Our August 2008 report identified four primary challenges with the U.S. voluntary market. First, the concept of a carbon offset is complicated because offsets can involve different activities, definitions, greenhouse gases, and timeframes for measurement. While most markets involve tangible goods or services, the carbon offset market involves a product that represents the absence of something—in this case, an offset equals the absence of one ton of carbon dioxide emissions or the equivalent quantity of another greenhouse gas. Project developers produce offsets from a variety of activities such as sequestration in agricultural soil and forestry projects, and methane capture. Specifically, carbon offsets can result from three broad types of activities: (1) reductions of greenhouse gases, which may include activities such as the capture of methane from landfills or coalmines, (2) avoidance of greenhouse gases, which may include activities such as the development of renewable energy infrastructure, and (3) sequestration, which may involve storing carbon dioxide in geologic formations or planting trees that take carbon dioxide out of the atmosphere. See figure 1 for a diagram of common types of carbon offset projects. An additional complication is that the parties involved in generating, buying, and selling offsets may also use different definitions of a carbon offset. The term is often used generically to describe reductions or avoidances of emissions of any or all of the six primary greenhouse gases. Furthermore, these six gases vary in their potency or climate forcing effect, referred to as global warming potential. See table 1 for a description of U.S. greenhouse gas emissions and global warming potential. Scientists have developed a concept known as carbon equivalence that takes these variations into account and provides a way to describe emissions of different gases in comparable terms. For example, methane is roughly equivalent in global warming potential to about twenty one tons of carbon dioxide, the most common greenhouse gas. Finally, the timing of an offset’s creation is complicated. In cases where offsets are sold before they are produced, the quantity of offsets generated from projects can be calculated using what is known as ex-ante (or future value) accounting. On the other hand, when offsets are sold after they are produced, the quantity of offsets can be calculated using ex-post accounting. Using future value accounting, consumers may purchase an offset today, but it may take several years before the offset is generated. Ensuring the credibility of offsets purchased before they are produced inherently involves a higher degree of uncertainty than purchasing an offset that has already been generated. The second challenge is ensuring the credibility of offsets. Our prior work identified four general criteria for credible carbon offsets—they must be additional, quantifiable, real, and permanent. A carbon offset project is generally considered “additional” if it decreases emissions of greenhouse gases below the quantity that would have been emitted in a projected business-as-usual scenario. “Quantifiable” means the reductions can be measured, and “real” means the reductions can be verified. “Permanent” means the emissions reduced, avoided, or sequestered by a project will not be released into the atmosphere in the future. Providing assurance that offsets are credible is inherently challenging because it involves measuring the reductions achieved through an offset project against a projected baseline of what would have occurred in its absence. For example, if a facility that emitted 200 tons of carbon dioxide per year implemented a project that reduced its emissions by 100 tons, it may have created 100 tons of offsets. See figure 2 for a hypothetical depiction of an offset project measured against a projected business-as- usual scenario. E m i s s i o n s w i p r o j e c t Our prior work found that additionality is fundamental to the credibility of offsets because only offsets that are additional to business-as-usual activities result in new environmental benefits. Several stakeholders we interviewed as part of our study said that there is no correct technique for determining additionality because it requires comparison of expected reductions against a projected business-as-usual emissions baseline. Determining additionality is inherently uncertain because, it may not be possible to know what would have happened in the future had the projects not been undertaken. There are many ways to estimate whether projects are additional, and many stakeholders said that applying a single test is too simplistic because every project is different from others and operates under different circumstances. There are many quality assurance mechanisms, commonly described collectively as “standards,” for assuring the credibility of carbon offsets in the U.S. voluntary market, but few standards, if any, that cover the entire supply chain. The proliferation of standards has caused confusion in the market, and the existence of multiple quality assurance mechanisms with different requirements raises questions about the quality of offsets available on the voluntary market, according to many stakeholders. The lack of standardization in the U.S. market may also make it difficult for consumers to determine whether offsets are fully fungible— interchangeable and of comparable quality—a characteristic of an efficient commodity market. The term “carbon offset” implies a uniform commodity, but offsets may originate from a wide variety of project types based on different quantification and quality assurance mechanisms. Because offsets are not all the same, it may be difficult for consumers to understand what they purchase. While the concept of carbon offsets rests on the notion that a ton of carbon reduced, avoided, or sequestered is the same regardless of the activity that generated the offset, some stakeholders believe that certain types of projects are more credible than others. Specifically, the stakeholders identified methane capture and fuel-switching projects as the most credible, and renewable energy certificates (REC) and agricultural and rangeland soil carbon sequestration as less credible. The stakeholders’ views on the credibility of different project types may stem from the fact that methane and fuel-switching projects are relatively simple to measure and verify, while other projects such as RECs, forestry, and agricultural and rangeland soil carbon projects face challenges related to additionality, measurement, and permanence. With respect to agricultural and rangeland sequestration and forestry, certain stakeholders said it is difficult to accurately measure emissions reductions from these types of projects. In addition, forestry offset projects may not be permanent because disturbances such as insect outbreaks and fire can return stored carbon to the atmosphere. Third, there are economic and environmental tradeoffs associated with using offsets in a regulatory program to limit greenhouse gas emissions. In many cases, regulated entities may find it economically advantageous to buy offsets instead of reducing emissions themselves. The Environmental Protection Agency (EPA) has stated that the cost of compliance with mitigation policies under consideration by the Congress decreases substantially as the use of offsets increases. Specifically, EPA’s analysis of the Climate Security Act of 2008 (S. 2191), introduced in the last Congress, reported that if the use of domestic and international offsets is unlimited, then compliance costs fall by an estimated 71 percent compared to the bill as written. Alternatively, the price increases by an estimated 93 percent compared to the bill as written if no offsets are allowed. Other studies show similar results. In general, the carbon price is lower in quantitative models of a U.S. compliance system when domestic and international offsets are widely available and their use is unrestricted. In the short term, lower prices make compliance with a policy to reduce emissions less expensive. Multiple stakeholders we interviewed as part of our study said that including offsets in a compliance scheme could slow investment in certain emissions reduction technologies in regulated sectors and lessen the motivation of market participants to reduce their own emissions. According to some stakeholders, if more cost-effective offsets are available as compliance tools, regulated sources may delay making investments to reduce emissions internally, an outcome that could ultimately slow the development of, and transition to, a less carbon- intensive economy. Fourth, allowing the use of offsets could compromise the environmental certainty of a regulatory program to limit emissions of greenhouse gases if the offsets do not meet requirements that underpin their integrity. If a significant number of nonadditional offsets enter the market, emissions may rise beyond levels intended by the scheme, according to some stakeholders. Nonadditional offsets could thus increase uncertainty about achieving emissions reduction goals. This concern underscores the importance of using quality assurance mechanisms to ensure the credibility of any offsets allowed into a compliance scheme. Using offsets in a compliance scheme could also increase administrative costs because of increased government oversight of quality assurance mechanisms used to ensure the credibility of offsets. Concerns associated with using offsets for compliance in a regulatory system to limit emissions could be minimized by restricting the use of offsets or including policy options for enhancing oversight of the market such as applying discounts or imposing insurance requirements on offsets with greater uncertainty or potential for failure. Certain stakeholders suggested imposing limits on the use of offsets in a compliance scheme to address some of these challenges, but stakeholders held different opinions about the potential effectiveness of this approach. Some said it may be necessary to place restrictions on the use of offsets in order to achieve internal emissions reductions from regulated sources. If all the effort to reduce emissions is in the form of offsets, then the compliance system may not provide the price signals necessary for long-term investment in technology at domestic industrial facilities and power plants, according to multiple stakeholders. They said that domestic abatement is central to achieving the long-term goal of any emissions reduction system. However, other stakeholders said that incorporating offsets into a compliance scheme will enable greater overall climate benefits to be achieved at a lower cost, as long as offsets are additional and are not double-counted. Our November 2008 report discussed the environmental and economic effects of the CDM and identified lessons learned about the role of carbon offsets in mandatory programs to limit emissions. First, with respect to environmental effects, the overall effect of the CDM on international emissions is uncertain, largely because it is nearly impossible to determine the level of emissions that would have occurred in the absence of each offset project. The CDM imposes a rigorous set of review requirements for applicants to complete before obtaining project credits, known as Certified Emissions Reductions (CERs), which can be sold or used for compliance with targets under the Kyoto Protocol.