RGGI: Mandatory scheme makes modest gains in northeast

By Hal Weitzman

Published: December 13 2009 23:12 | Last updated: December 13 2009 23:12

For much of this year, the US Congress has grappled with the thorny issue of a national cap-and-trade regime for greenhouse gas emissions.

The issue has been controversial. The House of Representatives passed a bill in June and the Obama administration was unable to push the Senate to fulfil its wish of having federal legislation in place by the time of the United Nations Climate Change conference in Copenhagen.

The Senate is unlikely to make significant progress on the issue this year, and getting any legislation passed looks like being an uphill struggle, with opposition from those who say cap-and-trade would lead to job losses in the industrial heartland and a loss of competitiveness.

Yet at the same time, one-fifth of the country’s states are already signed up to a mandatory carbon pollution regime. The Regional Greenhouse Gas Initiative – RGGI, or “Reggie” – unites 10 north-eastern US states in a plan to cut carbon emissions from power plants by 10 per cent by 2018.

RGGI was born of a desire by local leaders to act on greenhouse gas emissions at a time when the administration of George W Bush was failing to tackle the issue. “There was a lot of frustration that President Bush broke his promise to support federal legislation,” says David Littell, commissioner of Maine’s Department of Environmental Protection

George Pataki, the former governor of New York, was a prime force behind the new initiative. In 2003, he wrote to fellow governors asking them for help “to develop a strategy that will help the region lead the nation in the effort to fight global climate change”.

By 2005, Delaware, New Jersey, Connecticut, Vermont, New Hampshire and Maine joined New York in signing a memorandum of understanding committing themselves to an emissions reduction programme.

Massachusetts and Rhode Island, which decided at the last minute not to sign the memorandum over concerns about the lack of an opt-out linked to energy prices, both later opted to sign up in 2007, and were followed by Maryland. New Hampshire joined in 2008.

Although there are a number of regional non-mandatory carbon emissions programmes in the US, RGGI is the only mandatory programme, and also the most developed. As Washington has debated the subject, it has often looked to RGGI as the closest US model for its legislation. The programme’s backers say it has always been intended to be a path to a federal regime.

Starting in September last year, RGGI has held quarterly carbon dioxide allowance auctions at which power companies buy emissions permits by the tonne. By the end of a three-year compliance period – the first of which began at the start of this year – they are obligated to accumulate enough credits to cover their emissions.

The bill passed in the House of Representatives proposes to give away 85 per cent of carbon permits for nothing, mostly to electricity and natural-gas companies and manufacturers – a measure supporters say was necessary to secure the votes needed to pass the legislation.

By contrast, RGGI auctions all its allowances, a process that has raised $432m so far. That money is then distributed to member states, which invest them in energy efficiency and renewable energy projects.

Although RGGI has been warmly welcomed by cap-and-trade advocates, some observers note that since the regime set its emissions caps based on average annual emissions between 2002 and 2004, they were not aggressive enough. In the years since, emissions have fallen, in part because power companies have switched from coal-fired generation to less dirty natural gas. More recently, the economic downturn has resulted in big cuts in carbon emissions.

RGGI is also less ambitious than the climate bill that passed the House of Representatives, which envisages a 17 per cent reduction in emissions by 2020 as opposed to RGGI’s 10 per cent reduction by 2018. RGGI applies only to electric power generators bigger than 25 megawatts, while the House legislation would affect industries such as coal, oil, iron, steel, cement and paper.

“This was not as ambitious a programme as some others,” says Judi Greenwald, vice-president at the Pew Center on Global Climate Change. “But they are achieving modest reductions at modest prices. So from an economic and environmental point of view, it’s been a success.”

Mr Littell notes that the participating states will reassess the cap after three years. “We’ll look at it then,” he says. “We’re not necessarily committed to keeping the level exactly where it is until 2019.”

Ms Greenwald notes that RGGI has also played an important role in the political debate. “As much as we look at the European model, for a lot of US policymakers it’s really important to have something here,” she says. “The fact that it’s working, that they’re getting reductions and that it’s well-functioning market is very important from a US policy perspective.”

Should Congress ultimately fail to pass federal legislation, many expect that more US regions will follow RGGI in implementing mandatory emissions regimes, a prospect that worries some industrial companies concerned about the cost of complying with multiple regimes.

“A number of states and regions are holding back to see if a federal programme can be enacted,” says Peter Molinaro, head of government affairs at Dow Chemical, the largest US chemicals group. “If not, you’ll begin to see more agitation at the state level – history shows that in the absence of federal action, the states are the ones who do the work.”

Australia: Emissions trading blocked by entrenched interests

By David Fickling

Published: December 13 2009 23:09 | Last updated: December 13 2009 23:09

Were it not for the pylons strung alongside the road, visitors could drive through the Latrobe valley two hours east of Melbourne thinking it produced nothing more important than dairy products and wine.

But from the air, the picture is clearer: five vast geometric scabs covering a greater area than the valley’s big towns mark out the open-cast coal mines that provide more than four-fifths of electricity in the state of Victoria, Australia’s manufacturing heartland.

Australia’s dreams of coming to the Copenhagen conference with an agreed plan to cut its carbon emissions died last month among the rolling fields of the Latrobe.

The episode is a cautionary tale of how the push for sustainability can mesh uncomfortably with party politics and business interests, and a reminder that any significant shift in a country’s economy creates both winners and losers.

Green spending in a recession can be sold as job-creating stimulus, but the dislocations involved in decarbonising an industrial economy also risk being painted as job-killers.

Coal goes to the heart of that problem. It accounts for three-quarters of Australia’s electricity generation, and its abundance and accessibility means Australia enjoys some of the cheapest electricity in the developed world.

Whereas Italian businesses pay around 29 US cents for a kilowatt hour of electricity and Britons pay nearly 15, Australians pay just 6 cents. In western Europe, only nuclear-powered France is cheaper, at 5c/kWh.

It is no coincidence that Australia’s economy is thus more energy-hungry than those of its peers – one study, by the World Resources Institute, found it needs energy equivalent to burning 208.3 tonnes of oil to generate $1m of national income, compared with 141.2 for the UK and 122.8 in Italy.

The country’s unusually high dependence on dirty fossil fuels compounds this, meaning that reaching western European levels of emissions efficiency would be even more wrenching.

“This is going to change the way the economy runs,” according to Heather Ridout, head of the Australian Industry Group. “We’re putting a price on something for the first time. It’s like putting a price on the air we breathe and it’s very hard to factor into business models.”

The Labor government of prime minister Kevin Rudd was elected on a platform of action on climate change, after years in which his predecessor John Howard joined the US in refusing to sign the Kyoto protocol.

The emissions trading bill presented to Australia’s parliament earlier this year promised a modest 5 per cent cut in emissions by 2020, rising to 25 per cent conditional on broader international action. But the debate quickly became bogged down in a squabble about compensation.

Money was promised to households to help them pay bills expected to rise by $12 a week as a result of the ETS; more was set aside for polluting industries to help them make the transition to a lower-carbon economy, including A$3.5bn (US$3.2bn) for electricity generators.

In the Latrobe valley the cries were particularly loud. Victoria’s state premier John Brumby warned that two of the valley’s three power stations might be forced to close if more compensation was not offered, threatening every politician’s worst nightmare – blackouts.

TRUenergy, owners of the Yallourn power station, warned that their Hong Kong-based owners CLP could consider legal action if more money was not forthcoming, and took out full-page adverts in local newspapers campaigning against the scheme.

The denouement of this political drama was as unexpected as it was dramatic.

In late November Malcolm Turnbull, leader of the right-of-centre Liberal opposition party, struck a deal with the government to allow passage of the bill through the country’s Senate, doubling compensation to electricity generators to A$7.5bn. But the genie of opposition to the bill was already out of the bottle. The coal industry rejected the compensation as still insufficient to meet its transition costs.

Within Mr Turnbull’s own party, climate change denialists were gaining the upper hand, and just 10 days before Copenhagen he was deposed by Tony Abbott, who says that human activity may not be causing climate change and that global warming has stopped, although he simultaneously denies being a climate change sceptic.

The day after Mr Abbott’s elevation to the leadership, Liberal senators rejected the emissions trading bill in spite of the Turnbull amendments.

The lesson from all this, according to Anthony Green, an elections analyst for public broadcaster the ABC, is that in carbon-intensive economies narrow political advantage can trump pragmatism and, ultimately, action on climate change, even in the presence of lavish compensation offers.

Two-thirds of Australian voters back an emissions trading scheme, according to pollsters Nielsen, but 11 of the 14 most marginal Labor-held seats are in outer suburban, regional and rural electorates that are likely to feel the cost of carbon permits particularly keenly.

“This comes down to the idea that you can split Labor’s working-class base in coal-mining districts, and if the debate ends up being concentrated on the price of electricity then there’s mileage in that angle,” Mr Green says. “Of course, if we have another hot summer they may have to come up with more of a policy.”

Carbon trading: Emissions cuts at the lowest price – in theory

By Fiona Harvey, Environment Correspondent

Published: December 13 2009 23:10 | Last updated: December 13 2009 23:10

The question of how to fund cuts in greenhouse gas emissions has long vexed politicians. Those meeting at the United Nations conference on climate change at Copenhagen are no exception. They, however, have the luxury of ducking the question.

At Copenhagen, no firm decisions are likely to be taken on the details of how to ensure that finance is available, particularly in poor countries, to make the emissions cuts that will have to be laid out in any agreement.

Instead, world leaders are likely to sign up to a headline figure for the future financing required. Rich nations should commit to at least $100bn a year in financial assistance to help poor countries curb their emissions and adapt to the effects of climate change, the UN has suggested.

As part of this agreement, negotiators will draw up a menu of options for how this may be achieved, with the final list likely to be laid out later.

This is possible because it was decided as long ago as September that the conference would not produce a binding legal treaty, but rather a “political deal” that leaders would have to sign but that in the following months would need to be translated into legal language, with many details filled in, before it could be passed into law by national parliaments.

The mechanisms that are laid out will certainly include carbon trading. Most of the funding requirement will have to come from the private sector, and carbon trading offers one of the few ways of achieving such finance flows at a reasonable cost.

“Any treaty must be adequately financed, and since the the bulk of climate finance will flow through the private sector, it’s crucial that carbon markets work,” says Jennifer Haverkamp, climate talks director at the US campaigning group Environmental Defense Fund.

Carbon trading is also regarded as a “flexible” mechanism that can be adapted to benefit nations, regions and communities.

Carbon trading was first set up under the Kyoto protocol. Rich countries can make up part of their emissions-cutting targets by funding projects – such as wind farms or solar power generation – that reduce greenhouse gas output in developing countries. These projects are awarded carbon credits, each representing a tonne of carbon avoided, that can be bought by companies or governments.

Not only should such a system – in theory, at least – produce emissions cuts at the lowest possible cost, it should also benefit the poor countries where the projects are set up, by funding access to technology and infrastructure that such countries could not otherwise afford.

The knock-on benefits to local communities in the developing world are potentially huge – new forms of energy, for instance, that reduce reliance on burning biomass, which causes indoor air pollution, one of the biggest killers of women and children in developing nations.

In practice, however, the Kyoto carbon trading system – known as the clean development mechanism – has brought little benefit to many regions. The bulk of the credits generated have been in China, which arguably has least need of such finance, and the projects have involved the destruction of industrial gases which, although harmful, could have been destroyed at a fraction of the price.

Africa, by contrast, has reaped the least outside investment from the system, though arguably it has the greatest claim on funding.

Other problems have also become apparent since the system – which was designed before 1997, when the Kyoto protocol was signed, but only started up in 2005, when the treaty finally came into effect – has been in operation. The current mechanism is unwieldy, and project developers complain that it can take more than a year to process their applications for credits.

So the current system of carbon trading is scheduled for sweeping reforms that should help to preserve the guiding principles but improve its working in practice.

Lex de Jonge, chairman of the UN’s CDM board, says ways of improving the working of the system include allowing whole categories of projects to be considered as one, instead of having to be awarded credits one by one. “There are ways to improve the operation, to make it much quicker and easier,” he says.

Other options range from the simplest – having more people to oversee the award of credits – to the most radical, such as allowing countries to set targets for cutting their emissions and then awarding large tranches of credits to the government to be made available to fund projects.

Any reforms agreed – probably not until next year – must be laid out in legal language to give investors certainty and clarity. “Carbon markets will need clear rules to give businesses a steady signal to invest in efficiency and low-carbon technologies. Without strong rules, it will be nearly impossible to generate sufficient and sustainable finance,” concludes Ms Haverkamp.

Eco economy could unlock billions

By Fiona Harvey, Environment Correspondent

Published: December 13 2009 23:12 | Last updated: December 13 2009 23:12

For the past week, governments from around the world have been meeting in Copenhagen to discuss a new global framework on greenhouse gas emissions.

It is “the most important international gathering since the second world war”, according to Lord Stern, the economist and author of a landmark review of the economics of global warming.

The ministers, negotiators and officials will soon be joined by heads of state and government, in the hope of finalising an agreement that will take over from the Kyoto protocol, the main provisions of which expire in 2012.

So complex are these negotiations that an outcome is still impossible to predict, but one thing is certain: to be successful, a Copenhagen agreement must include significant financial commitments.

Industrialised countries must assist the developing world to curb its emissions, by investing in low-carbon technology, and to adapt to the effects of climate change.

If an agreement is signed, developed countries must also look to their own economies, and set out plans for how to achieve substantial emissions cuts, through efficiencies, alternative energy sources and innovative technologies such as electric cars.

But rather than see these commitments as a cost, countries should view them as an opportunity, argues Lord Stern. “The low-carbon growth story is going to be the only economic growth story of the future,” he says.

Achim Steiner, executive director of the United Nations Environment Programme, agrees: “Copenhagen could unlock billions of dollars across the global economy.”

The economic stimulus packages put in place around the world in the wake of the financial crisis are expected to result in finance flows of more than $500bn to green projects, according to estimates from HSBC. These projects range from renewable energy development and high-speed rail systems to insulating homes.

Public money is only part of the story. Mr Steiner also points out that investors, venture capitalists, bankers and other companies are waiting to see the outcome at Copenhagen before making investments in low-carbon infrastructure.

“There has been a period already where businesses and investors have been holding back,” he says. “This means a very significant amount of money is in a holding pattern in the global economy.”

The risk is that if there is no deal, this money would be diverted to other investments, including high-carbon infrastructure, such as new coal-fired power plants.

“If Copenhagen does not come up with a good signal, then a lot of that money will disappear. It will go on other things,” Mr Steiner warns.

Also at the Copenhagen meeting are a large group of other leaders – the mayors, governors and council leaders who make up local government around the world. The mayor of Copenhagen will welcome dignitaries from dozens of countries, including famous names such as Arnold Schwarzenegger, governor of California, and Michael Bloomberg, mayor of New York. The mayors of London, Stockholm, Johannesburg, Buenos Aires, Sydney and about 50 other major cities will also be present.

What they must discuss is how to take any overarching goals on emissions cuts arising from the summit, and translate them into action at the regional and local level. Implementing such cuts must involve local government because so many of the tasks involved can only happen at that scale – from schemes to encourage householders to insulate their homes, to changes to street lighting, to public transport and cycle routes.

For instance, delegates will hear how in New York, efforts to cut emissions are focusing on retrofitting existing buildings, including the Empire State Building. Copenhagen’s own district heating system will be shown off, there will be a report on Johannesburg’s new public transport system, and London’s aim to host a green Olympic games in 2012.

Michèle Sabban, president of the Assembly of European Regions, the biggest organisation of regional authorities in Europe, says: “National governments must recognise and take advantage of the crucial role regions play in tackling climate change and energy challenges. If they fail to secure a truly multi-level response to these challenges, our national leaders will be putting our environment and economic security at grave risk.”

But none of these initiatives are possible without financing. Although most of the funds needed to kickstart the green economy are being allocated at a national, and in some cases even at an international level, there will also be a role for local fund-raising, for instance through local taxation and rates, and special charges to encourage “green” behaviour.

One striking example is London’s congestion charge, a fee levied daily on cars entering a zone in the centre of the city. The scheme has cut car use relative to the levels that were being predicted without such restrictions. The revenues raised are not dedicated to environmental ends, but there is no practical reason why they should not be. Other cities looked at emulating the system.

Some funds from national governments will also cascade down to local governments who will decide the detail of how they are spent.

Some generate savings immediately. Chuck Reed, mayor of San Jose in the US, says: “Some of our efforts are being financed through energy savings that are recycled into additional efficiency and conservation measures. We place two years of savings from energy efficiency and conservation into a separate account to fund additional efforts [which] creates a revolving fund to keeps our efforts going in tough budget years.”

Developing nations have another route open to them. Under the Kyoto protocol, rich countries can meet their targets to cut greenhouse gas emissions by investing in projects – such as solar panels or wind turbines – that reduce emissions in the developing world. They do so by buying carbon credits, each representing a tonne of carbon dioxide avoided, which are awarded to the project developers under a UN system known as the clean development mechanism.

One example of the CDM in practice is Jakarta. There, so-called “carbon finance” of this kind has allowed the city to raise funds to cut greenhouse gases, which officials say has also helped the local economy by creating new jobs.

At the Copenhagen talks, the CDM will come under discussion, and in the next few years is likely to be subject to sweeping reforms. This may make it easier for local governments to gain access to the finance it offers, for instance by allowing whole sets of projects to be grouped together to apply for funding, instead of having to be considered for funding one by one, as is the case at present. This should significantly cut the administrative costs of such developments.

If a strong deal emerges from Copenhagen, local governments can hope that at least some of the finance they need to cut emissions will be unlocked. For that reason, they are lobbying hard at the summit. “Our citizens and cities will help implement the agreement signed by government officials at [Copenhagen],” says Sten Nordin, mayor of Stockholm. “We urge the decision-makers to sign [an] agreement, and to use this opportunity for real change. We need the legislation and economic means to put [the] words into action.”

Beijing races ahead of its peers to profit from fledgling trade

By Kathrin Hille in Beijing

Published: December 2 2009 02:00 | Last updated: December 2 2009 02:00

With a shy smile and a retiring manner, Liu Deshun has the slightly bedraggled appearance of an ageing professor. But make no mistake: this academic at Tsinghua University in Beijing is one of the world's most powerful players in the rapidly growing market for carbon credits.

As the deputy-head of the Global Climate Change Inst-itute at Tsinghua, often referred to as China's MIT, Prof Liu sits at the heart of an industry his country has come to dominate: the sale of carbon credits to developed countries under the United Nations scheme established under the Kyoto protocol.

Prof Liu not only knows how the carbon market ticks. Through the Tsinghua consultancy, he also helps wind the clock.

With close to a third of the world's 1,873 projects, China has raced ahead of its peers in exploiting a system intended to reduce carbon emissions by stimulating the use of cleaner technology that would not otherwise materialise.

Leading the domestic army of consultants servicing the Clean Development Mechanism, as the UN programme is called, is Tsinghua. It has registered 43 of China's 650 projects and helped conceive dozens of others.

According to analysis by the Financial Times, the sheer number of projects makes China's leading university for science and engineering the world's fifth largest CDM consultant and the world leader in terms of the number of carbon credits its projects promise to generate by 2012.

Its very success, however, exposes some serious flaws in a fledgling market.

"Getting a CDM project approved is really difficult because it is not easy to argue why a project is additional, why it would not happen without CDM," says Yang Zhiliang, general manager of Accord Global Environment Technology, one of China's leading private CDM consultants. "So we are always glad when Prof Liu looks at our projects, because he gives us valuable advice."

There is a good chance he will. For Tsinghua offers not only consulting services; Prof Liu is also a member of the expert group that reviews all those proposals for domestic approval.

Asked about potential conflicts of interests, Prof Liu laughs knowingly. "We should avoid it," he says in an interview.

"If our name is on the project documents, we have to keep our hands out of it. We have to do the projects that have nothing to do with us."

He maintains that his institute is not pursuing profit. "The revenues just cover our cost, and we take mainly projects that promise to be relatively easy, as they resemble others we've done before," he says.

This dominant position is partly an accident of history. Tsinghua has advised the government on climate change since the early days and Prof Liu helped design a large part of the framework with which China handles CDM projects.

Commercial peers have struggled to make money. The final CDM approval process can be lengthy and customers often draft contracts that require them to pay fees only if the project gets registered.

"The turnround time for one project is two to three years, and many firms just didn't survive that," says Ms Yang of Aget, which has registered five CDM projects.

Competition is further constrained by the fact that several provincial governments have set up CDM advisory services to push local projects. Many large state-owned companies use in-house consultants.

Nor do Chinese start-ups enjoy the global experience and connections of international consultants. Driven by strong foreign demand for Chinese carbon credits, Jersey-based Camco and some other international consultancies who advise potential buyers often take on projects in a very early phase, helping to steer them through the complicated approval process.

"Chinese projects are typically subscribed long before approval," says Anders Brend-strup, head of Camco's carbon credits business in China.

While Camco says that domestic approval in China is no more than a rubber stamp, many others struggle to secure even this first step.

"There are delays in the approval process, and there are problems with the performance of registered projects," says Ruth Dobson, a partner at PwC, the professional services firm, in Beijing.

But she sees these as teething problems rather than the result of manipulation. The most common problem is that projects do not produce the promised number of credits, known as certified emission reductions.

"One reason can be that utilisation rates of the equipment in question don't reach those envisioned in the proposal," says Ms Dobson at PwC, which in China conducts mainly due diligence on other consultants' proposals.

"That has to do with the overall quality of planning and that sometimes forecasts were just based on too optimistic assumptions. It is not very typical for companies here, especially smaller ones, to do comprehensive financial planning, so the learning curve is still going on as they have to do it for the CDM."

This is something not even Prof Liu can help with.

"My expertise is methodology," he says. "The young people will have to learn the commercial side of the business."

Carbon Capitalists Warming to Climate Market Using Derivatives

Comment: Scary but exciting.. I am all for carbon trading, but broker-dealers were the guys who made marshmallows out of housing debt. Imagine what they can do with carbon emissions!

By Lisa Kassenaar

Dec. 4 (Bloomberg) -- Across Uganda, thousands of women warm supper over new, $8 orange-painted stoves. The clay-and- metal pots burn about two-thirds the charcoal of the open-fire cooking typical of East Africa, where forests are being chopped down in the struggle to feed the region’s 125 million people.

Four thousand miles away, at the Charles Hurst Land Rover dealership in southwest London, a Range Rover Vogue sells for 90,000 pounds ($151,000). A blue windshield sticker proclaims that the gasoline-powered truck’s first 45,000 miles (72,421 kilometers) will be carbon neutral.

That’s because Land Rover, official purveyor of 4x4s to Queen Elizabeth II, is helping Ugandans cut their greenhouse gas emissions with those new stoves.

These two worlds came together in the offices of Blythe Masters at JPMorgan Chase & Co. Masters, 40, oversees the New York bank’s environmental businesses as the firm’s global head of commodities. JPMorgan brokered a deal in 2007 for Land Rover to buy carbon credits from ClimateCare, an Oxford, England-based group that develops energy-efficiency projects around the world. Land Rover, now owned by Mumbai-based Tata Motors Ltd., is using the credits to offset some of the CO2 emissions produced by its vehicles.

For Wall Street, these kinds of voluntary carbon deals are just a dress rehearsal for the day when the U.S. develops a mandatory trading program for greenhouse gas emissions. JPMorgan, Goldman Sachs Group Inc. and Morgan Stanley will be watching closely as 192 nations gather in Copenhagen next week to try to forge a new climate-change treaty that would, for the first time, include the U.S. and China.

U.S. Cap and Trade

Those two economies are the biggest emitters of CO2, the most ubiquitous of the gases found to cause global warming. The Kyoto Protocol, whose emissions targets will expire in 2012, spawned a carbon-trading system in Europe that the banks hope will be replicated in the U.S.

The U.S. Senate is debating a clean-energy bill that would introduce cap and trade for U.S. emissions. A similar bill passed the House of Representatives in June. The plan would transform U.S. industry by forcing the biggest companies -- such as utilities, oil and gas drillers and cement makers -- to calculate the amounts of carbon dioxide and other greenhouse gases they emit and then pay for them.

Estimates of the potential size of the U.S. cap-and-trade market range from $300 billion to $2 trillion.

Banks Moving In

Banks intend to become the intermediaries in this fledgling market. Although U.S. carbon legislation may not pass for a year or more, Wall Street has already spent hundreds of millions of dollars hiring lobbyists and making deals with companies that can supply them with “carbon offsets” to sell to clients.

JPMorgan, for instance, purchased ClimateCare in early 2008 for an undisclosed sum. This month, it paid $210 million for Eco-Securities Group Plc, the biggest developer of projects used to generate credits offsetting government-regulated carbon emissions. Financial institutions have also been investing in alternative energy, such as wind and solar power, and lending to clean-technology entrepreneurs.

The banks are preparing to do with carbon what they’ve done before: design and market derivatives contracts that will help client companies hedge their price risk over the long term. They’re also ready to sell carbon-related financial products to outside investors.

Masters says banks must be allowed to lead the way if a mandatory carbon-trading system is going to help save the planet at the lowest possible cost. And derivatives related to carbon must be part of the mix, she says. Derivatives are securities whose value is derived from the value of an underlying commodity -- in this case, CO2 and other greenhouse gases.

‘Heavy Involvement’

“This requires a massive redirection of capital,” Masters says. “You can’t have a successful climate policy without the heavy, heavy involvement of financial institutions.”

As a young London banker in the early 1990s, Masters was part of JPMorgan’s team developing ideas for transferring risk to third parties. She went on to manage credit risk for JPMorgan’s investment bank.

Among the credit derivatives that grew from the bank’s early efforts was the credit-default swap. A CDS is a contract that functions like insurance by protecting debt holders against default. In 2008, after U.S. home prices plunged, the cost of protection against subprime-mortgage bond defaults jumped. Insurer American International Group Inc., which had sold billions in CDSs, was forced into government ownership, roiling markets and helping trigger the worst global recession since the 1930s.

Lawmakers Leery

Now, that story -- and the entire role the banks played in the credit crisis -- has become central to the U.S. carbon debate. Washington lawmakers are leery of handing Wall Street anything new to trade because the bitter taste of the credit debacle lingers. And their focus is on derivatives. Along with CDSs, the most-notorious derivatives are the collateralized-debt obligations they often insured. CDOs are bundles of subprime mortgages and other debt that were sliced into tranches and sold to investors.

“People are going to be cutting up carbon futures, and we’ll be in trouble,” says Maria Cantwell, a Democratic senator from Washington state. “You can’t stay ahead of the next tool they’re going to create.”

Cantwell, 51, proposed in November that U.S. state governments be given the right to ban unregulated financial products. “The derivatives market has done so much damage to our economy and is nothing more than a very-high-stakes casino -- except that casinos have to abide by regulations,” she wrote in a press release.

Jet Fuel, Wheat

In carbon markets, many of the derivatives would be futures, options and swaps that would allow a company to lock in a price for carbon like it would for any other commodity related to its business, Masters says. Such derivatives are negotiated every day by airlines trying to guarantee future prices for jet fuel and farmers setting a future price for their wheat crop. A large, liquid market in carbon credits would serve to keep their price low, JPMorgan says.

“The reason why this is important is not because it’s going to create a new forum for us to buy and sell; it’s because the scale of what’s being contemplated here is absolutely enormous,” Masters says. “It’s going to affect your kids and my kids. The worst thing would be to introduce legislation that doesn’t achieve the environmental goal; that would be a crime of epic proportions.”

Not Convinced

Michelle Chan, a senior policy analyst in San Francisco for Friends of the Earth, isn’t convinced.

“Should we really create a new $2 trillion market when we haven’t yet finished the job of revamping and testing new financial regulation?” she asks. Chan says that, given their recent history, the banks’ ability to turn climate change into a new commodities market should be curbed.

“What we have just been woken up to in the credit crisis -- to a jarring and shocking degree -- is what happens in the real world,” she says.

Even George Soros, the billionaire hedge fund operator, says money managers would find ways to manipulate cap-and-trade markets. “The system can be gamed,” Soros, 79, remarked at a London School of Economics seminar in July. “That’s why financial types like me like it -- because there are financial opportunities.”

Masters says U.S. carbon markets should be transparent and regulated by the Commodity Futures Trading Commission. Standardized derivatives contracts -- securities that can be bought and sold by anyone -- should be traded on exchanges or centrally cleared, she says. The British-born Masters, who has an economics degree from Cambridge University, took over JPMorgan’s commodities business in 2007.

Allowances, Offsets

In a U.S. cap-and-trade market, the government would allot tradable pollution permits, called allowances, to emitters of CO2 and other greenhouse gases. The market would also likely include offsets -- credits generated by companies such as Eco-Securities that would have to demonstrate to U.S. agencies running the program that the offsets mitigate carbon pollution.

Point Carbon, an Oslo-based firm that analyzes environmental markets, estimates that by 2020 the U.S. carbon market could surge to more than $300 billion. That’s based on an assumption that the allowances, each representing a ton of carbon dioxide taken out of the atmosphere, would trade for $15. Bart Chilton, a commissioner of the CFTC, which would likely be one of the regulators of the carbon market, says it could grow as large as $2 trillion.

Goldman Building

As they wait for a U.S. cap-and-trade system to be introduced, the big banks are busy building, not trading. Goldman Sachs, for example, has fewer than 10 traders dedicated to carbon around the world.

“Carbon right now is not about sitting in front of a screen and clicking,” says Gerrit Nicholas, Goldman’s head of North American environmental commodities. “It’s all about running around talking to clients about what they can expect, how big it can be and what their risk is.”

Abyd Karmali, who heads global carbon emissions at Bank of America Merrill Lynch in London, says companies, banks and investors are all watching Congress.

“A lot of people are focused on Copenhagen, but what happens in Washington on federal cap and trade is, arguably, more important,” says Karmali, who’s president of the Carbon Markets and Investors Association, an international trade group. “This market is still in its very early stages. U.S. cap and trade would make an order of magnitude of difference.”

‘Ruinous Course’

Although U.S. President Barack Obama and his economic team support cap and trade, Washington politics could defeat it. The House bill passed in June by just seven votes, and senators on both sides of the aisle worry that imposing pollution caps on industry will result in higher energy bills for consumers at a time when U.S. unemployment tops 10 percent. Karl Rove, former president George W. Bush’s deputy chief of staff, wrote in Newsweek magazine in November that cap and trade “would put America on a ruinous course.”

Republican Senator James Inhofe of Oklahoma, who in 2006 called Nobel Prize winner and former Vice President Al Gore “full of crap” on global warming, boycotted committee meetings on the Senate bill in November.

Senate Majority Leader Harry Reid said on Nov. 18 that climate-change legislation may not be discussed until the spring, prompting speculation among others in the Senate that the bill won’t be passed before Congressional elections in 2010. The Obama administration is also driving to overhaul U.S. health care and develop proposals to push down unemployment.

House, Senate Bills

U.S. cap and trade, as currently configured in both the House and Senate bills, would mean the government sets an upper limit on emissions of seven greenhouse gases, including CO2, methane and nitrous oxide, for thousands of power plants, refineries and factories. Over time, the caps would fall, pushing emitters to adopt clean-air technology.

The government would give some pollution allowances to companies free to help them meet their caps during the first years of the program. Emitters who invest in cutting their pollution would have allowances to sell; those that don’t would have to buy.

The allowances -- similar to those that sold in Europe in mid-November for 13.5 euros ($20) -- would be tradable on an exchange or, if Congress allows it, between parties in an over- the-counter market. The credits garnered through offset projects such as the stoves in Uganda are distinct from allowances in that they may be generated on the other side of the world.

Accounting for Carbon

U.S. companies would account for carbon in long-term strategic plans, bankers say. For instance, utilities such as American Electric Power Co., which produces power from coal, would hedge the price of carbon over periods as long as a decade or more. Columbus, Ohio-based AEP is the biggest U.S. greenhouse gas emitter in the Standard & Poor’s 500, according to the London-based Carbon Disclosure Project, which collects such data. Companies like AEP would retain financial institutions to come up with customized derivatives contracts to help them manage their risk.

Derivatives contracts designed for a particular company or transaction, known as over-the-counter derivatives, are a hot- button issue in the larger debate over how the U.S. banking system should be regulated. Most CDSs and CDOs are OTC derivatives. They are created and traded privately -- not on any exchange -- and can be illiquid and opaque, says Andy Stevenson, a financial analyst for the Natural Resources Defense Council, an environmental group that supports the Senate legislation. The House cap-and-trade bill bans OTC derivatives, requiring that all carbon trading be done on exchanges.

OTC Derivatives

The bankers say such a ban would be a mistake. OTC derivatives are a $600 trillion market, much of which consists of interest-rate swaps designed to hedge risks for individual companies. “It’s a concern of ours if they limit the market,” says Pat Hemlepp, a spokesman for AEP. “It reduces the options when it comes to cap and trade, and we have told people that on the Hill. We do feel it’s best to have banks and other parties able to participate.”

The banks and companies may get their way on carbon derivatives in separate legislation now being worked out in Congress. In October, the House Financial Services Committee, headed by Representative Barney Frank, a Democrat from Massachusetts, approved a bill that would require collateral for all derivatives trading between financial institutions. And broker-dealers such as JPMorgan and Goldman Sachs would be forced to clear most derivatives contracts on regulated exchanges or through so-called swap-execution facilities. However, the new rules would not apply to end-users -- companies such as AEP that use derivatives to hedge operational risks.

Price Collar

The Senate environment bill, dubbed Kerry-Boxer for Senators John Kerry of Massachusetts and Barbara Boxer of California, the two Democrats who introduced it, contains little detail on how the cap-and-trade market would work. It sets a price floor of $11 per ton on carbon. The bill also creates a strategic reserve of allowances that the government could use to flood the market if the price of carbon shoots up.

“It will be the best-regulated market in the country,” Stevenson says. “The effort is to make all of the trading known to the regulator. That wasn’t the case in the mortgage market.”

Wall Street sees profits at every stage of the carbon- trading process. Banks would make money by helping clients manage their carbon risk, by trading carbon for their own accounts and by making loans to companies that invest to cut greenhouse gas emissions.

Chicago Climate Exchange

A clear U.S. price on carbon, determined in a large market, would help drive billions of dollars into investments to clean the air, says Richard Sandor, founder and chairman of the Chicago Climate Exchange and the Chicago Climate Futures Exchange. He is also the principal architect of the interest- rate futures market.

“What’s important is the price signal,” Sandor says. “It will stimulate inventive activity and cause behavior to change.” The Chicago Climate Exchange, the biggest U.S. voluntary greenhouse-gas-emissions trading system, trades 180,000 tons of carbon a day, up from 40,000 tons in 2006.

Over time, carbon, like other commodities, needs markets linked around the world, Goldman’s Nicholas says.

“If you believe the science and that something needs to be done about this, the market probably needs to be big,” he says. “Carbon could become an important commodity. I’m not saying it will be bigger than others, but it will be another important business for us.”

Polluters Only

Critics, including Senator Cantwell, espouse a smaller, less complex market in which pollution permits would be publicly exchanged only among fossil-fuel producers. Such a system may block progress on the environmental goals, says JPMorgan’s Masters.

“We say, ‘Let’s incentivize people to have the lowest-cost opportunities to avoid carbon emissions,’” she says.

Masters has been dealing with complex securities since she did a summer internship on JPMorgan’s London derivatives desk while she was at Cambridge. She joined the desk full time soon after graduating in 1991. The derivatives group’s task was to find ways to spread the risk of JPMorgan’s loans, partly to reduce the amount of capital it was required to hold in reserve against them.

Offloading Risk

In 1994, Exxon Corp. needed a credit line after it was threatened with a $5 billion fine for spilling 10.8 million gallons (40.9 million liters) of oil into the ocean off Alaska in 1989. Masters asked the London-based European Bank for Reconstruction and Development to take on the Exxon risk in exchange for an annual fee paid by JPMorgan, according to “Fool’s Gold,” a book by Gillian Tett (Free Press, 2009) that chronicles the history of credit derivatives at JPMorgan. The loan would remain on JPMorgan’s books and be insured by the EBRD, an international bank owned by 61 countries that supports development projects in Central Europe.

The bankers called the contract a credit-default swap.

Masters left the credit derivatives unit in 2001 to do other jobs at the bank. From 2004 to 2007, she served as chief financial officer of the investment bank. Since she took over the commodities division in 2007, its staff has almost doubled to 400 employees. The firm added Bear Energy to the division when it acquired Bear Stearns Cos. in the March 2008 heat of the credit crisis.

In December 2008, Masters led the purchase of UBS AG’s agriculture business and Canadian commodities operations. She now sits in a corner office in Bear’s former Madison Avenue tower. Outside her glass door are rows of traders making markets in metals and oil futures.

Subprime Carbon

Friends of the Earth’s Chan is working hard to prevent the banks from adding carbon to their repertoire. She titled a March FOE report “Subprime Carbon?” In testimony on Capitol Hill, she warned, “Wall Street won’t just be brokering in plain carbon derivatives -- they’ll get creative.”

Sitting in Cafe Madeleine, a small sandwich shop on a hilly stretch of California Street in San Francisco, Chan, 37, talks over coffee about her campaign. She’s brought her own ceramic mug from her crammed office across the street.

Chan started at FOE -- the biggest network of environmental groups in the world, with offices in 77 countries -- on a six- month fellowship after she graduated from the University of California, Los Angeles in 1994. Her first job was to pin responsibility for what FOE regarded as environmentally damaging projects on the banks that loaned the enterprises money.

Three Gorges Dam

In 1997, Chan uncovered and helped publicize loans to China’s Three Gorges Dam by banks including Morgan Stanley and Merrill Lynch. Since then, Wall Street banks have sought Friends of the Earth’s help in burnishing their environmental image.

In 2005, Chan worked with Goldman Sachs to write an environmental policy statement for the firm, she says.

Carbon isn’t like other commodities, Chan says. The government’s goal to reduce pollution means it will gradually diminish the number of allowances it issues, and that will be a powerful incentive for speculators to try to corner the market and drive up the price, she says.

While banks say they’re a long way from packaging securities from environmental credits now, Chan points to two deals that Zurich-based Credit Suisse Group AG completed in 2007 and 2008 that each combined more than 20 different offset projects, then sliced them into tranches and sold them to investors. The securities were the equivalent of carbon CDOs, Chan says.

Boom and Bust

Chan has an ally in hedge fund manager Michael Masters, founder of Masters Capital Management LLC, based in St. Croix, U.S. Virgin Islands. He says speculators will end up controlling U.S. carbon prices, and their participation could trigger the same type of boom-and-bust cycles that have buffeted other commodities.

In February 2009 House testimony, Masters -- who is no relation to Blythe Masters -- estimated that the early 2008 price bubbles in crude oil, corn and other commodities cost U.S. consumers more than $110 billion.

The hedge fund manager says that banks will attempt to inflate the carbon market by recruiting investors from hedge funds and pension funds.

“Wall Street is going to sell it as an investment product to people that have nothing to do with carbon,” he says. “Then suddenly investment managers are dominating the asset class, and nothing is related to actual supply and demand. We have seen this movie before.”

Companies Need Banks

Still, companies need the financial markets to help them drive down their greenhouse gas emissions at a reasonable price, says the NRDC’s Stevenson. “There are trillions of dollars needed to make this transition, and companies need the banks,” says Stevenson, a former trader for London-based hedge fund firm Brevan Howard Asset Management LLP.

Stevenson dismisses as overblown the concern that banks will soon be packaging greenhouse gas allowances into securities that look like CDOs. The banks stand to make more money, he says, as lenders to companies that need to invest in new power plants and factories to reduce their emissions. “I would argue that this is only a bonanza for the banks in that they get to go back to their day jobs -- which is lending money,” Stevenson says. “I’m suspect of them generating a lot from carbon trading itself in the early years.”

Northeast Test Case

A relatively small-scale cap-and-trade effort called the Regional Greenhouse Gas Initiative tells a cautionary tale. RGGI is a CO2 reduction program established by a group of northeastern and mid-Atlantic states in 2003 with a goal of cutting CO2 emissions from power plants in the region 10 percent by 2018. Ten states are now members. Trading in the companies’ pollution permits began in September 2008 -- in the middle of the financial crisis. As of mid-November 2009, prices of the pollution permits were down 50 percent, according to data compiled by Bloomberg.

Meanwhile, the 10 best-performing investment funds with climate change or clean energy as a central goal all plunged 40 percent or more in 2008, according to data compiled by London- based New Energy Finance. The shrinking global economy sapped momentum for developing new environmental projects.

“To mobilize capital now and begin a transformation to new energy technologies is a very risky business,” says Ken Newcombe, founder of C-Quest Capital, a Washington-based carbon finance business that invests in offsets. “Returns have to be reasonable to take on those risks.”

Risk Capital Vital

Newcombe is the former head of Goldman’s U.S. carbon market origination and sales department and one of the world’s first carbon traders. He holds a Ph.D. in energy and natural resource development from the Australian National University. Private money, including capital from banks, hedge funds and other investors, must keep flowing into the system to realize global environmental goals that the Copenhagen meetings will try to hash out, he says.

“The ultimate objective is economic efficiency,” Newcombe says. “How can we reduce the cost of implementing important public policy? Having a pool of risk capital is absolutely vital to the smooth introduction of a cap-and-trade regime in the U.S.”

As Washington debates climate policy in the shadow of the recent financial meltdown, lawmakers have a right to be wary, Newcombe says.

“There’s legitimate concern that there may be unseemly profits or untenable risks,” he says. “But a problem now is that the critical objective of stabilizing the financial system could lead to an overregulation of the carbon market.”

‘Such a Fog’

Meanwhile, the industrial firms that would be affected by cap and trade are eager for the game to begin, says Lew Nash, a Morgan Stanley executive director and the firm’s U.S. point person on the carbon markets.

“There is such a fog right now in terms of how the legislation is going to work,” Nash says. “There is a real economic desire here for price signals that will permit the market to properly price carbon. Our customers have little choice but to participate in this evolving market.”

Nash says his clients aren’t just looking for help figuring out how to use carbon trading to manage their emissions caps. Pricing carbon will also set the tone for strategic investments. If a company wants to build a new factory, for instance, it’s going to need to factor prospective carbon emissions into its construction and operational plans, Nash says.

Supporters of cap and trade see, over many years, a remaking of the U.S. industrial landscape and a sharp reduction in the gases that cause global warming. Little will happen, though, until the debate is resolved between the bankers who want more liquidity

Trade could hold the key to a climate deal

By Bård Harstad

Published: December 3 2009 20:28 | Last updated: December 3 2009 20:28

Our leaders’ recent confession that a legally binding climate agreement is not feasible this year may be no bad thing. The hope is that the new goal for December – to reach a broader “political agreement” – will establish a better foundation for a future climate deal than we currently have.

This is important, since a climate agreement currently faces three significant obstacles. To overcome these, there might be no solution other than to link any deal to new and existing trade agreements.

The first challenge is to encourage participation in a climate agreement. The problem is that while participating countries bear the costs of reducing their own emissions, countries that chose to opt out can nevertheless benefit from these reductions and, in addition, from a lower fossil fuel price when the participating countries reduce their demand.

The Kyoto Protocol failed to motivate the US, as well as big developing countries, to take part. But Russia ratified Kyoto after the European Union promised to support its admission to the World Trade Organisation. Clearly, some carrot is needed to motivate participation, and being a favoured trading partner is one of the few powerful incentives that can realistically be offered in international politics. Alternatives such as conditional development aid might be held out to the poorest, but explicit transfers to other countries would be politically unacceptable.

The second obstacle is compliance. Currently, few countries are on track to fulfil their obligations under Kyoto. The explanation is simple: the consequences of not complying are minor. While Kyoto requires non-compliers to repay their carbon debt in the next commitment period at 30 per cent interest, this penalty merely delays the problem and reduces the motivation to then comply.

Specifying explicit fines or fees for non-compliance, on the other hand, cannot be credible in an international agreement when they are not even credible in a more formal setting such as the EU. After violating the Maastricht Treaty in 2003, for example, Germany and France easily reneged and no fines were paid.

Trade agreements, however, are better enforced since it is in the victim’s interest to increase its barriers and reduce competition from the offender. Trade restrictions such as border taxes might also be the only credible sanction for climate treaties.

A third difficulty is stimulating the development of new technologies. Investing in solar technology, for example, must be sufficiently rewarded. For the private sector, this requires a large market and that intellectual property rights are protected. But for the public sector, such investments are still not worthwhile if better technology might become a liability when negotiating the allocation of quotas in the future. Denmark, a technology leader in wind power, has already felt the pressure to bear a larger burden of the EU’s obligations: once its investments were sunk, reducing emissions became inexpensive and this could be exploited by the other negotiators.

To prevent investing countries from being penalised in this way, quotas should be based on pre-specified formulas and not on whether a country happens to be at the technology frontier. Rigid formulas preclude exempting ill-prepared countries, however, and these may prefer to opt out unless participation is sufficiently rewarded. Being a favoured trading partner might be the crucial reward.

Implementing such a linkage is possible. The Montreal Protocol, successfully protecting the ozone layer, is already restricting trade with non-participants and non-compliers, although only in the substances controlled by the treaty. To repeat this success and overcome the obstacles for a climate agreement, signatories should become favoured trading partners while non-compliance should trigger a temporary denial of this status. Disputes can be solved by expanding the mandate of the WTO’s dispute settlement body or another mediator.

With the Doha Development Round negotiations stalled, a linkage to climate may even be a blessing for trade. There is a unique opportunity to link the two negotiations and achieve progress in both. That should be the goal for world leaders when they show up in Copenhagen.

The writer is an associate professor at Kellogg School of Management, Northwestern University and a contributor to the Harvard Project on International Climate Agreements