What Price Pollution?

In Europe, the Kyoto Protocol is spurring a brisk market in emission credits

There are stock trades and bond trades -- and now there are smog trades. The Kyoto Protocol has become a reality in Europe, and so has a new market in pollution credits. It's designed to allow European companies gradually and efficiently to reduce the amount of greenhouse gases they pump into the atmosphere by burning fossil fuels. Banks and exchanges are gearing up to service some 12,000 industrial installations across the 25 nations of the European Union under the program.

Trading worldwide will eventually amount to billions of dollars a year -- and millions in fees for the financiers who handle the trades. "A whole new business is emerging," says Peter Koster, chief executive of a new specialist bourse, the European Climate Exchange in Amsterdam. "The industrial sector can't have an attitude of wait-and-see toward this."

That's because the clock is already ticking. Kyoto formally went into effect on Feb. 16, and countries and companies are now counting back from March, 2006, when energy-intensive industries and public utilities in the EU must report their emissions from the previous year to their governments in order to get the right to emit CO2 the following year. This is part of the Emissions Trading Scheme set up by the EU to help member states comply with Kyoto. Here's how it works:

By the end of the first quarter, the EU will have assigned blocs of allowable carbon dioxide emissions to its member states, which have divvied them up among local industrial installations such as power plants and paper mills that have been entered into a "registry." Britain, for instance, was awarded an allowance of 736 million tons of carbon dioxide emissions, which it has distributed to over 1,200 plants across the country. Companies will be assigned a number of allowances based on their current emissions and targeted reductions. If a company or plant is able to emit less than the amount it has been allocated, it can sell the extra allowances in the new emissions markets. If a plant emits more than its allotment, doesn't meet standards, and wants to avoid fines for noncompliance, it will buy credits.


After a three-year grace period, the total number of credits handed out by the EU is expected to be reduced each year until 2012, when, under Kyoto, emissions must be cut to 8% below the level of 1990. Although initially limited only to EU members, the goal is to allow companies to trade credits worldwide. Indeed, there is already a Chicago Climate Exchange, although EU allowances can't be traded there. The companies that trade on the Chicago exchange do so on a voluntary basis because the Bush Administration has declined to sign the Kyoto treaty.

Several European countries -- including the Czech Republic, Greece, Italy, and Poland -- have not yet had their credit allocation requests approved. And Britain has raised some hackles by asking for a last-minute change in its carbon allocation, from 736 million tons to 756 million, pleading that its industries underestimated their likely emissions for the 2005-2007 period. The dispute may have to be adjudicated by the European Court of Justice.

Meanwhile, European companies are already starting to hedge their carbon risk, trading credits on the over-the-counter market and creating new revenue streams for commodity specialists such as Barclays Capital (BCS ), Dresdner Kleinwort Wasserstein, ABN Amro (ABN ), and Fortis Bank. The going price of a carbon allowance, which is equivalent to 1 ton of carbon dioxide, on Feb. 16: $9.92, down 9% since the beginning of the year, according to Point Carbon, a research firm in London that specializes in the market. A bevy of exchanges are jockeying to specialize in emissions trading, including the European Climate Exchange, whose futures and options will trade in London, Germany's European Energy Exchange, and France's Powernext. All expect to have their markets up and running by the end of March, offering companies the ability to hedge carbon emissions.

Over the next three years, depending on the price of carbon and the stringency of the scheme, businesses will spend $2 billion to $3 billion to comply with the program, according to Ilex Energy Consulting of Oxford, either to purchase credits or install equipment to slash emissions. While the first forward trade took place in 2003, the average transaction is still on the small side: about $1.8 million, according to traders. But with companies facing the new requirements this year, activity in the OTC market has picked up markedly. "This is a new commodity," says Claire Byers, manager for environmental products at Fortis Bank in Amsterdam. Once the futures and options markets get going, the combined market could grow to $58 billion in Europe alone, says the European Climate Exchange.

One of the most active players in the forward market so far has been Royal Dutch/Shell Group (RD ) -- which in the past two years has made much of its commitment to a cleaner environment. The energy behemoth, which has 46 installations covered under the EU plan, says emissions trading will help with its investment in pollution control. "It tells us whether it's more efficient [right now] for us to invest in new technologies, practices, or fuels," says Garth Edward, Shell's trading manager for environmental products, "or whether it's more efficient for us to buy or sell allowances in the external marketplace."

To meet the demand for carbon expertise from Shell and other big market participants like German power company E.ON (EON ) and electricity concern RWE (RWEOY ), financial institutions across Europe are starting to set up teams of carbon gurus, some of them poached directly from other industries and governments. Last spring, for example, Barclays Capital hired Louis Redshaw, a former manager of trading and marketing at French electric utility EDF, to head its three-person environmental products team in London.


While banks throughout the region are bolstering their carbon teams, the center for emissions trading in Europe is expected to be London. The European Climate Exchange, whose executives are based in Amsterdam, is using London's International Petroleum Exchange as its platform. In addition, Climate Change Capital, a specialist merchant banking group dedicated to climate-change markets, has sprung up in London's West End to help polluters cope with Kyoto. Like the traders at the banks, executives at Climate Change Capital say demand for carbon advice is on the rise, even though much of Europe Inc. is still waiting to hear what the exact emissions allowances will be. "In a market where a lot of information isn't ready, there has been a lot of activity," says John Metzler, a director of the group's financial products team.

Despite signs of a thriving market, some key issues have yet to be worked out. The EU hasn't ruled, for example, on whether industries such as aviation will eventually be drawn into the emissions trading scheme. Such question marks aside, executives at many European companies are already starting to view carbon emissions as a market-driven variable that's in the same league as raw materials or interest rates. The cost of attacking global warming has never been less cloudy.

By Laura Cohn in London

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