Otherwise, they have no credibility.  Without credibility, there is no market.  Without a market, the whole idea collapses.  I don't care about liquidity, I don't care about Sean making money (sorry dude).  I want a high hurdle to separate the phony projects from the real ones, Even if an occasional well intentioned project doesn't get built.  Without this, it's more likely that people will be duped - that's just the truth.  I'd rather have credibility, and have people play by some tough rules.

Sean, I just don't see how you don't get this.  I really can't figure out how some very bright people can't see that a credible, verifiable market is necessary.  Don't you see the stories in the paper about the "dubious offset market"?  I agree with many things you say, but on this issue I see a gap in the logic.  As Gar correctly points out, you need to get out of the weeds - it's not that damn hard.  If someone buys an offset, they need to know it's additional.  Period.  

Certainly not any of us Gristians.

I have this strange quirk where if you're pretty sure you're ship is taking on water it's important to plug all the holes. This is the origin of the phrase "tipping point." A ship can flood at anchor in a calm harbor and just settle lower in the water for days. You can close the hatches and pump her out at leisure.

That same amount of water in the bilges when there's a heavy swell can move about and shift suddenly and unpredictably causing a knock-down or capsize. The deal is; nobody can tell you where that point is. Chaotic systems can be like that.

Carbon offsets are an invitation to play tag with the planets "tipping points." We don't know where it is but the historical record is that the climate can shift radically in a dozen years or less.

Put the Carbon Back

Yeah, but the additionality issue is one of the big reasons. I don't think you can get that certainty with offsets. I'm not opposed to permits to pollute per-se; that is what a cap & auction system is after all. I'm opposed to project based savings. I'm also think major secondary markets, i.e. significant amounts of trading are a bad idea, something I am going to have to make time to post about.

Pangolin, I do appreciate your comments, but perhaps we'll never agree.  I believe that correctly pricing carbon will force people/companies to start plugging their holes.  A cap and trade system is my preferred method of doing that.  Economic signaling is important.

Naturescene, I think you may need to read up on how CDM projects are ruled additional.  Or you can read the new CRS Green-e GHG proposals.  It's certainly a hurdle, as Sean points out in many other posts on Grist, but it's also not as difficult as you make it out to be.  "Objective test"?  Some of the rules are objective, some are not.  It's a long discussion, and I'm really not the person to be leading it, but I'll just say having additionality rules in place is much better than not having them at all.  

On the one hand we have environmental additionality - the concept that a reduction project is going to lead to an overall reduction in emissions.  I'm pretty sure this is what Gar is talking about when he says additionality, but that is not always the understood meaning of the term.  For such a test, we must first establish a baseline of emissions; therefore, it may be advantageous to refer to this concept with terms such as baseline analysis or something along those lines.

Project or financial additionality is what Sean was writing about and what CDM uses to assess a project.  Whether or not a project would have been undertaken without CDM can never be known with certainty, and really isn't something we should be worried about.

Environmental additionality/baseline analysis = great

project/financial additionality = not so great

Naturescene, the CDM does not base additionality solely on investment analysis.  The CDM additionality steps simply seek to determine whether a project is UNLIKELY to be financially attractive and then moves on to consider additional barriers (regulatory, common practice, etc).  No, there is no definitive hurdle rate associated with financial additionality, but that doesn't automatically make it a poor concept which is the implication from Naturscene and Sean.  I still don't understand Sean's argument that financial additionality results in suboptimal investment.  That is purely a theoretical construct that, as yet, is not borne out in practice (at least in the voluntary carbon market).  The fact of the matter is that companies generally have financial principles in place that define metrics such as IRR and if there is a persuasive case to be made that a project is financially additional (i.e., a project doesn't clear that hurdle w/o revenue from carbon credits), you simply move on to the subsequent barriers analysis.  To quote Capster, this..."ain't that damn hard".    

I agree that there is no "iron-clad" measurement for financial additionality.  I agree that it could be messy, particularly at the start.  I'm OK with that, if in the end we have a true market that people can trust.  Without such a hurdle, there is no market.

As rcire points out, the CDM rules around additionality are not just on financial issues.  I'll also add that they don't look at a specific company's finances, but at project finances, using typical IRR and WACC.  I know it's not as precise as you or others would want, but in using these, they attempt to address another concern - that every project needs to be individually analyzed.  The CDM process allows for whole groups of projects to be considered additional on a prima facie basis.  This also makes the process easier, though keeps the hurdle high.  

I'm not trying to dismiss the discussion that Sean and Adam are having, I'm just asking that they get out of the details and focus on the larger issue of what we're trying to accomplish - credible reductions.  I know that right now there are many offsets being sold and traded that are simply not real.  They are resulting from projects that would have been done regardless.  It's just a way for a project developer to make more money, for no added value.  This is why offsets were recently attacked on the front page of the Washington Post, because of the belief that they are not real.  

Since the purpose of a project is to offset carbon emissions, that should be the only test needed for credibility.  It is impossible to prove whether or not a project "would have been done regardless."  Thus, we have subjective and loose tests for it.  I understand that the purpose is to lend credibility, but how much credibility comes with such subjective and discretionary "standards"?  The "financial additionality" criteria are really a way to avoid the more important issue of "environmental additionality".

Why should one project that will effectively offset carbon emissions be excluded from accepting offset revenues because someone deems it "likely" that the project would have occurred without offsets?  What happens if the potential offsetter, even though the project makes economic sense on paper without offsets, refuses to go through with the project if it is not certified as additional?

The financial additonality issue is a breeding ground for moral hazards.

Interestingly enough, the types of offset projects that are the most verifiable in terms of actual carbon offsets, are also the ones likely to not be applicable for offset revenues due to the financial additionality criteria.  That is the suboptimal investment Sean was writing on.

Standards are a must for the voluntary offset market in order to attract people to it, but the standards should spend more time focusing on the environmental impact of a project rather than the economic distribution of offset payments.

It is impossible to prove whether or not a project "would have been done regardless."

50% of the case against project based offsets from nations without caps being applied in nations with them. Thank you for acknowledging this

I want to ONLY pay people to do projects they would not otherwise do without factoring in carbon costs (financial additionality).  I don't want to pay someone for a project they would do based on its economics.  You state "What happens if the potential offsetter, even though the project makes economic sense on paper without offsets, refuses to go through with the project if it is not certified as additional?"  To which I state - HUH?!?  Who would NOT do a project that makes economic sense?  That's what companies do - weigh projects and invest in the ones that make economic sense.  This is one of the places where I don't follow you.  

Let's look at the alternative - we have no financial additionality, any "reduction" in carbon is considered an offset.  As I've stated previously, I am supportive of a cap and trade system, and like Sean, am supportive of market based solutions.  Without financial additionality, any project/activity that "reduces" carbon will be available as an offset, regardless of whether a company or person would have done it anyway.  So, using Sean's example, my car breaks down and I need to ride my bike to work - hey, I have an offset.  My chiller breaks down and I need to replace it - hey, the new chiller is more efficient (they all are), so I have an offset.  My company finds a new manufacturing process that is an improvement over the old one - and it requires less energy - so I've created an offset.

The problem with those three offsets generated?  They would have been done regardless.  Because they made economic sense on their merits.  But you would have me pay these people for something they are already doing.  Why?  Why pay for that?  

The other side of the coin - what happens in the market?  Well, now we have a market awash is offsets.  Everyone is submitting "projects" into the market that are offsets.  Liquidity is high, supply is high - so offset prices drop down to next to nothing.  What does this mean?  It means that many carbon reduction projects don't get built.  Why?  Because these projects need the value of offsets to make them viable (financial additionality), and since the offsets are priced low, the math doesn't work; they don't get done.  

So instead of increasing the number of projects - you've decreased the number.  And the "projects" that do get done are ones that WOULD BE DONE ANYWAY.  

The last point to make is my refrain on credibility - without it, people won't buy the offsets.  Without them buying the offsets, the offset cost stays low.  With a market awash in offsets, and no buyers, the market collapses.

I simply disagree with your comment that the tests are subjective and loose.  If you haven't, please read the Green-E GHG proposals.  Or read the CDM rules, or any of the many protocols out there for GHG.  Virtually all contain financial additionality.  And I recognize that they are not perfect, but as I outline above, the alternative is not acceptable.  

One quick comment on why financial additionality is so hard.  Perhaps this is implicit in your comments, but when you wrote that "Who would NOT do a project that makes economic sense?", it calls for an overview of industrial purchasing processes - which matter because consumption of fuel for thermal and electric generation comprise 67% of US GHG emissions.  Any serious effort to control carbon is therefore going to have to deploy capital in the industrial space - who are the biggest users of thermal and electrical energy.

Here, in a nutshell is how capital allocation gets done in an industrial plant.  

Step 1: Capital is allocated to legally mandated projects.  This often gets overlooked, but is big (in the petroleum industry, this can be more than 50% of the capital allocated in a given year for environmental health & safety compliance.)  It is not atypical for this to consume 100% of the dollars for capital investment in any given year in some industries.

Step 2: If there is any cash left after Step 1, someone in the corporate finance department looks at how much cash they've got on hand in a given year and decides how much is available for capital investment.  

Step 3: A managerial decision is then made to decide how to allocate those capital investment dollars between core and non-core activities.  Energy is always in the non-core bucket: the logic being that if the guy who is responsible for running your chemical separations plant comes to you and tells you that you can increase yields with a new separation technology, you not only trust him, but think he's spending his time wisely.  But if the same guy comes to you and tells you that you can increase profits by modernizing your energy plant, you're dubious on both counts.  (As much as you'd be if he came to you with a hot stock tip.)  

As a practical matter, this third test ends up manifesting itself as some variant of "core projects will recieve investment dollars if they have a return of X%.  Non-core will receive investment dollars if they have a return of >X%."   Qualitatively, my experience is that the spread between the core and non-core rates is widening, in spite of the rise in energy costs, because industrials have laid off so many mid-level managers.  A chemical plant that used to run with 200 employees today gets by with  50 or less - and the folks who left, more often than not were the energy & process integration guys.  (Another side effect of cost cutting in the manufacturing sector.)

The impact of all this is that lots of people don't do projects that make economic sense.  I have drawers full of two year payback (=40% rate of return) projects that past companies I've run have identified but could get built.  A steel mill in Northern Indiana has a $20 million investment they could make today with an 8 month payback - and the plant manager told me that he's going to build it as soon as his purchasing request gets approved (he's been submitting those requests for 8 years and counting.)  The list is lengthy - but the key point is that (a) lots of projects don't get built that make good economic sense and (b) the definition of "economic sense" varies from business to business and from year to year.  Even within one business, I can't apply a bullet proof formula to say what financial additionality means - and I certainly can't at a global level.  

I think this is naturescene's beef. (I know it's mine.)  Not that the theory of additionality isn't a good one, but that as a practical matter, it will always be a qualitative judgment made by one of us imperfect mortals.  And worse, it is too often made by folks with no real experience with industrial capital allocation.

Now watch what this does for additionality.  An industrial employee with a burn on for energy efficiency has a great project, but she knows that it's going to be really hard to get it funded, because her boss doesn't trust her energy judgment, and doesn't think it's a good use of her time to chase non-core investments.  She then finds out that there is money available to help push the project forward based on it's beneficial CO2 impacts.  But on closer inspection, she realizes that to get that money, she has to dive into additionality weeds, filling out wealths of paperwork on her internal capital allocation processes (perhaps getting signoffs from senior financial types).  Which is not only creating a hassle factor for her, but worse putting her in a position where she not only has to confront her boss' skepticism about the time she's spent on non-core dollars, but also all the time she's spending getting educated on the minutiae of GHG offset rules.  More often than not, this means that the project simply doesn't get done.

Meanwhile, the world is burning while we argue over additionality.

The price of carbon regardless of formal financial additionality will be a tipping point for a lot of these types of projects.

Just to be clear, you're saying that financial additionality should be thrown out because facility managers don't currently do projects that make sense.  So they are currently not being economically rational, in your model, and for some reason eliminating financial additionality is going to push them over the edge?  No, I don't think so.

I have been a facility manager, I've been the global director of utilities for a large consumer product company, and now I work for a very large energy company leading efforts on climate change (damn, this makes me sound old - I'm not, it's just been an interesting career).  So I hear what you're saying.  I know how capital is sometimes allocated.  I know that I did not do efficiency projects that had very good paybacks on paper.  I had to make choices about limited capital and constrained opex.  Plus, let's be honest, many of the projects look good on paper but in practice...not so much.  So credibility around these project was lacking (familiar theme, anyone?), and we would put a higher hurdle on some of them.  

Sean, you do fail to address a few of my points that I think are valid:

 - Allowing any reduction project to be considered an offset will result in a flood of offsets into the market, which will depress offset values, providing no value to companies who want to actually do offset projects - this would crush the number of carbon reduction projects done.  And it will give the "industrial employee with a burn on for energy efficiency" absolutely no incentive to look again because of carbon offsets.  Seriously, they are trading for a few dollars these days on the CCX, because they aren't credible.  A few dollars for a ton of CO2 is just not enough to push many projects - especially if all the hurdles you describe internally are in place.  While typing this up, I'm multi-tasking I'm on a call with CERA, and they are discussing the need for CO2 prices to be between $25 and $100/ton to make the shift from coal.  

 - How do you propose to maintain credibility in the market when there are, frankly, specious offsets floating around in there?  Please see my chiller or production line improvement examples above that generate "offsets" as a by-product, but which would have been done regardless.  How do you address the front page articles in the Post?  Why would anyone want to buy these offsets?

 - Lastly - you have this refrain about subjective rules.  I assume you've read the CDM rules and the Green-E GHG proposal?  You surely know that Jan Hamrin and her colleagues at CRS got input from many on the development of these rules?  You also must know that virtually every protocol for carbon offsets requires financial additionality?  I have in front of me a spreadsheet of research my team has done on offset protocols.  The real fact is that the rules are NOT all subjective, there are some easy ways for projects to get approved as additional, and as the expertise with specific project types grows with the certifiers, the process will become easier.  

I really wish you'd hit these items head on.  I'm interested in your thoughts on these issues, and how you would solve these.  

1. I wouldn't say facility managers aren't being economically rational; simply that financial rationality is more nuanced than simple IRR calculations.  A business that sends signals to it's managers to keep a laser-focus on their core business is hardly being financially irrational - it's simply acknowledging that rational capital allocation includes factors other than the next marginal capital investment dollar.

2. I'm not intimately familiar with the CDM and Green-E rules, but would love to see a post about them.  My experience with additionality comes from applying for (successfully, I'd add) offsets at The Climate Trust and CCX.  Perhaps they used those models?  I don't know - I just know that additionality compliance made me decide not to bother with those particular voluntary markets in the future which seems to be contrary to the intent of the programs to reduce carbon.  (Again, recall that we were deemed additional - it's not like we're being turned away because we're not additional; just that the effort to justify ones additionality isn't worth the return.)  Yes, this would be different if the offsets were more valuable, but that's still an awfully goofy outcome.

3. I agree with your larger point about market credibility, and I think we're in agreement that there are projects that are going to get done anyway.  My problem remains that I don't see the bright line.  In this regard, this conversation is reminsicent of various exchanges I've had with Jason Scorse on the credibility of economic projections.  In that case, I've argued that while economics is a good way to understand historical events, it does a really sh*&*y job at predicting the future - and yet we have scads of policies written up (including many in the carbon space) based on economists' shoddy crystal balls.  Jason has argued - quite legitimately - that while it may be flawed, it's the best tool we've got.  I mention this because at a philosophical level, I think we may reach the same detente on offsets and additionality.  In a voluntary market that is driven by offsets, we need some way of ensuring that we don't spend money on specious investments.  And - paraphrasing Churchill - additionality is a perfectly crummy way to do that, but for all the alternatives.  Which suggests to me that when all is said and done, the problem may lie not with additionality per se, but with the constraints of voluntary offset markets that are proscribed in a way that forces you into the additionality trap.  Meaning that we need to go to mandatory carbon markets, and something that looks like this.

Yet all over Gristmill they go through detailed scenarios where in a given set of rules the "market" will then respond rationally to reduce GHG emissions at the least possible cost to all parties.

The "market" is rational enough to cut global CO2 emissions but not rational enough to seize on an investment with an eight month payback to profitability?

Come again?

If you have any doubt that a "cap-and-trade" carbon market will lead to failure grab some other (non-Gristian) adult in your house and see if they can make sense out of this thread. It damn well better because cutting emissions is going to cost somebody and that person probably qualifies as a deep pocket where "market" fundamentalists are concerned.

Put the Carbon Back