1 Permanence Discounting for Land-Based Carbon Sequestration Man-Keun Kim Joint Global Change Research Institute University of Maryland Bruce A. McCarl Regents Professor of Agricultural Economics Texas A&M University Brian C. Murray Director Center for Regulatory Economics and Policy Research RTI International Presented at USDA Symposium on Greenhouse Gases & Carbon Sequestration in Agriculture and Forestry March 2005 Baltimore, MD

2 Conclusion First, Are offsets fungible? No, offsets are not fungible due to permanence issues such as saturation and volatility So, permanence considerations could affect the terms of trade for (potentially) land-based carbon sequestration and permanent emission reductions (fuel change, direct reduction etc.)

3 Presentation Outline/Study Objectives Examine market consequences of permanence characteristics of biological carbon sequestration Develop a grading standards approach Derive a permanence related grading standard discount Investigate the empirical magnitude of the grading standard permanence discount

4 Biological Sequestration and Permanence Approach to Equilibrium/Saturation - differential rate of accumulation over time and a long run decline to a near zero rate of net sequestration when carbon inputs and carbon decomposition reaches equilibrium Volatility - sequestered carbon can be rapidly released back to the atmosphere if practices are reversed Contract terms - influence offset value and involve project duration payment terms including possible maintenance

5 Saturation of Sequestration in Ag Soils and Forests West and Post, Oakridge NLBirdsey et al, USFS, FORCARB Note saturation by year 20Note saturation by year 80 Absolute Change in the Annual Rate of Carbon Sequestered Following a Change from Conventional Tillage (CT) to No-Till (NT) - (West and Post 2002)

6 Permanence and Grading Standards The question is whether the permanence concerns associated with sequestration may alter the value of the resultant carbon offset to purchasers in the market place Offsets are not fungible – from an offset purchaser’s point of a view, an impermanent sequestration asset may be worth a different amount than permanent offset In turn prices may differentiate based on permanence characteristics like a grading standard

7 Grading Standards Market grading standards Gasoline prices by octane level #2 Yellow corn, CD plywood, Long staple cotton etc Items receive a price premium/discount depending upon their characteristics and the consumer value of those characteristics Biological carbon sequestration may have consumer characteristics in terms of claimable quantity of offsets over time or cost due to permanence / dynamic flow of offsets

8 Deriving a Permanence Discount Suppose we consider two alternatives Perfect alternative without any permanence issues Imperfect alternative with permanence issues and a potentially discounted price Equate the effective cost per ton and solve for discount

9 Cost per ton Take cost paid divided by tons obtained But tons and cost arise over time Effective cost per ton (PE) today for perfect (permanent) offset P t – current and future carbon price, Q t – quantity of offset T is duration of the contract

10 Permanence Related Terms in Cost Buyback - At the end of the sequestration contract or when things like forest harvest occur, the purchaser has to buy new offsets to cover those previously held through the sequestration contract Maintenance cost – terms in the contract to compensate for efforts to maintain sequestered carbon that are not a pure function of quantity by year

11 Components of Cost Several relevant terms Price paid for carbon in year t Permanence discount Buyback after contract expires or when release occurs Maintenance cost independent of carbon quantity PE today B t – buyback, M t – maintenance cost, PDisc – permanence discount

12 Deriving a Permanence Discount A perfect offset has PDisc=0, without maintenance cost or buyback Assume a constant carbon price, P 0 PE equals the price for the perfect prospect

13 Deriving a Permanence Discount Now suppose we equates the cost per ton from an imperfect with a perfect prospect and solve for the permanence discount (PDisc): We assume a constant carbon price, P 0 This may be solved for solving for PDisc

14 Resultant Permanence Discount Permanence discount (PDisc): When is discount zero - No Buyback - No Maintenance cost

15 How Big is the Discount? Agricultural soil carbon sequestration 25 year lease with 100% buyback – approximately 49% price discount Maintenance cost at $5/acre – approximately 36% price discount Afforestation Harvest year 20 without reforestation – 52% Harvest year 20 with reforestation – 23% Harvest year 50 without reforestation – 20% Harvest year 50 with reforestation – 7%

16 Implications and Conclusions Permanence discount indicates the amount that the offset price would be reduced to reflect the alternative characteristics of the non-permanent offset Permanence considerations could substantially affect the terms of trade for (potentially) temporary carbon sequestration and permanent emission reductions Temporary storage may be an interim strategy (bridge to the future) Temporary storage may be an interim strategy (bridge to the future) but will face discounted prices if projects expire or maintenance costs involved