Offset quality. Hardly as riveting as nuclear meltdown, but if “complex,” “unmanageable” and “unwarranted assumptions” are themes of the month, the Government Accountability Office’s new report, “Options for Addressing Challenges to Carbon Offset Quality” carries the tune that’s in the air.

The GAO report, compiled at the request of Rep. Darrell Issa (R-CA), House Committee on Oversight and Government Reform chair, updates GAO’s 2008 “Lessons Learned” report on the European Union’s Emissions Trading System. The ETS relies on offsets from two UN programs, the “Clean Development Mechanism” (CDM) and Reducing Emissions from Deforestation and Forest Degradation (REDD). GAO’s 2008 report found that the EU ETS had “established” a market for CO2 emissions but noted that over-allocation of allowances in excess of demand had resulted in “a price collapse.” GAO concluded that Phase I of the ETS had “uncertain” effects on emissions in the capped countries while funding offsets of doubtful value, but held out hope that reforms could make the system work.

Offsets were a cornerstone of the Waxman-Markey cap-and-trade bill that passed the House in 2009 and of the ever-changing but never-publicly-disclosed proposals that Senator Kerry floated in the Senate last year. They have been touted as “cost control” measures to moderate rises in energy prices that would result from steadily reducing the cap in CO2 emission permits. Their allure lies in their apparent capacity to slip out of one of the iron laws of economics—that a constraint in supply (in this instance, via the emissions “cap”) requires a commensurate rise in price.

Offsets attempt to take advantage of (and fund) low-cost greenhouse gas emissions reductions or sequestration projects, particularly in developing countries, as an alternative to more costly reductions in the capped industry or country. The new GAO report documented three serious problems with offsets: additionality, measurement and verification. And GAO also raised questions about the permanence of sequestration projects like forests that can later be burned as fuel, relinquishing the climate benefits that were bought with offset credits.

Additionality is the problem of answering a hypothetical question. What would have happened if offsets hadn’t funded this project? GAO found many projects that have gotten a boost from offsets, but with no clear sense as to whether they would have been built anyway without the incentive of offset credit. What is the baseline? It’s an un-testable assumption. GAO found that it’s been a challenge for the UN and EU ETS to even write rules about how to review projects (which vary widely in concept, location, quality and cost) while the offset “industry” and large purveyors of offsets, particularly China, are clamoring for ever more streamlined UN approvals.

Measurement is a complex accounting problem—how much CO2 was avoided by this project or process or by preserving this forest? While global accounting firms assure us that they can provide systematic measurement and reliable figures, GAO found that measurement is neither consistent nor transparent, despite a decade of effort by the UN.

And verification – who’s checking on completion, operation and maintenance of these projects? Unsurprisingly, GAO reported that, “Project developers and offset buyers may have few incentives to report information accurately or to investigate offset quality.” Everyone in the offset business – from project developers to offset sellers and buyers ─ wants offset values set as high as possible. There’s a worrisome parallel to the 2008 financial collapse: the bubble in mortgage-backed securities arose in part because slicing and bundling mortgages into securities (and derivatives) made it impossible to identify and assess the value of a particular property whose value is securing the loan. Offsets start out as intangibles; everyone in the system is rewarded for over-stating their value. GAO argues that strong, independent oversight is needed, but its report raises serious doubts about whether oversight, which is administratively expensive to boot, can ever be sufficient.

Perhaps most tellingly, the new GAO report confirms the worst fears of offset critics ─ that the global offset system places new hurdles in the path of energy-efficiency and other decarbonizing measures, in the form of perverse incentives under the Clean Development Mechanism [CDM] program:

[A]n offset program may create disincentives for policies that reduce emissions. For example, under an offset program that allows international projects, U.S. firms might pay for energy efficiency upgrades to coal-fired power plants in other nations. According to our previous work [GAO’s 2008 report on the EU ETS], this may create disincentives for these nations to implement their own energy efficiency standards or similar policies, since doing so would cut off the revenue stream created by the offset program.

For example, some wind and hydroelectric power projects established in China were reviewed and subsequently rejected by the CDM’s administrative board amid concerns that China intentionally lowered its wind power subsidies so that these projects would qualify for CDM funding. In addition, our review of the literature suggests that in some cases an offset program may unintentionally provide incentives for firms to maintain or increase emissions so that they may later generate offsets by decreasing them. This potential problem is illustrated by the CDM’s experience with industrial gas projects involving the waste gas HFC-23, a byproduct of refrigerant production. Because destroying HFC-23 can be worth several times the value of the refrigerant, plants may have had an incentive to increase or maintain production in order to earn offsets for destroying the resulting emissions.

The HFC-23 offsets cited by GAO are perhaps the most egregious example of the perverse behavior that offsets induce. Credits for the destruction of HFC-23 represented 59% of the offset value traded in the UN’s CDM in 2009. HFC-23 is an unwanted by-product of the chemical reaction that produces the refrigerant, HCFC-22. Because its greenhouse gas potential per pound is 11,700 times that of CO2, destroying even a few pounds of HFC-23 earns vast offset credits even though the destruction process is not particularly costly or difficult.

Stanford University Professor Michael Wara calculated that whereas installing equipment to capture and destroy HFC-23 at all of the facilities covered by CDM would cost $100 million, these same projects are expected to generate $4.7 billion in CDM offset credits by 2012. Not surprisingly, the availability of huge sums in the offset market creates incentives for construction of HCFC manufacturing facilities beyond demand for the refrigerant, as well as incentives for developing countries to avoid mandating the installation of emission control equipment, all so that the “baseline” for project evaluation remains uncontrolled release. Enactment of a law requiring control equipment would raise the baseline and thus eliminate the potential for HFC-23 offset credit. You can bet China won’t be enacting that law so long as CDM allows credit for destroying HFC-23.

CDM projects must be approved for offset credit.  The process for approval of livestock methane capture projects illustrates the steps that GAO found that such projects generally have to follow:

(1) conduct either an investment analysis to show that methane capture was not attractive without revenue from the sale of offsets, or demonstrate that offsets allow the project to overcome some prohibitive barriers;

(2) demonstrate that methane capture is not already common practice in that area; and

(3) define an appropriate baseline from which offsets would be awarded.

The GAO report weighed the trade-offs in terms of accuracy, administrative cost and flexibility against the increased approval speed that might be available from a standardized approval process. Acknowledging that even the best oversight and management can’t assure high offset quality, GAO suggests limiting the fraction of CO2 reductions that offsets would be permitted to provide under national cap-and-trade programs.

[T]he emissions reduction program would ensure that only a fixed percentage of the emissions permits could be affected by any problems with offset quality. All existing emissions reduction programs we reviewed use this option. In the EU ETS, regulated entities are able to use CDM credits for 12 percent of their emissions cap, on average, through 2012. In contrast, a draft Senate bill [the “American Power Act”] would have allowed a greater number of offsets into the program—approximately 42 percent of the emissions cap during the first year of the program. These percentages are based on the total emissions cap, not the required emissions reduction. As a result, such limits could mean that regulated entities could use offsets for all of their required emissions reductions, assuming a sufficient supply of offsets was available.

In other words, GAO concludes that in the Senate’s failed cap-and-trade bill, offsets could have completely overwhelmed the cap (which only declines a few percentage points each year) for decades. That’s exactly what International Rivers and Prof. Wara predicted just days before Waxman-Markey passed the House (219-212) in June 2009.

To limit the problems with offsets, GAO suggests only allowing certain types of offset projects or discounting their value so that only a fixed fraction of the avoided emissions are counted, perhaps tailoring the fraction to the type of offset project. Disappointingly, GAO stops short of suggesting complete elimination of offsets so that emitters would face a real cap that would induce a real carbon price. And, of course, that would point to a much simpler, direct way to set a stable and predictable price: a gradually-rising carbon tax.