The Smog Trade

Will pollution credits help clean up the world?

The residents of Sala, a gritty industrial town in southern Slovakia, used to complain vehemently about the foul-smelling smoke and dust belching out of an aging local coal-fired plant that provides their hot water. But finding the $180,000 needed to switch the central boiler to more environmentally friendly natural gas wasn't easy. Although Slovakia's government committed to reducing pollution when it signed up to join the European Union, it didn't have enough cash in its coffers to pay for the conversion. And private investors were reluctant to get involved for fear of not being repaid.

But the stalled changeover finally got a green light early last year after some brainstorming by Environment Ministry officials in Bratislava. They came up with a novel idea: pay for the project by selling some of the plant's future pollution "rights," which would no longer be needed with a cleaner-burning fuel. A gas-fired facility would reduce the amount of pollution emitted by the equivalent of almost 2,500 metric tons of carbon dioxide a year, cutting the plant's emissions in half. It's one of four projects in the region grouped together to maximize their bargaining power with buyers. And the deal will help Slovakia meet its obligation to reduce greenhouse gases under the 2001 Kyoto Protocol.

Countries that are signatories to the protocol, including members of the European Union and the East European countries that will join the EU next May, are committed to cut greenhouse gas emissions, which are thought to cause global warming. Each signatory nation is awarded a certain number of pollution credits. The goal is to cut the overall amount of pollution, but it allows some horse trading among plants -- as long as there is a net decline. It's part ruthless capitalism, part Greenpeace idealism. "The environmental guy can now be a profit center," says G. David Ungar, vice-president at Evolution Markets, which brokered the Sala deal.

The ambitious agreement, which the U.S. declined to join, aims to reduce emissions in industrialized countries to an average of 5% below their 1990 levels over a five-year period from 2008. That's the year "carbon credits," known as Assigned Amount Units (AAUs) and worth one metric ton of carbon dioxide each, will be allocated formally to companies by their governments (for more on emissions trading, see this Special Report from Platts, which, like BusinessWeek, is a unit of The McGraw-Hill Companies).

Analysts say the market for trading these credits could explode once the treaty is fully implemented, which is expected later this year when Russia is likely to sign up. That will give it crucial momentum. Janina Scheelhaase, head of microeconomics and environmental economics at Prognos, a consultancy in Cologne, predicts that a global over-the-counter market worth $60 billion a year could develop by the end of the decade. A separate EU pollution trading scheme will add another $18 billion. That will dwarf existing, smaller scale trading worth about $10 billion. Broker fees could be worth up to $3 billion in five years.

To do the dirty work in Sala, the Slovak bureaucrats called in Evolution Markets LLC, a White Plains (N.Y.)-based brokerage that specializes in emerging energy and environmental commodity markets, to find a buyer and advise both parties on how to structure the trade. It didn't take long. On Dec. 6, 2002, Evolution Markets struck a deal to sell 200,000 of Slovakia's future pollution credits to Sumitomo Corp. in Tokyo to pay for its conversion to natural gas. Japan needs the extra breathing room if it is to reduce carbon dioxide emissions on the scale Kyoto envisages. And big companies like Sumitomo want to avoid a huge one-time hit to earnings for the cost of pollution-control equipment. They also view the credits as a hedge against even tighter restrictions in the future.

The Sumitomo-Slovak deal marked the world's first trade in the brand-new global market created by Kyoto. "This is basically a new form of project finance," says Ivan Mojik, head of the climate change unit in the Environment Ministry.

Although the amount of money involved was not disclosed, the Slovak deal is estimated to have been worth only $1 million. But there have been several other deals since then. What's more, the EU is in the final stages of drawing up its own system to impose even tighter emissions restrictions than Kyoto, which looks set to take effect in 2005. That will give the fledgling market another welcome boost, since the EU also will rely on carbon credits to reach its goals. Ludwig Niessen, a board member of Energy Exchange Austria in Vienna, says plans are already being drawn up to trade large volumes of emission rights on the exchange. Other stock exchanges are expected to follow suit.

More and more rust-belt companies in Eastern Europe are realizing the benefits of going green. Jozef Kollár, the chairman of Duslo, a large fertilizer and chemical company on the outskirts of Sala, recently struck a deal to sell some of its emission credits to the Netherlands, part of Duslo's plan to power its plants with cleaner natural gas. Ironically, the Dutch, who long ago cleaned up their factories and power plants, are trading because it's getting harder to meet emission-cut commitments. Many countries in Central and Eastern Europe, on the other hand, can make cuts more easily from their high level of pollution. Of course, trading in carbon credits already takes place on a very limited scale in some countries, such as the U.S. and Britain. But those involve domestic markets only. What makes the Kyoto and EU schemes so different is that both are compulsory and involve cross-border trades, which brings the issue into much sharper focus in corporate boardrooms and suites.

Big Western and Japanese houses are also starting to take a real interest. Düsseldorf-based utility E.ON and London's BP PLC both say they could soon start buying and selling carbon credits. Frankfurt development bank Kreditanstalt für Wiederaufbau is planning to invest in the market as a way of financing environmentally friendly investments in Eastern Europe. "It mobilizes capital for the poor countries and transfers modern technology there," says KfW board member Wolfgang Kroh.

Of course, it's early, and plenty of things could yet derail the market's development. If Russia doesn't sign on to Kyoto, that part of the market could be scuppered. And if one of the initial deals goes wrong -- say, because a seller fails to meet its promised cuts in pollution -- it could frighten away companies and investors. But if the case of the Sala heating plant is anything to go by, the benefits of pollution rights trading far outweigh the risks. "All the parties gained from that," says Miroslav Wöllner, director general of Slovakian environmental-engineering firm Menert. "And life is much nicer for the people of Sala." Cleaner air and a blacker bottom line. To activists and investors alike, that's a deal worth making.

By David Fairlamb in Sala, Slovakia

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