Permits vs. Offsets Under Investment Uncertainty

Abstract

A global crediting mechanism would enable developing countries without binding emissions reduction targets to participate in the international carbon market. Linking the framework on Reducing Emissions from Deforestation and Forest Degradation (REDD) as an offset program to major cap-and-trade programs is a particularly promising approach to increase both climate finance and cost-efficiency. However, the coexistence of permits and offsets also creates a classic case of interaction effects. In this paper, we explore how the availability of multiple compliance instruments affects energy investment incentives. Alternative trading and linkage schemes are compared using a real options model of firm-level investment decisions under stochastic prices and the ability to delay investments. We first isolate the critical design factors that drive private investments in the energy sector. We then identify policy regimes that balance the different concerns in the polarized debate for and against the inclusion of forest carbon offsets.