Designing Efficient Markets for Carbon Offsets with Distributional Constraints

This paper presents an assessment of the relative efficacy of three key instruments; baselines, trade ratios, and limits; which are under policy discussion in the design of carbon offset programs. Efficiency and distributional considerations are both present in choosing between them. We analyze the implication of the three instruments for the level of offsets and their composition (additional versus non-additional). We rank the instruments by their implications for total emissions, economic efficiency, and efficiency gain relative to a distributional transfer from capped to uncapped sectors. The analysis is conducted first in terms of a simple model of adverse selection in offset supply, and then calibrated numerically for the United States. Our major findings are as follows. First, the baseline and trade ratio can be coupled together to yield a higher welfare gain, relative to settings where the instruments are individually selected. In this case, it is optimal for the policy maker to select a trade ratio less than one to encourage the supply of additional offsets. Second, when the trade ratio is restricted to not fall below one, the baseline is the best instrument for maximizing welfare. Adjusting the baseline attacks the problem of non-additionality directly, while the other two instruments can only approach the issue indirectly. Third, efficiency gain per unit of redistribution from the capped sector is also highest for the baseline instrument. The numerical value of this ratio, however, is below standard estimates for the marginal excess burden of public funds, which shows that offsets are worthwhile overall only if the capped sector is not compensated fully for its loss of rents. Fourth, when the baseline instrument is not fully reliable, as in the case of international offsets, then the other two instruments come into their own. In this case we show that the trade ratio instrument is superior to the limit instrument