Screening and Adverse Selection in the Market for Voluntary Emission Reductions

Abstract

Tradable voluntary emission reductions (VER's), often called offsets, are a policy instrument designed to expand participation in emission cap regulations. In theory, voluntary reductions by unrestricted sources used as a substitute for increases in emissions, or unmet emission reduction obligations, from restricted sources lower the overall cost of achieving an emissions target. In practice, participation in these programs is often restricted using criteria unrelated to cost effectiveness. In this paper, I focus on a particular participation restriction (i.e., screen) commonly discussed in the greenhouse gas (GHG) policy gray literature called additionality. I show when the use of the criterion is inefficient and discuss alternatives for improving the efficiency of offset programs. Under the clean development mechanism: Parties not included in Annex I will benefit from project activities resulting in certified emission reductions; and…Emission reductions resulting from each project activity shall be certified…on the basis of: (a) Voluntary participation approved by each Party involved; (b) Real, measurable, and long-term benefits related to the mitigation of climate change; and (c) Reductions in emissions that are to any that would occur in the absence of the certified project activity. (excerpt, Article 12 of the Kyoto Protocol , emphasis added ) The cost effectiveness of emission cap regulations is clearly improved by allowing verified voluntary emission reductions (VER's), or offsets, from unrestricted sources to be substituted for the emission reductions obligations, or increases, from other sources. The underlying rationale for this statement is that as the number of (heterogeneous) sources considered for emission reductions is increased, so too will the possibility of finding low cost emission reduction sources. Under voluntary emission reduction provisions of emission cap regulations, sources obligated to undertake emission reductions can compensate others to reduce emissions in their stead. VER's created by the lowest cost abatement sources are the greatest source of potential gains from trade; and thus, the most likely sources to respond to the incentives provided by the offset provisions in an emission cap regulations. Conversely, criteria that screen the pool of participants reduce eligibility and increase the cost of achieving an emissions cap. The direct costs of screening further reduce the cost effectiveness of such regulations and leave one wondering, Why do screening criteria exist at all? Article 12 of the Kyoto Protocol is the first instance of the term additional as it is currently used in the environmental economics and climate change policy literatures. The meaning of in these settings is defined in Article 12 to be emission reductions greater than what would have happened in the absence of policy. A detailed rationale for its use and importance to the framers of the Kyoto Protocol is not part of the body of documents that commonly accompany the Protocol (i.e., annex, appendix, or preamble). Popular consensus 1 argues that the requirement of additionality is vital for