Understanding Carbon Offsets

Allowances

What is an Allowance?

Carbon allowances are issued by a government under an emissions cap-and-trade regulatory program. Each allowance (or emissions permit) typically allows its owner to emit one tonne of a pollutant such as CO2e.

Under a cap-and-trade system, the supply of GHG allowances are limited by the mandated ‘cap’. Allowances can allocated freely by the governing program, be purchased when auctions are held, or purchased from other entities that have an excess.

Location

The location of the emission sources covered by a cap-and-trade program depends on its scope set out in regulation or legislation. There are programs in the European Union, USA (California and RGGI), Canada (Alberta and Quebec), and emerging systems all over the word, including China, Korea and South America.

The EU Emissions Trading System (EU-ETS) is the largest cap-and-trade program covering over 40% of EU’s GHG emissions (as of 2020). The cap is set at minus 20% by 2020 and minus 43% by 2030 below 2005 emissions.

In the USA, there are two ETSs (as of 2020):

  • The Regional Greenhouse Gas Initiative (RGGI) started in 2009 and is the first mandatory GHG cap-and-trade system in the USA. It includes nine Northeastern and Mid-Atlantic states. Each state established its own cap and trade program that set limits on in-state CO2 emissions from electric power plants, with these programs then linked into a multi-state allowance market.
  • The cap and trade program established by California’s Global Warming Solutions Act AB 32 started in 2013 (CA ETS). It covers 85% of California’s GHG emissions, including the transportation sector. The California and Quebec cap-and-trade programs are linked.

Cost and Management Burden

Cost per tonne of CO2e (2019 data):

  • RGGI: US$5-6
  • California: US$14-18
  • EU ETS: around €20-30

Most RGGI member states allow non-capped voluntary buyers to purchase and cancel RGGI allowances. The purchase of CA or EU ETS allowances is also possible. The purchase of such allowances to make a voluntary emission reduction claim would not require a major management burden and ongoing-management costs would be minimal. Numerous environmental commodity brokers exist that can facilitate the purchasing and retirement of allowances.

You can find updated allowance price information and more details on program price floors and other aspect of these and other cap-and-trade programs here.

Environmental Integrity

Buying and canceling allowances from a cap-and-trade system offers an alternative to carbon offset credits for claiming emissions reductions. This approach has the potential to avoid offset quality issues, such as non-additionality, less of a concern. The purchase and voluntary cancellation of allowances reduces the available allowances in a cap-and-trade system, effectively “tightening the cap” and, in principle, reducing the emissions that can be produced by covered sources (e.g., power plants, large industry, and fuel suppliers). By this logic, purchasing and cancelling an allowance compels covered sources to achieve additional emissions reductions. However, some cap-and-trade programs have oversupplied allowance markets.

Cancelling[1] in an oversupplied market negligible effect. Canceling allowances will only result in additional emission reductions to the extent that allowance markets are not over-supplied. Oversupply can build up if the emissions cap is unambitious (i.e., higher than the projected business-as-usual (BAU) emissions). In such a case, a cap-and-trade policy in a country or region actually has no significant effect on emissions from covered sources. There will be too many allowances issued by the governing regulatory authority and result in an accumulation of surplus allowances in the market. More allowances that covered sources need to emit as much as they choose.

Oversupply can also be created if the covered entities engage in more mitigation than what is required by the cap. If a cap is ambitious, though, such over-achievement will be transient and will not lead to a build-up of surplus allowances.

In a cap-and-trade system with a long-term oversupply problem, cancelling surplus allowances will not lead to additional emissions reductions because it would simply remove some of the built up surplus. Cancelling allowances from an oversupplied market may lead to additional emission reductions later in time, assuming the oversupply was temporary and that there is a scarcity of allowances at a later date. However, such reductions would be subject to considerable uncertainty, as they would depend on continuation of emission trading systems over time and increasing stringency of the cap.

Historically, most cap-and-trade systems have been oversupplied with allowances. Many have also incorporated minimum price floors for new emission allowance sold at auction. And so, one clear signal that a market is oversupplied is that auction prices are at or near the program’s price floor.

  • The EU ETS was oversupplied for many years, but recent changes to the program have been instituted to neutralize that surplus (e.g., Market Stability Provisions), as can be seen in rising prices. If this trend continues, then it appears the oversupply problem for the EU ETS will have been mostly resolved.
  • The CA ETS has a price ceiling and price floor. To date the allowance prices have traded at or slightly above the floor price, indicating that there is no scarcity of allowances.
  • RGGI was severely oversupplied in the past because of a switch to natural gas from coal by many utilities and a weak economy. RGGI has a low price floor and allowance prices have traded at or slightly above this floor, indicating that there is no scarcity of allowances.

Potential Risks

Concerns related to the environmental integrity of allowances due to oversupply, presents a significant risk if used to make voluntary emission reduction claims. Buyers should not make such claims based on the voluntary retirement of allowances from oversupplied cap-and-trade programs.

Social and Environmental Co-Benefits

Unlike offsets, the purchase of allowances would not allow the purchaser to select for activities with sustainable development benefits.

Outlook and Considerations

Buying and canceling allowances from a cap-and-trade system offers an alternative to offsets but environmental integrity can only be ensured if allowances come from a system that is not oversupplied over the long-term.

The cancellation of EU ETS allowances has become a viable option as the EU ETS no longer appears oversupplied. RGGI and the CA ETS, however, are clearly oversupplied and should not be considered for voluntary allowance retirement. You should follow the developments under both systems as programmatic rules often change.


[1] We use the terms cancelling and retiring interchangeably. In some systems cancelling refers to deleting the units without using them for compliance and retiring as using them for compliance and then deleting them.