China Aims to Shed Its Dirty Dragon Image

The move to set up a carbon-credit exchange should boost investment in clean plants on the mainland, and heat up the global market for emissions credits

China gets its share of international criticism for its world-class air pollution, toxic river systems, and colossal energy inefficiency. And much to the chagrin of Beijing, its dirty dragon image seems likely to expand later in the decade when it is forecast to overtake the U.S. as the world's biggest emitter of greenhouse gases.

However, China's decision on Feb. 6 to team up with the United Nations Development Program (UNDP) and launch the developing world's first carbon-credit exchange could alter that scenario. It's a diplomatically artful move by Beijing that will increase incoming foreign investment in green technology on the mainland—and could be a game-changer for the $22 billion global trading market for carbon credits down the road.

Companies based in countries operating under the Kyoto Protocol—the international pact regulating greenhouse gas emissions—are hungry to do more deals in both environmentally-challenged China and India. The Kyoto Accord's so-called clean development mechanism program allows companies from the industrialized world to earn credits by investing in clean-energy projects in developing countries.

Selling Goodwill

These developed-world companies then use the credits to meet their targets back home—or sell them to corporate emission-belchers that haven't cleaned up their act and face future fines. In the U.S., which of course refused to join the Kyoto deal, about 250 companies have agreed to voluntary emission-target reductions and trade carbon credits on the Chicago Climate Exchange. In China, most of the action so far is with European and Japanese companies that need to meet mandatory emission-reduction targets between 2008 and 2012.

Kishan Khoday, assistant resident representative of the UNDP in China, points out that China is already "…supplying more than a third of the global supply of carbon credits," largely destined for countries and companies in Europe and Japan seeking to fulfill their Kyoto commitments.

Through UNDP assistance to local partners in China, the design of a Chinese carbon-credit trading exchange will be started in 2007 with a pilot program perhaps ready by the end of the year to help develop a more liquid market for such credits. "There is huge scope to expand the volume of green investment into China and to achieve broader sustainable development goals through this new, market-based mechanism," Khoday adds.

Trading on the Environment

Climate control experts are also encouraged by China's deeper involvement. "I think China's move is very meaningful and has historical significance," says Hironori Hamanaka, a Keio University environmental science professor and former Japanese government official, who helped shape the Kyoto treaty. "China is the second biggest country responsible for large emissions after U.S."

The eventual launch of a China exchange will also contribute momentum to an already blossoming trading-market for carbon credits forecast by the World Bank to hit $30 billion by 2010. The Chicago Climate Exchange and its affiliated European Climate Exchange are developing climate derivatives. New York financial services player XShares recently announced a deal with the Chicago climate bourse to create exchange-traded funds based on carbon-emissions credits.

Morgan Stanley (MS) is investing $3 billion in carbon credits and other projects to limit greenhouse gas emissions. Goldman Sachs (GS) is a major investor in the British-listed Climate Exchange (CXCHF), the parent of the European and Chicago climate exchanges, which provide futures contracts and options contracts for emissions.

Innovation Against Pollution

The beauty of the burgeoning market for climate investments, from China's perspective, is that it will boost its green street-credentials internationally—and it won't cost the country much at all.

In fact, overseas companies are clamoring to invest there because it is often far cheaper than spending for new plants and equipment to reduce their pollution output back home.

Last year, Japanese trading company Marubeni (MARUY) and two other firms earned emission credits for a developing a facility with Chinese chemical company Juhua Group to collect and dissolve a byproduct from the production of a chlorofluorocarbon, an ozone layer destroyer.

Hong Kong-based Noble Group (NOBGF), a diversified, commodity-focused company that is also active in carbon-credit purchases, last year set up a deal with Jinan Iron and Steel Group to buy credits the Chinese company earned for installing new equipment to manage and recycle waste gases from its steel mills.

Acid Rain Test

Noble's managing director of carbon credits, Thorsten Ansorg, is upbeat on China's plans to start an exchange, but thinks it will take a few years before it starts to have a real impact. Right now he is far more enthusiastic about the potential to buy carbon credits out of India. "At the moment, the level of issuance out of India is bigger and things are going speedier," he says.

Though the Bush Administration has had a toxic reaction to the Kyoto Accord, a number of state governments and companies such as Chevron (CVX), Duke Energy (DUK), General Motors (GM), and Pfizer (PFE) are pushing for free market environmental approaches like carbon-credit trading. In fact, the U.S. trading system for sulfur dioxide emission credits created in the early 1990s to fight acid rain is viewed internationally as a huge success.

If the U.S. starts to really get serious about greenhouse gas trading, or sets up federal emission caps like Europe and Japan, things could get interesting. But for now, the supreme irony is that China, home to some of the most polluted cities on the planet, is looking mighty green at the moment.