A Regulatory Framework for Carbon Capturing and Sequestration within the Post-kyoto Process

The option of capturing CO2 at large power stations and storing it in geological formations allows for the use of fossil energy resources without further destabilization of the climate system. From an economic point of view, the efficiency of Carbon Capturing and Sequestration (CCS) depends mainly on leakage rates, marginal costs of CCS (including the energy penalty) and the volume of available depositories. We show that if CCS is to become an option to buy time, a regulatory framework is needed. In particular, a framework has to be designed that creates incentives for profit-oriented firms and investors to reduce leakage rates as well as energy penalties, and to deposit carbon in safe depositories only. A generic model is presented in order to clarify the economics of CCS. The paper proposes a new instrument called Carbon Sequestration Bonds (CSB). It is shown that CBS must be combined with a CO2 tax or a tradable permit scheme in order to encourage firms to sequester the optimal amount of carbon. We discuss two version of this instrument: In the first version, a firm which intends to store carbon dioxide in geological formations has to buy a bond. The bond will be devalued by some kind of environmental authority after a fixed transmission time of the bond according to the fraction of leaked CO2. Proportional to the stored fraction of CO2, however, the company would obtain interest for the bond. A company can sell its bonds already during the transmission time if other agents on the market are ready to bear the risk of devaluation of the bond. It is argued that this system creates an incentive for firms to undertake CCS investments and at the same time to use relatively safe geological formations. In the second version of our proposal, emission permits have to be bought as long as it is not clear to which degree the geological formation is leaking. The permit can be traded on the market by CCS firms. If market agents trust in low leakage-rates, firms can sell their permits immediately. However, the value of the permit is uncertain as long as it is not proven which fraction of the carbon will stay underground. Over time, uncertainty on leakage rate can be expected to shrink for each individual formation. Based on this information the environmental authority decides sequentially how much carbon is accepted to be indefinitely stored in geological formations. Thus the second proposal reduces the ecological risks of CCS and increases the economic risks because investors may be discouraged to invest in CCS.