Climate Change and Forests: Emerging Policy and Market Opportunities

Chapter 9. The Permanence Challenge: An Economic Analysis of Temporary Credits

Carbon sequestered in biomass or soils may be released accidentally because of fire, windstorms, or other natural hazards or because of conversion of the land to agriculture or pasture. The so-called nonpermanence risk constitutes a fundamental difference between biological sequestration projects and projects that reduce the emission of carbon into the atmosphere. The risk of nonpermanence matters because sequestering carbon temporarily does not have the same effect on global warming as avoiding emissions permanently. To deal with the risk of nonpermanence, carbon sequestration through land use, land-use change, and forestry (LULUCF) projects under the Clean Development Mechanism (CDM) generates credits with finite lifetimes. Temporary Certi fied Emission Reductions (tCERs) last for one commitment period, with a new tCER issued at the next period only if verification shows that the carbon stock is still sequestered. Long-term Certified Emission Reductions (lCERs) may last longer, but they will expire before their final due date if periodic verification shows that the carbon is no longer sequestered. In addition, under current rules tCERs and lCERs cannot be renewed beyond the project’s last crediting period (a maximum of sixty years), regardless of whether the carbon is still sequestered or not.1 The current rules thus create a double liability for the carbon buyer. First, if the carbon stock underlying the credit is no longer sequestered or is not reveri- fied, then the holder of the credit suffers a debit that must be compensated for The Permanence Challenge: An Economic Analysis of Temporary Credits franck lecocq and stéphane couture 9 125 by the acquisition of a permanent credit or of another temporary credit based on a different carbon stock.2 The second liability arises at the end of the project’s crediting period when a replacement has to be found whether or not the underlying carbon stock is being maintained. However, the fact that tCERs and lCERs have finite durations may also provide an opportunity for buyers seeking to gain time until carbon is less expensive—for example, because they anticipate that their emissions will fall in the future. Our purpose in this chapter is to evaluate how much carbon buyers would be willing to pay for temporary credits (or streams thereof) relative to permanent credits and to discuss the implications for the attractiveness of LULUCF projects relative to other CDM projects. In the following section we show that the price of tCERs depends on the relative prices of carbon today and at the next commitment period. We then extend the model to lCERs (and to streams of tCERs) and show that their price depends on both the expected price path of permanent credits and the risk of nonpermanence. Next we provide empirical evidence that the risk of nonpermanence, though difficult to evaluate, is likely to be significant. As a result, the risk premium attached to nonpermanence is likely to be large. Finally, we discuss the implications of the preceding findings for LULUCF project developers. We suggest that few buyers are likely to be interested in temporary credits per se and that most will in fact demand quasi-permanent credits even from LULUCF projects. Given the magnitude of the nonpermanence risk premium, we explore some strategies that LULUCF project developers might adopt to make LULUCF-derived credits more palatable to buyers. The Price of tCERs In this section we discuss the value of tCERs relative to the value of permanent credits. Because tCERs expire at the end of the commitment period following the one for which they were issued, purchasing a tCER is equivalent to purchasing the right to defer the purchase of a permanent credit by one commitment period (not two, because the tCER must be replaced before it expires). At the present time, markets for carbon assets during the second commitment period, let alone subsequent ones, are virtually nonexistent.3 Thus the price of tCERs depends on the difference between the observed price of permanent credits today and the expected price of permanent credits during a second period. Precisely, let p1 be the price of permanent credits for the current commitment period, let E(p2) be the expected price of permanent credits for the next commitment period, and let r be the discount rate. A risk-neutral entity with obligations under the Kyoto Protocol will purchase a tCER if and only if its price ptCER is 126 franck lecocq and stéphane couture lower...