This blog post was originally published by Innovate 4 Climate on their website.

The coming year will see countries seek robust mechanisms to effectively increase the climate ambition of their Nationally Determined Contributions (NDCs) under the Paris Climate Agreement. Given the concerns on the economic costs of stronger climate action, certain compliance schemes are incorporating offsets as a way of containing costs. Offsetting is the practice of buying carbon credits from certified climate action projects.

The merits of offsets have long been debated, particularly on whether it deters organizations from undertaking stronger climate action by going for the 'cheap' option that has few sustainable development co-benefits. The latest research funded by the German Environment Agency shows that carbon offsets can avoid such disincentives only if safeguards are maintained to ensure the carbon price signal is not weakened due to external shocks (including the supply of offsets); and there are safeguards to certify and accept offsets with high environmental integrity.

Could offsets prevent organizations from reducing their own emissions?

The findings show the importance of policymakers setting and maintaining a strong carbon price signal through safeguard mechanisms. When actors anticipate the carbon price will be high in the future, they use offsets in addition to directly reducing their emissions to minimise risk and contain carbon costs, the study shows. The emission trading schemes (ETS) in the EU and Alberta were the only two case studies where carbon prices did increase to a point that it spurred businesses under compliance to combine direct emission reduction initiatives and indirect measures, such as offsets, to compensate emissions cost-effectively. Actors used their mandated quota of offsets to reduce emissions that otherwise could not be mitigated in the short-term.

However, when the carbon price of the compliance scheme was low, the study shows that offsets ended up being the least used instrument for reducing emissions. The examples of the EU ETS and Colombia particularly show that for compliance actors, the transaction costs of sourcing and securing offsets is much greater than the potential cost savings of using offsets. In other words, with a low carbon price it is easier to continue polluting and pay allowances than undertake the effort to buy offsets or mitigate.

Robust governance upholds environmental integrity of the compliance scheme

The governance of a compliance scheme is just as important as the price to avoid potential perverse effects of offsets.

The main critique of offsets is that the influx of offsets into an ETS can depress the compliance price signal, as the market would have a supply of both allowances and offsets. The logic is as follows: the compliance price signal goes down if the combined supply of allowances and offsets exceeds the amount of allowances needed within the compliance trading period.

However, case study findings suggest other factors – such as an economic recession – played a stronger role in depressing the compliance price signals than offsets.

Robust ETS must be designed in a way that allows them to effectively respond to external shocks that could depress the price and limit the use of offsets - such as economic recessions. A case in point was the price slump of the European Union Allowances (EUAs) after the 2008 economic crisis. Contrary to the critique of some commentators, we now know that there is little evidence that offsets were the determining factor in reducing the EUA price. In fact, the European Commission itself acknowledged that the lack of automatic volume adjustment in the context of reduced economic activity was the primary culprit of the credit glut and price slump for the EUAs.

The main reason offsets did not play a significant a role in depressing the compliance price signal was that most ETS analyzed were actually designed to restrict compliance actor's use of offsets. This was to ensure that market actors reduce their own emissions and to avoid an influx of offsets pushing down the carbon price signal. For example, the EU ETS and Alberta has quantitative restrictions on how much of an actor's compliance can be met using offsets, though the Albertan government did relax this restriction when the federally-imposed carbon price increased. The EU ETS, Alberta and Australia can also qualitatively restrict offset use based on which offsets (by project type and geography) are eligible for compliance. Strong carbon price signals were also important in supporting the development of more high quality and expensive offsets.

Restrictive eligibility criteria and governance processes on certifying offsets to environmental integrity and sustainable development principles are also important in ensuring cheap and controversial offsets do not undermine stronger climate action. A key criticism of the Clean Development Mechanism (CDM), under which most offsets were certified for EU ETS compliance, was the lack of a clear definition and measurement of sustainable development co-benefits, which led to inexpensive projects – like industrial gas projects – being certified. The EU placed restrictions on CDM projects types in successive periods to incentivize climate action in least developed countries.

What's next? Key takeaways for policymakers

Policymakers should consider using offsets when they intend on setting ambitious compliance schemes where a high compliance price may also carry real risks to the economy – such as facilities under the scheme shutting down or relocating, leading to loss of jobs – in which case offsets can act as a short to mid-term cost-containment measure to potential demand sectors, and drive additional emission reductions in potential supply sectors.

To truly make the business case for driving emission reductions in the sectors that rely on offsets, compliance schemes must couple robust design of managing supply and demand with a high level of ambition and a high price on carbon.

If policymakers decide to allow for the use of offsets, they should introduce both quantitative and qualitative restrictions on offset use in order to address risk of offset influx depressing the price signal of the scheme and ensure that offsets from high quality projects are used for compliance. Only those projects that are truly additional and contribute substantially to the UN's Sustainable Development Goals represent a legitimate contribution to climate action.

How offsets can help pave the way to a low-carbon economy post-2020 will be discussed in the next blog.

Blog series: Can offsets be a solution to global climate inaction?

This blog is part of 3 post series that highlights key research findings from a research project that is funded by the German Environment Agency and jointly conducted by Wuppertal Institute and South Pole. The reports on which these blogs are based are soon to be published on the UBA website and the findings will be further discussed in an I4C webinar on "How to raise ambition through carbon offsetting? Lessons learned and post-2020 prospects" at the end of September 2020.

Read the other posts in this series here and join the dedicated webinar to find out more about this topic.