It’s great that climate change returns to the Senate agenda this week. The Clean Energy Jobs and American Power Act, introduced by Sen. John Kerry (D-Mass.) and Barbara Boxer (D-Calif.) seems to be gaining some momentum, but the slow pace in the Senate makes it extremely unlikely that a vote will occur before the forthcoming U.N. climate conference in Copenhagen in December.

Failure to move a bill means it will be difficult negotiators to cut deals on future emissions targets in Copenhagen. Even so, the climate talks are likely to see progress on deforestation issues, Clean Development Mechanism (CDM) reform, and, perhaps, some advancement in the understanding of sectoral mechanisms.

Kerry-Boxer is probably as tough as any bill can be in the Senate. This is not necessarily a bad thing; I think that the bill is a great step in the right direction; establishing a cap-and-trade scheme in the United States will provide the right incentives for American industries to reduce emissions in the most cost-effective way. However, as drafted, Kerry-Boxer contains a number of international carbon offset policies that are likely, if they remain unchanged, to result in wild price swings and radical shifts in offset supply. This in turn will significantly undermine the ability for U.S. companies to use investments in international offsets as a cost-containment mechanism.

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What is the principle problem? The Senate, like the House-passed Waxman-Markey legislation, does treat offsets as a good cost-containment mechanism. The difference between the two, however, is where the offsets could/should come from. More specifically, the Waxman-Markey bill would allow 1 billion domestic offsets and 1 billion international offsets, for a total allowance of 2 billion. In the House bill, if the Environmental Protection Agency determines that the volume of domestic offsets is likely to be less than 900 million (and it certainly looks like it will be as the EPA has estimated the maximum domestic supply will be in the region of 500 million), then international offsets could be expanded up to 1.5 billion tons every year.

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The Senate proposal is not as generous on international offsets; Kerry-Boxer sets an unrealistic ceiling for domestic offsets at 1.5 billion tons, and reduces the acceptable volume of international offsets to 500 million every year. The EPA could allow up to 1.25 billion tons of international offsets if it determines, on an annual basis, that domestic offsets are likely to generate less than 900 million tons.

This provision is very problematic for those companies covered by cap and trade. The offset provisions of the bill need to be structured to create a steady supply of offsets and a market that sends a clear, predictable price signal to the private sector. As the bill currently stands, its offset provision would create tremendous uncertainty about the demand and admissibility of international offset credits into the U.S. market.

To rectify this, the Senate should allow the EPA to review the expected domestic supply in the first year of enactment and determine the likely supply of domestic offsets in order to reset the allowed volume of international offsets to realistic levels. The EPA could subsequently monitor the market regularly, but not with a mandate to reset offset ceilings annually.

Alternatively, any adjustments to the proportion of international offsets that are allowed into the United States could be treated as a “high-water mark.” In other words, if the proportion of international offsets allowed into the United States is increased to compensate for lack of domestic supply, this should represent the new minimum volume for international credits. The proportion should not be adjusted downward from one year to the next because, as mentioned earlier, it could prevent American companies from investing in new offset projects.

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International offset supply gets even more problematic when considering how proposed sectoral mechanisms would work across industry segments and geographies, and how they may interact or overlap with the CDM. In brief, it is essential that a transition to a sectoral mechanism is well thought through and does not present a disruption in the long-term price and demand signals to players in the private market.

This transition would mean that any CDM project that is registered before the start of the relevant sectoral mechanism should have its crediting period honored. Alternatively, the project developer should be given the option to transition to the sectoral mechanism within a certain period of time, say two years.

As it stands, Kerry-Boxer remains silent about how these pre-existing CDM projects would be treated, and indeed, it looks like it would simply stop issuing international offsets after 2016 for any project determined to be covered by a sectoral mechanism. This would create a disincentive for companies to invest until a sectoral mechanism is in place, losing tremendous opportunity for early action across the world. We have already seen how a lack of a long-term policy and price signals have disrupted the number of new projects entering the CDM in the last couple of years.

A special concern of mine relates to how credits from Reducing Emissions from Deforestation and Degradation (REDD) efforts will be brought to market. But stay tuned and find out more about this in my next post.