NONCOMPLIANCE, MONITORING AND THE ECONOMIC THEORY IN CARBON TRADING MARKET

Transcription

1 NONCOMPLIANCE, MONITORING AND THE ECONOMIC THEORY IN CARBON TRADING MARKET A thesis Submitte to the College of Grauate Stuies an Researh in Partial Fulfillment of the Requirements for the Degree of Dotor of Philosophy in the Department of Bioresoure Poliy, Business & Eonomis University of Saskathewan Saskatoon By Daniela Mihal Copyright Daniela Mihal, July 28. All rights reserve.

2 PERMISSION TO USE In presenting this thesis in partial fulfillment of the requirements for a Postgrauate egree from the University of Saskathewan, I agree that the Libraries of this University may make it freely available for inspetion. I further agree that permission for opying of this thesis is in any manner, in whole or in part, for sholarly purposes may be grante by the professor or professors who supervise my thesis work or, in their absene, by the Hea of the Department or the Dean of the College in whih my work was one. It is unerstoo that any opying or publiation or use of this thesis or parts thereof for finanial gain shall not be allowe without my written permission. It is also unerstoo that ue reognition shall be given to me an to the University of Saskathewan in any sholarly use whih may be mae of any material in my thesis. Requests for permission to opy or make use of material in this thesis in whole or in part shoul be aresse to: Hea of the Department of Bioresoure Poliy, Business & Eonomis University of Saskathewan, 51 Campus Drive, Saskatoon, Saskathewan, S7N 5A8 CANADA i

3 ABSTRACT Mihal, D., Ph.D., University of Saskathewan, Marh, 28. The Eonomi Impat of Non-Compliane in the Carbon-Offset Market. Supervisor: M.E. Fulton Aressing limate hange is a major unertaking. Agriultural soil has the potential to assist in ereasing the onentration of GHGs in the atmosphere by storing CO 2 in the soil. Carbon offset markets have been suggeste as a ost effetive means of reuing GHG emissions. Farmers an inrease their soil sink potential by applying Benefiial Management Praties (BMPs) that enhane arbon sequestration through improvements to soil, nutrient an livestok management praties (Fulton et. al., 25). Whether or not a market for arbon offsets will emerge epens on a number of fators whih mainly are relate to the profitability of the BMPs an the osts of implementing a arbon ontrat. Provie that a market for arbon offsets emerges, the effetiveness of the market epens, in part, on the egree to whih buyers an sellers in the market omply with the terms of the ontrats they sign. The resoure osts assoiate with monitoring an verifiation may result in inomplete monitoring. As long as monitoring is not perfet, non-ompliane will be an issue. The analysis that will be performe in this thesis introues non-ompliane in the eonomi analysis of arbon-offset market. The purpose of this work is to examine the overall ost effetiveness of the arbon-offset market when introuing nonompliane. Firstly the theoretial moel investigates the inentives for ifferent farmers to partiipate in the arbon offsets market as well as inentives for engaging in heating. The moel reognizes farmers heterogeneity with respet to ost ifferenes an examines the eonomi eterminants of farmers non-ompliane as well as the onsequenes of non-ompliane on the performane of the arbon-offset market. Results support the stanar fining that the extent of prouers non-ompliane ii

4 ereases with an inrease in the auit probability an/or an inrease in the penalty per unit of non-ompliane. In aition, the number of prouers partiipating in the arbon offsets market is shown to inrease with an inrease in the arbon-offset prie. The analysis then introues intermeiaries in the market that will take are of traing arbon offsets as well as monitoring prouers. The traers role in this stuy is playe by an IOF (investor owne-firm) or a PA (prouers assoiation). Within the IOF, the analysis fouses on the monopoly an oligopoly strutures. The key role of the traers is to guarantee, base on the amount of monitoring that is unertaken, that the emitters purhase only arbon offsets that atually orrespon to sequestere arbon. The analysis then examines three ases for the group that monitors farmers ompliane a group owne by for-profit traers, a government-run ageny an a group owne by the PA traer. This part of the thesis examines what impat the involvement of the traers in the arbon-offset market has on non-ompliane, as well as how the struture of the monitoring group affets non-ompliane an the amount of arbon offsets trae in the market. The results of the analysis show that the monitoring groups always unertake suffiient monitoring to ensure that full ompliane is ahieve thus, while nonompliane is possible, it oes not our in equilibrium. The fining suggests that the formation of a government monitoring ageny an potentially inrease trae output an lower the prie pai by emitters, still these hanges are likely to be small, partiularly when the traing setor is monopolisti. The overall analysis in this hapter shows that the optimal amount of enforement, an as a result the ost effetiveness of a arbon-offset market, epens on the nature of the organization that unertakes the enforement. The next onsieration of the thesis is the heterogeneity attribute to the timing of sequestration by ifferent farmers. The analysis fouses on the arbon offsets pooling by onsiering two strutures for the aggregator: a for-profit aggregator an a prouers assoiation. Pooling resoures enables the farmers to benefit from eonomies of sale. The priing sheule use by the aggregator is a two-part tariff. The two-part tariff is use as a way of proviing an inentive for the farmers sequestering iii

5 large amounts of arbon to partiipate in the pool. The stuy onsiers two alternatives for the oeffiients that might be use to eie on the amount of arbon offsets to whih eah farmer will be entitle: efault oeffiient an ustom oeffiients. Eah situation is moele in a prinipal agent framework. The analysis examines how the aggregator will target the monitoring servie for ifferent group of farmers. The investigation reveals that, uner ifferent senarios, a PA or a FPA (for-profit aggregator) might lea to the formation of a heterogeneous pool or a homogeneous pool of eah type. The last issue investigate in this issertation is the oexistene of a FPA an a PA in the efault oeffiient ase. The analysis show that both aggregator strutures an exist together in the market in the same time if the savings in the monitoring osts mae possible by the PA are smaller than the ost of organizing the pool. If this onition is not satisfie the FPA annot survive in the market an the prouers assoiation will ominate. In aition to proviing a better unerstaning of how the arbon-offset market may perform when introuing non-ompliane, the results of this stuy an assist in assessing the ost effetiveness of the arbon-offset market when enforement is unertaken by ifferent organizations. Furthermore, the last onsieration of the pooling option might help in seleting whih type of pool a heterogeneous or a homogeneous one might perform better uner ifferent alternatives. iv

6 ACKNOWLEDGEMENTS The author woul like to thank those that ontribute to the ompletion of this thesis: The College of Grauate Stuies an Researh for proviing finanial support. Dr. Murray Fulton, for being an exellent supervisor with his invaluable guiane, onstant enouragement an preious avie on effetive writing. I woul also like to thank Dr. Fulton for his moral support uring the most iffiult times when writing this thesis. Dr. Rihar Gray, member of my avisory ommittee for his enouragement, interest, an insightful omments at various stages of this stuy. Speial thanks go to Dr. Gray for his moral support an his valuable avies uring my Ph.D. program. Dr. Keneth Belher, member of my avisory ommittee for his interest, time an useful omments on this work. Dr. Joel Bruneau, member of my avisory ommittee for his interest, time an helpful omments in this issertation. Dr. Sumeet Gulati, the external examiner of my issertation, for his time an valuable omments an suggestions. I am very grateful to my referenes: Murray Fulton, Rihar Gray, an Kien Tran for the strong impat towars my employment opportunities. All the faulty, staff an grauate stuents in the Department of Agriultural Eonomis for reating a pleasant an stimulating working environment. My roommates as well as offie mates, Crina an Simona, for their support an frienship. My husban, Joni, for his bounless love, enouragement, patiene an support throughout this proess; an finally, My mother, Marika, my sisters Ala an Sonila, an my brother, Donal, for their unonitional love an moral support. This stuy has been one of the most hallenging an rewaring eneavours in my life. Weloming our baby girl, Eva Doris Sotiri, into our life, has been suh an exiting an hallenging experiene. While working on my thesis, I went through some iffiult time when I lost my father. This thesis is eiate in memory of my late an very loving father an to my husban Joni an our aorable aughter Eva. v

7 TABLE OF CONTENTS PERMISSION TO USE... i ABSTRACT... ii ACKNOWLEDGEMENTS... v TABLE OF CONTENTS... vi LIST OF TABLES... ix LIST OF FIGURES... x INTRODUCTION Bakgroun an Problem Statement Objetives of the Stuy Methoology Organization of the Stuy... 6 OFFSETS AND THE ROLE OF AGRICULTURE IN OFFSETTING NET GHG EMISSIONS Introution The Role of BMPs in Carbon Sequestration. Some Potential Co-benefits Relate to These Praties Some Important Consierations for the Carbon Market Conlusions THE ECONOMICS OF CLIMATE CHANGE AND NON-COMPLIANCE Introution Evolution of the Environmental Regulation Literature Robustness of the Effiieny Property in the Traable Permits Market Designing Agri-Environmental Poliies With Limite Information Carbon Offset Option an Compliane Monitoring... 3 vi

8 THEORETICAL DEVELOPMENT OF THE BASIC MODEL Introution Moeling the Farmers Problem Farmers Deision on Carbon Offsets Proution Extening the Basi Moel: Introuing Non-Compliane on the Farmers Sie Comparative Stati Results in the Basi Moel Conluing Remarks TRADING AND AUDITING CHOICES UNDER DIFFERENT STRUCTURES FOR THE TRADING SECTOR AND THE MONITORING GROUP Introution Priing an Traing Deision in the Monopoly an Oligopoly Cases Monopoly ase Oligopoly ase Choie of Auiting by a Governmental-Run Ageny Monopoly traer/ governmental ageny monitoring group Oligopoly traers/ governmental ageny monitoring group Prouers Assoiation Case an the Free Rier Problem Choie of Traing by the Prouers Assoiation Choie of the Auiting Level an Some Effiieny Consierations Conluing Remarks CAPTURING THE HETEROGENEITY ATTRIBUTED TO THE SEQUESTRATION PHASE COMPARING ALTERNATIVES WHEN CARBON OFFSETS ARE AGGREGATED IN A POOL Introution The Moel Default Coeffiient Case Aggregator s Problem For-Profit Aggregator Prouers Assoiation vii

9 6.2.2 Custom Coeffiient Case Aggregator s Problem For-Profit Aggregator Prouers Assoiation Comparing the alternatives Default oeffiient versus ustom oeffiients for the FPA ase Default oeffiient versus ustom oeffiients for the PA ase The oexistene of an FPA an a PA Conlusions SUMMARY AND CONCLUSIONS REFERENCE LIST APPENDIX Appenix A Moeling Large Final Emitters Problem A4.1 Large Final Emitters Deision on Abatement an Offset Purhasing A4.2: Extening the Basi Moel: Introuing Non-Compliane on the Large Final Emitters Sie A4.3 Conlusions AppenixA Appenix 5.1 Monopoly Case: Appenix 5.2: Oligopoly Case Appenix 5.3: Governmental Ageny Appenix A viii

10 LIST OF TABLES Table 5.1 Table 6.1 Table 6.2 Optimal θ in the PA an FPF ases. Numerial Simulation Results for Different Values of the Exogenous Variables 68 Summarizing the Results Obtaine for Eah Alternative in the Default Coeffiient Case 91 Summarizing the Results Obtaine for Eah Alternative in the Custom Coeffiients Case 17 ix

11 LIST OF FIGURES Figure 3.1 Uniform Stanars versus TPS to Reue Emission 23 Figure 4.1 Farmers Deision uner Perfet Compliane 39 Figure 4.2 Farmers Deision uner Non-Compliane 42 Figure 4.3 Supply Curves uner both Senarios 45 Figure 4.4 Comparative Stati with Respet to the Auiting Probability θ or the Penalty Variable γ 46 Figure 4.5 The Supply Curves Shift for a Monitoring or a Penalty Change 48 Figure 5.1 Monitoring Group Deision (Monopoly or Oligopoly Case) 53 Figure 5.2 Governmental Ageny Monitoring (Case of a Monopoly Traer) 58 Figure 5.3 Governmental Ageny Monitoring (Case of Oligopoly Traers) 59 Figure 5.4 Defining the Poole Prie in a Prouers Assoiation Case 64 Figure 5.5 Comparing Pries an Supplies of Genuine Carbon Offsets in Case of Monitoring Unertaken by For-Profit Firms or PA 69 Figure 6.1 The Perentage Change in Annual Soil Organi C Sequestration Rates uner NT, relative to CT 72 Figure 6.2 Soil Carbon Aumulation in Response to a Change in the Lan Management Pratie 73 Figure 6.3 The Coalition Area in the Default Coeffiient Case 8 Figure 6.4 The Default Coeffiient Case when the Pool is run on a For-Profit Basis. The Case of a Heterogeneous Pool 84 Figure 6.5 The Default Coeffiient Case when the Pool is run on a For-Profit Basis. The Case of a Homogeneous Pool 86 Figure 6.6 The Default Coeffiient Case when the Struture of the Pool is a PA. The Heterogeneous Pool Case 88 Figure 6.7 The Default Coeffiient Case when the Struture is a PA. The Homogeneous PA ase 9 Figure 6.8 The Default Coeffiient Case when the Costs of Aopting are the same. The Homogeneous & Heterogeneous Pool Cases when the Pool is run on a FP Basis 92 x

12 Figure 6.9 The Default Coeffiient Case when the Costs of Aopting are the same. The Homogeneous & Heterogeneous Pool Cases uner a PA Struture 93 Figure 6.1 The Coalition Area in the Custom Coeffiients Option (Case 1) 96 Figure 6.11 The Coalition Area in the Custom Coeffiients Option (Case 2) 97 Figure 6.12 The Solution for a FPA uner the Custom Coeffiients Alternative (Case 1) 1 Figure 6.13 The Solution for a FPA uner the Custom Coeffiients Alternative (Case 2) 11 Figure 6.14 The Solution for a PA uner the Custom Coeffiients Alternative (Case 1) 13 Figure 6.15 The Solution for a PA uner the Custom Coeffiients Alternative. The Consieration of a Homogeneous PA (Case 1) 14 Figure 6.16 The Solution for a PA uner the Custom Coeffiients Alternative (Case 2) 15 Figure 6.17 The Solution for a PA uner the Custom Coeffiients Alternative. The Consieration of a Homogeneous PA (Case 2) 16 Figure 6.18 Comparing the Alternatives of Custom Coeffiients Versus Default Coeffiient in the Case of a Homogeneous PA 11 Figure A.4.1 LFEs Deision uner Perfet Compliane 135 Figure A.4.2 LFEs Deision uner Imperfet Compliane 137 Figure A.4.3 Deman Curves uner both Senarios 139 xi

13 CHAPTER I INTRODUCTION 1.1 BACKGROUND AND PROBLEM STATEMENT The growing amount of greenhouse gases (GHG) in the atmosphere is regare as responsible for limate hange an global warming. In response to inrease GHG emissions an in an attempt to reue them, ountries have entere into international agreements suh as the Kyoto Protool (KP), whih ame into effet on February 16, 26. The Protool requires Annex B ountries to reue their emissions of six greenhouse gases (arbon ioxie, methane, nitrous oxie, hyrofluoroarbons, perfluoroarbons an sulphur hexafluorie) by at least 5 perent below 199 levels over the first ommitment perio A key feature of the KP is its use of market base instruments to eal with arbon emissions. The Protool allows for the use of three flexible implementation mehanisms: emissions traing (ET), Joint Implementation (JI) an the Clean Development Mehanism (CDM) (IPCC, 27). The treatment of arbon sinks i.e., the sequestering of arbon rather than a reution in its proution was left open uring Kyoto negotiations. The negotiating parties reahe a ompromise on this issue uring the Conferene of Parties in Bonn (July 21) by allowing a substantial reit to Australia, Canaa, New Zealan, Japan an Russia for arbon ioxie sinks ( Bohringer, 24 ). The subsequent COP7 in Marrakeh (November 21) approve arbon sinks to be use as a means of arbon reution by the Annex B ountries. 1

14 A sink is efine as any proess that removes CO 2 from the atmosphere (Unite Nations Framework Convention on Climate Change, 1992). Forests an agriultural soil have the potential to assist in ereasing the onentration of GHGs in the atmosphere by storing CO 2 in soil or in trees. Farmers an inrease their soil sink potential by applying Best Management Praties (BMPs) that enhane arbon sequestration through improvements to soil, nutrient an livestok management praties (Fulton et. al., 25), while forest managers an enhane arbon sequestration through afforestation, reforestation an forest management. Eah unit of arbon store in the soil or trees an be use to offset one unit of emission release from large final emitters (LFEs). If these units an be verifie an ertifie, they an be sol as arbon offsets or reits in a arbon-offset market. Allowing the traing of arbon offsets is one of the institutional innovations of Kyoto. Carbon-offset markets have been suggeste as a ost effetive means of reuing GHG emissions (Verammen, 22, Bloomfiel et. al., 23). An offset system an inrease the effiieny of meeting emission targets by allowing entities with potential GHG sequestration apabilities to supply offset reits to those that are require to reue GHG emissions. This option offers greater flexibility in ahieving emission reutions an hene the possibility of reahing environmental goals at a lower ost than woul be possible if the ountries i not have this alternative. About half of Canaa s total GHG emissions by 21 is antiipate to be release from LFEs (Government of Canaa, 25a). Base on their historial emissions, the level of proution an an emission intensity fator, the government oul be expete to alloate a large portion of initial permits to LFEs. Eah permit gives LFEs the right to emit one unit of emission; LFEs will be allowe to trae these permits. High ost ompanies an meet their aitional permit requirements by purhasing permits from LFEs with lower abatement osts. Permits an be expete to be trae until the point where the marginal abatement osts of all traers will be equalize. It is this ost equalization aspet that makes permit traing more ost-effiient than regulatory 2

15 approahes. Provie that sinks will be eligible as an option, LFEs an use offset reits as well to aress their emission potential. Although both forests an agriultural soil an serve as sinks, the fous of this work will be on soil arbon offsets reate as result of aapting BMPs in agriulture uner ontrat. Whether or not the market for arbon offsets will emerge epens on a number of fators whih mainly are relate to the profitability of the BMPs an the osts of implementing a arbon ontrat. BMPs buil up organi matter in the soil. Aoption of these praties brings a number of environmental an eonomi benefits suh as: improving soil quality an inreasing proutivity, improving moisture retention an ereasing irrigation nees, an ereasing soil egraation an erosion. Beause of the eonomi benefits, farmers have inentives to aopt BMPs voluntarily. In aition, they may fin an inentive to aopt these praties in orer to partiipate in arbon-offset market. Whether or not farmers will proue arbon offsets by applying BMPs uner a sequestration ontrat epens on the net benefits of suh an unertaking. Provie that a market for arbon offsets emerges, the effetiveness of the market epens, in part, on the egree to whih buyers an sellers in the market omply with the terms of the ontrats they sign. Compliane, however, shoul not be presume. Eah tonne of emission reue or offset reate has a value that is equal to the prie of a permit or a reit. This value an reate an inentive for LFEs to unerreport their atual emissions an/or for sink generators to overreport the arbon offsets reate from their emission reuing ations. Non-ompliane will be an issue as long as monitoring is imperfet. The possibility of non-ompliane arises beause it is ostly to etermine the ations of LFEs or farmers. Beause of this ost, farmers, as well as LFEs, are in a position to misreport. The monitoring an verifiation osts vary epening on the frequeny of monitoring an verifiation, auray of measurement, the quantifiation tehniques employe an the size of the ontrat. 3

16 Given the above onsierations, it is important to explore how the arbon offset market will be affete by non-ompliane on both sies. What role will market intermeiaries play in orer to guarantee that the arbon reits purhase by LFEs are legitimate? Whih organizational struture is more effiient in traing an monitoring? What is the impat of heterogeneity in the ost of proviing arbon offsets? What is the likelihoo of a homogeneous or a heterogeneous pool being forme in the arbon offset market? How o the various oeffiients that might be use to onvert the lan management praties into arbon sequestration amounts perform relative to eah other? This stuy tries to answer these questions. 1.2 OBJECTIVES OF THE STUDY The analysis that will be performe in this thesis introues non-ompliane in the eonomi analysis of arbon-offset market. The purpose of this work is to examine the overall ost effetiveness of the arbon-offset market when non-ompliane on both the eman sie (i.e., the LFEs) an the supply sie (e.g., agriultural/forestry prouers) of the offset market is introue. Monitoring an verifiation has the potential to reue or eter non-ompliane. One prospetive approah to aress monitoring an verifiation of the arbon-offsets is the involvement of a traer in the market with the responsibility of unertaking arbon offset traing. Traers will buy arbon offsets offere from farmers an sell verifie arbon offsets to LFEs. Even though traers an have ifferent strutures e.g., a for profit firm, governmental ageny, an assoiation of LFEs or an assoiation of arbon offset suppliers this paper will fous on the traing unertaken by for-profit firms an a prouers assoiation. The analysis then examines three ases for the group that monitors farmer ompliane a governmental run ageny, a monitoring group operating on behalf of the for-profit firms an a group operating on behalf of the prouers assoiation. The optimal amount of enforement is likely to epen on the nature of the organization that 4

17 unertakes the enforement sine these organizations iffer in their objetive funtions an their aess to information. Thus, an important part of the analysis will be an examination of the impat of organizational form on ompliane an hene on the ost effetiveness of a arbon-offset market. Carbon offset pooling is examine uner two organizational strutures for the aggregator: a for-profit aggregator (FPA) an a prouers assoiation (PA) both of whih are emerging in the arbon offset market. These two organizations iffer in a funamental way in the FPA ase, the aggregator hooses the farmers type while in the PA ase, the farmers hoose the type of the pool they form. The FPA hooses the alternative that provies her the highest profit, whereas in the PA ase the farmers hoose the alternative that provies them the highest benefit. This istintion rives the analysis performe in Chapter VI. 1.3 METHODOLOGY To ahieve the above objetives, this thesis uses ifferent theoretial approahes. The eisions by LFEs an farmers about partiipation in the arbon offset market are ritial to the reation of suh a market as well as to the performane of the market. The thesis starts by examining the LFEs an farmers behaviour. The LFEs problem, whether to unertake abatement or to buy arbon offsets, is visite uner two senarios: a full ompliane senario an a senario in whih non-ompliane is introue in the moel. The farmers problem of whether to aopt the benefiial management praties is similarly examine uner full-ompliane an non-ompliane. The LFEs an the farmers behaviour are both moele as eision making uner unertainty. The stuy ontinues by eveloping moels that examine the eisions mae by traers an monitoring groups, eisions that are ruial in ensuring the reliability of the offsets market. In this part of the thesis, the inspetion probability is enogenize. The involvement of the intermeiaries in the market serves as a guarantee for LFEs that the offsets they are buying are genuine. The monitoring group monitors the lan management pratie use by the farmers who sign the sequestration ontrat. The 5

18 eision of the traers is moele as a onstraine maximization problem. Traing an priing eisions mae by traers are examine as a response to the monitoring group s hoie of the auiting rate. A two stage game is use where the eision of the monitoring group is mae in the first stage. The game is solve by using bakwar inution. Both analytial an graphial illustrations are use to perform the analysis. When onsiering the prouers assoiation as the selete organizational struture, we eal with a poole priing strategy. The stuy then examines the traing an monitoring effiieny by omparing the results obtaine when onsiering ifferent organizational strutures for the traer an the monitoring group. This thesis moels separately two types of farmers heterogeneity: one eiate to suh harateristis of the farmers as management skills, experiene, an lan type an the other one eiate to the timing of sequestration. When onsiering the last mentione heterogeneity type, the analysis is performe uner the two-part tariff priing strategy. 1.4 ORGANIZATION OF THE STUDY The rest of the thesis is organize as follows. Chapter two examines the offsets option an the role of agriulture in offsetting net GHG emissions. Chapter three reviews the eonomis of limate hange an non-ompliane, an outlines the ontribution of this thesis. Chapter four evelops a moel of the farmer s hoie of whether to partiipate in the arbon-offset market or not. The paper then investigates the impat of introuing non-ompliane on the arbon offset market. The paper also examines the role of poliy instruments suh as auit probabilities an penalties in promoting ompliane. The fifth hapter of the thesis investigates the priing an output eisions of the traers involve in the market to failitate arbon offset traing. The analysis examines the extent to whih ifferent organizational strutures unertake monitoring, an the impat of this monitoring on the priing behaviour. Chapter six onsiers the heterogeneity attribute to the timing of sequestration by ifferent farmers. This hapter fouses on the arbon offsets pooling by onsiering two strutures for the aggregator: a for-profit aggregator an a prouers assoiation. The analysis onsiers two alternatives for the oeffiients 6

19 that might be use to eie on the amount of arbon offsets to whih eah farmer will be entitle. The last hapter summarizes the finings an onlues the thesis. 7

20 CHAPTER II OFFSETS AND THE ROLE OF AGRICULTURE IN OFFSETTING NET GHG EMISSIONS 2.1 INTRODUCTION Aressing global limate hange is one of the biggest hallenges of the 21 st entury. GHGs are largely being aumulate in the atmosphere ue to human ativities suh as inustrial, agriultural an househol ativities. This aumulation is mainly asribe to ativities that involve fossil fuel use, although eforestation is also a ontributor. As pointe out by Baumert et. al. (22), the hange in the omposition of the atmosphere has inrease the average global surfae temperature by about.6 C (1 F) over the last entury. Aoring to the assessment of the Intergovernmental Panel on Climate Change (IPCC, 27), temperatures are expete to rise between 1.8 an 4 C (3 to 7 F) by the en of 21 st entury if the trens in GHG aumulation are not amene. Suh temperature hanges might affet agriultural proution, water supply, forests an overall human evelopment. Regional effets suh as more frequent an severe roughts or storms, sea level inrease, more forest fires, hanges in agriultural proutivity an water supplies, an amage to vulnerable eosystems suh as oral reefs (WRI, 26) have alreay begun to be experiene. Meeting the limate hange hallenge requires esigning solutions that inlue evelope an eveloping ountries, many setors of the eonomy of a ountry, an options that range from well-known to the novel. The use of the biosphere is beoming inreasingly important for ountries that are attempting to manage their GHG emissions. Aoring to an FAO (24) report, the biosphere is onsiere to be a 8

21 arbon sink absorbing about 2.8 gigatonnes of C a year, whih represents 3 perent of fossil fuel emissions. This sink apaity reates an opportunity for the agriultural an forestry setors to ontribute to GHG reution in the atmosphere. In partiular, the ontribution of the agriultural setor in the reution or removal of GHGs an ome from three potential avenues (Weersink et. al.., 25). Agriulture an be a soure of GHGs, mainly in the form of nitrous oxie an methane. The emission of these two gases aounts for 97% of emissions oming from agriultural ativities; thus one avenue an be a iret reution in the emission of these gases. A seon alternative woul be the proution of biofuels an biomass energy whih oul be use instea of the fossil fuel base energy. This woul be one of the novel options that woul lower GHG emission levels. The thir avenue, whih is assoiate with the role of the agriulture as a sink, woul be arbon sequestration by using benefiial management praties suh as reue tillage, reue summer fallow, rop rotation, inrease perennial forages an pasture, an planting shelterbelts. In Canaa, it has been estimate that the agriulture setor an generate 1 Mt of CO 2 equivalents per year of offset reits beyon its business-as-usual reutions at a CO 2 equivalent prie of $Cn 1-15/tonne (Gov. of Canaa, 23). The extent to whih agriulture an embrae eah of these options epens on the inentives that woul be reate for eah of them. 2.2 THE ROLE OF BMPS IN CARBON SEQUESTRATION. SOME POTENTIAL CO- BENEFITS RELATED TO THESE PRACTICES The iea of transferable emission permits was first introue by Croker (1966) an Dales (1968). The iea was further evelope by Montgomery, 1972; Atkinson & Lewis, 1974, Tietenberg, 198; Seskin et. al., 1983, an Krupnik, However, it was the U.S. omesti experiene with reuing ai rain that initiate the popularity of emissions traing regimes as mehanisms for environmental pollution ontrol. The suess of this U.S. national program in meeting environmental goals in a ost effetive manner (USEPA, 22) enourage the iea of arbon emissions traing. Still, the inlusion of arbon offsets traing in the emission traing system woul be a novelty. 9

22 The response to global limate hange through the sequestration of arbon in the agriultural setor has varie aross ountries. The EU ratifie the Kyoto Protool in 22; however it has hosen not to use soil arbon sequestration in its strategy to reue GHGs. The EU, Japan an other eveloping ountries have oppose the inlusion of sinks in the Kyoto Protool by arguing that the unertainties surrouning the measurement an maintenane of arbon sequestere in the soil woul unermine ahieving real emission reutions. The hoie by the EU not to inlue sinks in their emissions traing sheme may have been mostly ue to the strength of environmental groups who i not want to ompromise the ahievement of emission reutions (Young et. al., 26). Other ountries like Canaa, Unite States, an Australia have supporte the inlusion of sinks even though the Unite States has not ratifie the Kyoto Protool. In 22, the Bush aministration announe the Climate Ation Plan as an alternative to U.S. ratifiation of Kyoto. The Unite States is enouraging the agriultural sequestration of arbon. A moest level of inentives an institutions to support soil arbon sequestration have alreay emerge. The Chiago Climate Exhange (CCX) was establishe in 23 with the goal of builing the skills an institutions neee to failitate the trae in GHG reits. CCX is the worl s first global marketplae for integrating voluntary legally bining emissions reutions with emissions traing an offsets for all six GHGs. However, the rules an regulations governing all aspets of sinks are still being evelope by the UNFCC. As mentione in the previous setion, part of the net emission target an be met by inreasing the arbon sequestration into agriultural soils through applying management praties that enhane the sink potential of the soil. The quantity of arbon store in soils is highly signifiant, with many of the fators influening the flow of arbon into an out the soil affete by the management praties applie to the lan. Beause of the iret benefits that might be assoiate with benefiial management praties, some farmers are likely to voluntarily aopt them regarless of whether they reate arbon offsets that oul be sol. In aition to this, inreases in euation an awareness, 1

23 tehnial support, training sessions an emonstration oul further inrease rates of aoption. Some of the prinipal lan management praties by whih agriulture is likely to sequester arbon are isusse below. Conservation tillage systems, whih inlue reue or zero tillage, reue the amount an intensity of tillage. Pretty et. al. (22) onsier tillage to be one of the main fators responsible for ereasing arbon stoks in agriulture soils; thus a onservation tillage system woul be one of the main lan management praties that woul inrease soil arbon retention. In a zero tillage system, planting is the only proess that isturbs the soil. In a reue tillage system, the tillage equipment that is use helps to maintain a goo resiue over (Agriulture an Agri-Foo Canaa, 24). Conservation tillage offers several benefits over onventional tillage. A reue or zero tillage pratie inreases the aumulation of soil organi matter whih gathers as a result of a greater rate of return of plant resiues ompare to the rate of eomposition of plant resiues. The inrease of soil organi matter means more arbon is store in the soil. Other benefits of soil organi matter aumulation inlue improvements in yiel potential, prevention of soil erosion an onservation of soil moisture. In aition, onservation tillage system reues the time spent on farm operations as well as the fuel requirements sine fewer passes are neee uner this tillage system. Reuing summer fallow is another lan management pratie suggeste to inrease the soil arbon retention. Summer fallowing an be efine as leaving a fiel without rop growth for a growing season. Fiels may be left fallow in orer to onserve soil moisture, ontrol wee problems an/or inrease the nutrient availability in the soil. But summer fallow ereases the organi matter level in the soil sine fewer resiues are returne to the soil. Less soil organi matter means less arbon sequestere in the soil. In aition, the lak of plant resiue over leaves the soil expose to erosion, whih in turn an inrease the salinity of the soil, reue willife habitat an lower water quality. Hene, reuing summer fallow an result in improve water quality an in a reue risk of erosion. Uner this senario, wees are ontrolle by using herbiies an soil moisture an be onserve by reuing tillage. 11

24 The other extreme to summer fallow pratie woul be ontinuous ropping in whih rops are grown every year with no fallow years in between. The result woul be an enhanement in the soil organi matter an in arbon storage. A rop rotation woul provie aitional benefits. A rop rotation woul help not only to buil organi matter but also to reue iseases by breaking their yle, to vary herbiie types in orer to reue the risk of eveloping herbiie resistane, an iversify the operation in orer to lower the proution risk. However, a more iverse rop rotation neessitates inrease management skills. Permanent over is a lan management pratie that is partiularly reommene for areas that are at high risk for suh problems as erosion or soil salinity. Permanent over refers to suh praties as perennial forages that help to buil up soil organi matter, inrease arbon storage, prevent erosion an reue pest problems in subsequent rops. Planting shelterbelts is another management pratie that ontributes in storing arbon. Co-benefits relate to this pratie woul be a reution in the risk of win erosion an a erease in the evaporation of the soil moisture. The proesses of plant proutivity, soil egraation an arbon sequestration are losely linke. Benefiial management praties that inrease the organi matter ontent of the soils typially have a positive impat on air, soil an water quality, as well as improving willife habitat. However, shifting from one management pratie to another is likely to involve some signifiant osts. The new pratie might require hanges in equipment, revising the management of the rop resiues an wees, an moifying the rop rotation in orer to prevent pest problems. These fators, as well as the lak of experiene or the lak of the initiative for hange, might explain why some farmers have not aopte suh praties as reue tillage. Farmers with ifferent harateristis will likely have ifferent inentives to aopt ertain lan management pratie sine they inur ifferent transition osts an must inur ifferent osts assoiate with the new operation. As a result, they might nee an extra inentive to 12

25 swith from one lan management pratie to another. Suh an aitional inuement for aoption of these praties might be the involvement in the arbon offset market by supplying arbon reits through sequestration ativities. This farmer heterogeneity is a key fator of the moel evelope in this thesis. 2.3 SOME IMPORTANT CONSIDERATIONS FOR THE CARBON MARKET For farmers to partiipate in the arbon market they must fin it eonomial to both aopt the BMPs an sign a sequestration ontrat. Signing a sequestration ontrat means a farmer is now require to omplying with the provisions of the ontrat. The ost of this ompliane must be onsiere when etermining whih farmers will partiipate in the arbon offset market. As Young (23) iniates in her paper, the amount of arbon that will be sequestere by a farmer epens on the soil type, the history of the lan an the partiular lan management pratie that will be applie. This range of fators affeting arbon sequestration makes it iffiult to esign a stanarize ontrat. The esigning an signing of the speialize ontrats will a important transation osts to arbon sequestration ontrats. To minimize these osts, it is expete that the government will set out suggeste formats for ontrats, thus saving the ators some legal osts of full ontrat reation (Allan & Baylis, 25). Another alternative that oul reue ontrating osts woul be a pooling system whih is able to sprea the aitional osts assoiate with iniviual ontrats. The pooling option is onsiere in two hapters of this thesis. The esign of the sequestration ontrats is ompliate by the issue of permanene. The arbon store in the soil an be release bak into the atmosphere if the agriultural pratie is hange. The release of arbon an be from natural hazars or from a eliberate hange in the pratie. If the ontrat assumes the arbon is sequestere on a permanent basis than a responsibility exists for someone to repurhase the arbon units that are release in the atmosphere. Sine the trajetory of the prie for arbon offsets is 13

26 unertain at the time of signing the ontrat, the buyers an the sellers fae a risk. If the prie of arbon offsets is high at the time the replaement of arbon reits is neee, then replaing might beome very ostly. Sine the arbon sequestere in soil is expete to be left there inefinitely, the eision to sequester arbon is effetively irreversible; this irreversibility reues the farmers ability to ajust to a new poliy or to withraw for a better alternative. As a onsequene, the option to efer the signing eision has an option value (Verammen, 22). Farmers woul nee to be provie with an option value in orer to make the ontrat profitable. In aition to this option value they might require a premium toay in orer to over the extra risk they unertake when they partiipate in a arbon sequestration sheme. The replaement of the arbon reits an be one through buying other permanent reits, purhasing insurane (if available) or purhasing temporary reits. The temporary reits are ommitte only for a speifie length of time an after this they expire an nee to be replae. The liability for replaement might be issue to the seller of arbon, the buyer, an inepenent broker, an insurer, or an aggregator. Several alternatives to aress the risk assoiate with offset reversal have been suggeste. These inlue the insure reits, temporary reits, partial reiting or time elaye reiting, arbon banks, an renting or leasing of arbon offsets. The option hosen to ope with the permanene issue will influene the transation osts as well as impat the istribution of the osts to the players in the market. Transation osts will play a key role in the suess or failure of the offsets system. Resoures will be neee to enourage farmers to partiipate in the market as well as to evaluate an ertify the arbon reits (Fulton, Çule an Weersink, 25). Taking into aount the ost of these resoures is an important onsieration. One way of lowering transation osts is offsets aggregation. This option an offer both lower risk an lower transation osts. 14

27 It has been propose that the arbon reits reate from sequestration as well as the traing of arbon offsets will be ounte in the national inventory whih has a subomponent fouse on agriulture. The GHG emissions an the soil arbon stok hanges will be estimate by the National Carbon an Greenhouse Gas Emission Aounting an Verifiation System (NCGAVS). As Weersink et. al. (25) point out, this system will use a variety of information soures suh as the Census of Agriulture, inustry assoiation ata, an satellite imagery. This information will onsist of the type of farm ativities, the lan area alloate to these ativities, the level of fertilizer appliation, an loal onitions. The NCGAVS estimations will be base on emission oeffiients an onversion oeffiients whih link the management praties to GHG reutions or arbon sequestrations. These oeffiients will be establishe by using sientifi experiments an omputer simulation moels. Computer moels suh as the Moel Farm Program whih takes into aount the management pratie, the type of soil an the type of rop will be use to etermine the level of emissions an arbon sequestration. The reliability of suh moels will be evaluate further by unertaking measurements at representative farms an researh sites aross the ountry (Agriulture an Agri-foo Canaa, 23b). Still, a level of unertainty exists over the oeffiients that will be use to onvert partiular praties into arbon sequestration amounts (Weersink et. al., 23). The amount of arbon sequestration will be ifferent in ifferent stages of sequestration. The terrestrial sinks are limite by the eosystem apability in interation with the lan management system (Lee., H.C. et al., 23). When applying a sequestering ativity, the soil sequestration potential inreases in the early stage of sequestration until it reahes a peak in a latter stage an then ereases until the soil beomes saturate. Thus, the stage of sequestration takes on a partiular importane in etermining the onverting oeffiients. Farmers may sequester ifferent quantities of arbon at the same point in time for the same lan size epening on whih sequestration phase they are. The analysis in Chapter VI aresses two types of oeffiients that oul be use in an offset pool to link the management pratie to the arbon sequestration. 15

28 Another important onsieration for eveloping a arbon offset traing system is the establishment of the baselines. The baseline refers to the level of GHG emissions or arbon sequestration that ours in a business as usual (BAU) senario, whih means in the absene of limate hange ation. The baseline establishes the stanars against whih the hanges an be measure. The atual emission reution is equal to the ifferene between the atual emissions an those that our uner the BAU senario. Offset reits will be issue only for these aitional tons of sequestere arbon an only these arbon offsets will be eligible to be trae in the arbon offset market. Establishing the baselines requires information about the eonomi trens that affet the output of the sequestering ativities, historial knowlege of lan management praties in ertain areas as well as other regional-speifi information. A number of methos have been propose for establishing the baselines suh as a ase-by-ase basis, a generi approah base on regional averages, a ynami approah whih aounts for future hanges or trens, an an approah that uses omparison to similar projet benhmarks (Government of Canaa, 25b). Eah of these approahes will be assoiate with some osts whih will a to the transation osts of the arbon traing system. The more ompliate is the approah, the higher are the assoiate osts. These higher osts will result in higher transation osts an a erease in the attrativeness of the arbon offset traing option. Lak of aitionality has been one of the main soures of ritiism of arbon offsets supplie by agriulture through no tillage. For instane, the CCX has been ritiize on these groups. As state from Kollmus et. al. (28), there were several oumente instanes where farmers reeive arbon offset revenue for pratiing no-till agriulture espite the fat that these farmers ha been pratiing no till for many years alreay (Page 7). Rewaring farmers who have been pratiing no-till with arbon offsets unermines the integrity of arbon offsets sine the buyer of arbon offsets will ontinue to emit while no further emission reution is ahieve from those farmers. CCX argues that it woul be unfair if the farmers who have been engage in no-tillage pratie for many years annot sell their arbon reits. Aressing this fairness issue 16

29 woul require other measures suh as tax/subsiy treatment an isounting of reits (Kollmus et. al. 28). The arbon traing system will require some form of monitoring an verifiation. An offset reit will be grante only for the units of reution or removal that are genuine. This neessitates the nee for a verifiation of the baselines an the hanges in the arbon stok. Beause of the value assigne to the arbon offsets in the offsets market, the farmers will have inentive to over report the arbon offsets reate from their sequestering ativities; thus monitoring an verifiation is ruial in ensuring farmers ompliane. As long as monitoring is not perfet, non-ompliane will be an issue. The non-ompliane issue is one of the main issues aresse in this thesis. The ost of monitoring an verifying the amount of arbon that has been sequestere will be an important omponent of the transation osts. One option for minimizing these osts will be a pooling option whih makes ost sharing possible. This alternative involves sharing of the fixe osts an enables farmers to benefit from eonomies of sale present in supplying arbon offsets. A pool an hanle large volumes so that per unit monitoring osts an be kept low. This solution, however, leaves open questions about the willingness of farmers with large sequestration potential to partiipate sine they might benefit more from partiipating in the arbon offset market as inepenent iniviuals rather than as part of a pool omprise of other farmers with ifferent sequestration potential. The free riing issue is one of the main issues explore for the pooling option. In suh a setting, farmers have an inentive to shirk on their ontribution an free rie on the ontribution of others (Harris et. al., 1998). Farmers who free rie attempt to benefit from gains reate by the pool without sharing in its osts. This woul negatively affet the benefits that farmers who o not shirk an obtain from using the pool option. Hene, the free riing problem is an important onsieration that shoul be taken into aount by the pool when making its priing an monitoring eisions. The last part of Chapter V explores further this ase. 17

30 2.4 CONCLUSIONS The global ommunity has reognize the hallenge of limate hange. Countries are searhing for solutions an are taking ations to ombat the problem. Agriulture is onsiere as a potential ontributor to the reution of GHGs. Part of this ontribution oul ome through soil arbon sequestration. This hapter explores the main lan management praties that are likely to play a signifiant role in enhaning soil arbon retention. The aoption of these praties shoul be supporte by poliy esigns that provie eonomi benefits to the farmers as well as enourage environmental benefits. Poliy esign for agriultural soil arbon sequestration is ompliate by suh issues as ontrat esign, non-permanene, baseline establishment, an monitoring an verifiation issues. Eah of these issues will have an effet on the inentives require to enourage prouers partiipation in the offset market an on the suess of the offsets system in reuing GHG emission in the most effiient way. These issues are aresse by the researh in this thesis. 18

31 CHAPTER III THE ECONOMICS OF CLIMATE CHANGE AND NON-COMPLIANCE 3.1 INTRODUCTION The problem of limate hange has been wiely treate by various eonomists in their researh work. This hapter examines how the environmental regulation literature in general an the limate hange literature in partiular have evolve through the years. Setion two fouses on the effiieny properties of market base instruments. Setion three examines how this effiieny property is affete when ifferent assumptions are relaxe. Setion four onentrates on agri-environmental poliies an the farmers behaviour uner these poliies. The arbon offsets option an ompliane monitoring is the fous of the fifth setion. The hapter onlues with an examination of the ontribution of this thesis. 3.2 EVOLUTION OF THE ENVIRONMENTAL REGULATION LITERATURE Sine the reognition of environmental problems suh as pollution, environmental eonomis has beome an important subjet within eonomis. In an eonomi ontext, soiety s welfare is maximize when soial marginal benefit equals soial marginal ost. An environmental problem arises when a market failure prevents the equalization of the soial marginal benefit with the soial marginal ost. Suh a situation an our as a result of an environmental externality suh as GHG emissions. In the ase of an externality, the private an soial osts will iverge. Environmental eonomis reognizes this ivergene between private an soial osts. As van Kooten (24) states, environmental eonomis is all about measuring non-market values, 19