additionality (and not necessarily financial additionality in its purest form, but also a barrier test, etc). And I will only support carbon offset standards that draw a hard additionality line. I realize it may not be all that efficient, but I do not think we should sacrifice quality for efficiency. And if that quality costs more, so be it.
    -Jeremy

  2. Adam Stein - April 3, 2008

    Excellent points, Jeremy. In my final post on this, I’ll get into the difference between offsets and allowances, which is really a critical distinction.

  3. GHG fellow - April 9, 2008

    I definitely disagree with the bulk of your analysis in the past 3 posts on additionality, though I applaud your effort to bring the conversation to the public. I think the comment below is probably the single best instance I can think of where you are incorrect and it is central to all other arguments you make.
    You write:
    “The first is the obvious one: carbon offsets can be used to satisfy emission limits under a cap-and-trade program. Non-additional offsets undermine the cap.”
    This is very much mistaken. If the cap starts at a certain period in time, say 2008, and the only reductions counted against it occur after that time period, these are real reductions, regardless of the economic incentive that may have produced them. In other words, increased efficiency that justifies itself through cost-savings, or a large increase in public transit use, which saves money compared to insurance and gasoline, are not financially additional reductions; they don’t need the carbon markets to make financial sense. However, if they occur ofter the baseline year, they are real, measurable reductions, that decrease emissions below the baseline and should be eligible as offsets. The whole point of a cap and trade system is to reduce GHG emissions. Why should we limit these reductions in anyway? Don’t we want to count every emission and every reduction in order to have a truly accountable system? Don’t we want to encourage behavior changes that become more likely the more financial sense they make?
    Having been a party to many conversations in the boardroom about cost-savings through sustainable measures, I can tell you one of the first questions is “can we generate carbon credits through these measures and make them more profitable?”. When the answer is no, these cost-saving measures are more often than not, taken off the table. Why would we encourage this as some sort of “quality” control measure? Isn’t the real quality we are all concerned about simply real measurable GHG reductions?

  4. Adam Stein - April 9, 2008

    Hi GHG fellow —
    Thanks for the comment. It seems pretty clear from your comment and similar ones along these lines that there is a real barrier to getting efficiency projects, even profitable ones, over the hump. It’s a shame, and also a huge opportunity to the person who can figure out how to unlock these savings.
    That said, it seems unworkable to me to treat these reductions as a source of offsets, particularly under a cap-and-trade system. The basic issue here is that such reductions would be counted twice. Once as offsets and again at the power plant, where the efficiency improvements would lower demand. You can call this an additionality problem, or you can just call it an accounting issue. Efficiency improvements are already encompassed in the cap.
    At least, that’s my quick take. Let me know if I’m misunderstanding the situation.

  5. GHG fellow - April 9, 2008

    Before I respond, can you clarify what you mean by “Efficiency improvements are already encompassed in the cap.”

  6. Adam Stein - April 9, 2008

    I mean that efficiency improvements generally result in electricity savings. And electricity generation is covered under any cap-and-trade scheme. So when an electricity purchaser implements an efficiency improvement that lowers demand, the local utility registers that drop in demand as part of its efforts to meet its cap. If the electricity user then also sold the drop as an offset, you’d have double counting of the reduction.
    So what you’d really hope to see in situations like this is that the utility would pay it’s customers to implement efficiency projects, on the theory that doing so would be cheaper than buying carbon allowances. Additionality is still a concern, but not for society — rather, it’s a business concern for the utility, which would want to get value for its money.
    I agree with you that efficiency seems to be a tough nut to crack. Dropping additionality doesn’t seem to be the correct policy approach though.

  7. Anonymous - April 9, 2008

    Firstly, the voluntary markets where TP sources it’s offsets aren’t operating within a cap – so efficiency is as good, if not better, than your current projects.
    Secondly, accounting for GHG reductions that feed into the grid is relatively simple – it’s the basis for all REC accounting after all (at least within the CCX), for instance. If you give credit here, you don’t give credit there. Done.
    So, if Company ABC increases efficiency and decides to capitalize on the GHG reductions, the utility company can not do the same with those reductions.
    Most importantly, none of this covers my other example of a measurable increase in public transit use, which makes financial sense, so would not be eligible under traditional financial additionality terms.

  8. Adam Stein - April 10, 2008

    Hm…I’m scratching the response I just wrote. I’m overcomplicating this. Basically, there are two scenarios here:
    1. Cap is in place.
    In this case, additionality is a non-issue. Efficiency projects are covered under the cap, and the price on carbon is the kicker these projects should need to get over their hurdle rate. There are all sorts of different accounting issues you can get into with how the cap is implemented, but none of them really matter at a fundamental level — offsets don’t enter into the picture. I’ve got one more post coming up on the difference between offsets and allowances.
    2. Cap is not in place.
    This is the situation we have now. A hopefully temporary situation, but the current situation nonetheless. In this case, no one in the voluntary market is interested in paying for reductions that are going to happen anyway, so additionality is important. There seems to be this misconception that if projects “pay for themselves” then they’re not financially additional. This isn’t true. If projects are self-financing but don’t manage to clear the hurdle rate for investment, than they can still be eligible for offset revenue. This is the case for many wind farms, and TerraPass and other offset retailers are happy to consider such projects.
    But the case where projects do clear the necessary hurdle rate — well, these are clearly not financially addiitonal, and buyers quite rightly aren’t interested in supporting them.

    As for the transit example — I don’t really follow. So far as I know, public transit systems are not revenue generators for municipal governments, they’re revenue sinks. Not sure where financial additionality enters into this.

  9. GHG fellow - April 10, 2008

    OK. In scenario 1, you are making a differentiation between offsets and allowances and in scenario 2 implying that allowances, or allowance-like, credits are not desirable by consumers. I disagree. I think they are made less desirable through the unceasing push by many in this market to only work with “additional” credits and to strongly discredit allowances as offsets. I am pretty sure that TP sold allowances as offsets when it first got started. Yes?
    The truth is most consumers are stuck taking your word on this because they aren’t professionals in this domain and on the surface, the analysis makes sense. Why give money to DuPont to reduce emissions if they are making money on these projects anyway? Right? That’s the question. A corollary is why give money to TerraPass when they are making money off of every transaction and definitely some of that money is either now or projected to in the future line the pocket of shareholders. Period. But that’s aside the point, and I am really not arguing against it.
    The reason financial additionality shouldn’t matter is that we want people to profit off of GHG reductions so as to avoid all of this political and academic babble and get on with the real work of implementing large-scale, revolutionary, GHG reduction projects NOW!!!
    Clearly, the hurdle rate is large enough that we have a huge problem on our hand. We aren’t seeing the “seemingly” profitable projects taking place in the scale that is needed to prevent catastrophic climate change. Lower the hurdle rate to the point where GHG reductions are profitable in and of themselves, and you’ll see an infrastructure overall. Consumers of offsets want that.
    Critics of “allowances” not being valuable as offsets, consciously or not, only want the offset world to look like another philanthropy game instead of the next full-on industrial revolution.
    I truly believe in the revolutionary power of markets, and that’s why I think financial additionality is misplaced concern that may make TP feel more confident in it’s “product” but that ultimately puts the brakes on real change.

  10. Adam Stein - April 10, 2008

    implying that allowances, or allowance-like, credits are not desirable by consumers
    No, that’s not it at all. Allowances can be fine to sell as emissions reductions. It’s just that additionality isn’t an issue for allowances, because there’s a hard cap. Additionality is an issue for offsets, because otherwise you’re just proposing a free bag of money for whomever wants it, which is just quite obviously not an environmentally helpful thing.
    I keep hearing these arguments for abolishing additionality, and they’re just totally missing the point: offsets are not what you want for rewarding efficiency projects. Allowances are. I’m not sure why this is so controversial — aren’t you the one who dislikes additionality?

  11. GHG fellow - April 10, 2008

    I based my quote, “implying that allowances, or allowance-like, credits are not desirable by consumers”, on your statement that, “In this case, no one in the voluntary market is interested in paying for reductions that are going to happen anyway, so additionality is important.” I really can’t see how I misinterpreted the statement.
    People can purchase allowances as offsets in the US voluntary markets through the CCX and many people do, include the US House of Representatives. Folks arguing the gospel of additionality, actually chided the congress for doing this, based on the same basic arguments you are putting forth on additionality.
    In terms of your final paragraph above, as if it wasn’t clear earlier, I am arguing in favor of allowances as offsets. Period. Separating them conceptually, in the method that your analysis takes, isn’t helpful and only serves to create an atmosphere where real genuine reductions from the nations largest emitters are commonly not respected in the open market because this large shadow of doubt is cast on them by thought leaders like TP.
    Intentionally or not, that’s what is happening.
    This quote really makes me laugh: “because otherwise you

  12. Adam Stein - April 10, 2008

    Hm. I’m not sure what else to say here. I’ve got a long post coming up on the differences between allowances and offsets — which are conceptually separate because they happen to be different things, not because TerraPass believes so — which will dig into these issues more fully.

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