The Effect of Allowing Pollution Offsets with Imperfect Enforcement

Several pollution control regimes, including climate change policies, allow polluters in one sector subject to an emissions cap to offset excessive emissions in that sector with pollution abatement in another sector. The government may often find it more costly to verify offset claims than to verify compliance with emissions caps, and concerns about difficulties in enforcement may lead regulators to restrict the use of offsets. In this paper, we demonstrate that allowing offsets may increase pollution abatement and reduce illegal pollution, even if the government has a fixed enforcement budget. We explore the circumstances that may make it preferable to allow offsets when enforcement is costly. When the government imposes a limit on emissions from firms in a particular sector of the economy, regulators may allow those firms to exceed their limits as long as they purchase enough pollution abatement in another sector to offset their own excess emissions. Allowing offsets can reduce the cost of emissions control, extend incentives for technological change to a broader range of economic activities, and develop capacity for pollution reduction in other countries. EU climate policy, current regional and proposed national US climate policies, and the US Clean Air Act all allow offsets (Broekhoff and Zyla, 2008). Offsets remain controversial, however, especially in climate policy (Wara and Victor, 2008). The difficulty of enforcing offsets is sometimes seen as a reason for restricting their availability. Offsets may prove difficult to enforce for several reasons. First, pollution in the capped sector is often from point sources, whereas offsets may include more diffuse sources that are not easily monitored through traditional compliance inspections. For example, changes in agricultural or forestry practices to store carbon in soils might be allowed to generate offsets in a climate policy that caps emissions from power plants. Second, regulations may require providers of offsets to demonstrate “additionality,” that is, that activities that create offsets in fact reduce pollution in that sector relative to business as usual (Montero, 1999; Bushnell, 2010). The public enforcement agency may find it costly or difficult to verify these claims of additionality. Finally, many policies allow offsets generated abroad, which may complicate verification and raise the costs of enforcement. For example, many offsets used in the EU Emission Trading System (ETS) derive from hydroelectric and wind projects in China (Capoor and Ambrosi, 2009), where corruption may pose a larger problem than in the European capped sector. In this paper, we study the role of offsets in a model of pollution control policy with imperfect enforcement. The previous literature has not considered questions of desirable market breadth with heterogeneous enforcement costs or of whether to allow firms in a capped