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


  • Heather Klemick


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

  • Heather Klemick, 2012. "What is the Optimal Offsets Discount under a Second-Best Cap & Trade Policy?," NCEE Working Paper Series 201204, National Center for Environmental Economics, U.S. Environmental Protection Agency, revised Jul 2012.
  • Handle: RePEc:nev:wpaper:wp201204

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    References listed on IDEAS

    1. Marshall, Liz & Kelly, Alexia, 2010. "The Time Value of Carbon and Carbon Storage: Clarifying the terms and the policy implications of the debate," MPRA Paper 27326, University Library of Munich, Germany.
    2. Arun S. Malik & David Letson & Stephen R. Crutchfield, 1993. "Point/Nonpoint Source Trading of Pollution Abatement: Choosing the Right Trading Ratio," American Journal of Agricultural Economics, Agricultural and Applied Economics Association, vol. 75(4), pages 959-967.
    3. James B. Bushnell, 2011. "The Economics of Carbon Offsets," NBER Chapters,in: The Design and Implementation of U.S. Climate Policy, pages 197-209 National Bureau of Economic Research, Inc.
    4. Joseph E. Aldy & William A. Pizer, 2015. "The Competitiveness Impacts of Climate Change Mitigation Policies," Journal of the Association of Environmental and Resource Economists, University of Chicago Press, vol. 2(4), pages 565-595.
    5. Montero, Juan-Pablo, 2000. "Optimal design of a phase-in emissions trading program," Journal of Public Economics, Elsevier, vol. 75(2), pages 273-291, February.
    6. Gan, Jianbang & McCarl, Bruce A., 2007. "Measuring transnational leakage of forest conservation," Ecological Economics, Elsevier, vol. 64(2), pages 423-432, December.
    7. Brian C. Murray & Bruce A. McCarl & Heng-Chi Lee, 2004. "Estimating Leakage from Forest Carbon Sequestration Programs," Land Economics, University of Wisconsin Press, vol. 80(1), pages 109-124.
    8. Harrison Fell & Dallas Burtraw & Richard Morgenstern & Karen Palmer, 2012. "Climate Policy Design with Correlated Uncertainties in Offset Supply and Abatement Cost," Land Economics, University of Wisconsin Press, vol. 88(3), pages 589-611.
    9. Juan-Pablo Montero, 1999. "Voluntary Compliance with Market-Based Environmental Policy: Evidence from the U.S. Acid Rain Program," Journal of Political Economy, University of Chicago Press, vol. 107(5), pages 998-1033, October.
    10. Shortle, James S., 1987. "Allocative Implications Of Comparisons Between The Marginal Costs Of Point And Nonpoint Source Pollution Abatement," Northeastern Journal of Agricultural and Resource Economics, Northeastern Agricultural and Resource Economics Association, vol. 16(1), April.
    11. N. Wear, David & Murray, Brian C., 2004. "Federal timber restrictions, interregional spillovers, and the impact on US softwood markets," Journal of Environmental Economics and Management, Elsevier, vol. 47(2), pages 307-330, March.
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    Cited by:

    1. 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.
    2. 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.
    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.

    More about this item


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

    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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