The Economic Impact of Non-Compliance in the Carbon-Offset Market

Carbon offset markets have been suggested as a cost effective means of reducing GHG emissions. This paper develops a model of heterogeneous emitters and producers to examine the consequences of non-compliance on the performance of the carbon-offset market. The analysis begins with the derivation of demand and supply curves for carbon offsets based on perfect compliance. The paper then considers the impact of non-compliance by producers on the supply of carbon offsets. Results show that the extent of producers' non-compliance decreases with an increase in the audit probability and/or an increase in the penalty per unit of non-compliance. In addition, the number of producers participating in the carbon offsets market is shown to increase with an increase in the carbon-offset price. Based on the supply and demand curves, the analysis then considers the price and the quantity traded that are established by private firms that are engaged in carbon offset trading. The key role of the traders is to guarantee, based on the amount of monitoring that is undertaken, that the emitters purchase only carbon offsets that actually correspond to sequestered carbon. Both an oligopolistic and a monopolistic trading sector structure are considered. The analysis then examines two different organizational structures for the group that monitors producer compliance – a group owned by the firms and a government-run agency. The results of the analysis show that both monitoring groups always undertake sufficient monitoring to ensure that full compliance is achieved – thus, while non-compliance is possible, it does not occur in equilibrium. Since the level of monitoring effectively determines the amount of carbon that is sequestered and that can be traded, a monitoring group owned by the traders can achieve monopoly profits for the sector, even when it is oligopolistic. Although the formation of a government monitoring agency can potentially increase traded output and lower the price paid by emitters, these changes are likely to be small, particularly when the trading sector is monopolistic.