The Kyoto Protocol: Threat...or Opportunity?

The new international agreement to reduce greenhouse gases could offer U.S. companies a chance to profit from the emerging global carbon markets

In 2001, President George W. Bush took the United States out of the Kyoto Protocol, the international agreement that commits the major industrial economies to reduce their emissions of greenhouse gases including carbon dioxide, methane, nitrous oxide, and several other substances. He argued that participation in the agreement would cause our nation economic harm. Since then, U.S. businesses have neglected it for the most part, focusing on the immediate challenges of the changing economic environment after September 11, which include the sharp drop in the stock market, recession, and corporate retrenchment.

That neglect will come to an end now that the Kyoto Protocol went into force in February following Russia's ratification of the agreement earlier this year. To date, 148 countries have ratified the Kyoto Protocol, but Russia's ratification was crucial in that it fulfilled the final part of the agreement, that 55 percent of the world's emissions in 1990 be represented. Executives of U.S. companies now ignore the Kyoto Protocol at their peril, not only because participating countries -- including the European Union, Canada, and Japan -- are implementing regulations that will affect U.S. subsidiaries in those countries (the threat) and but also because the Kyoto Protocol creates a new market for U.S. companies to explore (the opportunity). The international carbon markets created by Kyoto, which topped $500 million in 2004 and are expected to double in 2005, offer dramatic opportunities for U.S. companies.

The Threat...
With respect to the new regulatory requirement, the European Union's implementation of its collective commitment under Kyoto involves the creation of the European Trading Scheme (ETS), which establishes caps for emissions that are allocated by the National Allocation Plans (NAPs) among regulated companies in the form of European Union Allowances (EUAs). Companies may buy and sell these instruments within the EU in order to achieve compliance with their respective emissions limits.

This activity has led to a burgeoning market for EUAs, complete with all the underpinnings of a financial market -- trading desks, electronic trading, market monitors, and market commentary with talk of fundamentals (such as the impact of weather and oil prices on emissions patterns or regulatory drivers such as NAPs that are either too stringent or too lax), price volatility, and transaction volumes. In the first quarter of 2005, EUA prices moved from levels in the range of €6 to €8 to over €15, with increasing volume, driven by increased energy consumption during a relatively severe winter, a tighter than expected Polish NAP, and the perception that EUA and certified emissions reductions (CER) availability may be constrained because of the slow registration of projects by the clean development mechanism's (CDM) governing body, the Executive Board (EB).

A review of the NAPs issued to date shows that national authorities have focused on major emitters in the power, oil and gas, steel, ceramics, cement, and pulp and paper sectors. These lists include some U.S. subsidiaries. For instance, Spain's NAP sets caps for three plants operated and owned by AES Energía Cartagena, a subsidiary of Arlington, Va.-based AES Corp., for BP Oil Refinería de Castellón, a subsidiary of BP-Amoco, Kimberley Clark's plant in Salamanca and Vizcaya provinces, and cogeneration facilities operated by Dow Chemical Ibérica and Ford España. If these facilities expect to exceed the stipulated targets, they will have to compensate by purchasing EUAs or emissions reductions from the markets created by Kyoto's Clean Development Mechanism (CDM) and Joint Implementation.

The opportunities...
These flexibility mechanisms, and the EC Linking Directive that permits their use to meet emissions reductions obligations under the ETS, allow companies within the regulated economies of Kyoto's Annex I to purchase emissions reductions from projects in emerging economies, where the cost of curbing emissions is cheaper. Thus, a U.S. company with operations in Mexico could elect to undertake investments that would reduce emissions there and, through its Mexican subsidiary, sell them -- at prices now in the range of $5.00 to $7.00 per ton of carbon dioxide (CO2) (tCO2e) equivalent reduced -- to a buyer in Spain, Canada, or Japan.

The emergence of the CER market, however, has not been without complications. The most important is that the International Transaction Log, which is needed for recording the conversion of CERs into EAUs and preventing any double counting, is not yet in place. Beyond that, the administration of the CDM itself has been fraught with challenges related to the approval of the methodologies for calculating baselines and monitoring emissions during the operational phase of projects. Only four projects have achieved registration, after years of work. A large number now await final review for registration. And, at precisely the time when its workload is increasing rapidly, the EB's ability to conduct business has been hampered by resource constraints within the United Nations' system.

Even so, the European market for emissions reductions from the CDM has developed rapidly in the last six months as the original 15 EU members (before expansion in May, 2004) have issued their National Allocation Plans (NAPs) and received approval from the European Commission (not without revisions). In addition, the governments of the European countries with the greatest gap between their commitment under Kyoto and their current emissions -- Italy, Spain, the United Kingdom, the Netherlands, France, and Germany, totaling about 2 billion tCO2e for the first commitment period, 2008-2012 -- have launched programs to supplement private efforts to reduce emissions with major carbon funds. These include the Italian, Spanish, and Dutch carbon facilities, totaling over $400 million, placed with the World Bank's Carbon Finance Group, as well as the public-private initiatives of Germany's KfW Group and the private initiative of Belgium's Fortis Bank and France's CDC/IXIS.

At a recent industry conference in Amsterdam, representatives of major European utilities and other businesses reviewed project listings offered by carbon brokerages, searching for suitable projects to meet their emissions reductions requirements. Transactions have increased in sophistication, in part to address the needs of buyers to control key aspects of project risk related to the Kyoto Protocol. A CER transaction poses new challenges from the risk management perspective, for in addition to the well-known considerations of country and project risk, sale of carbon introduces new risks related to registration, changes to the baseline, and failure to receive certification of the projected volumes of emissions reductions due to changing operating conditions.

Of course, buyers and sellers concerned about the challenges of preparing and completing CER transactions can seek opportunities in the EUA market. Of interest to U.S. companies, especially those with operations in the former Eastern-bloc countries that have now joined the European Union, these new EU countries will assume obligations to begin reducing emissions in the years ahead. Since their economies still offer comparatively low-cost opportunities to reduce emissions, companies in line to be regulated in those countries might explore ways to reduce emissions and sell allowances under the ETS.

In addition, China, the world's hottest market in the first decade of the 21st Century, naturally offers tremendous opportunities to generate emissions reductions as rapid growth increases the economic viability of industrial overhauls that generate reductions in energy consumption. Another big source of emissions reductions for China pertains to the use of specialized chemicals, such as hydrofluorocarbons (HFCs), which are potent greenhouse gases. Through such actions, China could thereby deliver huge emissions reductions when expressed in terms of their equivalent value in CO2. There are rumors in the carbon marketplace that the World Bank's Carbon Finance Group is discussing the possibility of a specialized facility to help broker Chinese HFC-reduction projects on the carbon market. The flood of emissions reductions could have a noticeable impact on prices.

Opportunities for U.S. Companies
The financial possibilities are apparent for U.S. manufacturers of the technologies used to transform renewable energy resources such as wind and sunlight into useful electric power. Currently, several U.S. manufacturers of solar panels are selling virtually all their output to buyers in Germany -- hardly in Europe's Sunbelt -- where new standards and incentives have created a massive boom in rooftop installations. Likewise, Europe's boom in construction of wind farms has generated impressive opportunities for GE's wind turbine division, and there is evidence that several of the leading U.S. emerging-market trading partners, such as Mexico, are poised to experience wind power booms of their own. GE's "Ecomagination" initiative highlights how that company views climate-friendly technologies, among others, as a major business opportunity (and commercial battleground) in the years ahead.

Ironically, the opportunities extend even to U.S. companies active in the sectors among those deemed most vulnerable to Kyoto's emission reductions -- coal, oil, and gas. At an international conference convened in Washington, D.C. in November, 2004, 13 countries joined the U.S. in creating the Methane-to-Markets Partnership to promote the development and implementation of projects to capture a valuable source of clean energy as well as a potent greenhouse gas when allowed to vent directly into the atmosphere.

A common refrain at the November conference from companies engaged in these activities was that the ability to sell carbon credits from the projects was a critical part of the program. Indeed, in one speech, a former senior official in the Reagan administration who now heads an investment firm with extensive activities in Russia and Ukraine argued forcefully for completing the work to establish the carbon market.

EPA officials at the conference noted that U.S. emissions of methane are now 5 percent lower than in 1990 -- the same reference used in the Kyoto Protocol -- despite the economic growth that has occurred since then, and with no more incentive than the economic value of the methane itself. While their intent was to deflect charges that the United States' inaction on Kyoto implies inaction across the board, this achievement shows that reducing greenhouse gas emissions does offer attractive opportunities to those who take the time to exploit them.

If the United States doesn't exploit these opportunities, its international competitors will.

This article originally appeared in the 07/01/2005 issue of Environmental Protection.

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