The Society of Actuaries (SOA) Research department holds an annual Student Research Case Study Challenge. The program provides undergraduate participants an opportunity to apply their growing set of actuarial skills to a real-world problem. Participants in the 2020 competition were asked to create a carbon credit program for the fictional country of Pullanta that “encouraged reducing carbon emissions and generated revenue to fund climate change mitigation.”1 A fictional data set accompanying the case study tracked emissions data for each major company in Pullanta, with industry classification and other key information included.
Case study entries take the form of a written report of no more than 2,500 words. The word limit is a merciful feature for the judges, but more important, it forces participants to develop clear and concise responses to a robust set of questions. (In fact, the document that presents an overview of the case study and outlines the requirements weighs in at 2,950 words.) Everything from program design and implementation, discussion of data sources, limitations, assumptions, revenue/expense projections and evaluation of the risks of extreme deviations from assumptions is included. The required thoroughness of the proposals makes for some impressive entries.
A team from Arizona State University, with the team name “Emission: Impossible,” won the 2020 competition. Speaking of the winning team’s submission, a judge said: “Team Emission: Impossible, besides the routine actuarial analysis, realized the importance of providing the government with concrete recommendations on regulation. While most teams realized that remedies to the emission problem had to be done by sector, Team Emission: Impossible also recommended a unique floating bond for sectors with unique challenges.”
Another judge noted, “I liked Team Emission: Impossible’s ‘nearest neighbor’ methodology, where a comparison [of] attributes [from] several countries was used to derive the social cost of carbon development for the country in the case study.”2
The remaining sections of this article were written by the winning team (Brady Lybarger, Walker Reinmann, Kinsey Turk and Joseph Hoffman) to summarize their work. The full submission, along with the 2021 case study currently underway and winning entries stretching back to 2016, can be viewed on the SOA website.
Pullanta Case Study Review
Team Emission: Impossible’s program had two primary goals. First, companies needed active encouragement to reduce emissions over a long-term time frame. Second, the program must generate sufficient revenue for the government to maintain the program over its operational lifespan and fund further climate change efforts. The program was specifically designed to address these two objectives as directly as possible while avoiding the pitfalls that can affect credit systems as a whole.
The companies in Pullanta would be allowed to emit 1,000 metric tons of carbon per year for free, which allows very small companies to avoid the financial burden of paying for their relatively minor emissions. Companies that want to emit more than that set rate have the option to choose among three “emission bonds” that would provide credits every year for the next 10 years. Each credit would permit the company to emit 1 metric ton of carbon in that year. The number of credits given per year would decrease over the bond’s lifespan, forcing the company to reduce its yearly emissions over a long-term period. The three bonds (named bronze, silver and gold emission bonds) would allow the company to choose the rate at which it decreases emissions. The faster-decreasing bonds would be offered at a discounted price, encouraging more active reduction.
Figure 1: Yearly Carbon Credits Awarded by Bonds
Hover Over Image for Specific Data
The bond design for team Emission: Impossible’s program has one exception, which is applied to companies in the transportation sector. The transportation sector was identified as having unusually high emission increases per year, so a new instrument for only this sector was designed to encourage a more active reduction in yearly emissions. This instrument, called the transportation emission bond, would deliver credits yearly, akin to the previous bonds. However, the number of credits offered would be based on the sector’s emission reductions in the previous year. For example, if the transportation sector showed large reductions in emissions in a year, the program would reward the companies with more credits the next year.
To generate revenues for the government, the bonds would be sold at a value relative to the number of credits they are expected to disperse. In addition to this revenue, which would primarily be collected in the first year of the program, the government would profit from a closed secondary market. The secondary market would allow companies that may have extra credits in a year, either due to purchasing more bonds than necessary or through rewards from transportation emission bonds, to sell them back to the government at a slightly reduced value. These credits can then be sold to other companies at a slightly increased price, which generates extra revenue for the government while providing a financial safety net to protect companies from purchasing too many or too few carbon credits.
To find prices for the emission bonds, the price of a single carbon credit was equated to the social cost of carbon, which is a financial approximation of the impact of emitting a ton of carbon into the atmosphere. The social cost of carbon for Pullanta was approximated by finding countries with similar ecological features to Pullanta and averaging their social costs of carbon. This approach allowed for the creation of a price for the emission bonds, which companies could buy upfront or pay over a 10-year payment plan.
Solutions for Common Pitfalls
Team Emission: Impossible’s program was designed to address some of the most significant issues that can arise from a credit program. One such potential problem is placing too great of financial stress on companies, which would cause companies to decrease production or move out of the country altogether. This risk is addressed by allowing a base level of 1,000 metric tons of carbon to be emitted per year and establishing a guaranteed buyback of unused carbon credits.
Another common issue in credit programs is the phenomenon of larger companies using the program to choke out competitors by buying up credits and reselling them for a profit. The program’s closed secondary market would prevent companies from selling directly to others for increased prices and only would allow credits to be sold to the government for a reduced cost. Big companies would only incur notable losses if they attempted to buy up all of the available credits.
The final concern with the implementation of a credit program is its failure to actually reduce long-term emissions. This is mitigated by charging companies an expensive penalty for emissions higher than the allotted amount in their credit portfolios.
Many other risks and data limitations were taken into consideration in the design of this program, as well as tests for changes in base assumptions. The revenue and emissions per year were tested against modest and extreme changes in assumptions, such as interest rate and company activity in the secondary market. The program’s expected revenue and emissions appear to be sufficient to achieve its emission reduction goals and self-funding.
To apply a program like this to a real country would require more comprehensive data about the government and businesses, so expenses could be better predicted and changes could be made during the program’s lifespan. However, just from this analysis, the benefits of such a program on the environment would be noticeable for a country of any considerable size, and many of the risks could be mitigated with careful design and implementation.
Statements of fact and opinions expressed herein are those of the individual authors and are not necessarily those of the Society of Actuaries or the respective authors’ employers.
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