by Russell V. Thornton and Sangem Hsu

Late in November of 2000, the bad news was reported. The United Nations Framework Convention on Climate Change (UNFCCC) had failed to reach an accord on the global warming treaty known as the Kyoto Protocol. Today, the news has not changed: The United States and Europe remain at odds on greenhouse gas (GHG) issues. Essentially, nobody can agree on several key questions, such as the value of forests in terms of GHG sequestration, and issues involving developing countries.

According to a recent study from reinsurance giant Munich Re, the world economy will incur costs of $304 billion per year from the effects of climate change by the year 2050 unless urgent efforts are made to curb GHG emissions. The study was undertaken at the request of the United Nations and was part of the UN Environment Program's (UNEP's) financial services initiative.

In the study, which was presented to the 21st session of UNEP's Governing Council in February 2001, Dr. Gerhard Berz, head of the Geoscience Research Group at Munich Re, estimated specific losses and gains from global warming. When broken down by geographical sector, the projected losses are: EU countries, $72.4 billion; the United States, $68 billion; the former Soviet Union, $20 billion; and China, $18.7 billion.

The greatest worldwide losses are expected to arise from human health and mortality, amounting to approximately $82 billion. This is closely followed by ecosystem losses of $70 billion, including damage to mangrove swamps, coral reefs, and coastal lagoons.

The water industry is looking at increased costs of $46 billion. Agriculture and forest industries could lose $42 billion a year by 2050 as the result of droughts, floods, and fires.

After these impacts, the largest forecasted losses reflect increased energy costs ($23.2 billion), air pollution ($15.4 billion), and coastal protection, together with coastal land losses ($15.1 billion). To this, we must add $3 billion for more frequent natural disasters, including cyclones and hurricanes.

None of these numbers include potential costs and losses in the construction, transportation, and tourist industries.

Even though the correlation between climate change and the increasing frequency of extreme weather-related natural catastrophes has yet to be confirmed scientifically, Berz is firm in his position that "there can be no doubt to its plausibility and staggering significance."

Economics has emerged as a key driver for organizations that are considering early action on climate change. Businesses across a wide range of industry sectors have identified GHG emission reductions as a tangible business opportunity. Simultaneously, businesses are beginning to understand the costs associated with inactivity on the GHG issue.

Petro Source Carbon Company and MCN Energy Group have sold 1.9 million metric tons of carbon dioxide equivalent (CO₂e) emissions credits in two trades that, at the time of consummation, represented the first of their kind. The emissions reductions that created the credits were made possible by use of a technique that injects CO₂ underground to enhance the flow of oil from mature petroleum fields located in western Texas. An 82-mile pipeline gathers CO₂ from a number of natural gas treating facilities that would otherwise vent the GHGs into the atmosphere out of flue stacks. Using the CO₂ injection approach allows crude oil to flow more easily, thus decreasing the demand for electricity. This indirectly reduces sulfur and other smog-causing emissions.

This whole system of enhanced recovery has been made economically viable by the high price of crude oil in today's marketplace. The company recently announced a new long-term supply agreement for significant volumes of vent-gas CO₂ in Wyoming.

Petro Source Carbon Company's trading agreement does not restrict it from delivering emissions reduction credits outside of Texas, where the company is headquartered. "In fact," says company President Bill Townsend, "as a result of this agreement, Petro Source will have additional funds in which to invest in growing and expanding its CO₂ sequestration businesses." Agreements struck by companies like Petro Source send a message to governments that are struggling over rules for implementing the Kyoto Protocol.

Several Canadian energy companies involved in the Greenhouse Emissions Management Consortium (GEMCO) have agreed to the future purchase of options on 600,000 metric tons of CO₂ credits by the end of 2012. Ontario Power Generation was scheduled to purchase 1.3 million metric tons of credits generated in 1999 and 2000.

GEMCO's trading projects have introduced domestic oil producers in Texas, Utah, and Wyoming to an environmentally friendly concept that allows them to make some money. "We are very pleased to participate in a major carbon emissions reduction credit trade that takes place in the middle of the U.S. oil patch," said Aldyen Donnelly, president of GEMCO.

GEMCO negotiated another deal last year for TransAlta, Canada's largest private utility, which allows U.S. farmers to transfer emissions reduction credits (ERCs) they earn using crop techniques that increase the amount of carbon retained in topsoil. Perhaps this bolsters the argument that the climate change treaty should allow for tradable credits arising out of agricultural sinks.

Several other good learning examples gleaned from corporations quick to spot this opportunity can be found in Volume VIII of Case Studies in Corporate Environmentalism (Cutter Information Corporation, Arlington, Massachusetts).

GHG Trading Management Systems

Corporations are beginning to realize that air emissions (or lack of emissions) have financial value and should therefore be managed like any other item contained in the corporate balance sheet. Companies need to identify market opportunities, and assess the risks associated with climate change and air emissions regulations. Creatively developing internal GHG trading programs and participating in available government-sponsored or private trading transactions can unlock the value of air emissions reductions, while simultaneously helping to improve the environment.

At the heart of GHG trading systems lies the concept of "cap and trade." Well-designed systems set a firm and permanent limit on a particular regulated pollutant. This creates a marketplace for pollutant allowances, and permits the necessary flexibility to reach the most cost-effective reduction approach. Market efficiency in turn enhances the financial rewards and overall efficiency of the GHG management system.

The concept of cap-and-trade was first established under the U.S. Acid Rain Program, which originated in the Clean Air Act Amendments of 1990. The Acid Rain Program set a cap of 8.95 million tons of SO₂ per year, to be implemented in two phases. In Phase 1, electric generators emitting the highest amounts of SO₂ were required to reduce emissions. In Phase II, which began in 2000, almost all electric units (boilers) were required to reduce their emissions to roughly one-half of 1980 levels. The cap reduced the level of SO₂ that utilities were allowed to emit by roughly 50 percent.

The cap was assigned a value in allowances, which were allocated to all the affected sources. At the end of a given year, utilities must hold allowances equal to their actual annual emissions. One allowance permits a utility to emit one ton of SO₂ during a given year.

Allowances that are not used or traded can be banked for future use. Such banking of allowances might occur when a utility decides that its allowances will be worth more in the future than they are today. The utility might reduce its current emissions by installing control equipment or switching to cleaner-burning fuels. Later on, it could use its banked allowances in expansion projects, or sell them on the open market.

A company or individual can open an account in the program to buy, sell, or trade allowances. This has helped establish a commodity that attracts the U.S. financial markets. The Acid Rain Program has been extremely successful, and has achieved compliance with SO₂ requirements.

The utilities involved in the Acid Rain Program have banked 30 percent more emissions credits than required by law. It has been estimated that the banked emissions reductions exceeded 10 million tons in the year 2000. Even more amazing is that the projected cost of the program, first estimated at between $4 billion and $8 billion annually, is now predicted to amount to only about $1 billion when the program is fully implemented in 2010.

The success of any GHG trading scheme must have at its core transparency and credibility. One of the organizations on the frontlines of this work is Det Norske Veritas (DNV).

DNV is an international foundation specializing in the classification of shipping, third-party certification and verification, technical risk services, and management systems development. Established in 1864, and active in the United States for more than 100 years, DNV is an autonomous and independent foundation whose objective is "to safeguard life, property and the environment." Efforts to achieve that objective have involved DNV in projects where environmental improvement is a definable goal.

Over the past five years, DNV has taken part in a number of projects related to validation, verification, and certification of GHG emission reductions. These activities have included a pilot project for the verification and certification of emission reduction units (ERUs) for the Mexican ILUMEX project under the direction of the World Bank. This work concluded with the first verification and certification of an emission reduction project using interpretations of the various requirements set forth under the Kyoto Protocol.

DNV has since developed reference documents for the validation of GHG projects under articles 6 and 12 of the Kyoto Protocol (JI and CDM) for the World Bank's Prototype Carbon Fund. These documents provide instructions regarding the validation process, serve as a tool for third-party validators, and present a template for validation reports and the validation opinion. The methodology blends experience gained through environmental management systems with principles from financial auditing and industry standards, and applies a risk-based approach.

Since 1999, DNV has also led a project team that is assisting BP in achieving its global emission reduction goals through the delivery of an emissions audit and verification process. In 1997, BP made a commitment to reduce its corporate GHG emissions to 10 percent of its 1990 emission levels. In 1999, BP's business units worldwide were asked to prepare emission estimates for 1990 (the reductions target year) and 1998 (the emission trading baseline year) based on Group Reporting Guidelines.

Recognizing the need for both transparency and credibility in setting baselines, BP commissioned an independent GHG verification and audit drawing on the expertise of three consulting companies: DNV, KPMG, and ICF Consulting. The project has four goals:

• Review BP's guidelines and GHG protocols for carbon dioxide and methane

• Assess how a selected cross-section of business units have applied these guidelines

• Design an appropriate audit process

• Perform independent audits of the 1990 data, as well as annual emissions data

Together with other team members, DNV established an independent expert panel—consisting of internationally recognized GHG emissions policy makers, technical advisers, and environmental leaders—to oversee the audits and verification process.

The project is now in its third year. So far, annual emissions data from the business units for 1998, 1999, and 2000 units have been verified. DNV maintains membership in the World Business Council for Sustainable Development (WBCSD) and the International Emission Trading Association (IETA) to ensure smooth policy seams in these sensitive matters.

Other applications for cap-and-trade have also been created, as the examples discussed below indicate.

The South Coast Air Quality Management District in California created the RECLAIM program to reduce smog in the Los Angeles area. Under the program, stationary sources emitting more than four tons of NO_x and SO₂ annually have been required to cap emissions in declining amounts over the period 1994-2003. By 2003, NO_x emissions from RECLAIM sources are to be reduced by 75 percent and SO₂ emissions by 61 percent.

The resulting allowances are fully transferable and can be traded. The most significant advantage of the RECLAIM program has been the establishment of a "going price" for smog in the Los Angeles basin of between $640 and $5,560 per ton. These costs have contributed to annual compliance savings of 42 percent.

U.S. NO_x market trading systems have been given the "big green light" through the implementation of EPA’s NO_x SIP Call. This initiative sets caps on NO_x emissions for 22 states in the East and Midwest, and for the District of Columbia. In March 2000, an appeals court upheld EPA’s authority to set rules for the interstate transfer of pollution. The U.S. Supreme Court has refused to hear an appeal of the ruling brought by industry groups and 19 states, thus effectively allowing the SIP Call to go forward. Many states have initiated emissions trading in order to comply with the law.

Texas has created a system for trading Renewable Energy Credits (RECs) in connection with a state mandate requiring generation of 2,000 MW of new renewable energy (such as wind power) that can meet Renewable Portfolio Standards (RPS).

RECs typically represent one MWh of certified renewable power, which can be traded separately from the actual delivery of physical energy. Utilities must acquire and retire RECs based on their pro rata share of energy sales within the state.

Since some utilities will be long on renewables (that is, they will have excess energy capacity), and some will be short (with not enough capacity based on energy sales), a trading market has popped up. Remarkably, this Texas REC trading system will more than likely, either formally or informally, interact with emission reduction credits (ERCs) systems established for reductions of NO_x and carbon. It has already helped establish voluntary actions such as fuel mix labeling, verification of "green" pricing programs, use in federal RPS goals, and validated ERCs.

Faced with pressure from a variety of sources to "clean up their acts," many companies have been searching for something to help offset the costs associated with reducing pollution. GHG trading schemes represent a potential "hidden bounty" for those that use them wisely.

Now is the time to reactivate the interplay between environmental and financial motives. Many companies that have done so have already received pleasant, profitable surprises.