Pollution is Good Business for CCX Carbon Financial Instrument

Who knew dirty air could be such good business? Last year, the global carbon credit market topped $30 billion, and traders exchanged more than 1.6 billion metric tons of CO2 emission permits worldwide.

Unlike the rest of the world, however, the U.S. remained largely skeptical of carbon trading. Long after the EU adopted the Kyoto Protocol, they refrained from implementing any mandatory emissions limits or trading structures. (Smells too much of Al Gore-style eco-evangelism.)

But on March 17, St. Patrick's Day, NYMEX's Green Exchange launches its first carbon futures for trade, effectively opening up the States' infant carbon market on the world's largest commodities futures exchange. That - combined with the fact that all three remaining U.S. presidential candidates favor a mandatory CO2 trading system - might just turn the U.S.' current emissions trading scene into a major vehicle for global climate change.

Or will it? Analysts still can't decide whether carbon trading is an innovative application of free-market capitalism, or a wild goose chase for greenies. It all comes back to the hotly debated question: Can good business and conservation coexist?

Cap-And-Trade 101

Since 1751, we've spewed about 315 billion tons of carbon dioxide into the atmosphere - about half of that in the last 40 years. The IPPC estimates that, if left unchecked, global greenhouse gas emissions could rise another 25-90% over year 2000 levels by 2030 (CarbonPositive). That's bad news, since greenhouse-gas-related climate change also brings rising sea levels, crop failures and even worldwide species extinctions.

Policy makers and environmental groups have floated several approaches toward curbing greenhouse gas emissions, but few proposals have gained as much traction as emissions trading, also known as "cap-and-trade."

Cap-and-trade is simple enough: Governments (or international agencies) set a limit or "cap" on the total amount of CO2 a country can emit each year. Companies are issued emission permits, or "allowances," that give their factories the right to emit a certain amount of CO2 (or its polluting equivalent in other greenhouse gases). The cap alone should drive many companies to upgrade to more eco-friendly equipment, thus cutting down their emissions.

Since low-emissions companies won't need all their allowances, they can sell their surplus on the open market as "credits." Polluters that can't or won't upgrade their technology can purchase these credits to cover their emissions excess.

In addition, companies can pay someone to reclaim CO2 through green projects called "offsets." Calculated to absorb a given amount of atmospheric carbon, offsets effectively cancel out those extra emissions from high polluters. Common projects include planting forests to suck up greenhouse gases, or recovering methane from a landfill to fuel power plants.

Yes, the cap-and-trade system still allows polluters to pollute. But in theory, companies that can easily and cheaply curtail their output are likely to do so, since they can profit from selling excess credits. Indeed, the more they cut back, the more money they stand to make. Thus, CO2 reduction occurs as the least financial burden to society.

Reaction At Home

And yet, the cap-and-trade scheme isn't perfect. An accurately valued market depends on careful, rigorous measurement of CO2 emissions across local, national and global levels. It also requires an independent third party trustworthy enough to verify when offset projects have taken place, and that their emissions savings were counted properly. But companies cheat, particularly by exaggerating their CO2 output. And in many systems, the same third parties verifying an offset's legitimacy are also in charge of approving the project, too.

Some critics argue that cap-and-trade is fundamentally flawed, that it doesn't solve the carbon problem so much as redistribute it. Since low emitters just sell their pollution rights to the highest bidder instead of retiring them, pollution isn't reduced beyond the initial cap restriction. There's also the problem of "grandfathering," where the government gives credits to polluters, instead of charging for them.

Still, many analysts consider cap-and-trade better than its alternatives - the carbon tax or emission fees. True believers can point to the example of sulfur trading, which, in the last 10 years, has successfully curbed sulfur emissions in the U.S. by more than 50%.

Politicians in Washington are already sold on a CO2 cap-and-trade scheme; two separate bills in Congress propose a mandatory nationwide cap. For example, the Senate bill, America's Climate Security Act, would limit carbon dioxide emissions to 15% below 2005 levels by 2020, while still allowing state and regional initiatives to impose more stringent restrictions.

On the local level, 22 states have explored or established voluntary cap-and-trade programs, many modeled after the EU's system. The Regional Greenhouse Gas Initiative, supported by 10 Northeastern states, is set to start next year and aims to reduce CO2 emissions to 10% below the 2009 level by 2018. A similar collaboration, the Western Climate Initiative, involves seven Western states and even two Canadian provinces.

Voluntary Carbon Trading In The U.S.

So far, however, the U.S. carbon market remains voluntary. Experts still disagree on just how large our market could grow, but Morgan Stanley, already active in voluntary carbon credit trading, puts the domestic carbon offsets volume at $91.6 million in 2006. They estimate that figure could triple - or more - by 2009. A September 2007 report from Lehman Brothers projected a $100 billion market by 2020 (Bloomberg).

In the U.S., carbon credits and offsets have traditionally been traded in futures and options contracts on the Chicago Climate Exchange (CCX). CCX, which opened in 2003, is the world's first - and, until NYMEX's Green Exchange, North America's only - active voluntary carbon trading system.

CCX trades in annual contracts of "carbon financial instruments" (CFI), which represent 100 metric tons of CO2 (or CO2 equivalent). The contracts cover credits (set according to the CCX Emission Reduction Schedule) and offsets, regulated and verified by an approved CCX verifier.

The exchange has been a testing ground of sorts, a laboratory to experiment with the rules and standards that a future, national mandatory cap-and-trade system might adopt. But actually hammering out specific operations and regulations has been tricky.

"You don't come up with the rules of baseball sitting in a room with a bunch of lawyers," Scott Subler, chairman of the CCX offset committee, told the WSJ. Baseball evolved through years of trial and error on the sandlot, he says, and so far, "CCX has been the best sandlot."

On the other side, NYMEX's Green Exchange will tap into the vibrant European carbon market. It'll offer futures and options in European Union Allowances (EUAs) and Certified Emission Reductions offset credits [CER]which often run at different prices). Futures contracts on the Green Initiative will cover 1,000 metric tons of CO2 (or 1,000 EUAs).

"The Green Exchange will be more than a financial marketplace," says Andrew Ertel, president and CEO of Evolution Markets (one of the exchange's partners). "It will be an engine behind global efforts to improve the environment."

The Super Tuesday Spike

CFI) Contracts Daily Report" title="Carbon prices on CCX over the past two years" height="450" width="470">

Carbon prices on CCX over the past two years.

Source: CCX

If the Green Exchange performs anything like CCX, then Ertel might be right. Last month, prices on CCX more than doubled, swelling from below $2/CFI in November to about $5.50/CFI in mid-March.

Volumes have skyrocketed too, with January and February setting trading records. Almost 2.5 million people traded on Feb. 11 alone - more than CCX's average monthly trading volume for the entirety of 2007.

But the surge in carbon prices has less to do with a sudden attack of American eco-guilt, and more to do with the 2008 presidential primaries. All three remaining contenders favor carbon trading, and each has put forth his or her plan for a mandatory cap-and-trade system.

Carbon prices jumped after Super Tuesday, when Rep. John McCain - the only remaining Republican favoring a mandatory cap-and-trade scheme - secured his front-runner status. And since both remaining Democratic candidates also favor cap-and-trade, the possibility of a future mandatory national cap-and-trade system seems assured.

There's a lot of kinks to work out of the U.S. market when it goes mandatory - not the least of which that carbon prices run anywhere from 1 to 30 euros, depending on where you look (WSJ). And we still need to standardize just what qualifies as a legitimate offset project - does nuclear count? Or only renewable energy? What about energy-efficient projects? And so on.

CFI) Contracts Daily Report" title="Carbon prices on CCX more than doubled right after Super Tuesday" height="450" width="470">

Carbon prices on CCX more than doubled right after Super Tuesday.

Source: CCX

Still, while nothing's a sure bet in trading, the carbon market is probably as close as you're ever going to get. In our current political landscape, it's seems less a question of if prices will rise than when. Those who jump in now, before the impending nationwide carbon cap, may reap the rewards from dirty, smelly air. And that means a whole lot of green.

Links:

NYMEX's Green Exchange

Chicago Climate Exchange

International Emissions Trading Association

CarbonPositive

Offsets Market Evolving Slowly - WSJ, 2/27/08

PointCarbon's Carbon Market North America - 2/27/08

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