More Than Hot Air

Having promised that the United States would put forward its own climate change program, the president came up with a slippery scheme last February that understandably provoked jeers from Kyoto supporters. His plan hinged on voluntary reductions in greenhouse gas emissions and on reducing what he called “greenhouse gas intensity,” which is a measure of emissions per unit of GDP. One of the problems with this proposal is that a reduction in greenhouse gas intensity would still permit net emissions of greenhouse gases to rise. Moreover, the proposed “reductions” nearly equal reductions that have already taken place. In short, the president’s proposal on climate change is essentially a “business as usual” plan, and as such was coldly received by environmentalists and by most countries around the world.

In light of the intransigence of the Bush administration on Kyoto, it is in the world’s interest to find other, more creative, ways of achieving the treaty’s goals without requiring the United States to sign on to the convention. The most promising of these “alternative routes” is one that involves the use of market mechanisms to reduce emissions of the gases responsible for climate change.

Although the Bush administration has stated that it does not believe that market mechanisms can work in reducing emissions of greenhouse gases, this view is not widely shared. Some members of Congress (notably President Bush’s political nemesis in the Republican Party, Sen. John McCain) and certain powerful business interests have stated publicly that such markets can and should be attempted.

The United States has for more than a decade operated a similar, and highly successful, market designed to reduce emissions of sulfur dioxide (S02 ), the main cause of acid rain—a system put in place by President Bush’s father. Moreover, the United States has the necessary infrastructure—including a series of existing state-level markets in greenhouse gases—that could be used as a base on which to build a national, government-sanctioned market in C02 emissions. There are already brokers (even in the United States) who buy, sell, and trade the “right to emit” a variety of greenhouse gases, and a number of other countries have created government-sanctioned markets in these gases. So a future in which greenhouse gases are traded in much the same way that we now trade stocks and bonds is neither fanciful nor far away. It is already here. Some analysts even predict that C02 will one day become the world’s most traded commodity.

Businesses are far ahead of governments when it comes to market-based approaches to climate change. They know that there will likely come a time when public opinion will force them to limit their emissions of greenhouse gases, so they are working hard to find the most flexible, cost-effective, and realistic approaches to emissions reductions. They are investing tens of millions of dollars preparing themselves for a “carbon-constrained” future in which pollution rights will be bought and sold on international exchanges.

If and when the United States decides to create a market in greenhouse gases (either at the national or regional level), there will remain a number of outstanding issues for the global community to resolve. Chief among these is the question of how the myriad of competing national markets in greenhouse gases that are now in their infancy will ultimately interact. Britain, Denmark, Sweden, Japan, Australia, and a number of other countries are pressing ahead with the creation of national or subnational markets in greenhouse gases. In most cases, these markets differ substantially from one another, and may sometimes be wholly incompatible.

Creating national markets in greenhouse gases is akin to issuing a new form of currency. A country that forces companies and individuals to reduce emissions of C02 and other greenhouse gases—and then lets these “certified reductions” be traded—is essentially giving financial value to these emissions. It is using its credit-worthiness to turn C02 emissions into liabilities, and “government-certified” C02 emissions reductions into assets. As such, this new form of currency will be subject to country and political risks like any other currency. But if it is not convertible and can only be used in its country of issue, it will be of limited utility.

In fact, confining carbon markets to particular countries or regions would undercut one of the most important benefits of these markets: the ability of money to flow to where emissions reductions could be achieved most cost-effectively. If the markets were localized, they would only be able to allocate resources within countries or regions. Clearly, a series of incompatible national markets in greenhouse gases is not the most effective way of addressing climate change. But it may well be the most politically feasible approach to climate change for the time being.

If we are effectively to address what may well be one of the most serious long-term threats to human survival, we need to become more practical and market-minded. We need to look at how the United States can create a national market in greenhouse gases, one modeled perhaps on its existing S02 markets. Then we need to begin to discuss how this market can interact with the other national C02 markets that are being created around the world. Essentially, we need to begin designing a future in which national markets one day coalesce into an effective international market in greenhouse gases; a future in which markets go where our politicians fear to tread.

Market Power at Work

Ironically, the idea that markets can be used to address the issue of climate change has come, in large part, from the country at the very heart of the climate-change dispute: the United States. Specifically, it is based largely on the U.S. experience with markets in sulfur dioxide (S02 ).

In 1990, Congress established a program designed to reduce emissions of sulfur dioxide and nitrogen oxides (NOx), two of the major causes of acid rain. Emissions of S02 and NOx are caused by the burning of fossil fuels—coal, in particular—primarily to generate electricity. When S02 and NOx combine with chemicals in the air they can create acids that are deposited on the Earth by means of precipitation. This “acid rain” has caused considerable damage to plants, wildlife, and human health. At greatest risk from acid rain are communities located downwind from these fossil-fueled generators (in the United States, this has tended to mean states in New England and the northeastern part of the Midwest). What is remarkable about the U.S. Acid Rain Program is that instead of simply ordering electric utilities to reduce their emissions of SO2 the government designed a system of tradable emission credits that helped companies lower their emissions in the most flexible and cost-effective way possible.

In the 1990 amendments to the Clean Air Act, Congress mandated that by 2010 the United States had to reduce its emissions of S02 by 10 million tons compared to 1980 levels. To achieve these reductions, the government set a ceiling on emissions nationwide, and the Environmental Protection Agency (EPA) allocated emissions permits, or allowances, to electric utilities. For every ton of S02 emitted, the government said, utilities would have to have in hand a government-issued allowance. The utilities were permitted to sell unused allowances on the open market or, if they preferred, to hold them over for use another year (a process known as “banking”). Conversely, if a utility emitted more than its share of SO2 , it would be forced to buy surplus allowances from another company or face hefty fines. The government’s plan was to reduce the number of allowances over time and therefore reduce SO2 emissions nationwide.

The government did not tell utilities how they should reduce emissions; it set targets and let the utilities and the markets figure out the most cost-effective mechanisms for meeting them. If the utilities wanted to reduce their S02 emissions by installing pollution-control equipment, buying credits, switching to cleaner fuels, or a combination of all three, that was up to them. The S02 emissions trading program established monetary incentives for emissions reductions (income from selling surplus credits) and monetary disincentives for excess pollution (the need to buy surplus credits from other utilities).

By all accounts, the program has been extremely successful. According to the EPA, in 1995, the first year of its implementation, S02 emissions nationwide dropped by more than 3 million tons. Likewise, beginning in 1995, the largest utilities in the United States reduced their emissions of S02 by about 5 million tons (more than 50 percent) from their 1980 levels.

Interestingly, it was the trading that generated the greatest reductions. In 1990, when Congress first mandated the cap, the largest power plants in the United States (263 of which are closely tracked by the EPA) were emitting about 8.7 million tons of S02. By 1994, that figure had dropped to 7.4 million tons. But, in 1995, when trading in SO2 allowances began in earnest, their emissions plummeted to 4.5 million tons, even though power generation continued to increase. ² This, in turn, has led to improved air quality in much of the Northeast and Midwest, as well as a dramatic reduction in acid rain across the country.

Not a single utility participating in this program has failed to comply with the S02 reductions since the system was instituted. Moreover, the cost to the industry has been much lower than predicted. In 1989, the Edison Electric Institute estimated that meeting the targets that were about to be mandated by Congress would cost the industry an average of $7.4 billion a year by 2010. In 1990, the EPA revised these figures, estimating that the costs would be closer to $4.6 billion a year. But, in 1998, after three years of full-fledged trading, Resources for the Future, a Washington-based economic research institute, found that the actual costs of the program were likely to be closer to $870 million a year by 2010, just over a tenth of what the Edison Electric Institute had estimated in 1989. In fact, studies show that the savings made possible by market-based approaches to pollution reduction are enormous. According to one estimate, the S02 program alone will save utilities more than $2 billion annually over the more traditional “command and control” approaches to pollution reduction.³ And this does not even take into account the monetary value of the health benefits obtained by decreased pollution.

Businesses no doubt appreciate the shrinking price tag, but they like these market-based approaches to environmental protection for other reasons. First, they provide regulatory certainty. With a system like the Acid Rain Program, businesses know exactly what targets they are shooting for and don’t have to worry year in and year out about new rules being imposed by governments. In short, they can plan for the future. Second, market-based approaches are flexible and permit businesses to figure out for themselves how best to reduce their emissions. Lastly, the market creates new business opportunities. As the pollution-control markets develop, companies need a variety of business offerings that range from insurance to brokerage and trading services.

Additionally, there has developed in the United States a robust and burgeoning secondary market in S02 —a market that includes S02 calls, puts, and call spreads, as well as a wide variety of other, more complex, financial derivatives. These derivatives allow companies to manage their “S02 risks” more effectively. In fact, one S02 trader recently estimated that the value of spot trading in S02 between July 2000 and July 2001 was around $700 million. But, he pointed out, the market for S02 options is several times that size. As he explained it, S02 is one of the few markets in the world where the volume of trade in options far outstrips the volume of trade in the underlying asset.

The genius of these markets is that, by turning units of pollution into units of property (allowances), they make it possible to allocate resources for pollution reduction where they are likely to have the greatest impact. If you find that reducing emissions in your plant is costly, you can buy excess reductions from a plant somewhere else where such reductions are less costly.

Likewise, by aggregating information about the value of these allowances, the market sends signals about how much a unit of pollution is worth. This is the basic market function known as price discovery, and it is what makes market-based approaches to environmental protection so successful: by attaching a value to pollution, the market is telling polluters that emitting SO2 is no longer free, that it will cost them a very real sum of money (about $200 dollars a ton in today’s market), depending on the supply and demand for allowances. With this information, polluters can make rational decisions: should they accept the cost of continuing to pollute, or should they install scrubbers, change fuel mixes, or simply conserve energy?

The Nascent Carbon Markets

If a country (or a group of countries) were to set limits on its emissions of greenhouse gases, and if emission permits were made tradable, markets in greenhouse gases would emerge. Emitters of C02 would then have a variety of options available to them: If they believed that they could reduce emissions cheaply by changing their production processes or experimenting with new technology, they would have an incentive to do so. And if they decided to pollute, they could quickly determine the cost of their decision. In short, the market-based approach allows for the allocation of a scarce resource (the right to pollute) in the most cost-effective way possible.

Even though the Kyoto Protocol has yet to enter into force, markets in C02 are emerging because businesses believe that limits on emissions are inevitable. Nat-source, an energy and environmental brokerage firm involved in emissions trading, estimates that more than 55 million tons of carbon dioxide emissions have been traded between companies since 1996. Since the price of carbon in these trades has ranged between $.60 and $3.00 a ton, and since this analysis does not include intracompany trades, it is safe to assume that more than $100 million worth of CO2 has been traded in the past five years.⁴ Some analysts believe that, given the size of global emissions, this trade could be worth tens of billions of dollars by the end of the decade. A report published by Deutsche Bank estimates that the C02 emissions trading market could one day be worth as much as $60 billion a year. It also cites other research that puts the figure at anywhere from $150 billion to $250 billion from 2008 onward. This would make the CO2 market one of the largest commodity markets in the world.⁵

A number of private companies and organizations are already busy creating prototypes for carbon trading systems in the United States. The most notable of these experiments is the Chicago Climate Exchange (CCX). Established at the end of 2000 by Richard Sandor, a veteran of the Chicago Board of Trade, the CCX asked companies in the Midwest to voluntarily cap their emissions of greenhouse gases at 2 percent below 1999 levels by 2002. In coming years, the target will be tightened by a steady 1 percent a year.

The exchange serves as a market where participants can exchange carbon credits, either with other participants, or with domestic or foreign providers of credits. The CCX has already convinced a number of major Midwestern firms to participate in this prototype market, including the utility companies Cinergy and Alliant Energy, the Ford Motor Company, DuPont, International Paper, the agricultural cooperatives Agriliance, Growmark, and the Iowa Farm Bureau, and such nonprofits as the Nature Conservancy. The creators of the CCX hope that the prototype will become a national, and eventually an international, exchange for carbon credits.

In addition to the considerable carbon trading that is already taking place, there have also been a number of interesting related developments. The World Bank, Hancock Natural Resource Group, Deutsche Bank, and several other private banks and investment firms have announced that they are either creating, or are thinking about creating, carbon funds. Like mutual funds, these carbon funds would seek to invest in a wide variety of carbon projects around the world in the expectation that once governments agree to sanction carbon emissions (either through the Kyoto Protocol or some other mechanism), these credits will increase in value. And, like traditional mutual funds, these instruments will take advantage of the benefits of diversification and the professional management of portfolios.

There has also been progress on the international level. This past April, Britain created the first large-scale, government-sanctioned market in greenhouse gases. (Denmark has a national greenhouse gas trading system, but it is relatively small and only applies to one sector of the economy.) Unfortunately, it did so in a way that is exceedingly complex and idiosyncratic. This means that the British system is unlikely to be emulated by other countries, and it also makes it hard for the British system to exchange credits with other national trading systems.

The U.K. Emissions Trading Scheme, or ETS, has two main components. First, as of April 2000, companies in Britain have been subject to a “climate change levy,” a tax on the use of energy by businesses that is expected to amount to £1 billion a year. In exchange for an 80 percent reduction in this tax, some companies have entered into climate change agreements with the government. The agreements require companies to meet specific greenhouse gas emissions targets.

The second component of the system is based on absolute greenhouse gas emissions reductions against 1998–2000 levels agreed upon by a small number of companies. These companies have entered the system voluntarily, spurred by incentive payments of £215 million ($305 million) offered by the government. The incentives were auctioned off to willing participants this past March. The companies receiving these incentives must meet their targets or face stiff penalties.

Trading comes in because both the voluntary participants and the climate-change-levy participants can use emissions trading to meet their respective targets. Some 6,000 companies are eligible to participate in the market in order to obtain reductions in the climate change levy, and 34 companies (including large multinationals like Shell, British Airways, and Barclays Bank) have systems voluntarily in order to receive the government’s incentive money. The market has already seen more liquidity than many expected (with C02 being traded for between £8 and £8.5 a ton).

The European Union has announced that it plans to institute a C02 market by 2005. Some of the difficult issues EU planners are dealing with include: how markets with different structures (such as the British and the Danish markets) might interact; what sectors of the economy would be forced to participate in the market; and how emissions credits would be allocated, tracked, and verified. Meanwhile, Norway, Japan, Australia, France, and a number of other countries have also announced that they intend to establish greenhouse gas trading systems.

Even in the United States, there has been progress in the creation of carbon markets. Several states, among them Washington, Oregon, and Massachusetts, have passed laws that require utilities to limit their emissions of C02 , while at the same time allowing those who “over-emit” to buy carbon credits according to specific guidelines. This has effectively created local markets in greenhouse gases.

In Oregon, for example, utilities must pay a fixed amount for every ton of C02 their plants emit beyond a mandated base level. This money is channeled into the Climate Trust, a nonprofit that buys carbon credits on the burgeoning national and international “gray markets” (which are highly speculative and not sanctioned by any government) in C02 . Other states are considering similar systems.

San Francisco and more than 100 other U.S. cities have announced that they intend to reduce their emissions of C02 in accordance with the Kyoto Protocol. In California, a bill requiring reductions in C02 emissions by cars and light trucks by 2006 was enacted this past July. The law could have a tremendous impact on the ways cars and trucks are built in the United States since California is one of the largest car markets in the country.

Why the United States Needs a Market

Given the Bush administration’s stance on Kyoto and the way in which carbon markets are developing, it seems likely that the issue of climate change and carbon emissions will first be addressed in the United States by means of a national trading system for C02. This makes sense for a variety of reasons.

First, setting up a national trading system for C02 would not require the United States to enter into an international treaty. Congress need only set limits on the country’s emissions of greenhouse gases. Senators Joe Lieberman and John McCain have proposed a national cap and trading system for C02, but it has unfortunately found little political traction.

Second, the creation of a U.S. market in greenhouse gases would preempt what is likely to be strong and sustained pressure from Asian and European governments (and other Kyoto signatories) for the United States to reduce its C02 emissions. The notion that the rest of the world will take costly steps to reduce greenhouse gases while the United States (which produces nearly a quarter of the world’s C02 emissions) is allowed to increase emissions by reducing “greenhouse gas intensity”—as proposed by President Bush last February—is ludicrous. The United States is likely to be pressured both politically and economically to conform. Some small Pacific Island states are talking about suing the United States and Australia (which has also announced that it will not ratify the Kyoto Protocol) for compensation for any losses they suffer from rising sea levels as a result of global warming. And nongovernmental organizations such as Greenpeace and Friends of the Earth have called for boycotts against ExxonMobil and other American companies seen to be behind the Bush administration’s dogmatic stance on Kyoto. In short, we are witnessing the beginnings of a global backlash against the United States.

Of more concern to the United States, however, should be the impact that this backlash will have on the country’s companies and trading status. It is only a matter of time before we see Asian and European industries and consumers (who are forced to pay for emissions reductions) argue that their U.S. counterparts are engaging in anti-competitive behavior by not reducing emissions of greenhouse gases. It is unclear what legal recourse they might have, but it is not unreasonable to think that such a case could one day be argued in the World Trade Organization. This growing antipathy will put the country’s trading partners under intense pressure to force the United States to reduce its emissions. U.S. multinationals will be particularly exposed.

Finally, and perhaps most importantly, the history of market development shows that when a new market is created, those who get in early derive a number of advantages over those who come later. Among other things, the early birds get to establish the rules by which these markets operate.⁶ They also gain knowledge, expertise, and experience that they can sell to later market entrants. Likewise, new markets tend to create new jobs, new industries, and new wealth. If the analysts are right and carbon markets end up trading in the hundreds of billions of dollars a year, does the United States really want to stay out of this lucrative new business? Wouldn’t it be wiser—even safer—to experiment with these new markets at home, even if Washington objects to the Kyoto Protocol?

Moreover, if the United States is slow in setting up a national CO2 market, established markets in Europe or Asia may decide to allow trading in U.S. carbon emissions reductions. This would not only give European and Asian companies preferential access to the cheapest emissions reductions to be had in the U.S. markets, it would also allow the European and Asian markets to set the rules by which U.S. carbon credits are traded, that is, to determine the value of U.S. carbon reductions and thereby define the terms by which U.S. companies reduce their emissions.

For these reasons, the most important question facing U.S. lawmakers today is not whether the United States should establish a government-sanctioned market in greenhouse gases, but rather when and how it should do so. Some of the issues they will have to address include: Will the U.S. market be created by the Environmental Protection Agency (which oversees the market in S02)? And if so, what role will the Department of Energy and other government agencies play? Where will the credits be sold? How will the credits be allocated? Will the market be limited to the United States, or will it be a regional market involving Canada and Mexico? Will “nonpoint” sources of carbon emissions (cars and trucks) be included? And perhaps most importantly, how will this market interact (and possibly exchange credits) with other markets around the world?

Politically, the creation of a U.S. market in greenhouse gases need not be all that problematic. There is growing agreement that climate change is a real problem (President Bush has himself admitted as much). This is of no small importance: until recently, many politicians refused to acknowledge the possibility of climate change. Moreover, the White House has gone to great lengths to publicize the virtue of markets in reducing pollution. Not only has the administration proposed strengthening or extending cap-and-trade systems for S02 , nitrogen oxides, and mercury, but the president’s own economic report for 2002 devotes most of a chapter to the benefits of market-based mechanisms for controlling pollution. The next step—the one that it appears President Bush is not ready to take—is to extend this faith in markets to include emissions of greenhouse gases.

In announcing an ineffectual climate change initiative this past February, President Bush missed a historic opportunity to prove his critics wrong. Had he announced the creation of a national market in greenhouse gases, with realistic and achievable caps on CO2 emissions, he could have kept the United States out of the Kyoto Treaty he says is “fatally flawed” and still appeared serious about addressing climate change. Furthermore, the United States could have designed its C02 market to be everything the president says Kyoto is not: business friendly, flexible, and cost-effective.

It is now up to Congress to remedy what appears to be a serious environmental misstep on the part of the administration. If the United States acts quickly, it will be in a position to help establish the rules by which all future carbon markets will operate. If it dallies, it will almost certainly forfeit this leadership to Europe.

World Policy Journal www.worldpolicy.org

Notes

1. The Kyoto Protocol to the United Nations Framework Convention on Climate Change, sometimes referred to as the Kyoto Climate Change Treaty, was adopted by over 160 nations in Kyoto, Japan, in December 1997. The overall aim of the protocol was to reduce greenhouse gas emissions by 5.2 percent of 1990 levels by 2012. The United States signed the treaty in December 1998, subject to ratification by the Senate. In March 2001, the Bush administration announced that it would not send the treaty to the Senate. At the Bonn Conference in July 2001, representatives of 178 countries agreed to revise the protocol to make it more acceptable to the United States and other countries. The new target was for developed countries as a whole to achieve a 5 percent reduction in greenhouse gas emissions below 1990 levels by 2008–12. To achieve this cumulative result, each region or country has been assigned a target. For instance, the European Union must reduce emissions by 8 percent below 1990 levels, while the United States must reduce emissions by 7 percent, and Canada by 6 percent. Additionally, financial incentives and emissions trading are to be permitted. To enter into force, the treaty needs to be ratified by countries emitting 55 percent of the world’s greenhouse gases. As of September 2002, all 15 EU member states and Japan, together with a number of developing countries had ratified the treaty. This means that the treaty will go into effect if, as expected, Russia and Canada ratify it this fall.

2. See EPA Summary of Emissions Scorecard 2000, at www.epa.gov/airmarkets/emissions/score00/index.html.

3. See Matthew Most, “Free Markets Face New Threats,” Environmental Finance, March 2001.

4.“Review and Analysis of the Emerging International Greenhouse Gas Market” (executive summary of a confidential report prepared by Natsource for the World Bank Prototype Carbon Fund, March 22, 2002).

5. See Janine Scheelhaase, “International Greenhouse Gas Trading—New Business Options for Banks and Brokerage Houses,” Deutsche Bank Research, December 7, 2001.

6. These rules will include definitions of how emissions are to be measured and monitored. They will also establish what kinds of emissions reductions and which mitigation (e.g., carbon sequestration) strategies are acceptable, whether emissions reductions from other countries will be accepted within the system (and at what “carbon exchange rate”), and how markets between countries will be harmonized. If the United States dallies, it may find itself forced to enter a market designed by and for the benefit of others.