Carbon offsets can, in theory, reduce emissions efficiently, but in practice problems like non-additional projects, self-selection, and weak regulation mean they may fail to cut – and can even increase – global emissions unless embedded within properly capped compliance markets.
Carbon offsetting has become a cornerstone of global climate policy, but do carbon offsets actually reduce global emissions?
In this episode of Economics Unpacked, economists Rohini Pande and Daniel Xu examine the theory and real-world evidence behind carbon offset markets – from the Clean Development Mechanism in China to today’s voluntary carbon markets.
Economics Unpacked brings cutting-edge economic research to the public by breaking down complex policies with world-leading experts. If you’re interested in economics, public policy, or international development, this series is for you!
Transcript
What if fighting climate change was as simple as writing a check? Imagine you could offset your own pollution by paying someone else to cut emissions for you. That’s the promise of carbon offsets. Ever since the 1997 Kyoto Protocol, governments and companies have spent billions on carbon credits to offset their own emissions. In 2022, the booming voluntary offset market was worth around $2 billion. But are they actually helping the planet, or just a convenient mirage?
Welcome to Economics Unpacked, a VoxDev series where we talk to experts to try to answer the big questions in economics.
To get started, let’s talk to Rohini Pande, who has spent decades working on international carbon markets and climate policy design. One way to picture carbon offsetting is to think of a small village.
Rohini Pande: At one end, there is someone cutting down forests in order to grow crops or have cattle rear. At the other end of the village, there is someone who is using coal in order to run just a very basic industrial operation. Now the industrial operation that, say, produces steel plates is going to sell for more than having low-level cattle rearing going on at the other end of the village. So if the person who's producing steel could simply pay the villagers who are cutting down forests in order to have their cattle graze – to not have their cattle graze, just pay them the money that they would get from it – it could still be that there are overall productivity gains for the village. The producer of plates doesn’t reduce their own emissions but reduces the total emissions in the village by paying someone else to undertake a less productive activity.
Crucially, the net effect is a cut in overall emissions. At least that’s the theory.
Rohini Pande: You could imagine doing this at scale, where someone producing steel in the United States chooses to reduce emissions across the world, or keep them constant, by simply paying villagers in DRC not to cut down trees or not to create scaffold in new pasture land. So this seems like a no-brainer.
Unfortunately, there’s a catch.
Rohini Pande: The main reason why this doesn’t work is something economists call the problem of asymmetric information.
The problem of asymmetric information in this setting has two parts. The first part is more obvious: how do you check that when you pay someone not to cut down trees, they actually do what they say? That’s not easy to do on an international scale, but not impossible either. With regulations and reporting, it can be done. The second part is more subtle, and it has its own word: additionality.
Rohini Pande: In order for this logic to work, the manufacturer in the United States needs to know that if they did not pay the money to the farmers in DRC, they would have cut down the trees.
These offset schemes only work for the climate if projects are truly additional. That is, the emission reductions would not have happened without the offset. This concept of additionality is absolutely crucial. If I pay for something that was going to happen anyway, then my money didn’t actually cause any extra cut in emissions, but I still get to claim the credit and keep polluting as usual. In that case, global emissions end up higher than we think. The offset buyer emits above their target, and the offset project doesn’t actually reduce anything extra. Economists point out that when offsets are non-additional, they’re basically selling hot air – credits with no real climate impact.
Enter our next economist to look at what the real-world evidence tells us.
Daniel Xu: Hi, my name is Daniel. I’m an economist.
Daniel and his colleagues looked at data from one of the largest carbon offset programmes in the world: the United Nations Clean Development Mechanism.
Daniel Xu: That’s one of the programmes where there's very careful planning procedures. Very detailed project documents were posted publicly online so that we can study them. And then we merge these documents with quite detailed data from Chinese manufacturing firms, which allows us to look at very detailed information about these firms production, sales, abatement effort, and also their emission performance, for close to a whole decade, both before this programme and also after this programme. But in addition, more importantly, we also gather firms who didn’t participate but were very, very similar to these firms, allowing us to contrast the behaviours.
In other words, Daniel and his colleagues have the data to study not only what offsetting firms did, but what they would have done without the carbon offsetting programme. That will help us answer whether there is additionality or not.
Daniel Xu: Compared with firms who never participated in these programmes, we find that firms who actually applied and get enrolled in these programmes not only did they not reduce their carbon emissions – in fact, their emissions went up by a big amount.
Hang on, emissions went up?
Daniel Xu: We were really surprised by the finding. We would have expected that due to some compensation policy cycles that these projects didn't really reduce carbon emissions by a meaningful amount. But we didn’t expect that the carbon emissions would actually go up for these firms who participated in the programme.
So what is going on?
Daniel Xu: First, these firms just self-select into participating in these carbon offset markets. Imagine some firms who were already experiencing very high growth trajectory. And they find the benefit of participating in this programme is really high. So not surprisingly, once they are in, compared with the firm that even looks very similar before, these firms will actually produce more, sell more, and end up emitting more compared with the firms that didn’t participate. The second reason is that these carbon offset programmes often give these firms additional credits and financial resources, and they get to improve their technology for the better and end up grabbing more market share from their rivals, that allows them to grow even more and also emit more.
And what’s the lesson then?
Daniel Xu: A lesson we can learn is that many theories in economics sound theoretically reasonable and nice, but to implement them for firms in developing countries, the details matter.
And where does this leave us with carbon offsetting? Back to Rohini.
Rohini Pande: The basic problem with using a model of carbon offsets is that it’s simply trading between two parties with no overall emissions cap. So there is no guaranteed pathway necessarily from the trade of carbon offsets towards global net zero.
Let’s return to our village to see what's been going on.
Rohini Pande: We began by talking about a single steel producer and a single farmer. But consider a single village or multiple villages where there are now, say, six steel producers and several farmers. If each producer of plates wants to reduce their emissions, they can individually engage in trade with a farmer, and they may end up at very different prices. I might think that this farmer is a risky farmer so I offer a lower price. And there is no overall reason why the total amount of emissions in this market is going to reduce over time in any well-defined way. What I describe is how the voluntary carbon market works right now: it has a set of buyers, a set of sellers, they engage in bilateral trades at many different prices. Compare this with a case where we have a single market with a cap and a regulator, so there is a village headman who is now in charge of making sure that the total amount of emissions in the village or the set of villages covered by the market don’t exceed a certain amount.
What Rohini and others suggest is moving from voluntary markets towards a single compliance market.
Rohini Pande: What we need to do is create such a compliance market on a global scale, where the producers of nature-based solutions or renewables also enter the market and have a set of permits, which is equivalent to the amount of emissions that they would have made if they were not reducing their emissions.
Is this realistic?
Rohini Pande: Right now what we see is a number of domestic compliance markets that allow in small amounts of nature-based projects. So we see this, for instance, in Korea, we see this in New Zealand. And interestingly, the EU ETS, perhaps the most well-known domestic compliance market, has just announced that it's going to allow in some number of such projects in order to have firms reach the 2040 target. So it’s already happening, but it's happening on a small scale. And I think if we can put in place the right institutions, we can actually make this a way of unlocking climate finance on a global scale. I'm hopeful that there is a path we can take as a world that will not keep us at below 1.5 degrees, but will keep us below catastrophic levels of global warming. But I think in order to reach that we need to combine a lot of technological advances with thinking carefully about individual and global and country incentives to undertake the right actions, and then to put in place policies that correctly incentivise the right actions.
There are currently more than 30 such compliance markets in the world, so Rohini and others are optimistic that this is possible.
If you enjoyed this video, please like, subscribe, and share, and comment below if you have any other questions. You’ve been watching Economics Unpacked, brought to you by VoxDev.