Noncompliance, monitoring and the economic theory in carbon trading market

Addressing climate change is a major undertaking. Agricultural soil has the potential to assist in decreasing the concentration of GHGs in the atmosphere by storing CO2 in the soil. Carbon offset markets have been suggested as a cost effective means of reducing GHG emissions. Farmers can increase their soil sink potential by applying Beneficial Management Practices (BMPs) that enhance carbon sequestration through improvements to soil, nutrient and livestock management practices (Fulton et. al., 2005). Whether or not a market for carbon offsets will emerge depends on a number of factors which mainly are related to the profitability of the BMPs and the costs of implementing a carbon contract. Provided that a market for carbon offsets emerges, the effectiveness of the market depends, in part, on the degree to which buyers and sellers in the market comply with the terms of the contracts they sign. The resource costs associated with monitoring and verification may result in incomplete monitoring. As long as monitoring is not perfect, non-compliance will be an issue. The analysis that will be performed in this thesis introduces non-compliance in the economic analysis of carbon-offset market. The purpose of this work is to examine the overall cost effectiveness of the carbon-offset market when introducing non-compliance. Firstly the theoretical model investigates the incentives for different farmers to participate in the carbon offsets market as well as incentives for engaging in cheating. The model recognizes farmers’ heterogeneity with respect to cost differences and examines the economic determinants of farmers’ non-compliance as well as the consequences of non-compliance on the performance of the carbon-offset market. Results support the standard finding that the extent of producers’ non-compliance decreases with an increase in the audit probability and/or an increase in the penalty per unit of non-compliance. In addition, the number of producers participating in the carbon offsets market is shown to increase with an increase in the carbon-offset price. The analysis then introduces intermediaries in the market that will take care of trading carbon offsets as well as monitoring producers. The traders’ role in this study is played by an IOF (investor owned-firm) or a PA (producers’ association). Within the IOF, the analysis focuses on the monopoly and oligopoly structures. The key role of the traders is to guarantee, based on the amount of monitoring that is undertaken, that the emitters purchase only carbon offsets that actually correspond to sequestered carbon. The analysis then examines three cases for the group that monitors farmers’ compliance – a group owned by for-profit traders, a government-run agency and a group owned by the PA trader. This part of the thesis examines what impact the involvement of the traders in the carbon-offset market has on non-compliance, as well as how the structure of the monitoring group affects non-compliance and the amount of carbon offsets traded in the market. The results of the analysis show that the monitoring groups always undertake sufficient monitoring to ensure that full compliance is achieved – thus, while non-compliance is possible, it does not occur in equilibrium. The finding suggests that the formation of a government monitoring agency can potentially increase traded output and lower the price paid by emitters, still these changes are likely to be small, particularly when the trading sector is monopolistic. The overall analysis in this chapter shows that the optimal amount of enforcement, and as a result the cost effectiveness of a carbon-offset market, depends on the nature of the organization that undertakes the enforcement. The next consideration of the thesis is the heterogeneity attributed to the timing of sequestration by different farmers. The analysis focuses on the carbon offsets pooling by considering two structures for the aggregator: a for-profit aggregator and a producers’ association. Pooling resources enables the farmers to benefit from economies of scale. The pricing schedule used by the aggregator is a two-part tariff. The two-part tariff is used as a way of providing an incentive for the farmers sequestering large amounts of carbon to participate in the pool. The study considers two alternatives for the coefficients that might be used to decide on the amount of carbon offsets to which each farmer will be entitled: default coefficient and custom coefficients. Each situation is modeled in a principal agent framework. The analysis examines how the aggregator will target the monitoring service for different group of farmers. The investigation reveals that, under different scenarios, a PA or a FPA (for-profit aggregator) might lead to the formation of a heterogeneous pool or a homogeneous pool of each type. The last issue investigated in this dissertation is the coexistence of a FPA and a PA in the default coefficient case. The analysis show that both aggregator structures can exist together in the market in the same time if the savings in the monitoring costs made possible by the PA are smaller than the cost of organizing the pool. If this condition is not satisfied the FPA cannot survive in the market and the producers’ association will dominate. In addition to providing a better understanding of how the carbon-offset market may perform when introducing non-compliance, the results of this study can assist in assessing the cost effectiveness of the carbon-offset market when enforcement is undertaken by different organizations. Furthermore, the last consideration of the pooling option might help in selecting which type of pool – a heterogeneous or a homogeneous one – might perform better under different alternatives