Abstract

When included as part of a larger emissions rights trading system, carbon offset projects can automatically achieve a given reduction of emissions in a cost-effective manner. One major concern with this system, however, is the risk of emissions reversal-the deliberate or accidental release of carbon back to the atmosphere long after carbon credits have changed hands. This downside risk may adversely affect the market value of offset credits and undermine the integrity of the carbon trading system. To address this weakness, at least two financial responsibility rules have been proposed. One calls for the imposition of liability, ex post, upon project developers. The other alternative, an ex ante measure, requires that project developers have adequate liability insurance coverage prior to undertaking any offset projects. Taking the view that project developers can control the severity of financial losses arising from reversal and assuming a negligence rule of liability for harm, this paper employs the methods of mechanism design to examine the impact of ex-post liability rules and ex ante liability insurance requirements on incentives to reduce risk. We find that the relative ranking of these two rules crucially depends on the extent of uncertainty regarding the legal standard under liability rules: if uncertainty regarding the legal standard is sufficiently large, then incentives are more pronounced under insurance rules than under liability rules; if the uncertainty regarding the legal standard is sufficiently small, however, then the converse is true.