A recent McKinsey Quarterly article by Marcel Brinkman takes a closer look at the economics of international offsets and their role in meeting proposed climate change initiatives.
Domestic and regional carbon markets are expected to continue to grow from €100 billion in 2008 to approximately €800 billion in 2020. In developed nations, emissions caps and the related carbon trading is an effective way to reduce carbon emissions. Unfortunately the role of carbon markets in developing nations is unclear and may be more limited than initially thought.
Companies that operate within these markets have a few choices in order to stay within their caps: they can reduce their emissions through internal abatement; buy credits from other companies domestically or buy international offsets (most will likely utilize all three in their strategy). Brinkman points out that there is no mechanism that links the domestic markets with the international offsets. He contends that the offset market will become the “de facto international price mechanism”, that prices will vary based on local market conditions and that arbitrage opportunities will develop between the domestic and international markets.
The price differences will be a result of global supply and demand factors. On the demand side, developed countries may place limits (or have already – EU) on the amount of international offsets imported into the domestic carbon market in order to force local abatement initiatives. In addition, there is a significant amount of overhang due to the fact that many Eastern European countries have emission caps above their current emissions levels. On the supply side, initial offsets would be created from the cheapest sources. As this low hanging fruit is exhausted more expensive sources of offsets will be pursued (similar to what is happening in oil exploration & production). There are also concerns about how offsets are created. Many do not believe that the “project based” system actually creates additional carbon savings, as many of these projects would most likely be pursued anyway. Companies and countries will get credit for carbon reductions that would naturally take place. There are several proposals to reform the project based mechanism and scale up offset markets. The supply of credits and their cost would eventually be determined by the system in place and they type of credits allowed.
McKinsey has estimated total demand (both hard and soft) for offsets to be approximately 1.9 gigatons by 2020, based on their internal carbon market model, resulting in a price of €13 a ton while the price in the EU market for a ton of carbon to be closer to €29. Estimated 2020 demand of almost 2 GT represents significant growth from the 140 megatons of offset credits that were issued in 2008. However, this will fall significantly short of McKinsey’s estimate of 17 GT of abatement necessary to limit global warming to two degrees. (The Intergovernmental Panel on Climate Change “IPPC” suggests that the global community needs to limit emissions to 44 GT in order to limit global warming to two degrees. Hence 17 GT of cuts will be needed to meet these goals.)