WHAT A GAS-Carbon Trading

Carbon trading has become a huge business in the past few years. But is it really going to save the planet, or is it just a lot of hot air?


Carbon trading has become a huge business in the past few years. But is it really going to save the planet, or is it just a lot of hot air?

Soaring oil prices, politicians’ growing focus on the dangers of climate change and mounting demand for energy among emerging economies could push the carbon trading market toward the trillion dollar point by 2020.

The market in the trading of carbon—measured as a reduction in 1 metric ton of carbon dioxide or its equivalent in other greenhouse gases—climbed to $64 billion in 2007, more than double the $31.2 billion recorded in 2006 and nearly six times the amount tallied in 2005, according to World Bank statistics. Bankers, traders and brokers are helping to develop this growing financial marketplace by keeping trading liquid and flexible as they help corporations manage the long-term costs linked to reducing carbon dioxide emissions and complying with government mandates.

The global attention on climate change and reducing greenhouse gases will only continue against a backdrop of events, from this summer’s Group of Eight summit in Japan, to the current US presidential campaign, to talks now under way to create a successor pact to the United Nations-linked Kyoto Protocol by the end of 2009.

“Political agendas and policy decisions, both large and small, affect the market,” says Karan Capoor, senior carbon markets specialist in the sustainable development operations group at the World Bank in Washington, DC. “It creates a long-term expectation that this market is not going to go away.”

Capoor points to the European Union’s recent proposal to extend the life of the European Union Emission Trading Scheme (EU ETS) until 2020 as an example of a “big picture shift” that affects the market. The EU’s decision to let European Union Allowances (EUAs) earned in the second phase of the program to be banked, or remain valid, through 2020 is an example of a policy decision that produces a smaller marketplace shift. “This creates confidence in the market for the future and encourages companies to make investments in reducing their emissions,” adds Capoor. The initial phase of the EU ETS ran from 2005 to 2007 while the second and current phase runs from 2008 to 2012.

Carbon Captures Headlines
Climate change is set to capture headlines when the G-8 leaders gather for their 34th summit in Hokkaido Toyako, Japan, in early July. Environmentalists, policymakers and carbon market players are waiting to see if the industrial country heads of state move to slash worldwide greenhouse gas emissions by 50% by 2050. In late May environment ministers from the G-8 nations backed the 50% target for mid-century. Last year the G-8 summit leaders agreed to consider halving global emissions by 2050, a proposal favored by Canada, France, Germany, Italy, Japan and the United Kingdom. It was opposed by the United States and Russia. Leading scientists are also advocating a 50% cut in global emissions by that time to minimize the risks stemming from devastating climate change.

A new US administration is expected to put a mandatory cap on carbon emissions.
In June the Japanese government advanced the case for carbon trading when prime minister Yasuo Fukuda announced a pledge to cut Japanese greenhouse gas emissions by 60% to 80% by 2050 and create an experimental carbon trading scheme for industry this fall. “This is a big deal,” says Capoor.

Annie Petsonk, chief international counsel for the Environmental Defense Fund in Washington, DC, says the Japanese government’s decision could signal another step for the carbon market’s growth. “However, much remains to be seen in terms of how the government will implement that commitment,” she adds. “Japan’s announcement does underscore the fact that, internationally, the US is a laggard rather than a leader when it comes to the battle against climate change.”

The US presidential campaign is another event that players, from environmentalists to investment bankers, will be eyeing later this year to determine each candidate’s stance on legislation to cap carbon emissions in the US and create a cap-and-trade system. Previous legislation, known as the Climate Security Act, would have mandated a 66% cut in US greenhouse gas emissions by 2050. When US senators debated the bill this spring before its demise in June, the price of carbon offsets traded on the voluntary Chicago Climate Exchange (CCX) jumped from $5 to $7 a metric ton, Capoor points out. “It focused attention on capping carbon emissions and created more demand for them,” she says, noting the carbon offsets on the CCX were trading at about $3 to $4 earlier in the year.

Sponsored by US senators Joe Lieberman and John Warner, the bill’s proponents said greenhouse gas emissions would have been reduced by about 2% a year between 2012 and 2050, based on 2005 emission levels. Opponents said the mandates would push fuel prices higher and slash jobs. Forty-eight senators voted for the bill while six additional senators, including the presumptive presidential nominees, Illinois Democrat Barack Obama and Arizona Republican John McCain, wrote letters saying they would have cast favorable votes if they had been in Washington. President George W. Bush, who opposes any cap on emissions, had vowed to cast a veto.

Environmentalists were not deterred by the bill’s demise, though some organizations criticized it for not setting more aggressive emissions targets or doing more to develop renewable forms of energy. “It was an important step forward in the process that demonstrates political progress and recognition of the urgency of the issue,” says Rick Duke, director of the Center for Market Innovation at the Natural Resources Defense Council in New York City. “It shows [the US is] marching in the right direction.”

Market players are confident that a new administration, whether Republican or Democratic, will create a mandatory cap on carbon emissions, and most are adamant that a cap-and-trade system should be a part of a larger program to reduce outputs of carbon dioxide.

Abyd Karmali, global head of carbon emissions at Merrill Lynch in London, says carbon trading is the most efficient way to reduce carbon emissions as long as the quantitative limits—the cap—produce enough scarcity to create a price that can mobilize capital and stimulate innovations in technology. “Carbon trading is not, however, the whole solution and needs to be implemented in a joined-up way as part of a broader suite of polices and measures that may be more applicable to some sectors not appropriate for emissions trading.” Karmali says.

Ryan Schuchard at Business for Social Responsibility in San Francisco agrees that carbon cap-and-trade programs should be a piece of a larger policy set by governments to reduce greenhouse gas emissions. The other primary pieces of a solid government policy would include technology incentives, product standards and tax incentives. A 21-member task force sponsored by the New York City-based Council on Foreign Relations stresses the need to support any cap-and-trade system with a variety of other steps: less dependence on foreign oil, greater energy efficiency gained with traditional targeted regulations, and improved energy infrastructure.

But cap-and-trade programs do work. “By turning emissions reductions into commodities, carbon markets lead companies to reduce emissions at the lowest cost, while driving entrepreneurs to continuously improve,” Schuchard says. “If legislation makes emissions more expensive while creating opportunities to buy reductions, the market will expand.” Adds Karmali: “The key determinant of success in carbon emissions trading is whether the [cap] set is tighter than the business-as-usual emissions trajectory.”

Currently, the EU ETS, the largest compulsory carbon reduction scheme, and the carbon credits linked to the Kyoto Protocol are responsible for nearly all of the $64 billion of carbon trading tallied by the World Bank for 2007. The voluntary markets are less than 1% of that total.

Trading System Under Fire
Carbon offsets, whether the European Union Allowances traded under the EU’s trading scheme or the Certified Emission Reduction certificates, known as CERs, traded to meet commitments mandated by the Kyoto Protocol, are generally traded in three ways. The first is through the half-dozen private exchanges around the world, such as the Chicago Climate Exchange or the European Climate Exchange; the over-the-counter market, where a broker can match a buyer and seller; or bilaterally, in a trade between two companies.

The Kyoto Protocol’s Clean Development Mechanism (CDM) has come under increasing criticism for creating a system where projects in developing countries that would have been built anyway are receiving grants for carbon reduction.

The CDM is a scheme that lets a corporation in a developed country, committed by Kyoto to reducing or limiting its carbon emissions, to buy emission credits from a project in a developing country that has ratified the pact. That means, for example, that a German power plant that is spewing out too many tons of carbon dioxide each year can buy CERs from a Chinese wind farm generating renewable energy or an Indian sugar plant that has replaced a generator running on diesel fuel with a machine that is friendlier to the environment.

But before the project in the developing world can sell its carbon credits, or offsets, the project must be vetted and approved by the UN body that oversees the program. Some environmental groups and academics claim companies in developing nations, from wind farms to chemical companies to sugar mills, are abusing the system and claiming carbon credits for projects that would have been built anyway. That means the CDM scheme may not be leading to any real reductions in greenhouse gases.

In a working paper issued in April, two Stanford University academics detailed their review of the CDM and concluded it was in urgent need of reform. “We suggest that the actual experience under the CDM has had perverse effects in developing countries. Rather than draw them into substantial limits on emissions, it has, by contrast, rewarded them for avoiding exactly those commitments,” say the authors, Michael Wara and David Victor.

CDM spokesperson David Abbass counters that projects registered under the CDM are vetted according to its rules, and to qualify for credits any emission reductions must be real, measurable, verifiable and “in addition” to what would have occurred without the project. “Unclear additionality is currently the principal reason that projects are sent back for review or rejected,” says Abbass. “The CDM welcomes public and academic scrutiny. In fact, it is designed to ensure such scrutiny. Virtually every document about every project registered under the CDM is available on the UNFCCC [United Nations Framework Convention on Climate Change] website.”

Abbass also notes that developed nations committed to limiting or reducing their emissions under the Kyoto Protocol can use offset credits to cover only a part of their commitment. The offsets have to be supplementary to emission reduction measures taken at home.

“Some stakeholders argue that the process is too rigorous; others argue the opposite. This is perhaps a good indication that the regulator is succeeding in its role,” says Abbass.

Since the first CDM project was registered in 2004, the scheme has issued more than 152 million CERs, the equivalent of 152 million tons of carbon dioxide. That represents more than 1,000 projects.

As the merits of the CDM are debated, initial talks are under way for a successor pact to the Kyoto Protocol, which some say is key to the future of carbon trading. In early June ministers from about 170 countries met in Bonn during the second session of a two-year push for a replacement vehicle that will widen and toughen the existing pact that expires at the end of 2012. United Nations officials would like to wrap up a new deal in Copenhagen in December 2009 to give companies and investors as much advance knowledge as possible of coming changes and provide national parliaments with time for ratification.

“There is a need for the carbon market to be seamless between the end of the first Kyoto budget period in 2012 and the start of the post-2012 market under the replacement agreement,” says Karmali. “Our view is that the science is growing ever more compelling and stakeholder pressure is building for a new longer-term agreement.” He worries, though, that a December 2009 wrap-up date may be too early for an incoming US administration, and 2010 may be more realistic. The next set of talks will be held in August in Accra, Ghana.

Experts agree that the key to a successful replacement protocol is getting the US and emerging economic giants, such as China and India, on board. “I think there will be a new protocol. It will be last minute and after a lot of gnashing of teeth,” says Henry Lee, a lecturer in public policy at Harvard University’s John F. Kennedy School of Government in Cambridge, Massachusetts. The US will demand that India and China sign a new pact, he says.

The need to entice China into the next global climate agreement was underlined by a recent report clearly showing that China has become the world’s leading emitter of carbon dioxide. The annual report, released in June by the Netherlands Environmental Assessment Agency, indicated that China’s emissions in 2007 were 14% higher than those of the US. “There’s a shot at getting China” as long as its leaders know signing on will not restrict their growth, adds Lee. “But in India the politics are tougher.”

In the meantime, most environmentalists are undeterred if banks are making money in the carbon trading process. “If there are ways for people to do good in the world by doing well for themselves, that is fine,” says Petsonk. “There is a role for banks and brokers to play in helping to reduce carbon emissions.”

WHAT IS CARBON TRADING?
A carbon offset is a financial measurement that represents a reduction in greenhouse gas emissions from a source anywhere around the planet. One carbon offset represents a reduction of 1 metric ton of carbon dioxide or its equivalent in other greenhouse gases.

Different greenhouse gases have different global warming potencies, and the goal of the United Nations-linked Kyoto Protocol is to lower overall emissions of six greenhouse gases—carbon dioxide, methane, nitrous oxide, sulfur hexafluoride, hydrofluorcarbons and perfluorcarbons—by 5.2% below 1990 levels by 2012. The reduction represents a 29% cut compared to the worldwide emissions that would be expected by 2010 without the protocol.

The International Treaty Behind the Market
Carbon trading’s roots lie in a 1989 deal where a US power company attempted to offset its carbon dioxide emissions through a tree-planting endeavor in the western highlands of Guatemala. Since then, the push to reduce emissions of carbon dioxide and other greenhouse gases has spread to 181 countries through the Kyoto Protocol. An international agreement linked to the United Nations Framework Convention on Climate Change, the Kyoto Protocol’s major feature is the adoption of binding targets for greenhouse gas reductions by 37 industrialized nations and the EU.

The pact was agreed in Kyoto, Japan, in December 1997 but did not enter into force until February 16, 2005. The first phase of mandatory emissions reductions runs from 2008 to 2012. Talks are already under way for a successor pact, which the UN hopes to have in place by the end of 2009. The United States and China, the world’s two largest emitters of carbon dioxide, have not ratified the pact.


# Paula L. Green