Getting a Head Start

On February 14, 2002, President George W. Bush and the U.S. Environmental Protection Agency (EPA) unveiled their Clear Skies Initiative and the long-awaited proposal for a multi-pollutant cap and trade program. Currently, there are two separate interstate cap and trade emissions trading programs regulated by EPA: the seasonal Nitrogen Oxides State Implementation Plane (NOX SIP) Call market in 21 eastern states and the annual sulfur dioxide (SO2) market nationwide. The EPA's new proposal combines the two and adds mercury -- regulating all of them under one umbrella program.

For the Clear Skies Initiative to become enforceable, the U.S. Congress must pass legislation and EPA must draft and finalize regulations, a process that could take several years. The proposed official start date for the NOX component of the program is 2008 (the date after which companies will be penalized for emissions in excess of caps -- without the purchase of emissions allowances), while steeper SO2 reductions and a new mercury cap will not be implemented until two years later in 2010. Challenges by the Democrats and environmentalists may change the final emissions cap levels, and there remains some skepticism of whether mercury will truly be a "tradeable" commodity, but one thing is near certain: a multi-pollutant cap and trade program will be a cornerstone of the Clear Skies Initiative.

Under the NOX SIP Call, 21 Eastern states and the District of Columbia are required to submit state implementation plans indicating which sources in each state will reduce NOX emissions that contribute "significantly" to ozone pollution in downwind states, principally in the Northeast.

Power plants and other major industrial sources must comply with deadlines for reducing emissions under the NOX SIP Call program by May 30, 2004. This deadline was set under a court order.

From a financial perspective, there are two major incentives for a company to reduce emissions early and position itself to be an early seller of credits. The first is that early trading prices under previous EPA cap and trade programs were among the highest prices ever transacted.

The second reason: based on previous EPA cap and trade programs, companies that reduce emissions in advance of the implementation date of the program have been eligible to receive additional "Early Reduction Credits," generating an even greater financial asset when the program becomes officially enforced.

For example, let's say that a company emits 10,000 tons of NOX today, and they reduce it to 3,000 tons by 2006. Under the new EPA program (which forces an average 58 percent reduction from historical levels), their allocation may be 4,200 tons per year. This means they will have 1,200 tons per year to sell beginning in 2008. In addition, they will be eligible to file for Early Reduction Credits for reducing their levels below the 4,200 before 2008 -- a total of 2,400 tons worth of early credits (1,200 in 2006 and 1,200 in 2007). So in 2008, when the program is officially implemented, they will have 3,600 credits to sell -- at likely peak market prices. Since the market for emission allowances is likely to develop many years before the first implementation year of the Clear Skies Initiative, there will also be the opportunity for "forward sales" of anticipated future reductions. For example, vintage 2004 NOX allowances under the SIP Call have been trading since 2001.

As companies review their compliance plans to prepare for multi-pollutant regulations, and as they monetize their emissions, they should factor in the greater value of early emissions reductions.

There is a strong incentive for companies to overcomply and make excess reductions -- which can likely be sold at the highest prices in the market -- and, for some well-positioned firms that have a lower incremental cost of compliance, may ultimately finance pollution control systems.

Companies that wait too long in evaluating their systems and planning for multi-pollutant may miss the boat.

Multi-Pollutant Rule is Coming: Seven Reasons to Act Now

Trading is likely to be a cornerstone of the Clear Skies Initiative. Here are seven reasons why it makes sense for companies to act now on emissions:

1) Money is cheap -- financing investments in pollution control technology costs less today.

2) SO2 and NOX prices under the current programs are relatively high; early reductions of emissions prior to the finalization of regulations implementing the "Clear Skies Initiative" will not only position those companies to sell allowances under the future regulations but will also facilitate the sale of allowances under the current programs to immediately help finance the installation of equipment to position affected companies for the tighter future caps.

3) Early sellers in previous markets profited (Evolution Markets has price charts dating back to the introduction of the SO2 market in 1992 and the NOX market in 1998 at the market data section of its Web site at www.evomarkets.com).

4) Investing in sulfur control equipment will have the additional benefit of providing particulate matter reductions that will be required under separate forthcoming regulations.

5) Supply and demand for equipment favors early action; there is likely to be a crunch for control equipment, such as flue gas desulfurization and selective catalytic control systems as 2008 approaches.

6) When it comes to public relations benefits, the early birds get the worm.

7) Early action equals Early Reduction Credits, a key component of every EPA program, including NOX SIP and SO2.

Emissions Trading Primer

Q: What is emissions trading?

Emissions trading is a market mechanism that allows companies and industries to more easily comply with U.S. Environmental Protection Agency (EPA) regulations while reducing overall pollution over time. Emissions trading turns gases such as sulfur dioxide and carbon dioxide into tradeable commodities.

It works this way: companies buy emissions reduction credits, which are created when a company reduces emissions of certain pollutants -- in particular nitrogen oxides (NOX) and sulfur dioxide (SO2) -- below regulatory requirements. If the company that purchased the credits also reduces emissions, they may sell their credits. In order to reduce acid rain, companies traded sulfur dioxide credits under an EPA program -- which has resulted in a 50 percent reduction of SO2 emissions in 10 years.

While there is currently no regulatory framework for greenhouse gas (GHG) trading in the United States, companies are increasingly trading GHG credits, also known as carbon credits, in much the same way they trade NOX and SO2 in anticipation of a voluntary program, and as a way to meet the challenges of cutting CO2 emissions. Greenhouse gases include CO2, methane, nitrous oxide, hydrofluorocarbons, perfluorocarbons and sulfur hexafluoride.

Q: How does emissions trading benefit a company?

The trading of emissions reduction credits (ERCs) gives companies incentives to invest in new technology, such as scrubbers, improve a facility's operational efficiency or take other measures to cut emissions. The EPA's "cap and trade" system, set up under the acid rain program, provides some great examples. Under this system, credits are awarded when a company reduces emissions below a regulatory level regardless of how they achieve it.

These credits can be sold to companies that cannot cost-effectively meet their regulatory requirements. The proceeds can then be used to offset the cost of the new technology. Companies can also "bank" the acid rain ERCs to meet future compliance requirements at their own facilities. The same basic framework is being used for the private trading of greenhouse gas credits, currently traded in the form of "contracts."

The ability to purchase emissions credits provides buyers with the much-needed flexibility to determine how and when to invest in reduction technology to get under the cap. Without this flexibility, many companies would not be able to comply with regulations.

Q: What is the impact on public companies in particular?

In terms of greenhouse gas emissions, some global organizations are pricing the "carbon risk" into their project rate-of-return calculations, recognizing that in addition to new risk factors that need to be considered, carbon credits in themselves offer potentially new and additional long-term cash-flow benefits.

Q: How big is the emissions trading market currently?

American analysts have projected that the market for emissions control of greenhouse gas should reach $17 billion by 2010 -- based on the price of $26 a ton of carbon. According to World Bank statistics, the emissions market could grow up to $60 billion by 2020.

Q: Which industries are currently active in the market?

The energy sector, public utilities, and heavy industry such as steel are active in the marketplace today.

Q: What is the proof that emissions trading really works?

According to the EPA, the federal sulfur dioxide program has reduced emissions by 50 percent. In a recent editorial, The New York Times described emissions trading as "a market mechanism favored by Americans that has been shown to greatly reduce the costs of emissions control." (June 17, 2001) And a recent Business Week editorial described emissions trading is "a proven mechanism" in the United States. (June 25, 2001)

THE KYOTO PROTOCOL

Q: How does emissions trading relate to the Kyoto Protocol?

Companies whose businesses involve high levels of greenhouse gas emissions -- primarily carbon dioxide (CO2) are preparing for regulations requiring them to reduce those emissions, whether it's by the Kyoto Protocol, which advocates an international emissions credit trading system to reduce GHG emissions, or some other program. By preparing for early trading of GHG emission credits, these companies are positioning themselves to take advantage of whatever market-based initiatives result from Kyoto or other developing GHG emissions programs.

Q: Why should companies get involved with emissions reduction credits and trading for greenhouse gas emissions?

Since global climate change is seen as one of the most important environmental issues of the 21st century, there is increasing pressure on business to adopt initiatives to cut greenhouse gas emissions, thought to be a major contributor to global warming. One such initiative is emissions credit trading. Companies can take voluntary steps now to establish their own emissions credit programs for greenhouse gases, in anticipation of "some type" of GHG market-based initiative, which seems likely, at some point, either on a national or international scale. By doing so, they can demonstrate their commitment to reducing carbon dioxide emissions and best position themselves to have their reductions recognized whenever a formalized program is introduced.

Q. What steps do companies need to take if they want to start a GHG emissions credit program?

Since there is no regulatory framework for trading these credits, it is important for companies involved with the trading, or those planning to become involved, to have their own protocols and procedures in place for analyzing, measuring and verifying GHG emissions, with assistance from an independent organization specializing in such activity. The protocols should be transparent and consistent with current and anticipated national and international GHG trading programs. With this approach, a company can create what is known as a GHG emissions portfolio for making decisions about creating credits for trading.

Q. Why is this important?

A properly designed and verified GHG reduction program should be capable of withstanding scrutiny under any national or international emissions trading program similar to those outlined under the Kyoto Protocol. This means that the value of the credits is more likely to be widely recognized and lasting under any proposed GHG program. Those GHG emissions reduction programs that lack proper design or verification procedures may be excluded from certain trading schemes in the future, or the value of credits created may be lowered, reflecting higher risk.

e-sources

Environmental Defense Fund Fact Sheets:

Global Warming: Fact vs. Myth (EDF) -- www.environmentaldefense.org/pubs/FactSheets/e_GWFact2.html

The Kyoto Negotiations -- www.environmentaldefense.org/pubs/FactSheets/kyoto

Emissions Trading: The Market is Moving! -- www.environmentaldefense.org/pubs/FactSheets/kyoto/c_emtrading-bonn.html

This article originally appeared in the 04/01/2002 issue of Environmental Protection.

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