OR43 OPERATIONS RESEARCH SOCIETY CONFERENCE

UNIVERSITY OF BATH UK. SEPT 2001

Carbon Credits Flawed Solution to a Systemic Problem

Keith T Linard
Director, Centre for Business Dynamics & Knowledge Management
University of New South Wales (Australian Defence Force Academy)
CANBERRA ACT 2601 AUSTRALIA
Tel: -61-2-6268-8347 Fax: -61-2-6268-8337
E-mail : keith#@#yahoo.co.uk

ABSTRACT:
This paper reports a systems dynamics research project, conducted for an Australian firm planning to
specialise in carbon sequestration and offsets projects, to understand the financial viability of a carbon
credits business.1 The project set out to identify and analyse the key systemic interrelationships
between increasing community sensitivity to greenhouse issues, government policies designed to
achieve carbon emissions control, the economics of the emitting firms and the economics of firms
establishing particular carbon credits sequestration options.
The modelling suggests that purchase of carbon credits, as an emissions offset strategy, is a desirable
short term option (3 to 5 years) for industrial firms, and a viable medium term option (5 to 10 years) for
power generation utilities, as they seek to maximise return from existing capital investment. However,
the taxation and pollution penalties policies necessary to make firms seek such a solution will change
the economics of alternative energy options and of industrial processes, thereby reducing the demand
for carbon sequestration. The economic viability of forestry based carbon offset projects, on the other
hand, require long lifetimes to show an economic return.
Keywords: Greenhouse gas; carbon credits; environmental economics; system dynamics modelling.

BACKGROUND
This project details the conceptualisation, formulation and development of a system dynamics model of
using carbon credits to offset carbon emissions. The model was prepared for an Australian company
which had developed a formal business plan for investing in forests for CO2 emissions offsets. The
companys original analysis suggested that being an early starter in this field could reap it significant
financial benefits. The focus was on the viability of national carbon credits marketplace, which was
seen by the client as a prerequisite to investment, given the planning uncertainties associated with the
development of an international market for carbon credits.
The project drew on public data from the Australian Bureau of Agricultural and Resource Economics
(ABARE) and the Australian Greenhouse Office (AGO) as well as commercial-in-confidence data
from the client firm. The latter data has been modified in this paper and the public model to protect its
commercial interests.
In presenting this paper, we acknowledge the diversity of factors relating to greenhouse gas emission
levels. We also acknowledge the scientific debate regarding the long term net effect of forestry

1
The paper draws on 1998 work done, under the authors direction, by students in their major assignment for the System Dynamics
Modelling subject in the Master of Management Studies program at the Defence Academy, in particular: Dwyer, B, Stuart, S &
Cusack, L, Carbon Credits Project Report and User Manual.

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planting on greenhouse gases. The focus of the model is limited to the financial viability of a specific
carbon credits trading proposal, based on investment in forestry development.

SYSTEM DYNAMICS MODELLING

System dynamics modelling (SDM) provides a framework for understanding complex problems where
there is dynamic behaviour (quantities changing over time) and where feedback impacts significantly
on system behaviour. It provides a framework and rules for qualitative description, exploration and
analysis of systems in terms of their processes, information, boundaries and strategies, facilitating
quantitative simulation modelling and analysis for the design of system structure and control.
This project used system dynamics to provide a holistic outline of the factors that contribute to the
greenhouse gas effect at the global level. The feedback relationships that exist between major
components of the system, and especially the inter relationships between government taxation and
pollution charges policy and the likely reactions by energy producers and polluting industries.
Why SDM
The issue confronting the client was the commercial viability of Carbon Credit Trading. It had already
undertaken traditional financial (spreadsheet based) analyses and had made a decision in-principle to
invest. It is legitimate to ask what value-added SDM might bring. This question becomes even more
pertinent when analysis of the model shows that basic micro-economics concepts (supply-demand and
price / cross-elasticity of demand) are key drivers in the model.
SDM is not about modelling systems. It is not about building a bigger and better mathematical black
box which will forecast answers to life, the universe and everything. Rather, SDM is process of
mutual learning, involving the modeller and clients/stakeholders, concerned with understanding the
causal interrelationships, and especially delayed feedback interactions, which impact on the system. If
contributions from other sciences (engineering, economics, psychology etc) can assist this process, they
are / should be incorporated.
In this particular case, the SDM process, through its focus on the inherent delays in creating natural
carbon sinks, and the feedback impact of government policy instruments on the financial viability of
green technologies, was able to communicate effectively to management the longer term risks to
commercial viability of carbon credits.
SDM Development Methodology
SDM usually involves situations where there are systemic problems characterised by feedback and
delay. Key aims of such modelling include improving understanding of the problem context and
identifying interrelationships and possible intervention points. Accordingly, scope definition, model
specification and model building tend to be iterative processes, with mutual learning between the
modeller and the client. Accordingly, it differs significantly from traditional software application
development. In the absence of an accepted methodology, the Centre for Business Dynamics has
developed the following seven stage iterative framework (Figure 1), based on its consulting and
research experience and drawing on the SDM literature, especially Wolstenholme and Richardson2.

2
Wolstenholme, E., S. Henderson & A. Gavine: The Evaluation of Management Information Systems - A Dynamic and Holistic
Approach. Wiles, Chichester, 1993.
Richardson, G. and A. Pugh: Introduction to System Dynamics Modelling. Productivity Press, Portland, 1981.

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Figure 1: Seven Step System Dynamics Modelling Methodology

Stage Model Focus Client Focus

Stage 1: Project scoping and outcomes definition Confirm scope and deliverables
Project Planning deliverables with client
Tools include: timeframe clarify clients understanding
Prince2 budget of system dynamics
skills required clarify expectations from
text & flow charts
project mgt, risk mgt and risk assessment modelling
configuration mgt tools team specification
Stage 2: State problem contexts, symptoms and Confirm understanding of
Problem Conceptualisation patterns of behaviour over time. business with client
Tools include: Identify basic organisation structures Confirm understanding of the
core business processes problem with the client
text & graphs outcome performance measures
Confirm organisation
causal loop or influence patterns of resource behaviour over time
performance measures with the
diagrams system boundaries & time horizon
client
SSM rich pictures Identify feedback relationships
hexagons key resource states and associated flows
cognitive mapping key delays
past review reports key causal interrelationships
Restate problem, e.g. using SSM
Stage 3: Initial Prototype(s)
Model Formulation Map-Model-Simulate-Validate-Reiterate Confirm basic logical structure
and model functioning with client
High level system map: Basic stock-flow model
of key business processes Confirm key variables
20 - 40 variables
Tools include: Confirm business rules
key stocks, flows & auxiliaries
System dynamics software key targets performance indicator(s)
key feedbacks & delays
Output graphs & tables from the Run - Simulation - Validate
system dynamic model(s) Where there are a variety of core processes in the
organisation, they may need to be developed as
independent sub-models
Stage 4: Detailed Prototype(s)
Model Development Map-Model Simulate-Validate-Reiterate Confirm basic structure and
logic with subject area experts
Iteratively elaborate model, challenging
system boundaries Confirm key variables with
stocks, flows, auxiliaries subject area experts
Tools include: complexity / simplicity in business rules Confirm business rules with
System dynamics software add multi-dimensional arrays if applicable subject area experts
Identify & build policy levers & reports
variables relevant to decision makers
output reports for decision makers
Stage 5: Quality Assurance Confirm model outputs with
Model Validation Do validation and verification tests subject area experts
Iteratively revise model Independent testing
Stage 6: Installation & Training Installation & Training
Model Handover
Stage 7: Use of model identifies need for fine-tuning. Evaluate model against original
Model in use criteria.

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MODEL FORMULATON STAGE

The processes and results of the first two stages (Figure 1), whilst critical for the success of this project,
are not dealt with here. The output from stage 3, Model Formulation, was a high-level system map
identifying the key sub-modules of the system, and the associated causal-loop sub-modules. These
were developed iteratively with the client. Mutual learning was fundamental in this stage, and was
critical in gaining the clients confidence in the final product. The high-level map (Figure 2) displays
the (highly simplified) interactions of the sub-modules.
In essence the concept map traces the presumed causal interactions (based on the teams collective
wisdom and research, especially reports of ABARE and AGO) between key policy indicators or levers
and short and long term industry responses. (S refers to a causal change in the same direction; O
refers to a causal change in the opposite direction.)

Figure 2: Emissions Trading - High Level System Map

Increasing nett emissions result in pressure for increasing application of taxes or penalties; increasing
taxes or penalties increase the attractiveness of Carbon Credit schemes and at the same time make a
switch to green technologies (both green energy and energy efficient industry) more economically
attractive. An increase in either or both these trends serves to reduce net carbon emissions. However,

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as firms switch to green technologies, albeit after some delay because of the investment requirements,
there is a much reduced incentive for these firms to continue investment in carbon credits.
This qualitative analysis, very early in the project, identified Switch to Green Technologies to be the
major risk factor for the financial viability of the Carbon Credits project.
This area is further addressed in the qualitative causal loop diagrams, Figures 3 and 4.
Fossil Fuels & Green Energy Sub-Module (Figure 3)
The fossil fuels module is impacted by government policy, the national demand for energy and the
level and nature of existing infrastructure investment in energy production and industrial equipment. In
Australia, most power generation is coal based and hence a heavy contributor to greenhouse gases.
(Australia has miniscule investment in wind generation or other green energy generating systems.)
Energy demand in Australia is increasing and, using existing fossil fuel generation, aggregate
emissions will increase. The unsatisfied demand constitutes an energy gap, which can be satisfied
using fossil fuels or green energy sources,.
Government policy on emission levels, whether in terms of pollution taxes or quantitative emission
limits, will impact on both the attractiveness of carbon credits and on the attractiveness of investment
on green energy generation sources and green user technologies. In the short term, given policy
supporting carbon credits markets, both emissions taxes and quantitative controls will boost demand,
and hence market price, for carbon credits whilst allowing power companies to amortise current
investment in fossil fuel generating systems. Depending on the price differential with green
generating power, the carbon credits scheme could foster increased investment in fossil generation.

Figure 3 : Fossil Fuels & Green Energy Sub-Module

The marginal current cost differential in favour of dirty power generation over green power is
approximately 30%, although this is lessening. Pollution taxes would , of course, narrow the gap.

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Economies of scale, as green generating capability became more attractive, would further reduce the
price differential. As investment in green generating capacity increases, and especially as existing
generation capacity tends towards the end of its economic life, the attractiveness of Carbon Credits will
lessen.
Green Technology Sub-Module (Figure 4)
The green technology module is driven is also driven by the degree to which pollution taxes and
charges change the relative financial attractiveness of existing technologies in industry. In the short
term, carbon credits will allow firms a breathing space, both to get a return on existing investment and
to research better ways of creating and delivering their product. ABARE research suggests that
Australian firms typically work on a pay-back-period approach to major investment, with a typical
time horizon of 3 to 5 years. This suggests that, within a short time of the introduction of the level of
pollution taxes required to make carbon credits viable, firms would be ready to invest in available
green technologies.

Figure 4: "Green" Technology R&D Investment

Conceptual Stock-Flow model

The project incorporated a number of other causal-loop models which developed along similar lines of
reasoning, including Natural Compensators for Carbon Emissions Sub-Model; Market Forces Sub-
Module; Emission levels sub-Module. The next step in the modelling process was the development of
a conceptual stock-flow model, which included the key resources (stocks) and their transformations,
and the key flows, or business rules, which drive the transformations. This is depicted in Figure 5.

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Figure 5: Conceptual Stock-Flow Model

This conceptual model highlights the key interrelationships: the level of excess emissions impacts on
government policy decisions on the level of pollution taxes and charges (and associated quantitative
controls). These in turn impact on both the attractiveness of carbon-credit markets and on the
attractiveness of green technologies (whether for generating energy or for end use).

MODEL DEVELOPMENT
The process of model development from the above conceptual plumbing to the final product was an
iterative one. Each of the sub models and their inter relationships were examined in detail. System
boundaries, stocks and flows, overall complexity / simplicity were challenged with a view to refining
the utility and operation of the model. Bais validation and verification was undertaken.
The final project model consists of seven component sub models. These are as follows:
Energy Use from Fossil Fuel,
Resultant Emissions,
Carbon Sinks,
Cleaning Technology,
Alternate Energy Usage,
Policy, and
Carbon Credits.
The key sub-models are shown below together with a brief explanation of the major components.
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Energy Use from Fossil Fuel

Initial Fossil Fuel Use pa: Fossil fuel based energy in 1997/98 accounted for 94% of total energy
consumption (4810.1 PJ).3
Fossil Energy Use This stock represents current energy demand of the industry under consideration.
ABARE predicts total energy consumption to grow by 1.4% during the period 1997/98 - 2014/15.4
Expected Increment Fossil Use pa This variable indicates the predicted percentage per annum rate of
change for fossil (non-renewable) energy use pa in the absence of policy changes promoting green
technologies. ABARE predicts the growth rate to be 1.8% per annum.5
Increment Green Energy Supply This variable is the output of the Alternative Energy Sub-Model and
is impacted by the price of pollution taxes / price of carbon credits, after a 3 year delay.
Resultant Emissions

Initial Emissions This constant is taken from ABARE and AGO who have recorded emission data for
industry sectors since 1990. AGO reported emissions from the energy sector to be 339 Mt in 1997/98.6

3
ABARE, Research Report No. 99.4, p. 26
4
ibid, p. 42
5
loc cit
6
AGO, National Green House Gas Inventory, Fact Sheet 2, 1998

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Carbon Emissions This stock represents the current emission levels of the client sector.
Rate of Emissions This rate represents the rate of change in emissions as predicted by ABARE, for the
period 1997-2015, with the modelled effects of technology and natural carbon sink changes included.
Annual Growth in Emissions This variable incorporates ABARE historical and predicted data.
Emissions to Target Emissions Ratio This variable is a KPI. If the resultant figure is greater than 1
then a gap is indicated. It is assumed that if the result is greater than one then policy pressure may be
invoked upon organisations to comply with the emissions target. It is also assumed that, in such a
circumstance, organisations will have a greater propensity to purchase carbon credits to address their
excess emissions. This would have an upward effect on the price of credits. It is also assumed to
increase interest in green technologies.
Effect of Technology on Emissions The use of green technology in energy production processes will
reduce emissions. However, they are starting from a miniscule base and require significant time to
have noticeable effect.
Effect of Sinks on Emissions This variable portrays the effect of Carbon Sinks on emission levels. It
is assumed that 1 million acres of trees would consume 300 tonnes of Carbon emissions.7
Natural Carbon Sinks

Initial Hectares This represents an assumed value for the number of hectares that currently exist.
Natural Carbon Sinks This stock represents the capacity of Carbon Sinks to offset emissions in
MegaTonnes per annum.
Rate of Change of Carbon Sinks This rate represents the natural rate of growth of forests and the rate
of growth introduced by investment in carbon credits.
Hectares Planted This variable function introduces the delay inherent in forest (carbon sinks) growth
into the model.
Maturation Time It is assumed that of the variety of tree types considered for generation of carbon
sinks, some take 7 years to grow to maturity and others up to 20 years to grow to maturity. An third
order delay function approximates to the net effect of this..

7
Cuss V., PM, Carbon Emissions, ABC Radio, 1999

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Carbon Credits

Initial Price This represents the initial price of one tonne of carbon, set at $30.00. (Estimate by AGO).
Effect of Ratio on demand for Carbon Credits As the gap between target and actual emissions
increases organisations have greater propensity to invest in carbon credits to offset their emissions.
Effect of (GreenTechPrice) Ratio on Credits: As the price of credits approaches the price
differential between current and green technologies, attractiveness of carbon credits will fall.
Rate of Change of Price This rate represents the rate of change of the price of carbon credits as the
factors affect the supply and demand of carbon credits.
Carbon Credits Price This stock is equivalent to the price per tonne of carbon equivalent emissions.
It is reasonable to suggest that as emission levels increase in relation to target emissions then the price
per tonne will increase. This also assumes that the demand for carbon credits increases.

MODELLING RESULTS
The model was designed to provide Carbon Solutions Pty Ltd with a decision support and analysis tool
to support their commercial endeavours in demonstrating to clients the commercial advantage of using
carbon credits. The model achieved this by showing that it is currently cheaper to purchase carbon
credits to offset carbon emissions than to convert their production infrastructure from fossil fuel based
to an alternate clean energy source.
However, the model demonstrated that this result was very sensitive to assumptions on the impact of
Carbon Credit incentives on green technological investment and investment in green energy
generation capacity. In particular, the following uncertainties were identified in relation to the industry
sector in question:
A $30 per tonne carbon emission tax was close to the level of making new plant investment
economic, based on emission levels alone
In addition, increased efficiencies could be expected from green technologies (i.e., introduction
of new technologies can be expected to induce business process reengineering, with spin off
economies) not taken into account in the model.
Also, spin-off markets could also be expected from green technologies (i.e., new markets from
sales of hitherto waste products) not taken into account in the model.
In the event, the client decided the risks outweighed the potential commercial result.
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