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FT Investing in a Sustainable Future March 24, 2010, New York

White Paper

Curbing Climate Change

By Josh Margolis / CantorCO2e

Change is coming. The market solution to changing the climate & the best steps for carbon reduction.

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We stand on the precipice of monumental change; change that is driven by greenhouse gas legislation written by state lawmakers. Like a tsunami, this change begins with a ripple of legislation from both coasts, and will build to an apex in a very short amount of time. This wave will affect nearly every business and citizen. Some business leaders understand the importance of this phenomena and how it can positively impact their operational and financial performance. Others will be caught blithely unaware and find their plans swamped by a failure to anticipate and plan for a carbon-constrained world. The use of market-based mechanisms, specifically emissions trading, will ease this transition and ensure emission-reduction goals will be achieved in the most cost-effective fashion.

Confronted with the need to chart a path to a carbon-constrained future, policymakers have different scenarios to consider. Some lawmakers will want to defer to command and control, narrowly prescribing controls for affected sources. This mode of regulation was once the only tool regulators applied and many have a natural tendency to feel better when they’re telling sources exactly how, where and when they should control their emissions.

Another option for policymakers is to seek to impose a carbon tax. In this case, government discerns an undesirable activity (i.e., burning fossil fuels), determines that a tax needs to be imposed to curb this behavior and creates the regulatory and administrative mechanisms to collect the necessary tax. If all goes well, the additional cost makes the polluting behavior more expensive, affected sources use less carbon containing fuels and collected tax monies are wisely used by the government to promote and subsidize measures that reduce greenhouse gas emissions.

Alternatively, the business may purchase surplus allowances from other facilities. A company able to operate without consuming all its emission allowances may sell surplus allowances, thereby turning a waste stream into a profit stream. A company that fails to comply with the rules is sanctioned and, if warranted, deprived of the ability to operate

A third option, the one that holds the most promise, is the use of emissions trading. In emissions trading, policymakers set an emissions reduction goal with the help of scientists, determine the carrying capacity of the atmosphere, draw up greenhouse emission allotments among businesses, and monitor and enforce the rules. Each business is given (or offered the opportunity to purchase) a declining emissions checkbook and is required to operate within its budget. As the checkbook declines over time, each affected business must alter its operations to emit or produce less.

Alternatively, the business may purchase surplus allowances from other facilities. A company able to operate without consuming all its emission allowances may sell surplus allowances, thereby turning a waste stream into a profit stream. A company that fails to comply with the rules is sanctioned and, if warranted, deprived of the ability to operate.

While the carbon reduction issue has only recently become of high importance to U.S. politicians and businesses, a mandated emissions trading program has been in effect in Europe for over five years, in compliance with the Kyoto Protocol. Having participated in the development and operation of emissions trading programs since 1985, I can say that some programs have performed admirably while others have fallen short of their goals. Looking at these programs, it’s unmistakably clear that well-designed cap and trade programs share a majority of the following elements:

1. Regulators, industry and the public must demand change and environmental improvement. Absent this demand, which must be paired with a willingness to accept the potential costs and structural disruptions associated with this change, there’s no sense in embarking on a costly program.

2. The goals of an emissions trading program must be clearly stated. Explicit and understandable goals establish the program’s objective and define a baseline for effectiveness.

3. Sectors that contribute to the pollution problem should be included in the emissions trading program proportional to their contribution to the problem. Program designers must involve the sources that directly contribute to the global warming problem. Failure to do so will place an unnecessary burden on and raise compliance costs of those sources included in the program. Further, emissions from sources excluded from the program must be otherwise addressed through other means (e.g., command and control rules).

4. An effective program must be based on an emissions inventory that accurately represents all significant emissions sources. Starting with an inaccurate emissions inventory (too high, too low or not inclusive of all sources) will frustrate efforts to evaluate the success of the program and, ultimately, derail emission reduction goals.

5. A comprehensive permit system should be in place. Regulators must have a means to convey each source’s operating obligations and withdraw the opportunity to operate within the system if permit obligations are not observed by the source. Likewise, sources must also understand that if they meet the appropriate standards (as defined within their permit) the regulator will not hinder their operation.

6. There should be a meaningful feedback loop. Sources must clearly understand that positive actions will be rewarded and negative actions penalized. Those who comply and make early reductions should be able to continue to operate and be able to sell surplus allowances. Those whose emissions exceed their allowances should suffer a meaningful enforcement penalty. This means that the financial penalties associated with noncompliance should be much more costly then cost of controls and allowances.

7. Profits should correlate with social good. On a macro level and (to the extent possible) a micro level, program designers should design the program in a fashion that endeavors to closely correlate participant profits with socially desirable goals. In particular, and to the extent feasible, safeguards should be included to minimize the chance that the same actions that produce profits also yield negative consequences for a large number of program participants and/or society.

8. An emissions program should be efficiently and effectively administered with clear and unchanging rules, consistent decisions and adherence to timeliness and schedules prescribed in the regulations. Compliance managers will make emission control decisions with multi-year horizons if they believe the rules (and allocations) governing the program will not change. The prospect of changing rules (and allocations) will shorten the investment horizon and cause managers to defer investments that rely upon anything but the most immediate paybacks.

In reality, policy makers will likely use all three tools command and control, a carbon tax and emissions trading to address different aspects of the global warming problem.

9. An effective emissions banking process should be included. A bank simply is an administrative mechanism that allows sources to create, gain recognition for and store air credits for later use or sale. Among other reasons, creating an emissions banking process allows companies to feel secure that once created as a result of voluntary efforts, air credits can be saved and stored away for future use or sale. The lack of a bank will cause managers to forgo emission controls that produce surplus reductions if such reductions cannot be used in a contemporaneous fashion.

10. The program should be self-supporting. A program that lacks the resources for its implementation (one that is not sustainable using program-derived revenues to pay its operating costs) will fail, regardless of how elegant its design, well intentioned its regulators or enthusiastic its industry users.

11. The administration of both the air quality rules and the emissions trading program should be under the control of a single regulatory entity. Multiple agencies with different levels of control can result in implementation of programs with conflicting goals, an unevenly applied permitting and offset program, or exemptions for significant air pollution contributors.

12. The program should be developed with the support of industry and government champions. These champions must clearly understand the alternative approaches and appreciate that an emissions trading program provides a better solution than a traditional command and control option.

13. Input from all stakeholders should be sought. Failure to gain this support will likely result in a system that is either unused, fails to accomplish its goals or doesn’t serve its intended users.

14. Allowance allocations should be fair and consistent with the program goals. Policymakers should make such distributions after considering historical emission levels, the effects of economic recessions, the magnitude and speed of the reduction expected of each participant and the effect that forthcoming rules would have if the trading program was not adopted.

15. Allowances should be allocated, not auctioned. Historically, successful emissions trading programs have relied upon allowance distribution systems where a source is offered a declining emission checkbook without cost to the source for the initial allocation. Another option is to allow entry into the system only to those who participate in a government-sponsored auction. The free distribution method puts tons into circulation and rewards sources who discover they can benefit economically by reducing their allowance needs and selling their surplus. In contrast, an auction is another form of a carbon tax, one that delivers revenues to the government without the obligation to make prudent decisions regarding the use of such monies. An auction forces participants to purchase near- and long-term allowances, begging the question as to how sources will recover these costs. Of course, the ultimate bill is delivered to the customer who purchases the products. At the outset of the program, an auction pits sources in direct competition with speculators and financial players who may be better funded and therefore better able to initially acquire needed allowances. An auction also puts sources in a cost minimization mode (they do what’s necessary to acquire the least amount of allowances at the outset), rather than a profit maximization mode (“over compliance” can free up allowances that can be sold) that comes with a free allocation.

16. Start the program with scarcity of supply. Regardless of how the allowances are distributed, the program should commence with a scarcity of supply. Over allocations will result in a low allowance price and a sense of complacency amongst participating sources.

17. The mechanics of trading the commodity need to be clearly defined and carefully structured. Trading will only occur if participants can reliably predict how trades will be processed and if transaction costs are minimized. The steps necessary to accomplish a trade should be simple, easy to understand and replicate, and be predictable.

18. Regulators must resist the urge to meddle with the market. Air credit markets operate best if the regulator’s role is limited to registering the transactions, maintaining information about available credits, monitoring source activity and enforcing against non-compliers. There may be some need for the regulator to also play a role in ensuring credits are free and clear of liens, encumbrances and pledges that may not be known to buyers. Regulators should not seize upon price fluctuations as an excuse to step in and adjust the program, allocations or other attributes of the program.

19. The program should be designed to facilitate integration with other cap and trade programs. States that go it alone are doing so in large part because they lack leadership from Washington. Nonetheless, each state or region – California, RGGI, etc., should be mindful they can only be successful if they adopt programs that can be integrated with other like programs, ultimately enabling policymakers to act in concert.

In reality, policy makers will likely use all three tools – command and control, a carbon tax and emissions trading – to address different aspects of the global warming problem.

We will likely see rules that mandate specific performance standards along with fees imposed on a per ton emitted basis. And we will also see a cap and trade system that’s imposed upon a portion of those companies that emit greenhouse gases. These tools work best when wielded by skilled hands to address specific problems.

Companies that don’t prepare for a carbon-constrained future are missing the opportunity to participate in policy and methodology, rather than having solutions thrust upon them. Industry, policymakers and consumers have started thinking about smart, effective and profitable approaches to reducing greenhouse gas emissions. Those who fail to see the ripple on the horizon for what is – a warning of bigger changes to come – will fall victim not to a carbon constrained world, but rather to their own inaction.

Cap and Trade;Risk Management ;

*Footnotes

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