Emission Permission

Bartering in carbon dioxide will be big business

9 min read
Emission Permission

Trouble Signs

One U.S. PROGRAM to control nitrogen oxides by means of emissions trading remains mired in controversy, as conflicts between "upwind" and "downwind" states stymie agreement

This is part of IEEE Spectrum's special report: What's Wrong—What's Next: 2003 Technology Forecast & Review.

A decade from now, one of the world's most vibrant and unusual markets will be dealing in our most notorious overabundant commodity—namely, the greenhouse gases (GHGs) believed to cause global warming. The stock in trade will be permits allowing companies to emit specific quantities of carbon dioxide, methane, and other kinds of GHGs. No such world market has been officially sanctioned as yet, but some countries already have launched national markets, with private companies established as brokers, and trading has taken place on a trial basis. If, as expected, the Kyoto Protocol takes force internationally this year, it will be a powerful inducement for businesses in countries that have approved the protocol to join in the trade.

The main point of emissions trading is to reduce the overall cost of meeting emissions targets by giving industry strong incentives to meet goals and the flexibility to find the most cost-effective solutions. Organizations that manage to emit less than their allotted quota of gases—by retrofitting plants, building cleaner or more efficient plants, or just shutting some down—can profit by selling unneeded emission permits to companies unable to stay within their quotas.

Provided the complexities of setting up international markets for greenhouse gases can be resolved, the market for GHG emission permits will be huge. For carbon dioxide (CO2) emissions alone, "you're looking at a base commodity, like steel and fuels," observes Matthew Most, who chairs a nonprofit trade group called the Emissions Marketing Association (Milwaukee, Wis.). "You can't farm the fields and you can't run the steel mills, you can't make a widget without using electricity that came from fossil fuels, thereby generating CO2."

Total emissions of carbon from fossil-fuel combustion were estimated at about 6 gigatons in 1990 and 6.5 gigatons in 2001. If the Kyoto goal is to reduce emissions in the industrial countries to 5 percent below 1990 levels by 2010, annual emissions will have to be lowered by 0.8 gigaton over the next eight years, or about 0.1 gigaton per year. Accordingly, if all industrial countries were to achieve reductions entirely by means of emissions trading, about 100 megatons of carbon would be traded yearly in world markets.

Tech Watch

One of the more potent tools already available to emissions traders is eSPEED, developed by Cantor Fitzgerald LP (New York City) at a cost, the company says, of more than US $400 million. A mature system, eSpeed handles business-to-business trading in a wide range of financial instruments and commodities over a dedicated network. It consists of 22 hubs, relying on Cisco Systems network architecture and servers from Sun Microsystems, Compaq Computer, and Microsoft

First NOx and SO2, next CO2, then the world?

Experts are confident the GHG markets will work because they have seen similar markets make a dent in other airborne pollutants, starting with volatile organic compounds and nitrogen oxides (NOx). In particular, for the past decade, U.S. utilities and industry have maintained an active exchange for emission credits for sulfur dioxide (SO2), one of the key pollutants implicated in acid rain. After a slow start, the exchanges now trade to the tune of US $2 billion worth of credits per year. The system has helped enterprises reduce costs of complying with SO2 limits by a third to a half [see "SO2: Setting the Best Example"].

As for Most, when not helping lay the foundation for international GHG markets, he trades SO2 emissions for Boston-based Edison Mission Energy. The bulk of his workday is spent at multiple computer monitors, closely watching the relative prices of fuels and sulfur dioxide emissions credits. Based on what he's learned, he's sure CO2 trading is on its way and that a lot is at stake. But Most is also quite sure that if companies are not required to "cap and trade" (the term insiders use to describe the essence of emissions markets), they will not be much inclined to do so. That's the rub.

It is a deep irony that the United States, having demonstrated the effectiveness of emissions trading, and having sold the rest of the world on the concept in the negotiations that led to the 1997 adoption of the Kyoto Protocol, now takes the position that the protocol is fatally flawed and says it will formulate an alternative approach to greenhouse gas reduction.

Without the United States, by far the world's largest emitter of greenhouse gases, any international trading system will be much smaller and less effective than it could be. At the same time, U.S. companies—above all, those multinationals with non-U.S. subsidiaries—will find themselves in a quandary: whether to participate in emerging GHG markets completely, partially, or not at all.

Emissions, domestic and abroad

While staying aloof might aid energy-intense U.S. firms in the short run, they are sure to suffer criticism from abroad; and in the longer run, they could fall behind other companies that have become more expert in the arcane art of emissions trading. That, anyway, was the cautious conclusion of a recent study from the pro-Kyoto Pew Center on Global Climate Change (Arlington, Va.).

Many U.S. companies and industrial sectors already participate voluntarily in a program to register GHG inventories and reductions, which must be stated in terms of carbon equivalence [see "How Many CH4 Molecules Equal One of CO2?,"]. It is managed by the U.S. Department of Energy (Washington, D.C.) and was set up under the United Nations Framework Convention on Climate Change, which the first President George Bush signed in 1992 and the U.S. Senate ratified. Though the younger Bush has rejected the protocol to that treaty, his administration does want to bolster this voluntary GHG reporting system and create transferable credits for GHGs.

Uncertainties about the official U.S. situation compound concerns about the mishmash of trading plans evolving globally, as people forge ahead with systems in anticipation of Kyoto restrictions. Fledgling GHG markets have been launched in Australia, Denmark, and the United Kingdom. The European Union has drafted a proposed continent-wide trading plan.

Denmark, for one, introduced CO2 trading with its Carbon Dioxide Quota Act of 1999, which set its electricity producers a national ceiling of 23 million tons annually, to be further reduced to 20 million tons after 2003. Producers exceeding allowances are fined, with proceeds going to energy-saving projects.

The United Kingdom published a framework for greenhouse gases in 2001, and trading proper began last spring. Besides encouraging emissions allowances to be created and sold, the framework gives companies the option of entering into individual climate-change agreements with the government and reaping a discount on the national energy tax, known as the UK Climate Change Levy. Even in the United States, where such taxes are still anathema, experimental markets are forming in Massachusetts and Chicago. (They also exist north of the border in Ontario.) Meanwhile, brokers are positioning themselves for what they expect to be a mammoth business.

Natsource, with 180 employees in New York City, Washington, D.C.; Calgary and Toronto, Canada; London; Tokyo; and Sydney, Australia, brokered the first deals, for example, in the fledgling Danish and British systems. It was rated the top GHG broker by the publication Environmental Finance (London) in 2000 and 2001.

Its major competitor, the trading firm Cantor Fitzgerald LP (New York City), continues to pour millions into an electronic GHG trading exchange called CO2e.com (Toronto). Founded by the late Carlton Bartels, Cantor's emissions trading group was devastated but not destroyed in the 9/11 attacks on the World Trade Center, in which Bartels himself and close colleagues died. CO2e.com has a powerful trading tool in eSpeed [see Tech Watch].

How GHG emissions trading works

CO2 chart

It is a remarkable fact, and one worth lingering on, that parties all over the world are creating systems to trade greenhouse gases and actually starting to barter, even though not required to by law. How do they go about doing that?

There are two different kinds of permit trading systems. In one version, cap-and-trade, government regulators issue emissions allowances up to pre-set caps for various kinds of GHG sources, such as an individual utility's power plants, within an overall national ceiling. Sources emitting less than permitted can sell excess allowances to sources exceeding their caps.

In the alternative, baseline-and-credit system, each source's performance is measured against a baseline, which is not necessarily fixed permanently and can, for example, be adjusted downward year to year. Those coming in below the baseline obtain tradable emissions credits.

Sound simple? It's not. Figuring how many credits parties are entitled to will be a small nightmare.

When a global GHG trading system is up and running, the governments involved will have complex rules to determine who's short and long. In the meantime, as trial transactions take place in experimental systems, the procedure is for the buyer and seller to obtain the services of some credible third authority, who confirms that the seller is entitled to a credit, known technically as a verified emissions reduction.

One of the organizations developing standards for such verification is the IEEE, whose Power Engineering Society has a committee writing rules to "quantify, verify, and certify" greenhouse gas reductions by electric utilities. A voting draft is to be ready this July, with a fully accepted standard ready for use by 2005.

Pending agreement on such standards, people have been improvising creatively. For example, several years ago, Ontario Power Generation Inc. (Toronto) agreed to purchase credits from USGen New England Inc. (Bethesda, Md.) for up to one million tons of carbon equivalent. They would be earned by sequestering and destroying methane that otherwise would be emitted from a landfill in Rhode Island.

Much more recently, says Corinne Boone, managing director of the Canadian operations of Cantor Fitzgerald's CO2e.com in Toronto, the company brokered a much bigger purchase of allowances by Ontario Power: the utility bought credits for 6 million tons, and options for 3 million more, from Blue Source LLC (Salt Lake City), an aggregator of emissions reductions. When IEEE Spectrum expressed surprise at a U.S. entity's being so active as a seller of allowances, Boone noted that about half of the U.S. states have adopted some kind of GHG reduction requirements, creating many opportunities for traders.

Down the yellow brick road

In this ever more complex Oz-like world, there's still plenty to work out. "When you're trading sulfur dioxide," says Daniel L. Chartier, president of the Emissions Marketing Association, "you know exactly what you're dealing with—it's like gold-backed currency." With CO2 and the other greenhouse gases, which must be stated for trading purposes in terms of carbon equivalence, prices are all over the map.

Steve Drummond, CO2e.com's CEO, told a gathering last July in Cologne, Germany, that parties have been trading CO2 experimentally in the context of the Kyoto Protocol's proposed Clean Development Mechanism, a financial device permitting credits to be used in energy-efficient development projects, at US $1-2 per ton of carbon equivalent. He said the Dutch government has bought reductions at US $7-9 per ton and the World Bank's Prototype Carbon Fund at US $3.50 per ton.

Drummond predicts that prices will settle at US $4-6 per ton by 2010, when a global system should be in place. Much depends, though, on how allowances are allocated between now and then.

Pricing, emissions-control technology, and other aspects of trading could get much more complicated as efforts to control other pollutants become part of the mix. The Bush administration, in a Clear Skies initiative unfurled last February, proposed expanding the trading of emissions credits from SO2 to NOx and mercury. In fact, utilities in 19 northeast U.S. states are setting up an NOx trading system to go into effect in 2004.

And lately, Senator James M. Jeffords (Ind.-Vt.) has been leading a campaign in Congress to get greenhouse gases included in Clear Skies. If Jeffords gets his way, the results could be devastating, observes Dallas Burtraw, a senior fellow at Resources for the Future (Washington, D.C.). This is because remedial measures taken to reduce GHG often differ a lot from measures used to reduce the other types of emissions. (Capturing and sequestering CO2 may be a good long-term option. At present, switching to other fuels is often the only realistic way of reducing GHG, whereas desulfurizing flue gas has been the principal means of achieving reductions in SO2 emissions and selective catalytic reduction is the main tool for NOx.)

Deregulation adds yet another wrinkle to trading. Burtraw points out that if the United States does end up setting limits to GHG emissions and establishes a cap-and-trade system, designing a method to distribute allowances will present a bigger headache for profit-making deregulated utilities than it was in the mid-1990s. When SO2 allowances were distributed among public utilities then, they were guaranteed returns based on their costs (the so-called cost-plus basis).

"Everybody should be talking about this," Burtraw told Spectrum. "Utilities now will be in the position of farmers who have just found oil under their fields. Those utilities aren't going to give away those future returns for free, any more than the farmer would. And how those allowances are distributed is a big issue with big implications for overall economic efficiency, as well as fairness."

How much would be at stake in that distribution? Billions of dollars a year just for SO2 and NOx. But if the United States were to adopt the Kyoto Protocol after all and strive for full compliance by 2012, requiring a 30 percent reduction in GHG emissions from 1990 levels, the allowance created would amount to "an asset with an annual value of about $450 billion [in 1997 dollars]," Burtraw and coauthors concluded last June in a study published by the Electricity Journal.

A much more modest U.S. program aiming to reduce emissions by 6 percent from a projected baseline level by 2012 would still generate allowances worth $14.8 and $32.6 billion a year. And what if the United States makes no commitments and establishes no GHG trading system? Will U.S. companies participate in the emergent global system anyway? You can bet your bottom dollar they will, because—as noted above—they already are.

To Probe Further

Read about GHGs in "The Emerging International Greenhouse Gas Market," Pew Center on Global Climate Change, March 2002, at http://www.pewclimate.org/

Look up "The Effect on Asset Values of the Allocation of Carbon Dioxide Emission Allowances," by Dallas Burtraw et al., in Electricity Journal, June 2002, pp. 51-62

A primer on "Multilateral Emission Trading," by Alexander E. Farrell and M. Granger Morgan, is in The Commons in the New Millennium, edited by Nives Dolsak and Elinor Ostrom, MIT Press, forthcoming

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