Cost of Carbon: Discounts , Fungibility and Agricultural GHG Offset projects

1. Cost of Carbon:Discounts, Fungibility and Agricultural GHG Offset projects Bruce A. McCarl Distinguished and Regents Professor of Agricultural Economics Texas A&M University Presented at Climate Change Segment of Advanced Resources Class College Station, Feb 2011

2. Fungibility A number of concepts have arisen that are likely to differentially characterize the contribution of alternative possible offsets within the total regulatory structure. These involve: Permanence Additionality Leakage Uncertainty GWP General concern price may differentiate based on characteristics like a grading standard

3. Why is Permanence an Issue • Volatility of sequestered carbon- sequestered carbon can be rapidly released back to the atmosphere on reversal of practices, fire etc. • Saturation /New Equilibrium - differential rates of accumulation over time and a long run decline to a near zero rate of net sequestration • SustainabilityofPractices – crop rotations and herbicide resistance plus land diversion • Contract duration and liability terms -project payment terms, liability and duration influence offset value including leasing • Uncertainty – how much carbon is sequestered and retained (not entirely a permanence issue but closely related)

4. Saturation/ New Equilibrium of Sequestration in Ag Soils and Forests Soil C sequestration over time after a change from conventional to zero-tillage operations Birdsey et al, USFS, FORCARB Note saturation by year 80 West and Post 2002 Soil Organic Carbon Sequestration by Tillage and Crop Rotation: A Global Data Analysis Soil Science Society of America Journal 66:1930-1946 (2002) Note saturation by year 20

5. Permanence and The Price of Carbon • The question is if such items are allowed whether the permanence concerns associated with sequestration may alter the value or quantity of the resultant carbon offset in the market place • Offsets are not fungible – from an offset purchaser’s point of a view, an impermanentsequestration asset may be worth a differentamount than permanent offset • General concern price may differentiate based on permanence characteristics like a grading standard

6. Fungibility • Grading standard #2 Yellow corn, CD plywood, Long staple cotton • Receive a pricepremium/discount depending upon product characteristics and consumer cost of using • GHG offset (especially carbon sequestration) may have consumer cost effects being not fully claimable permanence (plus additionality, leakage, and uncertainty) Smith, G.A., B.A. McCarl, C.S. Li, J.H. Reynolds, R. Hammerschlag, R.L. Sass, W.J. Parton, S.M. Ogle, K. Paustian, J.A. Holtkamp, and W. Barbour, Harnessing farms and forests in the low-carbon economy: how to create, measure, and verify greenhouse gas offsets, Edited by Zach Willey and Bill Chameides, Durham, NC: Duke University Press, 229 p, 2007. McCarl, B.A., "Permanence, Leakage, Uncertainty and Additionality in GHG Projects", Paper developed as input to book Quantifying Greenhouse Gas Emission Offsets Generated by Changing Land Management, A b ook developed by Environmental Defense, 2006. http://agecon2.tamu.edu/people/faculty/mccarl-bruce/papers/1149.pdf

7. How to derive Permanence Discount? • Permanence discount can arise in terms of a • Price discount where like three grades of gasoline one needs to pay more for a more permanent item • Quantity discount where the saleable quantity is reduced to a quantity that one can permanently count on or is discounted for its impermanent terms • Either way one gets less than would be paid for a more permanent asset like capturing methane from a landfill or a manure lagoon and immediately burning it up Kim, M-K., B.A. McCarl, and B.C. Murray, "Permanence Discounting for Land-Based Carbon Sequestration", Ecological Economics, vol. 64, issue 4, 763-769, 2008.

8. How to derive Permanence Discount? • Effective price (PE) today for impermanent offset – carbon sequestration Cost of impermanent • Equivalent Price = __________________________ Quantity received • What is cost -- • Quantity of offsets over time times carbon price • Plus if leasing the cost of obtaining replacement credits when the contract expires • Plus cost of maintaining practice that is not related to carbon (ie money to maintain practice and monitor carbon • Note last two terms zero for permanent assets as GHG is destroyed

9. Cost of Carbon -- Breaking it down : QGHGO Nominal quantity of offsets The quantity of GHGE offsets that can be claimed before discounts is the difference from the time path of net GHE emissions and increments in sequestration by the target entity before and after possibly discounted back to the current period. This consists of changes in o       Direct sequestration- amount of additional carbon stored in soil or in multiyear standing plants or trees over time. o       Methane and nitrous oxide emissions. o       Fossil fuel emissions due to changes in input usage o       Carbon releases in input manufacturing.

10. Fungibility- How do we derive price discount? Note I have a non constant price variant

11. Fungibility- How do we derive price discount? To derive price discount for permanence etc add some terms (Pdiscount, buyback and claimable offsets) then equate a perfect perpetual offset with an imperfect one

12. Fungibility- How do we derive price discount? Permanence case

13. Fungibility- How do we derive price discount? Permanence case When is discount zero No Buyback No Maintenance cost 25 year lease with 100% buyback – 48% price discount Maintenance at 10% of cost -- 36%

14. How Big is the Discount? • Agricultural soil carbon sequestration • 25 year lease with 100% buyback – approximately 49% price discount • Maintenance cost at $5/acre – approximately 36% price discount • Afforestation • Harvest year 20 without reforestation – 52% • Harvest year 20 with reforestation – 23% • Harvest year 50 without reforestation – 20% • Harvest year 50 with reforestation – 7%

15. Do we include items that are not permanent • Contract terms like leasing and liability can handle non permanent characteristics • Trading is designed to allow cheaper offsets to be used than can be developed by the initial emitter. So the question is are these impermanent items cheaper despite permanence? • Many things are impermanent • Policies that reduce fossil fuel use leave the resource in the ground as a potentially volatile source of emissions • CCS is impermanent as it puts items in places where they could be released from and which requires maintenance/monitoring costs • Sequestration strategies may provide a bridge to a lower cost emission reducing future where CCS or other things can be cheaply used • Sequestration has other benefits in water quality, erosion and is non competitive with food in some ways

16. Carbon Sequestration and Uncertainty • Quantity of land-based carbon sequestration is subject to uncertainty - buyers may incorporate uncertainty in theiroffering prices • Uncertainty is used to describe • Phenomena such as statistical variability, lack of knowledge or surprise • Lack of confidence in a single value • This paper presents an empirical confidence interval based uncertainty discount approach • Then we apply to an East Texas case Kim, M-K., and B.A. McCarl, "Uncertainty Discounting for Land-Based Carbon Sequestration", Journal of Agricultural and Applied Economics, forthcoming, 2009. http://agecon2.tamu.edu/people/faculty/mccarl-bruce/papers/1121.pdf

17. Issues on Uncertainty– Shortfall Penalty • Purchaser of carbon credit faces risk of having the quantity sequestered falling below the claimed level (shortfall penalty) • Example: US SO2 trading - penalty for excess emissions of SO2 is set at $2000/ton  annual adjustment factor which is 3-5 times offset price • Substantial interest on behalf of the purchaser directed toward ensuring that the potential offset credits acquired can be safely relied upon to exceed the environmental commitments

18. Sources of Uncertainty • Climate and other factors like pests, fire etc. • Aggregation induced sampling error at a regional scale • Carbon pool measurement error, and • Inter-temporal variation in the duration and permanence of carbon sequestered in the future

19. Uncertainty Issue (3) – Appropriate Distribution • Site level - Carbon distribution for a year highly variable according to a Canadian soil scientist I once heard talk. But site level is not right basis • Spatial aggregation- aggregation of multiple sites (or farms) generating carbon credits • A contract for 100,000 tons may require 800 US farms of an average farm size of 500 acres • Temporal aggregation - multi-year contracts with the same group of carbon credit suppliers • Project commitments spanning over a number of years expected due to the slow change characteristics of carbon

20. Empirical Risk Within one year Over 5 years Moral : Aggregation over time and geography reduces risk Don’t use numbers from crop modelers

21. Empirical Uncertainty Discount The uncertainty discount from a confidence interval approach Discount = Multiplier * Relative risk * Carbon/Yield relation We get a CV of 6.3% resulting in the uncertainty discounts of 10.2%for a 95% confidence level and7.9%with a 90% confidence level Kim, M-K., and B.A. McCarl, "Uncertainty Discounting for Land-Based Carbon Sequestration", Journal of Agricultural and Applied Economics, forthcoming, 2009. http://agecon2.tamu.edu/people/faculty/mccarl-bruce/papers/1121.pdf

22. Fungibility - Uncertainty * CV

23. Cost of Carbon -- Breaking it down : Additionality (ADD) Under the KP concern that activities only receive credit if they would not have been done in the absence of GHGE offset incentives. If under BAU land would have left farming to grasslands that project for such a transformation should receive a discount. Need projection of without project baseline along with assumption on whether reduction in baseline would also receive credit. Raises issue current offset practices may be discontinued to become eligible to start them anew and qualify for offset payments This discount should be higher at low carbon prices than at higher prices

24. Additionality and Baselines • Premise: Only reductions/sequestration other than what would have occurred without the project are considered additional • Crediting programs may exert additionality requirement for offset crediting (e.g., CDM and JI/Kyoto Protocol) • To determine additionality, you need a project baseline

25. Project Baselines • A quantification of what would occur (over time) on the project land if no project were adopted • Practice adoption (e.g., tillage adoption) • Carbon consequences (dynamic) • Basic approaches • Project-specific • Structured case study of project conditions • Performance standard • Analysis of cohort group data to determine prevailing practices and GHG performance

26. Estimating Baseline for Ag Soil C Tillage Project I • Performance Standard Approach: • Obtain data on tillage practice adoption • Segment relevant cohort group (e.g., farmers in a specific region, state, district, county,…) • Estimate probability of no-till adoption for relevant cohort group • Predict adoption forward over project period • Quantify adoption to soil carbon effects using biophysical models (e.g., Century, EPIC) or emission factors (IPCC) • Combine (4) and (5) to quantify soil C baseline over time

27. Estimating Baseline for Ag Soil C Tillage Project II • Project-specific Approach: • Barriers test: determine if there are any legal, institutional, technological, or market barriers to no-till adoption on the project site • If so, then the project is completely additional • Compare no-till to conventional tillage on traditional economic grounds for the project site • If conventional-till is more profitable without carbon payments, it should be the baseline and the no-till project is additional • If no-till is more profitable without carbon payments • No-till is baseline • Project is not additional

28. Baseline selection issues • Value of extra precision • Landscape heterogeneity • Uncertainty reduction for buyer and seller • Cost of extra precision • Data collection • Analysis • Incentive compatibility • Do subjective evaluations leave too much discretion and opportunity to game the system ? • Adverse selection: Will set standards favor entry of “bad” (non-additional) projects? • Updatable?

29. Fungibility - Additionality * CV Texas Rice Case – 67% acreage reduction in 15 years 12% price discount when converting to grass, 4% to trees

30. Cost of Carbon -- Breaking it down :     Leakage (LEAK) GHG offsets can be undermined if leakage or slippage occurs. Actions to reduce net emissions may alter current or anticipated production levels, in turn creating alterations in market conditions (e.g. price effects) that can induce emission increases elsewhere The sectors, particularly agriculture are highly competitive. Elements of the markets are global with commodities moving freely throughout the world. As such leakage is certainly a concern. Localized projects will stimulate additional economic activity domestically or internationally. Findings range from 20-80 percent, can use Murray et al formula.

31. Fungibility - Leakage e is the price elasticity of supply for off project producers. E is the price elasticity of demand for commodity produced. Cot is GHG emissions per unit of increased commodity production outside project. Cpr is GHG offsets per unit of reduced commodity production in project. P is relative market share and is quantity of commodity produced by project divided by market amount produced. * CV Murray, B.C., B.A. McCarl, and H-C. Lee, "Estimating Leakage From Forest Carbon Sequestration Programs", Land Economics, 80(1), 109-124, 2004.

32. Fungibility - LeakageInternational Scope of Participation Note All datat are index nubers of production in a category Participating production is offset by production elsewhere

33. Fungibility - Empirical Beaumont through Columbus Texas area has historically produced rice. In 1985, 600,000 acres. In 2000, 214,000 acres. Policy, environment and markets are applying pressure. Today, many rice producers are in quest of new opportunities. Trees, other crops and pasture provide possible alternatives to some. * CV Perm Add Leak Uncer All Saleable Rice to crops 30% 12% 32% 10% 62%38% Rice to pasture 50% 4% 17% 10% 64%36% Rice - trees(pulp) 30% 1% 16% 10% 48%52% Rice - trees (saw) 10% 1% 16% 10% 33%67% Not additive

34. Is this a problem – in a model Not always Full coverage eliminates leakage Multi period is handled in fasom Additionality handled by dynamic baseline Uncertainty is not

35. What issues might IAM modelers consider? Fungibility - Aggegate

36. Is this a problem – with projects Always Partial coverage virtually insures leakage Multi period needs to be handled when buyback or maintenance Additionality depends on rules Uncertainty is there

37. SO WHAT Fungibility can be a problem Opportunities are not perfect substitutes Projects may aggravate problem Modelers will lose hair over payment schemes Big Holy Trinity

38. Cost of Carbon Including the gap Private cost Carbon will cost money to produce, sell, and measure, govt may help Not all carbon may be saleable  where DISC = (1-ADD)*(1-LEAK)*(1-UNCER)*(1-PERM)

39. Cost of Carbon Private cost PDC – Cost producer incurs to switch from current practices (estimated by models we have looked at) PAIC - Cost to get producer to adopt above PDC in terms of incentive to get trained bear extra risk etc. MTC - Transactions cost to assemble, measure, monitor, certify, sell, carbon GC - Government cost share

40. Cost of Carbon Breaking it down PDC – Cost producer incurs to switch from current practices Incremental difference in o      Revenue implications of altered yield (change in yield times relevant price over all commodities). o      Cost implications of altered input usage (change in input usage times relevant price) over all inputs o       Cost implications of new equipment requirements and the salvage value for displaced equipment Has been done by most who have looked at cost of carbon

41. Cost of Carbon -- Breaking it down PAIC - Cost to get producer to adopt above PDC Offset of PDC marginal cost is not sufficient for adoption Incremental incentive to overcome osubstantial learning time, oincreased risk otransition investment costs Kurkalova, Kling, and Zhao find a PAIC of about $3 per acre would be needed for Iowa corn and soybean farmers $12/ tonne using West and Post's 0.25 tonne/ acre Lewbowski, Plantinga and Stavins compute logit probability of afforestation given incentives What could we do

42. Cost of Carbon -- Breaking it down MTC- Transactions cost Carbon must be marketed and cost arises o       Assembly Costs o       Measurement, and monitoring o       Certification o        Enforcement  o       Additional adoption cost incentive estimates o        Management of adverse outcomes

43. Cost of Carbon -- Breaking MTC down Assembly cost Emitting entities emit large quantities of GHGs. (How much from a 100 megawatt coal power plant) It not economically efficient for a purchaser in quest of 100,000 tons to deal with a single farmer. 100,000 tonnes at 0.25 tons per acre = 400,000 acres 400 acres/farm =>1,000 farmers (avg U.S. is 460 acres) This implies role for brokers who aggregate producers and sell permits. Cost arises in such process. Crop insurers get 25% or 1/3 above what is paid to farmers Minn water quality 50%

44. Cost of Carbon -- Breaking MTC down Measurement, and monitoring Conveyance will require measurement and monitoring to establish offsets are being produced and continue. This requires the development of a low cost measurement and monitoring approach that involves a sampling based scheme integrating field level measurement, computer simulation, and remote sensing on some dynamic and geographical basis. Mooney et al propose a scheme and assert that (1) efficiency depends on the price of C credits. (2) costs largest in areas with greatest heterogeneity (3) in case study cost <= 3% of the value of a C-credit.

45. Cost of Carbon -- Breaking MTC down Certification Certain bodies may develop and certify offset quantity estimates for practices and then monitor that the practices continue. For example a government rating could be established that indicates the number of offset credits from a tillage change under a set of circumstances. Costs of obtaining such a certification as borne by private parties and by the government would be relevant cost components.

46. Cost of Carbon -- Breaking MTC down Enforcement Contact enforcement may require hearings and setup of an enforcement entity Further this may arise between traders or within an assembly group Some estimate is needed of costs that will be encountered for the enforcement of permit contractual obligations.

47. Cost of Carbon -- Breaking MTC down Additional adoption cost incentive estimates Cost may well be encountered involving education and training of producers on how to alter their practices so that they most efficiently produce greenhouse gas offsets. These costs need to be estimated in a way so that one does not double count the producer adoption incentive terms as discussed above

48. Cost of Carbon -- Breaking MTC down Management of adverse outcomes Certain classes of offsets are volatile and subject to uncertainty including possible destruction by extreme weather events, fires, floods etc. Brokers and or contracts may include procedures to insure against certain types of failures. These may involve within contract enforcement mechanisms, insurance planned safety margin where more offsets are produced then are sold allowing make up for shortfalls

49. Cost of Carbon -- Breaking it down How do we get at this? - Alternatives 1. Examine existing but immature markets GEMCO, Overseas. California, RGGI Chicago climate exchange 2. Examine similar enterprises Wetlands , Oilman Forester who consolidates SO2, Water quality Coops, Mortgage sales 3. Engineer something 4. Simulate a world

50. Cost of Carbon -- Breaking it down GC- Government cost share Government may have an active role in some of the assembly measurement and monitoring producer education sale thus may offset some proportion of the total costs.