Markets created for carbon credits from management of the biosphere, of course, will be heavily influenced by the many other commodities produced by the biosphere (food, wood, etc.). Food security may, for example, be a reason for a government to continue its policy of agricultural subsidies in the absence of forestry (carbon) subsidies. On the other hand, some studies (e.g., Callaway and McCarl, 1996) have shown that when diverting agricultural subsidies to carbon payments, the net impact on the national budget could be zero. In tropical countries, the institutions and subsidies for forest clearing may remain as part of the package to promote economic development. Only if the monetary value of carbon stocks and sinks is recognized and paid for will markets be efficient in encouraging C sequestration. Some developing countries see markets for C offsets as providing resources to facilitate capital inflows to finance conservation and other activities.

An emerging instrument that is likely to have a large effect on carbon sequestration is the tradable emissions permit. Tradable permits to deal with environmental pollutants have precedents in other areas. In the USA, for example, there is an active market for sulphur emissions permits (Burtraw, 2000). Firms with excess emissions permits can trade these to firms in need of additional permits. Thus, incremental emissions are no longer free, but incur additional costs to the firm. Firms that have excess permits can either sell those permits or forego the opportunity of receiving a payment – an opportunity cost. Such an approach allows the market to reallocate emission permits, and thus emissions, to the users that receive the highest return from the permits, thereby distributing carbon emissions permits to the most efficient users. This approach is beginning to be contemplated in addressing the problem of increasing atmospheric carbon and is endorsed in the Kyoto Protocol.

Currently, there are a series of brokers prepared to trade carbon credits in the USA and Europe, e.g., Natsource and Canto Fitzgerald (Stuart and Moura-Costa, 1998), and the Sydney Futures Exchange in Australia is planning to begin trading in the latter part of 2000¹). In addition to tradable carbon emission permits, the door is open for consideration of an analogous instrument, tradable “carbon offsets”. Activities, such as planting and protecting forests, could provide carbon sequestration services that could be sold or traded.

To date there is only limited experience with certified carbon offset instruments. In the USA, the electrical power industry, through the Edison Electric Institute (EEI - an association of private electrical power companies), has formed the Utility Carbon Management Tree Program whereby the various member companies invest money into a project fund to develop or purchase carbon offset credits (Sedjo, 1999a). Another market approach has been created, the Certified Tradable Offsets, issued by the Costa Rican government, and the first carbon-backed securities worldwide (Stuart and Moura-Costa, 1998). These offsets are like JI or CDM as defined in the Kyoto Protocol, but would be tradable.

A potentially serious problem with carbon offsets is that there may be carbon leakage. Leakage refers to the situation in which a carbon sequestration activity (e.g., tree planting) on one piece of land inadvertently, directly or indirectly, triggers an activity which, in whole or part, counteracts the carbon effects of the initial activity. It can be shown that most of these types of problems arise from differential treatment of carbon in different regions and circumstances, and the problem is not unique to carbon sequestration activities but pervades carbon mitigation activities in the energy sector as well.

In land use, leakage can occur from either protection or planting activities. Suppose, for example, that a forest or wetland that was to be cleared is instead protected. Protection of one such forest or wetland may simply deflect the pressure to another piece of land that is not protected and will be cleared instead. Leakage can occur across both spatial and temporal boundaries. Additionally, a forest protected in one year is subject to the possibility of clearing in subsequent years.

A similar situation may also exist with activities such as tree planting. Trees provide at least two services: producing industrial wood and sequestering carbon. Trees planted for carbon sequestration, because they may eventually be used for wood, can affect expectations about future industrial wood prices, thereby influencing the planting decisions of forest products companies. If carbon credits are provided to carbon forests but not to industrial forests, and if some carbon forests are anticipated to enter future timber markets, then forest industrial firms may reduce investments in new forests. Such a reduction would partly offset carbon sequestered in the newly planted carbon forest, thereby reducing the net total carbon that would have accumulated by both industrial and carbon forests (Sedjo and Sohngen, 2000). This leakage effect would not occur if both industrial and carbon forests could expect to receive payment for both their carbon and their wood.

Leakage from industrial forests, resulting from forests established for carbon purposes, has been estimated by Sohngen and Sedjo (1999) to be about 40%, globally, assuming that all carbon forests are made available to the timber market. This compares with estimated leakages in the energy sector of about 5%–20%. No estimates of leakage generated from protection activities are available, but it is suggested that it may vary by country and site, unlike planted forests that are linked through the global timber market.

The leakage problem may be addressed reasonably well within nations by caps imposed on total emissions, but leakage of emissions across national boundaries may still occur in the absence of global coverage.

Conceptually, a permanent net carbon offset should be equivalent to a tradable emissions permit. If a new activity permanently reduces net atmospheric carbon by one tonne, the climatic implications are the same as if the tonne of carbon was never released. Thus, a carbon-offset credit would be equivalent to a tradable emission credit. However, since carbon offset can quickly be liquidated, offset credits have greater liability problems. One approach might be treated on an annual (or decadal) basis as the rental of (perhaps temporary) carbon sequestering services. Although different from carbon emissions permits, they nevertheless would expand the number of “credits” available, and thus have a mitigating effect on the market price of the credits. A discussion of some of the options is presented in IPCC (2000a).

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