Cost of Carbon and Discount

1. Cost of Carbon and Discount Man-Keun Kim Texas A&M University Presented at AGEC 689 Climate Change Class

2. Global Climate Change • Global climate change has become an important policy issue because of its potential consequences and inherent complexity • There is significant future risk that negative impacts will outweigh benefits • Society has become concerned and is acting • Do something now! – Precautionary principle

3. Global Climate Change, cont. • What shall society do to mitigate global climate change? Reductions in GHGE to stabilize atmospheric GHG concentration The Kyoto Protocol President Energy Intensity Program (Emission reduction program that involves an 18% reduction in GHGE intensity by 2012)

4. Agricultural GHGE Offset (AO) • Mitigation options • Direct reductions in GHGE • Agricultural GHGE offset (AO) • Carbon sequestration (such as afforestation) • Bio-fuels • AO includes • Land use change such as afforestation and perennial pasture • Tillage change, nutrient and residue management such as conservation till or no till

5. AO, cont. • AO is appealing since it may be • Relatively inexpensive • Contribute to other agricultural and environmental goals by increasing biodiversity or decreasing soil erosion • Land-rich countries like U.S., Canada, and Russia, AO projects can potentially account for significant emission reductions

6. AO, cont. • GHGE Credit Market GHG Dollars for sequestering/removing GHGE Credit BuyerGHGE Credits Credit Seller Atmosphere GHG Emitters Brokers Farmers

7. Question: • If producers adopt AO projects and sell GHGE offset, • At what price to a buyer? • How much could producers sell? • Not all carbon may be salable • GHGE Offset vs GHGE Credit • Quantity of the AO may needs to be discounted to reflect the practical contribution to GHGE offset as suggested by the Kyoto Protocol

8. Break-Even Offset Price • Break-even offset price:

9. Break-Even Offset Price, cont. • Formally: • Where, P is break-even price per unit of carbon • PDC = Producer Development Cost • PAIC = Producer Adoption Inducement Cost • MTC = Market Transaction Cost • GP = Government Payment • QGHGO = Quantity of GHGE Offset from AO project

10. Derivation • Decision regarding adoption of AO project • Assume that producers are risk averse and follow von Neumann expected utility maximization • Mean-variance utility – see Silberberg and Suen (2000) • EU = m – RP • Where m = mean of income and RP = risk premium • Producer maximizes the difference between mean and the risk premium in a risky situation

11. Derivation, cont. • Producer adopt the AO project if and only if

12. Derivation, cont. • The first part, the difference between expected net returns, is PDC • This term is the costs for producer to switch from the current practice to the AO practice • Revenue implications of altered yield and/or switched alternative, • Cost implications of altered input usage over all inputs, • Cost implications of new required equipment and • Salvage values of displaced equipments

13. Derivation, cont. • The second part, the difference between the risk premiums, is PAIC • This term is the cost to get producer to adopt the AO as a results of the change in risk as measured by the variance • Even when the AO practice raises producers’ expected net return, they may be reluctant to adopt AO practices, requiring a premium that is captured by PAIC • PAIC is used to remove the hesitancy of producers by compensating for changes in risk

14. Derivation, cont. • Implementation of an AO project involves market transaction costs (MTC) when producers sell GHGE credits to a buyer • MTC arise from transfer of a property right (GHGE credits here) since parties to exchanges incur costs in finding one another, communicating, and exchanging information • Also, there may be a necessity to inspect, monitor, and enforce adequate operation of the AO project

15. Derivation, cont. • The government payment (GP) may exist along with government policies such as the Conservation Reserve Program (CRP) • When producers adopt afforestation, there may several subsidy programs in Texas including: • Forestry Incentives Program (FIP), • Stewardship Incentives Program (SIP), • Environmental Quality Incentives Program (EQIP), and • Conservation Reserve Program (CRP)

16. Derivation, cont. • The quantity of GHG offset (QGHGO) is composed of • Sequestered carbon from atmosphere to soil or vegetation, • Removed GHG from altered management of the farming system (eg. Methane, N2O) and • Saved carbon emissions from reduced fuel usage

17. Recall Break-Even Offset Price • Recall break-even offset price per carbon unit • Where, P is break-even price per unit of carbon • PDC = Producer Development Cost • PAIC = Producer Adoption Inducement Cost • MTC = Market Transaction Cost • GP = Government Payment • QGHGO = Quantity of GHGE Offset from AO project

18. Discounts • When an AO project is under consideration, there are some possible discounts that may arise based on the AO characteristics of additionality, leakage, permanence, and uncertainty • These factors may reduce the effective GHGE offset

19. Discounts and Credit • Role of discounts - as a common discount procedure, the GHGE credit (QGHGOC) is calculated by • where,  is the GHGE discount (0  1)

20. Break-Even Offset Price w/ Discount • Thus, break-even offset price is • Now we need to investigate these discount factors

21. Discounts • There are four discounts • Additionality (ADD) • Leakage (LEAK) • Permanence (PERM) • Uncertainty (UNCER)

22. Discounts, cont. • Additionality • Additionality concerns arise the projected region has had substantial adoption of the AO practice before any GHG programs are implemented and that this adoption is projected to continue in the future • In such a case, the offsets created by the project are not entirely additional and a discount may be needed to reflect business-as-usual AO practice adoption

23. Discounts, cont. • Additionality, cont. • Policymakers want to only count GHG offsets that would not have occurred under business as usual and credit buyers would naturally desire to pay only for additionalGHG offsets • Before the AO project goes into effect, are there any practices which are already used or would be used in the future without AO related incentives? If yes, apply discounts

24. Discounts, cont. • Leakage • AO may alter current or anticipated production levels, in turn creating alterations in market conditions (e.g. price effects) that can induce emission increases elsewhere • Afforestation – Reduce crop production – Crop price increases – Additional land is allocated to crop elsewhere – Increase GHGE

25. Discounts, cont. • Leakage, cont. • If an AO project succeeds, is there any possibility that the GHGE reduction would be offset by market induced alterations in practices elsewhere that increase GHGE? If yes, apply discounts

26. Discounts, cont. • Permanence • GHG offsets generated by land-based, particularly sequestration, projects cannot be guaranteed to be permanent because of potential reversal of the practices and potential uncontrollable events that would lead to release of the sequestered offsets. • That is GHG offsets by the AO project may not be permanent

27. Discounts, cont. • Permanence, cont. • If an AO project increases absorption of the carbon into the biosphere, will the carbon stay there? What happens when AO incentives are discontinued?

28. Discounts, cont. • Uncertainty • Variety of uncertainties related to an AO project • Year-to-year weather variations along with the uncertain incidence of fire or pests coupled with many other factors will cause this uncertainty • Uncertainty also arises due to sampling issues • Measurement of GHGs across the landscape is not possible • We must rely on sampling and sampling comes error causing uncertainty

29. Challenges: • How can we find cost of carbon? • How can we estimate discounts factors? • What will be the cost of carbon? • Empirical investigation

30. PDC • Budgeting: comparison of crop budget • Econometrics: Statistical methods to explain producers’ decision • Adoption model • Land-share model • ASM • CGE

31. PAIC • Econometrics: Statistical methods such as adoption model • See Kurkalova, Kling, and Zhao (2001) • Estimate from historical prices, crop yields and cost data • Differences in risk premiums

32. MTC • No market so we have to find proxy • Previous studies • McCann and Easter (1998, 2000) etc. • Examining similar markets – GEMCO, Chicago Climate Change (but immature markets) • Interviews with government agencies and producers

33. QGHGO • Biophysical simulations • EPIC • Century • FORCARB

34. Derivation of Discounts • Net present value (NPV) of the benefits of gains from the AO project without discounts: • Net present value (NPV) of the benefits of gains from the AO project with discounts:

35. Derivation of Discounts, cont. • From above equations • Thus, we need to find NPV 0 and NVP 1 • How to find NPV?

36. Example • AO project: Afforestation on current crop fields • Project area: 10,000 acres • GHGE offset rate is constant over time • Forest: 3 tons/ac/yr • Project horizon: 100 years

37. Example, cont. • Currently, crop lands are converted to forest lands 0.25%/yr (business-as-usual change) • Project GHGE offset • 10,000 ac * 3 tons/ac/yr * 100 yr = 3 million tons

38. Example, cont. • Baseline (business as usual GHGE offset) • Year 1 10,000 ac * 3 tons/ac/yr * 0.25%/yr = 75 tons • Year 2 Year 1 + 10,000 ac * 3 tons/ac/yr * 0.25%/yr = 150 tons And so on • Baseline offset is 378,750 tons for 100 year so that ADD discount is 13%

39. Example, cont. • If crop production is discontinued in this region, crop price increase • This increase in price encourages crop production in other regions, let say, 10% accompanying with increasing GHG emission by 10% • Leakage discount would be 10%

40. Example, cont. • Sequestered carbon would be released to the atmosphere when the AO project is discontinued • Assume that forest will be harvested in year 50 and most of carbon stored is released • PERM discount would be 20%

41. Example, cont. • From biophysical simulation (EPIC), the coefficient of variation (CV) of carbon sequestration rate is around 10% • In this case, UNCER would be 16% with 95% significance level under normality assumption • UNCER = t*CV, where t* is a critical value with specific confidence band

42. Example, cont. • Thus, GHGE offset credit would be QGHGOC = QGHGO (1-ADD)(1-LEAK)(1-PERM)(1-UNCER) = 3 million tons  (1-13%)(1-10%)(1-20%)(1-16%)  1.6 million tons

43. Wrap Up • One of key mitigation project is the agricultural GHG offset to stabilize atmospheric GHG concentration. • Society needs to consider cost of carbon and discount factor when producers can sell GHGE offset credit • Discount factors are proposed (i) additionality, (ii) leakage, (iii) permanence and (iv) uncertainty

44. Wrap Up, cont. • Formal discussions, and empirical investigations can be found in • McCarl, Tanveer, and Kim (2004) – journal paper “How Much Would Carbon Cost a Buyer?” • Man-Keun Kim (2004) – Dissertation “Economic Investigation of Discount Factors for Agricultural Greenhouse Gas Emission Offsets” • On-going project