Opinion | Banking on Offsets? A Brief Due Diligence

Setting the StageIn 1988 independent energy producer Applied Energy Services (AES) was planning to build a series of coal- and gas-fired powerplants around the United States. AES’ CEO Roger Sant noted at the time that he would have preferred to construct wind farms or solar arrays, but that the economics just didn’t work. Instead, with the support of the World Resources Institute in Washington, DC, AES committed to funding a carbon offset project for each of its power plants. The very first offset project, based on expanding an agroforestry program in the uplands of Guatemala operated by the nongovernmental organization CARE, was matched to AES’ first powerplant in Thames, Connecticut.Since then, carbon offsets have become integral to global climate change mitigation efforts, even as concerns have persisted about the quality of offset markets, whether offsets represent “carbon colonialism,” and whether offsets are a ploy by the fossil-fuel industry to distract from what’s really needed to tackle climate change.And offset markets have been volatile. The voluntary carbon market effectively collapsed in the years following 2009, in part the result of scandal after scandal. The Kyoto Protocol’s compliance-based offset market collapsed a few years later when countries transitioned to the Paris Agreement.But then new aviation sector targets, corporate net zero targets, and national Paris Agreement targets, all based on the ability to utilize carbon offsets, caused offset markets to rebound. In fact, offset proponents anticipate explosive industry growth in coming years. The Task Force on Scaling Voluntary Carbon Markets suggested in 2021 that a 10x to 100x increase in the use of offsets will be needed to deploy the needed “climate capital” around the world to meet global climate targets.At the same time, the flow of reports and news stories questioning the environmental integrity of offsets has become a deluge, causing voluntary markets to again stumble. Offset proponents have responded with the message that these are just normal growing pains for a new market, and that as long as buyers buy quality offsets they have nothing to worry about. Unfortunately, faced with an intangible commodity, buyers have had little ability to judge for themselves which offsets actually are fit for purpose.Despite the industry’s growth expectations, anyone with a material interest in the future of carbon offsets should explore questions including:

• Why did offsets get so contentious after the World Resources Institute and other leading environmental groups originally promoted them as a technically and economically sound tool for advancing climate change mitigation objectives?
• Why have we been having the same arguments about offsets, and seeing the same front-page exposes, for 20 years?
• Why are offset markets having so much trouble delivering a consistently “quality product” after 35 years of practice?
• Why have efforts “fix” carbon offsets failed, and will the proposed Assessment Framework of the Integrity Council for the Voluntary Carbon Market (ICVCM) finally turn the corner toward a quality market?

What Is the Problem? Albert Einstein once noted that "If I had an hour to solve a problem, I'd spend 55 minutes understanding the problem, and five minutes working on solutions." So, what is the problem when it comes to creating a quality offset market?The answer is deceptively simple: the intangibility of offsets. As British journalist Dan Welch puts it: “Offsets are an imaginary commodity created by deducting what you hope happens from what you guess would have happened.” What could possibly go wrong? Here are a few of the challenges:

1. How do we balance the key objectives of carbon offsets, cost-effectiveness and environmental integrity, when they are inherently at odds with each other?
2. How do we address the fact that one can’t empirically test for the quality of an intangible commodity? At best one can be more or less confident in the hypothesis that “this is a quality offset.” It’s analogous to the U.S. judicial system is which juries are entrusted with the task of evaluating the hypothesis that “this defendant is guilty.” Certainty is usually not on offer.
3. How reliably can we quantify an intangible commodity like carbon offsets based on a counter-factual prediction of the future?
4. Can we adequately preserve the “quality” of an intangible commodity market when offset project developers are naturally incentivized to promote lower quality offsets in order to reduce their business risks. Gaming is inevitable.

There is no shortage of useful information and literature by which to explore these and other questions, and I can just scratch the surface here.Point #1 Carbon offsets are based on advancing two competing goals: cost-effectiveness and climate change mitigation. There is no set of offset market rules that can simultaneously maximize for cost-effectiveness and environmental integrity. Rather than just ignoring this fact, we should actively decide on what the balance should be, since market rules depend on that decision. Note that the weaker the performance of offsets against the criteria discussed in Point #2, the more “cost-effective” the offset market for buyers.Point #2 There are a number of qualifying criteria commonly discussed in the context of offsets, with the three fundamental criteria being: additionality, permanence, and avoiding leakage. These criteria have been around since the first offset projects, but we’ve learned much more since then about the challenges of applying qualifying criteria to an intangible commodity that can’t be empirically observed or measured. There is no way to “test” for these criteria in the conventional sense, which enormously complicates the goal of a delivering quality offset market.

• Additionality. “Additional” avoided or removed tons are directly attributable to the demand created by the offset market. Offsets cannot represent tons of CO2 (or its equivalent) that would not have been emitted to the atmosphere, or that would have been removed from the atmosphere, regardless of the existence of the offset market.

Certainty regarding whether a proposed offset project is the result of offset market demand, as opposed to the many other potential drivers or motivations that might be in play, is rare at best. Which makes “additionality testing” a misnomer. Imagine trying to design a pregnancy test kit without ever being certain that a woman was or was not actually pregnant. When it comes to offsets, we can only be more or less confident regarding an offset project’s additionality.With no empirical way to test for additionality, some proportion of non-additional tons will be approved as offsets even under the best of circumstances. The inverse is also true. The size of each “error” depends on how strictly the rules are written. Unfortunately, the two “errors” are inversely related. That’s why prioritizing offset market inclusivity and cost-effectiveness by definition reduces the market’s environmental integrity.The challenge of keeping non-additional tons out of offset markets is complicated by the fact that the number of “naturally” avoided or removed tons vastly exceeds the number of tons likely to be attributable to the existence of offset markets. A plethora of public policies cause billions of tons of emissions to be “avoided,” and the natural carbon cycle removes hundreds of billions of tons of CO2 from the atmosphere every year.

• Permanence. The warming impact associated with CO2 emissions lasts for a long time, and the equivalent cooling impact of offset should last just as long.

But how long is long enough to be permanent? Applying the Oxford dictionary’s definition of permanence would dramatically constrain the scope (and cost-effectiveness) of offset markets. As a result the criterion has in practice lost much of its relevance, with some types of offsets simply delaying emissions for a short period.

• Lack of Leakage. Market or behavioral feedbacks following the implementation of offset projects can undermine their cooling impact,” and need to be netted out. As with additionality, however, there is no empirical way to measure the potential leakage associated with different kinds of offset projects. We might be more or less concerned about leakage depending on the category of project, but quantifying that leakage is almost always subjective.

Point #3 Once qualified, how does the number of offsets get quantified? Dan Welch characterized the answer as “deducting what you hope happens from what you guess would have happened.” What we guess would have happened is called the project baseline, and it is counter-factual in the sense that it’s a prediction that cannot be empirically validated. Recent studies have suggested, however, that the baselines used in project types including avoided deforestation and cooking stoves have resulted in an estimated 600% over-issuance of offsets.Point #4 Offset providers face an inherent conflict of interest. Even if motivated by tackling climate change, identifying and launching high quality offset projects is costly and risky. What if buyers end up not buying the offsets you’ve spent a lot of money bringing to market?The most obvious way to manage this business risk is to find ways to game the system. The more non-additional, impermanent, or leakage-prone a project, the lower its business risks. Gaming is therefore inevitable. Project developers might not even realize they’re gaming the system if they’ve convinced themselves of a project’s “quality.” As Margaret Heffernan noted: “In failing to address climate change, all the forces of willful blindness come together like synchronized swimmers in a spectacular water ballet.” Conclusion: Where to for Offsets?Building a market around an intangible commodity is never going to be easy. But absent the explicit recognition of the implications of offset intangibility during market design, a gamed and low quality market is to be expected. As one carbon offset expert puts it: “at the project level, everyone kind of has an incentive to see how much they can get away with without raising alarm bells among buyers - but the systemic outcome is a crash.”The potentially good news is that it’s not really that hard to identify steps that would help “fix” how offset markets work.

• Deciding how the goals of offset cost-effectiveness and environmental integrity will be balanced when it comes to market design. Only then can specific rules for implementing the additionality, permanence, and leakage criteria be developed.
• Deciding “how good is good enough?” Would a 90/10 ratio of “high confidence” to “low confidence” offsets be acceptable? About how 80/20? 70/30? The answer has big implications for offset rulemaking, recognizing that there can never be a perfect market.
• Explicitly consider the reality that gaming (or at least attempted gaming) will be pervasive when designing market rules.
• Carry out 3^rd party due diligence on offset quality to better inform offset buyers.

Could these and other steps be implemented to promote a quality offset commodity? Sure. In fact, the relatively recent launch of multiple ratings agencies is an important step in this direction. That said, an offset market designed for high quality would look very different from today’s market. Including:

• More business risk
• Smaller size, with less growth potential
• Fewer categories of qualifying projects due to stricter permanence rules
• Fewer qualifying projects in each category due to stricter additionality rules
• Substantially higher offset prices

That’s why efforts to “fix” offset markets tend to nibble around the edges, the equivalent of trying to build a slightly better mousetrap. Today, the ICVCM’s proposed Assessment Framework could substantially tighten prevailing offset rules. But the ICVCM makes no mention of the challenges of an intangible commodity, of the reality that we can only be more or less confident in an offsets’ quality, or the need to balance the objectives of cost-effectiveness and environmental integrity. Because the ICVCM is in effect trying to improve the existing mousetrap, is seems likely to fall well short of what a complete quality re-think of the “offset quality mousetrap” would deliver.There is even a legitimate question for the reasons described above as to whether carbon offsets can ever be “fit for purpose” when it comes to being massively scaled for climate change mitigation efforts, in effect substituting for the failure to implement the necessary public policies. Just because market mechanisms have become thought of as an almost universally applicable “hammer” doesn’t mean climate change is “nail.” There is also a proposed movement to encourage companies to move away from claiming “offsets” against their carbon footprints, and instead toward funding “contribution claims” that don’t deliver the same quantified commodity. Whether companies will have any interest in funding “contribution claims” remains an open question.The future of offset markets today is radically uncertain. Offset markets could evolve in many different ways, of which the “explosive growth” scenario is probably the most risky. These markets have collapsed before, and if we don’t structurally reform them in favor of better quality offsets, they probably will again. brief bio Dr. Mark C. Trexler has more than 30 years of regulatory and energy policy experience. He has advised clients around the world on climate change risk and risk management. Mark joined the World Resources Institute in Washington, DC, in 1988, where he worked on the first carbon offset project, the CARE Agroforestry Project in Guatemala. Mark founded and directed Trexler Climate + Energy Services (TC+ES) from 1991–2007. After TC+ES was acquired by EcoSecurities’ in 2007, Mark directed its Global Consulting Services Group until 2009, and was Director of Climate Risk for the global risk management firm of Det Norske Veritas from 2009-2012. He is widely published on business risk management topics surrounding climate change, including in the design and deployment of carbon markets. Mark has served as a lead author for the Intergovernmental Panel on Climate Change, and holds advanced degrees from the University of California at Berkeley.Today he directs climate risk knowledge management at the Climatographers, and is co-developer of the Climate Web, the closest thing today to a collective intelligence for climate risk assessment and managementLearn more through Mark's LinkedIn profile.

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