Carbon Offsets: The Next Multibillion-Dollar Energy Industry

by Mark Perlis, Dickstein Shapiro LLP

With support from the Obama administration, Congress is moving toward enactment of comprehensive climate change legislation.

On May 21, the U.S. House of Representatives’ Energy and Commerce Committee approved a cap-and-trade bill to reduce carbon emissions dramatically across major sectors of the U.S. economy. At its core, the legislation establishes annually declining caps on total emissions from covered sectors, including electricity, from 2012 to 2050. Covered entities, including electricity generators, will be required to acquire emission allowances for each ton of greenhouse gas (GHG) emissions. These tradable emission allowances will establish a carbon price that should reflect the costs of emissions reductions.

Achieving reductions in emissions from the electricity sector on the order of 20 percent by 2020 and 80 percent by 2050 will require enormous investments in renewables, nuclear generation, carbon capture and sequestration technologies, new, highly efficient natural gas and combined heat and power facilities and end-user, energy-saving devices and practices. The electricity sector’s capital costs for physical assets will be on top of the financial costs for allowances to cover actual emissions. The total costs to the electricity sector and their direct impact on electricity prices likely will be far greater in the coming decades than the costs incurred by the industry in prior decades to become a more efficient, lower-carbon industry.

Estimates of the total costs of capping carbon in the electricity sector vary widely and depend critically on assumptions about the design of the ultimately enacted cap-and-trade program, both in the United States and internationally. Many of the most contentious features of the U.S. cap-and-trade legislation involve how the total costs to the electricity sector and electricity customers can be mitigated.

While the complex, emission-allowance allocation has attracted the most public attention, an equally important means of mitigating the costs of carbon-emission reductions is the authorization of a program for carbon offsets. Under the Energy and Commerce Committee bill, up to 2 billion tons of offset credits may be utilized across all sectors–in place of allowances–to cover actual emissions. Half of these credits may come from domestic emission-reduction projects, and half of the offsets may originate internationally. It is expected that electricity generators may be able to acquire offset credits–in lieu of emission allowances–to cover between 30 and 50 percent of expected emissions.

If offset projects can reduce GHG emissions at lower costs than electricity generators can reduce their own GHG emissions, acquiring offset credits rather than emission allowances may become the most cost-effective strategy. A $10 to $20 per ton price for allowances (on the low end of most estimates) implies a market for offset credits of as much as $20 billion annually. Thus, electricity generators that face a “cap” could be purchasing as much as $5 billion to $10 billion in offset credits annually.

The current legislation provides few details on offsets. The pending House bill requires domestic offset credits to be from projects that reduce, avoid or sequester GHG emissions, provided that emission reductions are “verifiable,” “additional” to a baseline, “permanent” and without “leakage.” The Environmental Protection Agency will be charged with writing regulations to define eligibility criteria for offset projects and to establish methodologies for measuring amounts of GHG emission reductions. These regulations will be complex and controversial. International offset credits will be expected to meet similar criteria but also might be subject to international treaty standards.

The offset credit market and the allowance market will be linked, and arbitrage opportunities might arise. Electricity generators might create offsets through direct investments in projects, or they might choose to purchase offset credits uncoupled from product output. The carbon-offset regime thus will be a compliance tool and a new, global and potentially profitable industry in its own right. For now, electricity generators should monitor closely the development of rules and investment opportunities for acquiring carbon-offset credits.

Author

Mark Perlis is a partner in Dickstein Shapiro LLP’s energy practice. He has been active in emission markets for 20 years and advises electric industry clients on climate change legislation. Reach him at perlism@dicksteinshapiro.com.

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