Josh Margolis keeps a grueling schedule, brokering deals between buyers and sellers and forecasting how government actions could affect his clients. But his obsession is not stocks, or bonds, or oil futures. As co-CEO of the San Francisco–based company CantorCO2e, Margolis is part of an exploding branch of finance in a new commodity: carbon.
Mainstream financial institutions including Merrill Lynch, J.P. Morgan, Deutsche Bank, and Goldman Sachs are joining the booming carbon market, which continues even through the current economic jitters. According to the World Bank, global trades in this market in 2007 were valued at more than $64 billion, more than doubling since 2006. Skip Willis, president and CEO of Carbon Capital Management, a Toronto-based “carbon monetization” corporation, predicts that by the end of 2008 the global carbon trading system will have topped $100 billion. “This is a market that barely existed five years ago,” Willis says.
The carbon market was born out of the 1997 Kyoto Protocol, which mandates the curbing of carbon emissions. To comply, the 182 nations that signed the protocol must meet targets for reducing emissions of greenhouse gases—climate-warming gases that include the common industrial by-products carbon dioxide and methane. Meanwhile, many companies are participating in carbon trading voluntarily, either to build a green reputation or in anticipation of looming regulation. (DISCOVER recently did its own carbon-offset experiment; see the results on the bottom of the next page.) The United States never signed the Kyoto Protocol, but growing concern in this country over climate change may soon bring some form of regulation here, too. Joseph Romm, who served as acting assistant secretary of energy during the Clinton administration and now edits a climate policy blog as a senior fellow at the Center for American Progress, predicts that “the United States is clearly going to have a carbon trading system in the near future.” He notes that the president-elect supports such a plan.
Behind the carbon wheeling and dealing lies a market mechanism called cap-and-trade. “What a cap-and-trade tries to accomplish is the most cost-effective way to achieve emissions reductions,” says Eric Klein, a senior broker with the New York office of the emissions trading company TFS Green. The government sets a cap limiting the total amount of greenhouse gases that an industry, sector, region, or the country may emit. It then sells or grants permits to businesses covered by the cap. Each permit essentially allows the license holder to release the equivalent of 1 ton of carbon dioxide and can be traded among emitters and financial institutions. “Over the course of the year,” Klein says, “if you emit above and beyond the amount covered by your permits, it’s your responsibility to buy more of them on the open market. If you emit less than your limit, you can sell your extras on the open market.”
Mandatory carbon trading programs, such as the European Union Emissions Trading Scheme (EU ETS) that began in 2005, have their roots in the U.S. Clean Air Act amendments of 1990. That legislation, which Klein calls “the granddaddy of all emissions trading markets,” created a cap-and-trade system for utilities to reduce the sulfur-based pollutants that cause acid rain. “A cap-and-trade system says, ‘You have to reduce overall emissions, but how you do it is your business.’ That flexibility saves a lot of money,” according to Robert Repetto, economist emeritus of the Yale School of Forestry and Environmental Studies and senior fellow at the United Nations Foundation. Ultimately, Repetto says, the Clean Air Act resulted in the reduction of acid rain pollution more quickly than expected, and at much less expense than what traditional regulation would have cost.
Replicating that success is not as straightforward as it sounds. First, carbon emissions are not currently well quantified. The Clean Air Act amendments required power plants to install instruments that record their acid rain–causing emissions and to report the numbers to the Environmental Protection Agency. Yet in Europe’s carbon trading system—a likely model for the United States—businesses are not required to use monitoring instrumentation. They are allowed to determine their carbon emissions by “calculation.” Although third-party auditors check the process, Michael Wara, a Stanford Law School professor and a researcher at the Stanford Program on Energy and Sustainable Development, acknowledges that there is reason for concern when emitters are doing their own carbon accounting. “Enron is always a specter in the background,” he says, referring to the accounting scandals that sank the giant energy-trading company in 2001.
According to Larry Lohmann, a researcher with the U.K.-based nonprofit the Corner House and editor of a book criticizing the carbon trade, “Even here in Europe, we’re nowhere near being in possession of the technology and enforcement we would need to run a respectable cap-and-trade program, which we’re already supposedly running. The margin of error for what’s coming out of the stacks is way too wide to say whether emitters are in compliance with regulations. And when it’s left up to the companies to do the reporting, they have a huge amount of discretion in saying how much they’re emitting.”
The second problem concerns the validity of offsets, a feature of most existing carbon trading systems. “Under a cap-and-trade program,” Margolis says, “offsets are a form of currency to help participants meet the regulations. If you need to emit less carbon, you can change your process, you can change what fuel you use, or you can find a company that you can pay to reduce those tons for you, which is what happens when you buy an offset.” A company that needs to eliminate 1,000 tons of emissions from its ledger might pay for a project that will plant enough trees to absorb that amount of carbon dioxide.
Lohmann points out that to show that an offset project does what it claims—actually reduce emissions—“you have to argue that there will be lower emissions than would have been the case without the project. That type of measurement is just doomed from the start. And people are aware that it can’t be verified, which opens the way to making any claim you want to make. There have been a lot of complaints about so-called carbon cowboys making a lot of money on nonexistent carbon reductions,” Lohmann adds. “But since the question can’t be decided scientifically, there’s no sheriff.”
Stanford’s Wara and his colleague David Victor recently investigated a group of offsets offered under the Kyoto Protocol’s Clean Development Mechanism (CDM), which can be purchased for compliance with the E.U. trading scheme. “The basic idea of the CDM is that you cut emissions in a place like China in lieu of reducing them in Europe,” Wara says. “So we need to be certain that we’re really cutting in China. Otherwise the whole goal is undermined.” For instance, power from a new Chinese wind farm or hydroelectric plant might displace electricity that would otherwise come from carbon-spewing fossil fuels. If the developers of these projects can show that these renewable energy sources would never have been built without offset money, then the carbon emissions saved by the new plants can be sold as offsets.