Letting The Free Market Clear The Air

Trading permits for pollution may make fixes for global warming cheaper

Julie Hardwick, a manager at a petrochemical division of oil giant BP Amoco PLC (BPA) in Naperville, Ill., logs on to her computer each day to see how the market is doing. She's not pursuing private riches on company time. Instead, she's participating in an internal market at BP: trading in permits to emit the greenhouse gases that cause global warming. The profits from a successful trading strategy will go straight to the bottom line of her business unit--which in turn influences pay scales. Says Hardwick: "It's fun."

It's good for the environment, too. For the next 10 years, BP plans to ratchet down its emissions by 4% annually by giving each of its 150 business units a quota of emission permits and encouraging them to trade. If a unit cuts emissions and has leftover permits, it can sell them to units that are having trouble meeting their goals. Hardwick says she saved up permits in part by fast-tracking a furnace upgrade that allowed for the elimination of a second furnace. As a sizable side benefit, BP's program has unleashed a wave of creativity about ways to cut fuel consumption that has saved BP millions of dollars, according to Jeffrey S. Morgheim, BP's climate-change manager and trading-program guru.

Now comes the key question: Will trading of emissions permits be given a chance to work on the global scene? At stake is the success of the Kyoto Protocol, a greenhouse gas-reduction treaty signed three years ago as part of the U.N. Framework Convention on Climate Change. In November, representatives from more than 150 countries will gather at The Hague to set the rules for compliance with the treaty. Of the three compliance mechanisms on the table, two involve giving credits for investments to cut greenhouse gases. But trading of permits, which has the support of the U.S. government, most multinational corporations, and the vast majority of economists, is the only one with an incentive to find cost-effective solutions.

FAIRNESS. BP isn't alone on the emissions trade frontier. Everyone from Royal Dutch/Shell Group (RD) to DuPont (DD) is giving it a try. Not only are they convinced it's the most cost-effective approach, they want to get experience before government mandates kick in. "They have to stay ahead of the curve. Something's coming. And they can't tell their shareholders they didn't see it," says Neil Cohn, a greenhouse-gas trader with New York-based energy broker Natsource LLC.

In an effort to enlarge markets, companies have even begun to band together. In October, seven of them formed Partnership for Climate Action with the hope one day of linking systems to expand trade opportunities. And next month, CO2e.com, a Web site specializing in emission trades that was jointly developed by Cantor Fitzgerald & Co. and PricewaterhouseCoopers, will begin marketing customized software for creating corporate exchanges. Emissions exchanges are also in the works in the U.K., Denmark, and Norway, and under consideration in France and Germany. In Chicago, futures market pioneer Richard Sandor, CEO of Environmental Financial Products LLC, is working on a Midwestern regional trading model designed to scale globally. "There is an inevitable drive for a market-based solution to global warming," he says.

However, trading of permits is not universally popular. Critics point out that monitoring and enforcing compliance outside the confines of big corporations is difficult because of the vast number of different emission sources. Fairness is another sticking point. Under the protocol, industrialized nations have until 2012 to lower their emissions by an average of 5% below 1990 levels, while developing countries including China and India have no such mandated restriction. Industrialized nations say that creates an unfair playing field. Still others argue on moral grounds that heavy polluters should be forced to clean up their factories at home, not use trading as a low-cost alternative.

RAIN FOREST DESTRUCTION. Whether or not trading is adopted internationally, countries such as the U.S. could still use trading domestically as a tool for reducing greenhouse gases. For instance, the Environmental Protection Agency could give permits to corporations and let them trade among one another. Under government pressure, some corporations are already beginning to trade for "offset rights." Offsets can be anything that displaces carbon emissions, from clean energy sources such as solar and wind power to so-called "carbon sinks"--forests and fields that absorb and contain carbon dioxide. The Nature Conservancy has brokered several deals over the past two years, pumping cash from companies such as Wisconsin Electric and Detroit Edison (DTH) into rain forest preservation projects based in Central and South America. According to Michael Coda, director of the group's Climate Change Program, nearly one-quarter of the world's carbon dioxide emissions are due to rain forest destruction. "Never before has there been an economic incentive not to burn down the rain forest," Coda says.

Backers of trading worry that the political momentum is moving away from the free-market approach and toward less efficient traditional regulation. "We're heading toward a very political meeting at The Hague. Gains will be undermined if we get political decisions that obstruct responsible, market-based approaches," says Thomas R. Jacob, manager for international and industrial affairs for DuPont.

So backers of trading are marshalling their counterarguments. While acknowledging that it's impossible to monitor every source of a country's emissions, they say that it's possible to get a good, rough idea by measuring how much coal, oil, natural gas, and other fossil fuels are consumed. As for fairness, they say that the exact number of permits that each country gets is something that can be worked out in the political process. The important thing, they say, is to establish clear rules of trading. "Until you can quantify the problem, you can't solve it or negotiate," says Sandor.

The advantage of trading is that it directs society's efforts toward the most cost-effective means of cutting greenhouse-gas emissions. Charles River Associates Inc., a consulting firm that is critical of the Kyoto Protocol, says that its estimate of the top cost for compliance with the Protocol drops from $280 a ton if there's no trading of permits allowed, to $100 with limited trading, to $60 in a completely open market.

Other estimates for the cost of compliance are considerably lower (table). Sandor, who helped develop the market for trading sulfur dioxide, a cause of acid rain, points out that opponents predicted sulfur dioxide emission permits would sell for as much as $1,000 per ton. Instead, they trade today for about $150 a ton. He thinks greenhouse-gas permits could end up trading for about $20 per ton of carbon--and that trading will eclipse the $3 billion sulfur-dioxide market at least tenfold.

Cleaning up greenhouse gases isn't purely a drag on the economy. As BP's experience shows, it can stimulate creative thinking about energy efficiency that actually saves money. It could also stimulate the development of new technologies such as solar power and wind power. Add in reduced health-care costs from cleaner air, and the problem of global warming begins to look like an economic opportunity. The answer to global warming might be as simple as buy low, sell high.

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