"Warming of the climate system is unequivocal, as is now evident from the observations in global average air and ocean temperatures, widespread melting of snow and ice, and rising average sea level." With these words, the UN's Intergovernmental Panel on Climate Change (IPCC) made certain that the reduction of greenhouse gas (GHG) emissions, which are widely believed to have contributed to global climate change, will be a policy issue for decades. Carbon trading markets are the most popular solution for reducing GHG emissions, and in particular carbon dioxide emissions, which are the largest constituent of GHG emissions.
Carbon trading refers to a system to control the emission of carbon dioxide whereby governments or international bodies set an overall limit on the amount of carbon that can be emitted. Allowances are then granted (or auctioned) to large emitters of carbon, such as electric utilities, paper mills, and chemical plants, which are then freely tradable. Companies who will be emitting more carbon than they have permits to emit must therefore buy additional credits on the open market, while those who will emit less can sell their credits.
This system is attractive to governments for several reasons. First, it easily enables sliding reductions in carbon emissions over a number of years. Every year, the number of credits granted can just be decreased by the government. Second, it creates a flexible and efficient market for carbon reduction, encouraging reduction of carbon emissions by those companies who can do so at the least cost. After all, a company for whom reducing carbon emissions is expensive will buy excess credits from a company that can reduce carbon emissions cheaply. On the hand, in the words of economist Jeffrey Sachs, carbon trading is "hard to implement, it's hard to monitor, it's non-transparent, it's highly political, highly manipulative, which is why the banks love it, the banks all want to trade, this is an investment banking dream."
What does all this mean for investors? The implications of a widespread carbon trading scheme, especially encompassing U.S. carbon emissions, are vast and highly dependent on the details of any pending legislation. However, a few investment themes are likely to play out, regardless of the details.
Financial services companies and related businesses with prior experience trading carbon, with exchanges for trading carbon-emission credits, and those involved with providing real-time data to financial institutions and utilities would all stand to benefit from the emergence of new markets to expand into.
The quickest way for an electric utility to directly reduce GHG emissions is to switch from coal power to natural gas power. This will, of course, not be sustainable over the long term as natural gas prices rise, and given that investments in other forms of carbon reduction would have large long term payoffs. Over the long term, generating power from low-carbon sources will be critical to meeting carbon cap requirements. Oil and natural gas companies will have to add the cost of CO2 emissions permits to the cost structure of their products. Fossil fuels are a price-setter. As their price rises, the price of energy from all sources will rise, making previously expensive energy generation technologies competitive. This will encourage investments in nuclear, solar, geothermal, tidal, wave, hydroelectric, and wind energy, all of which offer significant carbon reductions over coal, oil, and natural gas.
Johnson Controls (JCI) offers another interesting play on carbon trading. The company specializes in building efficiency services (i.e., helping reduce electricity usage in buildings), and already offers one contract that promises to deliver a fixed reduction in GHG emissions.
For paper companies, such as Weyerhaeuser Company (WY) and International Paper Company (IP), carbon trading also offers a double-edged sword. On the one hand, their GHG-emitting plants would now be subject to increased regulation, while on the other hand, their forestry assets in North America and overseas would become more valuable, depending on how legislation defines "carbon sinks." A carbon sink accumulates and stores carbon, effectively offsetting a certain level of emissions. Power companies such as the Canadian company Cleco Power (CNL) are already investing in "carbon sinks" and offsetting carbon use by participating in efforts to stop deforestation. Cleco participates in the UtiliTree Carbon company, a consortium of 40-plus U.S. utilities that manage wetlands and plant trees to offset deforestation in the southern U.S., Malaysia and Belize. The trees and plants in forests absorb carbon dioxide, but quantifying their effect is difficult, making their legal status as carbon sinks to offset emissions uncertain. h t t
Everyone that pollutes lots of CO2 would be in trouble-
American Electric Power Company (AEP), an electric utility, produces more carbon dioxide each year than any other company in the U.S. With its strong base of coal-powered plants, AEP may be hard-pressed to meet the carbon cap placed on it by regulators, and will therefore need to resort to buying credits on the open market or investing in carbon sinks. The impact on coal-powered generators is unknown, though, until the details of the auctioning versus grant system are determined. For this reason, similar outlooks hold for TXU (TXU) and Dynegy (DYN), both of whom have large coal assets. Ultimately, electric utilities will pass on a portion of the costs of any carbon trading system to their consumers, resulting in higher energy bills for the end-user. This will lead to growth in demand-side management (DSM) initiatives targeted at saving the end-user electricity, which would further hurt utilities.
Depending on the details of the particular carbon trading scheme, Oil, gas and coal companies would either have to purchase emissions credits themselves, or would likely have to lower the price of their products, as customers would have to purchase allowances to cover the carbon dioxide emissions released by their use.
Domestic auto manufacturers are at risk, should the U.S. government decide to include transportation under the cap and trade system. In this case, the domestic manufacturers, such as Ford and General Motors (GM) will be disadvantaged relative to those manufacturers who have made further advances in hybrid, fuel-cell, and other fuel-efficient technologies, such as Honda Motor Company (HMC) and Toyota Motor (TM). Other effected transportation companies would include those in the airline, railroad, air delivery & freight services, and shipping industries.
The effectiveness and costs of any carbon trading scheme depend on its structure and method of permit distribution.
Under a Cap & Trade scheme, an explicit national cap is set on greenhouse gas emissions. That cap is then divided into tradable permits, which are then distributed to all regulated firms for a set fee, through an auction, for free, or through a combination of those methods. As the number of tradable permits remains constant, achieving the countries emissions target is easy, albiet costly. A notable example includes the Clean Air Act of 1990, which implemented a successful sulfur dioxide and nitrous oxide trading system. Within five years, participating power plants reduced emissions by more than 20% at a cost less than one-third of the lowest estimates originally made.
Under a baseline & credit scheme, an implicit national cap is set on greenhouse gas emissions. The cap is constructed as the sum of individual baseline levels of emissions for all regulated firms. That is the key difference between baseline and cap and trade. Under cap and trade the number of permits is constant. Under baseline, they aren't. The reason is that the baseline is constructed as the product of firm size (in terms of energy usage) and a constant which measures desired firm efficiency (in terms of emissions vs. energy usage). As a firm grows in size, its baseline increases, as the efficiency constant remains the same. The effectiveness of this type of plan is held to be lower than that of cap & trade, which also means that its economic impact is more muted. A notable example is the Kyoto Protocol. Participating countries were expected to reduce their emissions to 5.2% below their 1990 baseline by 2012. However, since the protocol's creation in 1997 there have been several revisions, and most participatory nations have formed their own carbon trading markets, like the EU.
When permits aren't distributed at auction, the costs of polluting are reduced, lowering the effectiveness and economic impact of the scheme. So, phase I of the EU's scheme, which had a very small impact on lowering emissions, also had a very small cost, estimated at .1%-1.1% of GDP over the scheme's 3 years (.033%-.37% on an annual basis). The costs and benefits of carbon trading are, therefore, looked at in two ways. One, in the benefits accrued in the future versus the costs borne in the present, and two, the effectiveness of carbon trading versus the effectiveness of other forms of regulation, like carbon taxes, federal grants or tax incentives for research into clean energy and energy efficiency.
In terms of the first, although there is scientific consensus that global warming is occurring and that it will cause a loss of agricultural output, a loss of biodiversity, an increase in water scarcity, an increase in the spread of disease, an increase in coastal flooding and shoreline erosion, and an increase in environmental insurance expenses, there is no consensus on the magnitude of said changes. According to the Stern Review, the costs of global warming will reach numbers like $9 trillion dollars, well above the costs of carbon trading. On the other hand, other estimates place the costs at $100 billion, below the costs of carbon trading. However, combined with the eventual reality of peak oil, there is scientific consensus that global warming mitigation strategies like carbon trading deserve serious attention and possible implementation.
Carbons trading's largest competitor is carbon taxation. Taxation is simpler. Find out how much fossil fuels a company is using and a government can accurately estimate its level of carbon emissions. Then, apply a fixed fee for every ton of estimated emissions. There are fewer outcomes involving failure, where the cost of pollution becomes disproportionately high or low. On the other hand, carbon trading schemes involve an implicit or explicit cap in emissions, while estimating the long-term impact of a tax on polluting behavior would involve a lot of guesswork. Furthermore, it often makes sense for a company in a hard environmental situation to simply pay another company to reduce carbon emissions, rather than spending the resources required to do so for itself. With taxation, the burden can't be traded on the market to the companies most cheaply able to carry it. Also, carbon trading already has a lot of support internationally (the Kyoto Protocol). More important than all of that, however, is the design of the strategy picked, rather than the type of strategy. Both strategies have the potential to fail (or succeed) depending on the details. For the market, both strategies make polluting carbon more expensive, with the key difference that taxation would cut financial intermediaries out of the picture.
In January of 2005, the EU created the largest carbon trading market in the world. The EU established national emission caps for each participating country, which then provided individual polluters with allowances. In Phase I of the European Unions carbon trading scheme these allowances were provided for free, but were intended to be less than the actual amount of emissions that would have otherwise been released, requiring these companies to purchase additional allowances on the carbon market or reduce their level of pollution. Because there was an over-allocation of allowances at the beginning of the plan, greenhouse gas emissions did not fall as much as was expected. As companies began to realize that there was an over-allocation, the market price of carbon allowances fell. From May of 2006 to December of 2007, prices fell from €30/ton to €0.03/ton. In the second and third phases of its carbon trading scheme, the EU will slowly decrease the number of allowances that are provided for free, until that number reaches 0. As that happens, the impact of the scheme will likely increase.
Taking care of the palent has to start somewhere, but it's very discouraging when whatever small steps are taken by nature travelers is more than offset by society's indifference.