Energy and Emissions Markets

Collision or Convergence?

Tom James, Peter C. Fusaro

• Publisher: Wiley
• Year: 2011
• Print ISBN: 9780470821589
• eBook ISBN: 9781118170069
• Edition: 1
• Topic: Business
• Subtopic: Commodities
• Index: Business

Written by best selling author Peter C. Fusaro and renowned energy market expert and commentator Tom James, this book demonstrates that the forces of energy and environmental issues and linked more than ever before. The beginning of European emissions and trading in 2005 and the implementation of the Kyoto protocol have accelerated efforts already underway in the US to use market forces to remediate environmental issues. Topics such as emissions trading, renewable energy trading, the fourth dimension in energy trading, and new outcomes on green project finance will be analyzed in this book.

1 Setting the Stage for Collision or Convergence

As we approached the year 2005, one key question on the minds of corporate Europe was “What effect will the new dynamic of a pan-European emissions market have on the energy markets and industry?” With the rest of the world watching closely, on January 1, 2005 the European Union Emissions Trading Scheme (EU ETS) came into being. The fourth dimension of energy markets was born. Prior to this, traders and energy buyers only had to focus on the price of the fuel, quality of material, delivery time and location. Now, the cost of emissions from the use of that fuel also had to be taken into account in the whole cost equation.

Industry and traders alike could no longer depend on the simple arithmetic of oil, gas, coal and power prices to determine the “best deal”. From this point onwards, energy producers, industry and traders had to examine the emissions cost of their energy production/ source as a key component of their financial decision-making. Now, faced with alternative fuel sources, a company might find that the notionally cheaper source might, in fact, prove the more expensive once the cost of emissions generated by that fuel are taken into account.

What we have witnessed since the launch of the EU ETS is a convergence, an embracing of emissions trading and its uses as a commercial advantage, as a marketing tool–as in the case of green, carbon-neutral taxi firms being launched in England–and as a mechanism which helps firms finance the upgrading of technology to beat emissions-reduction targets and claim the attendant financial benefits by selling excess emissions credits.

Before going any further, let us clarify what we mean by “emissions trading”. Technically speaking, emissions trading is a market-based approach to reducing levels of pollution. It was developed to help reduce pollution at a lower overall cost for pollution emitters (“emitters”). Since its invention in the late 1960s, it has mostly been used to deal with different kinds of air pollution, although it has also been used with water pollution. According to economists, the advantages of effective emissions trading are that it allows emitters flexibility in choosing how to address their pollution-reduction obligations; it encourages the use of the most economically efficient pollution-reduction measures, thus allowing emitters to save money while placing the minimum possible burden on the economy as a whole; and it encourages innovation in finding less expensive ways to reduce pollution.

Interestingly, soon after the launch of the EU ETS, with gas prices in Europe soaring to record highs in mid 2005 (in line with escalating international oil prices which reached close to US$70 a barrel in September 2005), the European power-generation community started burning more coal than ever before. This was because the cost of coal plus the emissions cost was still cheaper than burning natural gas or oil for electricity production. This drove an increase in demand for emissions credits and a surge in price which saw emissions credits rise from around €5 per MT of carbon dioxide (CO₂) at launch to over €30 within seven months. The substantial rise in the value of emissions credits started to give a large economic pay-back to those industries covered by the scheme because the credits are transferable, tradable instruments which could be sold at a premium to help subsidize the purchase of cleaner energy technologies or to upgrade plants to reduce emissions.

So where did this approach to emissions reductions–creating a market mechanism that forces industry to cut emissions by a set amount over time while providing economic incentives to do so–come from?

In the late 1960s, John Dales, a Canadian economist, developed the idea of using tradable emissions rights as a way to reduce the economic costs of pollution control. Several emissions-trading programs have been put into place since then, and it may come as a shock to some to hear that the earliest scheme was put in place in the United States. The largest of these schemes is the American Acid Rain Program for sulfur dioxide (SO₂) emissions from electricity generators, which was started in 1995. This system has so far been regarded as a success: reductions targets have been met and sometimes exceeded, and reductions costs have been lower than they were under other pollution-reduction regimes.

The energy industry (encompassing oil, gas and power producers) is the world’s leading emissions polluter but is set to become the leading supplier of environmental solutions because it’s good for business. Today, as carbon intensity continues to grow while time to stabilize carbon dioxide and other greenhouse-gas (GHG) emissions is increasingly limited, the industry is at a turning point on global warming. This issue goes way beyond the Kyoto Protocol, which initially operates only for the period 2008 to 2012 (although discussions on arrangements for the period beyond 2012 are already under way), and will engage all countries in greenhouse-gas reductions over the next century.

The oil industry has the financial strength, intellectual capital and global presence to provide these global solutions. BP (with its “De-carbonization of fuel” strategy), Shell and Chevron Texaco have already taken the lead but other companies are not far behind. The carbon footprint of the major oil companies is complex and ever changing as a result of factors that include ever-evolving oil and gas production profiles, new pipeline transportation, refining and marketing, storage, and their growing involvement in the power industry. Therefore, the solutions will come from within the industry and include more efficient, environmentally benign technology but also basic changes in standard industry practices. Industrial best practices will now have a proactive environmental component, because it makes financial and commercial sense.

Environmental issues are now framed as corporate financial issues. Greater financial disclosure of corporate environmental risks, including climate change, has brought environmental issues in from the periphery to the forefront of corporate fiduciary responsibility. Increasingly, the environmental performance and the financial performance of companies are intertwined.

This also influences how consumers use energy and has an impact on automobile manufacturers, electric utilities, building owners, commercial banks and insurance companies.

Automakers are increasingly concerned about carbon dioxide emissions per vehicle and utilities now pay more attention to cutting their greenhouse-gas and other air emissions. Oil and gas companies are increasingly concerned about their emissions as production, refining, transportation and distribution liabilities and we have seen in Europe oil majors investing in what is called “carbon capture” and storage techniques, where carbon dioxide is captured from oil fields or from power stations and fed back in to the ground, sometimes back in to the oil fields.

Bank share valuations could fall if they lack adequate risk-management strategies for carbon, and several banks such as JPMorgan Chase have now enunciated new environmental lending policies with teeth. Insurance and reinsurance companies are at the forefront of confronting and addressing financial risks arising from, for example, catastrophic crop failures as a result of climate change, and health-related risks arising from linkages between climate change and infectious disease. These new financial risks for insurance and reinsurance companies may actually prompt them to drop coverage for certain companies. These new risks are beginning to prompt change and the creation of environmental markets.

The future promises more financial disclosure about potential liabilities. Indeed, Innovest Strategic Investors, the green Moody’s, has already shown that companies perceived to be more environmentally aware are also more financially successful.

The EU ETS has had a positive effect on industry and its strategy towards emissions reductions by focusing attention on emissions as a potential financial liability which, if not handled properly, could run into many hundreds of millions of euros for some companies. If managed properly, however, the strategy promises substantial rewards for those achieving faster reductions than required, with the emissions credits above and beyond a firm’s requirements being sold at a profit.

The EU ETS is an example of how market-based solutions through emissions trading are undoubtedly the way forward for the energy industry and energy-intensive industries. Environmental financial products for SO₂, which causes acid rain, and nitrogen oxides (NOx), which cause urban smog, began in the U.S. in 1995 and 1999, respectively. These pollutants were reduced through “cap and trade” mechanisms which are also now part of the Kyoto Protocol. Despite general perceptions to the contrary, emissions trading was made in America, and proposed by the U.S. delegation at the Rio Climate Convention Treaty in 1992. Today, we have a US$10 billion environmental financial market for SO₂ and NOx. The carbon markets are using the same template developed by the U.S. under the auspices of the first Bush Administration and proposed by the Environmental Defense Fund (now called Environmental Defense), an environmental group based in New York, with the implementation of the Clean Air Act Amendments of 1990. Contrary to the widespread perception that the U.S. is doing nothing on global warming, environmental law in America continues to focus on more stringent regulation of emissions reductions. In fact, in March 2005 the Clean Air Interstate Rules (CAIR) were passed to reduce SO₂ and NOx emissions by 2015 by a further 70% and 65% respectively–once again, the most exacting standards in the world. Furthermore, the U.S. is now looking to implement the first emissions-trading rules for mercury, another known toxin. It is the energy industry that bears the brunt of this clean up. Trading mechanisms have been proven to work and also be cost effective.

The U.S. has one of the most advanced emissions-trading markets in the world, trading US$3 billion in notional-value SO₂ allowances each year as prices rose to over $800 per ton in the spring of 2005. It also has the most advanced nitrogen oxide (NOx) markets in the world, with allowances trading at up to US$40,000 per ton during the summer of 2004 in the Houston/Galveston area, which has the worst air pollution non-attainment in America and has to reduce its NOx levels by 80% in 2008. Additionally, the California RECLAIM market for Southern California air quality has had active SO₂ and NOx markets as well. Such market-based solutions are now being embraced by several green hedge funds trading in SO₂, NOx, carbon and renewable-energy credits, as well as by emitters. After all, emissions trading is also about speculation.

Europe begins its regime

Signed in December 1997, the Kyoto Protocol is the international agreement intended to reduce emissions of greenhouse gases (especially CO2, methane and CFCs) in developed countries. The Protocol requires, for example, that the European Union reduce its emissions by 8% below 1990 levels by 2012, which equates to a reduction of 340 million tons of CO2 emitted into the atmosphere.

The emissions-trading scheme started in the 25 EU Member States on January 1, 2005 and, after the launch value of approximately €5 per MT of CO2, it rose quickly to a high of around €30 in mid 2005. If we take an average value of €20 per MT of CO2 emission credits, the EU trading scheme was handling emissions credits worth €6.8 billion. A key aspect of the EU scheme is that it allows companies to use credits from Kyoto’s project-based mechanisms, joint implementation (JI) and the clean-development mechanism (CDM) to help them comply with their obligations under the scheme. This means the system not only provides a cost-effective means for EU-based industries to cut their emissions but also creates additional incentives for businesses to invest in emissions-reduction projects in developing nations such as China and India, and in South America and Africa. In turn, this spurs the transfer of advanced, environmentally sound technologies to other industrialized countries and developing nations, giving tangible support to their efforts to achieve sustainable development.

The launch of the EU ETS and the implementation of the Kyoto Protocol in February 2005 have provided a wake-up call to corporate America. Multinational corporations in the U.S., Canada and around the world are starting to realize that they have compliance difficulties in many locations. The consensus emerging in the U.S. is that a climate-change regime will be in place in the next two to three years.

The issues of environmental financial liabilities and the emergence of climate-change risk have made U.S. companies extremely nervous about proceeding in market development with such near-term uncertainty and potential impact to their bottom line. In December 2004, Fitch Ratings issued the first ratings agency report on emissions trading, and with emissions trading now clearly on the balance sheet, clarity is starting to come to the issue of climate change in the U.S.

The long-term impact of these market-based solutions has been to reduce pollution in a cost-effective manner and accelerate the introduction of more environmentally benign technologies. It has also given industry time to implement new, cleaner technology and fuel sources, with minimal economic disruption to the capital-intensive energy industry, the agricultural industry and other industrial sources of pollution. The markets have actually created concrete and measurable emissions reductions for American business, although the news media turns a blind eye to it.

Emissions-trading markets are not true commodity markets in that they are “cap and trade”, which means that emissions are ratcheted down over time. For the U.S. SO₂ markets, this involves a 35-year regime of reductions and more stringent standards until the year 2030. For CO₂ and other greenhouse-gas reductions, we will need a 100-year program that engages the entire world and sets quantifiable long-term benchmarks to reduce emissions. Implementation of the Kyoto Protocol is a modest first step to global emissions reductions, but the larger question is whether there will be significant CO2 reductions in the next two decades to meet carbon stabilization in the atmosphere. The reality is that the entire world is in this for the long haul. There is no quick technological fix as long as the world is addicted to fossil fuels, whose consumption continues to rise. That habit is not going to change, as has been evidenced in the past year with record oil, coal and natural-gas consumption, despite higher prices. We need a climate-change regime that will aggressively reduce global carbon intensity, including both stationary and mobile sources, accelerate technology transfer and increase energy efficiency. The U.S. will lead in this effort.

Already, commodity CO2 used for enhanced oil recovery in Texas and Wyoming is now married to carbon sequestration efforts in those states. The use of naturally depleted geologic formations is being pushed forward by the oil industry and the U.S. Department of Energy. Again, unknown to most of the world, the U.S. is leading in these green efforts.

In the United Kingdom, British Petroleum (BP) announced in early 2006 that it will remove CO2 from natural gas out of the North Sea before burning it in an onshore power station, and then, using existing pipeline, transport the CO₂ gas back out to sea down in to a nearby depleted oil field.

Turning to mobile sources of pollution, hybrid gasoline/electric vehicles that reduce CO2 tailpipe emissions and increase fuel economy are now being embraced by the U.S. public as well as other nations. In California, tailpipe emissions will be regulated in 2009, with these regulations subsequently being adopted in New York and other states, despite legal challenges from the automobile industries. Once again, these will be the first such standards in the world. We also have many energy-efficiency devices that reduce building loads from both commercial and residential buildings, again leading to a reduction in greenhouse-gas emissions.

What has been lacking in America is the mandate of the federal government. This is now beginning to change. Federally mandated standards are needed to create fungible commodity markets so that the rules bring a realistic financial value to emissions reductions, rather than the US$1–2 per ton shown on the Chicago Climate Exchange. The point is that both the SO₂ and NOx programs are mandated and have financial penalties for non-compliance. The low carbon prices of today reflect the market valuation of “voluntary” standards. Companies would rather sit on their carbon inventories toda...

Table of contents

• Contents
• Foreword
• Glossary
• 1 Setting the Stage for Collision or Convergence
• 2 The Birth of the Global Emissions Market
• 3 Schemes Green Trading
• 4 Global Schemes Trading
• 5 Market Mechanisms for Reducing Emissions
• 6 Overview of the Carbon Exchanges
• 7 Carbon Collides with Power–The European Experience
• 8 Legal Agreements for Emissions Trading
• 9 reen Power Trading: Developments and Opportunities
• 10 What Risk? An Introduction to Managing Risk
• 11 Risk-Policy Guidelines
• 12 Managing Financial Risk for the Environment
• 13 Investment Opportunities in Emissions
• 14 Broader Issues for Business–Global Emissions Markets
• 15 What the Future Holds: Opportunities for Global Market Convergence
• Appendices
• Index