Optimal two-part pricing in a carbon offset market: a comparison of organizational types.

AuthorFulton, Murray
  1. Introduction

    One of the consequences of the Kyoto Protocol (KP) and the increased focus on the role of greenhouse gases (GHGs) in climate change is that market-based approaches to reducing GHG emissions are being actively developed. In Europe, the European Union (EU) operates an emissions-trading scheme (ETS), (1) while in the United States, the Chicago Climate Exchange (CCX) trades carbon offsets among exchange members. (2) In Canada, a number of provinces have announced plans for carbon-trading schemes; four of them have joined the Western Climate Initiative (WCI), a consortium of Canadian provinces and states developing a regional cap-and-trade system (WCI 2008). The WCI and the Regional Greenhouse Gas Initiative (RGGI), a consortium of Northeastern and Mid-Atlantic states (see RGGI 2008), are part of the International Carbon Action Partnership, a group of countries and regions from around the world that has formed to actively pursue the development of mandatory cap-and-trade systems in carbon. (3)

    The agriculture and forestry sectors are likely to be important suppliers of carbon offsets to the carbon market, both through carbon sequestration activities (for example, the storing of carbon in the soil or in trees) and through activities that reduce GHG emissions. For instance, estimates made by the United States at the time the KP was being negotiated projected that forest, cropland, and grazing land management sinks could have accounted for about half of U.S. reduction commitments (U.S. Department of State 2002). In Canada, the federal government estimated that agricultural and forestry sinks could provide in the order of 15--20 million metric tons of carbon offsets relative to a total of 270-300 million metric tons of reductions required under the KP (Government of Canada 2005). Food and Agricultural Organization (FAO) estimates indicate that dryland soils in the world could sequester somewhere in the range of 12,000--16,000 million metric tons of carbon (FAO 2004).

    In the case of agriculture, since carbon offsets are sold in units that are much larger than most individual farmers can supply, carbon sequestration from a number of producers must be aggregated to fulfill contracts. (4) As a consequence, market intermediaries--or aggregators, as they are known--are emerging to perform this economic function. Some of these aggregators are organized as for-profit firms, while others are organized by farmers' associations. Examples of for-profit firms are as follows: C-Green Aggregators Ltd., a privately owned company that contracts with farmers in Manitoba, Saskatchewan, and Alberta for carbon sequestration (the carbon they acquire is sold on the CCX; C-Green Aggregators 2008); and AgCert International, an Irish company founded to generate emission reductions from livestock farms (AgCert International 2008). Much of AgCert's sales of carbon credits has been direct to individual emitters. On the producer association side, the Iowa Farm Bureau has created AgraGate Climate Credits Corporation to aggregate carbon credits for sale on the CCX (AgraGate Climate Credits Corporation 2008). AgraGate administers the project, transacts trades on the exchange, and distributes earnings to project participants.

    The pricing structure used by the aggregators varies according to the type of project, among other things. For instance, for carbon sequestration projects, AgraGate and C-Green use only a variable fee. Farmers are paid a per metric ton [CO.sub.2] equivalent fee equal to the carbon price obtained from the CCX less a service fee; AgraGate charges a 10% service fee, while C-Green charges a 15% service fee (AgraGate 2008; C-Green 2008). (5) In contrast, AgCert takes possession of the carbon credits created through manure lagoon projects and receives the revenue from the sale of these credits. Farmers pay a portion of the cost of the lagoon; in return, they receive direct financial benefits in the form of lower manure handling costs (they also receive nonpecuniary benefits in the form of better odor management and other environmental gains). This pricing structure represents the aggregator taking a large mark-up (farmers receive no variable payment) and paying the farmer a negative fixed fee (farmers pay only a portion of the fixed cost).

    The emergence of aggregators, and particularly those operated by producer associations, raises questions around the mix of variable and fixed fees that aggregators can be expected to use. There is a sizeable literature involving optimal two-part pricing by a monopolist or public agency that sells to heterogeneous consumers or buys from heterogeneous firms (for example, Oi 1971; Ng and Weisser 1974; Leland and Meyer 1976; Auerbach and Pellechio 1978; Ordover and Panzar 1982; Laffont and Tirole 1993). This literature shows that the sign and size of the optimal fixed fee and the extent to which the optimal variable fee is raised above marginal cost depend on the relative responsiveness of consumption/production and participation to the pair of pricing variables. In general, optimal pricing by a monopolist is a scaled-up version of optimal pricing by a budget-constrained public agency because inverse elasticity pricing underlies both the variable and fixed fee pricing formulas.

    The purpose of this article is to examine optimal two-part pricing by an aggregator in the carbon sequestration market. In addition to constructing a framework for evaluations of the emerging carbon offset market, the article makes two contributions to the theoretical literature on efficient pricing with two-part tariffs. First, we derive specific pricing formulas for a market intermediary that simultaneously has monopsony power with respect to upstream purchases and monopoly power with respect to downstream sales. This implies that three elasticities--inframarginal supply by farmers, participation by farmers, and demand by the large final emitter (LFE)--are combined within each optimal pricing equation. With the exception of Ordover and Panzar (1982), the firm setting the two-part tariff in the standard pricing models has either monopsony or monopoly power, and so there are just two elasticities within each pricing equation. The analysis also pays particular attention to the properties of the farmer participation elasticity because the size of this elasticity largely determines whether farmers pay a fixed participation fee or receive a signing bonus when contracting with the aggregator. For instance, we show that the negative fixed fee paid by the aggregator in the manure handling case is consistent with a relatively elastic participation elasticity for farmers. In contrast, the pricing structure observed in the soil carbon sequestration case is consistent with the participation elasticity and the inframarginal supply elasticity being roughly the same.

    The second theoretical contribution of the article is that it considers the pricing decisions of three different organizational types: a for-profit firm, a public agency, and a producer association. A public agency is included because this organizational form has been the focus of a great deal of the literature on optimal two-part tariffs; the public firm also serves as a useful benchmark for the pricing behavior of the other two organizational types. The for-profit firm and the producer association are examined because they are the organizational forms emerging in the carbon offset market. Consideration of the producer association is particularly important since the optimal two-part tariff for this organizational form has not been extensively examined in the literature. (6) As will be seen, the three elasticities discussed here enter the pricing decisions of the producer association in a rather counterintuitive way because the goal of the producer association is to restrict output in order to raise the price paid by the LFE while continuing to earn zero profits.

    The paper is structured as follows: Section 2 describes the formal model required for the analysis. Section 3 derives the optimal pricing equations for the profit-maximizing monopolist and the public agency, while section 4 gives the main pricing results for these two organizations, first under the assumption that the key elasticities are fixed, and then more generally. Section 5 compares the pricing decision by a producer association and a public agency, and section 6 presents a discussion and concluding comments.

  2. The Model

    The model is a standard static partial equilibrium model of a vertical economic system.

    There are four agents in the system: (i) a competitive large final emitter of GHGs; (ii) a group of heterogeneous farmers that can potentially produce carbon offsets; (iii) an aggregator that serves as an intermediary in the carbon offset trading market; and (iv) an industry regulator.

    The setup in this model is similar to that in Ordover and Panzar (1982), who examine optimal pricing by an upstream monopolist who sells to firms that in turn sell to a competitive downstream market. In both their model and the one in this article, the choice of pricing variables affects the aggregate volume of production, which in turn affects the final downstream price faced by competitive agents. Ordover and Panzar (1982) allow for general nonlinear pricing with heterogeneous firms and only restrict their attention to two-part pricing when firms are assumed to be homogeneous. The analysis in this article is unique in the literature because it focuses on two-part tariffs with simultaneous upstream and downstream pricing and firm heterogeneity. (7)

    The analysis begins with an in-depth examination of each of the agents.

    Regulator

    The regulator is passive in that it specifies a maximum level of emissions, [bar.x], for the LFE, but it provides this firm with the option to purchase carbon offsets for emission levels that exceed [bar.x]. This threshold amount is exogenous to the analysis. For example...

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