TRADING GREEN

Climate change is now an increasing global priority – and the Green Exchange initiative is creating new opportunities in managing emissions.

 

Environmental concerns have come and gone over the years, much like hemlines that rise and fall. Now that ebb and flow has ceased and reducing greenhouse gas emissions is firmly at the top of the new administration’s “to-do” list.

Data show that the average temperature of the Earth’s near-surface air and oceans has risen significantly since the mid-20th century. For example, temperatures since 1970 climbed at nearly three times the average for the 20th century as a whole. The billion-dollar question is whether this is a normal variation in climate, or whether human actions caused and may accelerate significant global warming in the future. Based on the “greenhouse effect,” the more carbon dioxide and heat-trapping gases from smokestacks, tailpipes and burning forests, the warmer our surface temperature may become over time.

Not all scientists agree that climate data from relatively few years can be extrapolated into meaningful scientific conclusions. But recently, the prevailing debate about climate change appears to have shifted from “Is it real?” to “What are the benefits and costs of doing something about it?” Even businesses that previously opposed taking action on global warming are now working to shape the actions that are taken.

In 2009, environmental initiatives are on the “top three” list of President Barack Obama – along with fixing the U.S. economy and healthcare system. While the legislative framework is still to be determined, experts agree that there is enormous potential for market-based solutions to address U.S. carbon emissions and other pollutants.

 

CAP AND TRADE TAKES OFF
The most business-friendly solution is called “cap and trade.” This program assigns an emission limit to each large-scale emitter of greenhouse gases. The limits become stricter over time until the nation reaches its ultimate pollution reduction goal. More efficient companies that emit less than their quota can sell their extra emissions permits (such as European Union trade allowances, or EUAs) to less efficient ones. Companies also get credit for emission-reducing projects in developing countries (Certified Emission Reductions, or CERs) and in emerging economies.

The cap and trade program enacted by the Clean Air Act of 1990 met its goal of reducing the sulfur dioxide (SO2) emissions that cause acid rain – and at a much lower cost than either industry or government predicted. In 2005, the European Union implemented a cap and trade emissions trading system covering carbon dioxide (CO2) emissions from a handful of industries, including power stations, oil refineries and steel plants.
“After three years of testing the concept, the European Union completed its first year of full compliance with its emissions trading scheme in 2008,” says William Bumpers, partner and head of the global climate practice for Baker Botts LLC. “This has turned into a remarkably robust market, approaching €100 billion in annual trading. The U.S. market could be at least twice the size, because we have a larger, more carbon-intensive economy and proposed legislation would cover more emissions sources.” 

Since 2006, the listed carbon derivatives space has grown rapidly in the United States, based largely on voluntary initiatives to reduce emissions. The first mandatory U.S. cap and trade program for CO2, the 10-state Regional Greenhouse Gas Initiative (RGGI), hosted its initial carbon auction in September 2008. In addition, new exchanges and products have created hedging and trading opportunities for a variety of market participants. Top traders include utilities, transportation companies, factories, chemical plants and other emissions sources, as well as banks, brokers, environmental and global macroeconomic hedge funds, and other financial traders.
“Although it is difficult to quantify, market participation appears to be broadening out. Empirical data suggest that more hedge funds and asset managers are getting active in the carbon space,” according to a September 2008 report by Jeffrey Wells of Morgan Stanley’s listed derivatives group.

 

POISED FOR LEGISLATIVE ACTION
Volume is expected to skyrocket if and when a federal compliance program is implemented, although legislation that passes in 2009 or 2010 would not be fully phased in until at least 2012. One market that is ready for legislative action is the Green Exchange initiative, which began trading in March 2008. Under the Green Exchange moniker, global carbon-based contracts (EUAs and CERs) as well as SO2 and nitrogen oxide (NOX) emissions contracts are currently offered for trading. Upon its approval as a separate futures exchange by the Commodity Futures Trading Commission, the Green Exchange plans to introduce a more comprehensive range of environmental futures, options and swaps contracts.

“With the Green Exchange initiative, we will offer market participants a substantial opportunity to get in on the ground floor of emissions hedging and trading in the United States related to a national compliance program,” says Randy Warsager, director, green products for CME Group. “An extensive base of North American and other energy and power traders are active in CME Group energy products. They are familiar with our execution platform and can benefit from cross-margining these contracts with our energy products. Add in the financial safeguards of our well-established clearinghouse, and you can see why we expect an enthusiastic reception from new participants as the U.S. emissions markets mature.”

Adds Bumpers, “The Green Exchange initiative will become an important and efficient risk management platform. As companies face compliance with emissions caps, the Green Exchange initiative can be the basis for creative new financial products.”

 

LOOKING TO EUROPE

While the United States often is a technology leader, it is far behind Europe in developing a cap and trade system covering emissions. Launched in January 2005, the European Union Emission Trading System (EU ETS) is today the largest multi-national emissions trading program in the world. Driving its growth are ambitious plans by the European Union to reduce the EU’s overall emissions to “at least” 20 percent below 1990 levels by 2020. As announced in January 2008, the EU expects to meet this goal by reducing greenhouse gas emissions by at least 20 percent, using renewable resources to meet 20 percent of the EU’s final energy consumption, and raising energy efficiency 20 percent by 2020.

In practical terms, the EU ETS is the primary mechanism for encouraging companies to reach this goal. Phase one of the trading program covered carbon dioxide emissions from large sources – including power stations; oil refineries; coke ovens; iron, steel, glass and cement factories; and paper manufacturers. Phase two expanded the program to include the petrochemical industry, aluminum smelters, waste disposal companies and some agriculture. Phase three – likely to be implemented in 2012 – is expected to cover more sectors and more emissions, such as nitrous oxide and methane.

“The EU ETS has put a price on carbon and proved that trading in greenhouse gas emissions works,” according to the European Commission’s Web site. However, the commission simultaneously cites the need for additional data and more uniform rules across countries in order to meet the EU’s carbon reduction goals. One concern is that individual countries have given out too many emissions permits to companies that are large-scale emitters.

Although not all EU market participants agree with proposed changes to further reduce emissions, most appear to be fully on board with the overall concept.

“We have argued for many years that emissions trading is the most economically efficient and environmentally effective way of dealing with aviation’s impact on climate change,” says Willie Walsh, chief executive officer of British Airways.  “We support the introduction of emissions trading for airlines in Europe, and are keen that urgent progress is made to establish a global system.”

 

 

 

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