Could greenhouse gas emissions trading solve the climate change problem? asks Julian Richardson.

Fossil fuel consumption and other energy-intensive human activities have dramatically increased the amount of carbon dioxide and other greenhouse gases (GHGs) in the earth's atmosphere. Scientists agree that surface air temperature and sea levels are rising. According to the US National Academy of Sciences, "human-induced warming and associated sea level rises are expected to continue through the 21st century." What is unknown is the magnitude of temperature and sea-level change, and the speed with which it will occur.

Even small changes in the climate can have potentially catastrophic ecological, social and economic impacts, and policymakers around the world have sought ways to reduce GHG emissions. In 1997, 159 governments signed the Kyoto Protocol establishing global and national targets for reductions of 5.2% of the industrialised world's 1990 level of emissions. Despite the opposition of the US government, which considers the treaty's targets unrealistic and economically harmful, the Kyoto Protocol will likely come into force later this year, when the Russian Federation is expected to join more than 90 other countries in ratifying the agreement.

Although there are scientific uncertainties about the details of global warming and political differences about the best ways of addressing the problem, all nations agree that climate change poses significant global risks and that reductions in GHG emissions will have a cost. Once the Kyoto Protocol is in effect, national governments will allocate their emissions obligations among carbon-intensive domestic industries, which will, in turn, pass these costs to consumers. Many companies in Europe anticipate spending $10m or more to comply with the treaty.

The preferred policy response for reducing GHGs is a capital market innovation known as emissions trading. Based on successful efforts to reduce acid rain pollutants, emissions trading restricts the total amount of GHGs that can be released into the atmosphere. Under the Kyoto Protocol, a national government can issue shares of its agreed limit in the form of tradable certificates that provide evidence of compliance with targets. Energy, power and other companies can decide for themselves whether to reduce their GHG emissions or purchase these certificates from another entity with surplus permits. Such permits become available when a business has exceeded its target for emissions reductions.

By introducing a trading scenario, emissions trading allows for 'price discovery' of the cheapest abatement opportunity. If every company were simply forced to reduce its GHG emissions by a specified amount, but not allowed to trade, the differing marginal abatement costs per ton would be inequitable. Companies that are generally more energy/carbon efficient would find it more expensive than an inefficient company to reduce further their emissions. Moreover, the total cost of abatement would be higher.

Because emissions trading produces the least-cost solution to climate change, businesses support it over a carbon tax or other policy response. Another advantage of emissions trading is its ability to create incentives for developing innovative abatement technology as the market-determined price of carbon rises. With a tax, the price per ton is set, and the only incentive is to adjust production levels, which generally benefits neither business nor society. With some exceptions, the global community of non-governmental organisations accepts emissions trading as the favoured policy option because it delivers measurable environmental benefits.

Restricting the emission of GHGs will have a profound impact on the market dynamics of carbon-intensive industries. On one hand, compliance regulations may be a barrier to entry for new competitors. On the other, existing businesses may find themselves with stranded assets. A coal-fired power station, for example, may no longer be economically efficient when the cost of carbon has been included. Some company's products may be replaced altogether by low-carbon substitutes.

New suppliers of abatement technology will enter the market, and increasing numbers of consumers and investors will hold companies accountable for their environmental performance. Moreover, carbon-intensive businesses will have to develop new skills and competencies, for example, in emissions monitoring and trading. The companies that are most successful at using carbon emissions trading as an additional source of revenue will be able to reduce their cost of capital and gain competitive advantage.

Sox, NOX and acid rain
In the US, emissions trading has already played a central role in the reduction of sulphur dioxide (SO2) and nitrous oxides (NOX), the primary components of acid rain. Because electric power generation is responsible for about two-thirds of SO2 emissions and one-third of NOX emissions, the Clean Air Act of 1990 required electric utilities to lower their emission of these pollutants by 8.5m tons compared with 1980 levels. In 1995, the first year of program compliance, SO2 emissions decreased by 3m tons, according to the US Environmental Protection Agency (EPA). Over the first four years of the program, SO2 emissions from the largest, highest-emitting electric utilities were about 5m tons below 1980 levels.

The cost of these reductions has been significantly less than anticipated. In 1989, the utility industry estimated that the cost of compliance for its companies would be $7.4bn. A year later, the EPA estimated compliance costs of $4.6bn. Based on actual compliance information, a 1998 report by Resources for the Future estimated the cost of SO2 emissions reductions at less than $1bn.

The EPA attributes the large reductions in emissions and the lower-than-anticipated costs to the decentralised, market-driven approach of the Acid Rain Program. EPA administrator Christie Whitman said that the program has "achieved more air pollution reductions, more cost effectively, than all other air programs combined."

Kyoto and trading
Despite its enthusiasm for market-based solutions to environmental problems, the Bush administration has opposed the Kyoto Protocol. Noting that the US accounts for 20% of man-made emissions and about 25% of the world's economic output, President Bush says that the Kyoto targets are "unrealistic" and that US compliance "would have a negative economic impact, with layoffs of workers and price increases for consumers." On the other hand, the US government has undertaken initiatives to cut 'greenhouse gas intensity' (the ratio of greenhouse gas emissions to economic output), and to protect and provide transferable credits for emissions reductions. Individual states, impatient for federal action, are imposing their own restrictions on GHG emissions. The complex mix of legislation across states adds to the cost of doing business in two or more states with slightly different emissions regulations. A number of pending bills in Congress, including one that calls for a domestic 'cap-and-trade' system, are aimed at providing greater consistency, clarity and certainty for US businesses.

The Bush administration's resistance notwithstanding, the Kyoto Protocol will likely be ratified in 2003. The agreement will enter into force 90 days after 55 governments, representing at least 55% of the developed world's 1990 global emissions, ratify the treaty. The Russian Federation and other countries have declared their intent to ratify the Kyoto Protocol, which would meet the threshold for industrialised countries' proportion of greenhouse gases. The initial period of compliance is 2008 to 2012.

The Kyoto Protocol's emphasis on emissions trading has accelerated the development of GHG markets around the world. Today, there are 37 international, regional, national, local and company-internal trading schemes. Denmark, for example, has established a cap-and-trade scheme for CO2 produced by the country's power companies. Denmark is also exploring bilateral and regional trading regimes with other Scandinavian countries.

The world's first legislatively backed national greenhouse gas market is the UK Emissions Trading Scheme (ETS), which opened for business in April 2002. Under the Kyoto Protocol, the UK is committed to a 12.5% reduction in greenhouse gases. As an inducement to participate in the ETS, the government has provided financial incentives to firms that voluntarily adopt emissions reduction targets for greenhouse gases. Envisioning that such trading will become an important risk management tool, the government wants companies to develop trading expertise before 2008, Kyoto's first year of compliance. The 34 organisations that have taken on legally binding reduction targets have the choice of trading just CO2 emissions or all six greenhouse gases covered by the Kyoto treaty (in addition to carbon dioxide, the gases are methane, nitrous oxide, hyrdrofluorocarbons, perfluorocarbons and sulphur hexafluoride).

A European Union-wide trading scheme is expected to begin in 2005. With some 5,000 companies in Europe facing emission controls, the European Parliament recently approved a mandatory cap-and-trade system with strong compliance features. The trading scheme must be approved by member states, some of which have sought exemptions for their industries. EU Environment Commissioner Margot Wallstroem calls emissions trading the "lynchpin of a cost-effective climate change strategy for the European Union."

The Chicago Climate Exchange, a private US initiative aimed at introducing clarity and consistency to domestic GHG activity, will administer a voluntary program of emissions reduction and trading. The exchange has commitments from power, forest products, manufacturing, oil and gas, and agricultural companies to reduce emissions in their operations, starting with a target of 2% below 1999 levels in 2002 and reducing emissions 1% per year thereafter. Anticipating some form of mandatory US government program to reduce GHG emissions, the initial participants are located in seven US Midwestern states: Illinois, Indiana, Iowa, Michigan, Minnesota, Ohio and Wisconsin. The exchange plans to cover to all of North America in 2003 and globally in 2004.

The GHG markets in the UK, Europe and US take different approaches to emissions trading. For example, some are public and other private; some trade all six GHGs and others just CO2. Despite such differences, the markets share many more common features. These include credible emissions baselines, proof of environmental impact, monitoring and verification procedures, and proof of ownership of the reductions.

Embryonic and fragmented, the global market for trading GHG emissions is growing rapidly. The World Bank estimates that some 67m tons of GHG emissions were traded in 2002 and that carbon trading should become a multi-billion-dollar market within a few years. GHG emissions could eventually become the world's largest commodity market - one that is deep and liquid, with secondary and derivative markets. (UNEP), The United Nations Environmental Programme, estimates that the market will reach $2trn by 2012.

Emissions trading has a key role to play in the inexorable transition to a carbon-constrained world, where businesses will face new financial and operational exposures. Fundamental to developing compliance and risk management strategies will be a better understanding of a company's GHG emissions profiles and the marginal cost of emissions reductions. Because a substantial portion of emissions trading will be done on a forward market and be based on project-generated emissions reductions, there will be many credit, efficacy, hazard, price and political risks that require risk management solutions. Of course, for the early movers and leaders in this sector there are opportunities as well as risks. Emissions reductions inevitably bring focus on other production costs. Contrary to expectations that participation in an emissions trading market will increase costs, a number of major oil companies have found that it has given them a cost advantage over their competitors.

By Julian H Richardson

Julian H Richardson is Vice President, Marine & Energy Practice in the UK operations of broker Marsh.