Carbon is the next gold

Consultants and financiers scramble to stake their claim in the trillion-dollar carbon market

By Victoria Schlesinger

On a February evening in the Butterfly Lounge overlooking San Francisco Bay, the jackets and ties and nametags finally came off. Attendees of the Carbon Forum America conference were sharing a nightcap and talking frankly about who will profit in the United States due to climate change. Would it be the banks, the traders, the greenhouse gas–emitting industries, or the public? A utility company employee who had already tossed back a few leaned heavily on a table, lamenting the problems with American capitalism. A CFO seeking funding for his solar venture called the carbon economy a “bunch of hot air.” And standing in small groups, as servers offered up hors d’oeuvres and glasses of wine, financiers projected the size of a possible US carbon market. With its potential to reach $1 trillion by 2020, it seems everyone wants a cut.

The drinks and blunt musings came after a long day of panel presentations, where the questions of who will win and who will lose under proposed federal global warming legislation simmered beneath reserved exchanges. The conference began with an inspired speech about the significance of launching a carbon market—one in which companies buy, sell, and trade the right to emit carbon dioxide (CO2) to reduce the amount of greenhouse gases released into the atmosphere. It’s widely believed the world must slash CO2 emissions 80 percent by 2050 to avoid the worst effects of climate change, including sea level rise, catastrophic weather, and ecosystem degradation. “You are taking part in something that really matters,” James Cameron, vice chairman of Climate Change Capital, a cleantech investment group, told the crowd. “You’re finding ways to solve a problem that, ultimately, if we are successful, will have taught us how to achieve a level of cooperation between us as humans that, perhaps, we’ve never achieved before. That is the nature of the endeavor that is involved in the global carbon market.”

Cameron, a tall, dapper Brit who wore pinstripe pastel socks and carried a fedora, received warm applause for his opening words. Next up was Nancy McFadden, senior vice president of public affairs for Pacific Gas & Electric (PG&E). “I’ll bring this down to a level maybe not so lofty ...,” she began. It was a minor jab that alluded to the countrywide tension about how the $1 trillion will be divvied up. Financiers like Cameron, companies such as PG&E whose CO2 emissions will be regulated, and environmentalists are now heatedly debating the rules for a market that could be in place as soon as next year.

With about two-thirds of states pursuing regional carbon markets and climate change legislation in the absence of a federal policy, companies fear a regulation nightmare. As a result, the business sector is demanding the government establish a nationwide policy with a single set of rules as quickly as possible. An alliance called the United States Climate Action Partnership, made up of more than two dozen major corporations including General Motors, Duke Energy, and BP America, has pledged to help “enact an environmentally effective, economically sustainable, and fair climate-change program consistent with our principles at the earliest practicable date.”

Almost every process of modern life emits some CO2—transportation, heating, cooling, manufacturing, even exhaling. That’s why regulating the molecule is not only an unprecedented undertaking, but for most of us, an intangible one. Because trying to reduce an invisible and ubiquitous substance is by its nature an elusive effort, in the last year many economists have argued that the simplest solution would be to tax emitters for each ton of CO2 they produce. But most companies, financiers, and environmental advocates favor a more complex regulatory system, called cap-and-trade, for its cost effectiveness and incentives. “[A tax] doesn’t motivate the people  here [at the conference] to get up in the morning and do something,” said Josh Margolis, co-CEO of CantorCO2e. Like Margolis, many conference goers offer financial services, such as investing, trading, and funding, to businesses that will be regulated and see their bottom line affected. “Do you think about steps you can take to minimize your taxes, or do you think about how you can earn more revenue? Most of my clients like to earn revenue,” Margolis said.

To create a US cap-and-trade system, the federal government would set a limit on the amount of CO2 the country is allowed to emit, then ratchet down the limit each year. This makes the gas a valuable commodity that businesses can buy if they need to emit more or sell if they reduce their emissions. To monetize emissions, the government would issue carbon allowances, each of which would permit its holder to emit one metric ton (Mt) of CO2. For example, if a company called Alota Power typically emits 100 million Mt of CO2 a year but then invests in cleaner technology that reduces its emissions to 80 million Mt annually, it has 20 million unused allowances it can sell on the carbon market. Suppose Whata Steel Corp is struggling because it usually emits 130 million Mt but under the cap is permitted only 110 million. It can buy the 20 million carbon allowances it needs from Alota Power.

In practice, a cap-and-trade system would regulate two types of companies: those that sell energy sources, such as coal and oil, or those that use a lot of energy, such as utilities and oil refineries. Because of the accounting mess that would ensue, individuals or residences wouldn’t likely be regulated. They will be affected, however, by rising energy and product prices. The climate change policy that legislators agree on will determine who gets the allowances, how many they receive, and who oversees the system. The EPA estimates that a single allowance of one Mt of CO2 could be worth between $37 and $51 by 2020. Given that the US emitted roughly 6 billion Mt in 2004, it’s easy to imagine the carbon market’s size. “We’re talking about handing out money,” says Union of Concerned Scientists (UCS) climate program economist Chris Busch. “If you’re handing out money, everyone’s going to get in line and make arguments, which sound like principled arguments, for why they deserve to get the money.”

For the first time in history, there’s a price on air.

Those making the loudest arguments are businesses that will most likely be regulated—and therefore required to pay for polluting—under climate-change legislation. They are pushing for cap-and-trade rules that best serve their interests, fighting over how low the cap should go, whether it could be broken under certain circumstances, and how carbon allowances should be handed out—for free, by auction, or both. What emitters want differs from what environmentalists want, and financiers and politicians have different ambitions altogether. “It’s contentious,” said Antonia Herzog, a climate legislation advocate for the Natural Resources Defense Council, about the carbon market design. “This is where the money is, so basically it’s a food fight right now.”

At Carbon Forum America for instance, where most attendees were from the financial sector, the wants of industry didn’t seem to be of central concern. David Struhs, vice president of environmental affairs for International Paper, the world’s largest paper products company, found that out when he registered for the conference. In his presentation, Struhs told the crowd, “The nice lady at the counter … went through ‘Are you a technology provider, a consultant, a lawyer, a project developer, a trader, financial services, government employee …’ and that’s when I broke in and said, ‘industry.’ And she said, ‘Oh, we don’t have that one. I’ll just put you down as ‘other.’” Struhs paused. “Ladies and gentlemen, I think this is symptomatic of one of our problems.”

Emitters may have been an afterthought at the conference, but they wield significant influence with members of Congress, who will design climate change policy. International Paper, like most large emitters, is arguing for the government to distribute carbon allowances free of cost to those with a history of emissions. Under this scheme, because International Paper emitted 10.5 million Mt last year, the company would likely be given 10.5 million allowances. Additionally, industry would like the cap—which will decrease over time to shrink the country’s total emissions—to lower as slowly as possible. “From the perspective of what’s actually doable, you would hope that the reduction curve would start relatively shallow and grow deeper over time,” said Doug Stilwell, International Paper’s manager of environmental health and safety. “Because we don’t have a ready answer. We all know of ways we can save a little [emissions], but nobody knows how we can save a lot.”

Many environmental groups oppose handing out allowances for free and instead advocate auctioning them off in a cap-and-trade system. In this scenario, companies would buy carbon allowances up front from the government, bidding against one another for whatever price the market will bear. Environmentalists argue that an auction will help discover the price of carbon, prevent companies from lobbying politicians for extra allowances, and ensure a system that benefits the public. The funds generated from an auction, they say, should help taxpayers. MIT economist John Reilly has explored a system modeled after Alaska’s distribution of oil revenues to state residents; he found that equally dividing carbon allowance rebates could distribute $1,600 to $4,900 annually per family of four.

International Paper opposes an allowance auction for the same reasons as most emitters. “A tremendous amount of capital will be sapped out of the emitters to purchase the right to do what they have historically done,” Stilwell said. “Which would you rather we do—spend the money to reduce the emissions or buy the right to continue to emit?” Stilwell conceded it was not an either-or situation, though he also said that companies would move offshore if compliance became too costly.

There’s a worry, however, that companies won’t invest in reductions even if they receive the allowances for free, but rather will add the value of allowances to their business costs. As a result, product prices would go up, and the profit could be passed on to shareholders. As Busch from UCS, which supports an allowance auction, explained, “A scalper is selling Super Bowl tickets. Would you expect him to sell the tickets for less if he got them for free?”

The concern isn’t trivial, as evidenced in the European Union. There, a carbon market established in 2005 is helping countries meet their commitments under the Kyoto Protocol—the international climate change treaty the US didn’t ratify. In the first experimental phase of the EU carbon market, called the European Trading System (ETS), allowances were given to emitters for free. Nonetheless, some utility companies raised the price of electricity as if they had purchased the allowances. As a result, power generators pocketed around 1 billion euros in 2005. To correct the problem, the ETS is moving to a hybrid model in which some allowances are given for free and others auctioned. The aim is to transition all industries to 100 percent auctioning by 2020. “The right approach is to look at the affected industries and to make an assessment as to how they function and how they can pass price along,” said David Hone, group climate change advisor for Royal Dutch Shell, the world’s third-largest corporation.

After three years of experimenting, EU companies are like carbon market veterans when compared to their American counterparts. Hone attended Carbon Forum America, and he thought the tension among participants was due to a lack of experience with emissions caps. “A lot of people in companies don’t imagine, for instance, that the carbon price can pass through in the services they offer; therefore they see the possibility of auctioning as a threat to their profitability,” he said. “We’ve experienced the same tension in Shell, but we now have a lot more economic input into our assessment of this than we did originally.”

To gain similar insight, US companies are contracting experts to advise them, and therein lies the opportunity for financial intermediaries, such as brokers and banks. Financiers are expected to handle half to two-thirds of the trades in the $1 trillion carbon market, which might explain why they dominated Carbon Forum America and why Struhs was peeved that industry was left off the registration list. In his presentation, Struhs described the plight of a fictional company deliberating over whether to spend money to reduce their emissions or buy carbon allowances. “They recognize that NatSource charges these exorbitant fees,” Struhs said, poking fun at the financial services company sharing the stage with him. “But they also recognize that there will be certain circumstances where NatSource can provide them with the low-cost alternative.”  Reclining in a leather booth at the Butterfly Lounge, Brian Prusnek, the 30-year-old vice president of policy for Climate Change Capital, explained the relationship between emitters and financial experts more bluntly. “Companies that are going to be regulated are going to have to spend money to comply with regulation. Every penny they spend is possibly a penny or half penny for us.”

Financiers will rarely earn that much, but they do stand to gain business from a cap-and-trade system.

With so much attention on the design of a carbon market, the environment might seem like the birthday kid missing her own party. But there’s a reasonable explanation: Whether the government gives away or auctions allowances makes no difference to the atmosphere. As long as the annual cap on CO2 emissions is put in place and reduced each year, we’ll be working toward our target of lower emissions. “Allowances are about how you spread and divide up this pool of value,” said Janet Peace, senior economist for Pew Center on Global Climate Change. “So the cap isn’t affected by how you divide it up, as long as you have a cap.”

Still, no one believes a cap-and-trade system alone can solve a problem as vast as climate change. Even a market booster like Cameron doesn’t think so. “The carbon market will produce innovation, it will find bigger markets for technology, but it can’t be expected to do everything that’s necessary to make the transformation,” he said. We also need, Cameron added, incentives to increase energy efficiency in commercial buildings and homes; higher fuel efficiency standards while we research electric- and hydrogen-powered cars; and major government investments in clean energy research and development,  “But it’s without question the most significant policy lever we’ve got. It best fits the problem we have. It deals with the diverse range of decisions that have to be made every day all over the world. It does help overcome unnecessary barriers between human beings in solving the collective action problem. And it will create wealth worth having when it’s done."


Damn straight - James Cameron rocks!

Is it supposed tobe COOL to buy the right to pollute? I'm new here, but have heard of this idea before and always assumed it was some sort of a joke, like the ancient idea of buying indulgences so one could sin. Does this actually make sense to anyone besides maybe someone like the former managers of a company called Enron which brought rolling black outs to California?

@Siver Bear - dude you spent too much time as an altar boy as a grom. By creating a market for co2 emissions, coupled with legally binding targets, countries and companies have start paying the true price for their activities. As a result investment, at scale, will be channeled to reduce GHG emissions and generate cleaner energy. Companies that adapt will still make a profit and only now in conjunctiuon with the environment. Wealth can still be created, only now it's wealth worth having.