It’s happening right now

The new millennium will see full scale trading of greenhouse gas emission (GHG) reduction credits and right now smart businesses are preparing to take advantage of the global GHG market. Boardrooms around the world are reviewing strategies to both combat risk and capitalize on emerging market opportunities. On the one hand potential liability is being assessed and planned for, while on the other hand managers are looking to build new sources of revenue through the creation of emission credits in their production processes. The greenhouse gas emissions market is a brand new source of competitive advantage. Heads Up!

As part of an integrated approach to the issue of GHG emission limitations, utilities are introducing clean and efficient technologies, switching to cleaner fuels, and investigating power generation through methane capture. Heavy industries such as petroleum are introducing internal emissions trading systems, investing in renewable energy sources, and investigating the opportunities for CO2 sequestration in forests around the world.

However, direct intervention in the production process is frequently expensive, time consuming and requires significant management capacity. As a result, and in addition to these efforts, many businesses are starting to use emissions trading as a quick and cost effective route to achieving risk management objectives. Trades can be structured for immediate or future settlement, option contracts can provide flexibility without obligation, and swaps can occur between GHG and other emissions offsets such as SO2 and NOx. Trading is the most efficient tool available to business managers as they adapt to a limited GHG emissions environment.

Nuts and bolts

In December 1997, most OECD and East European countries agreed to binding emission targets and negotiated a legal framework that enshrines this undertaking – the Kyoto Protocol. In essence, industrialized countries (in effect their major emitter industries) must reduce their emissions of greenhouse gases by at least 5% below 1990 levels over the commitment period 2008-2012. So how can business respond to these regulatory changes without being hit with crippling and rigid compliance costs?

Recalling the economic fundamentals of "gains from trade", a general trade in greenhouse gas emission credits will be most efficient when those buying emission credits pay someone else to reduce emissions who can do it more cheaply that they can. For example, already efficient US power generators may well find that they can earn far more emission reduction credits for their money by purchasing credits in countries with less developed energy industries. The Kyoto Protocol allows three main routes to acquiring emission reduction credits on the international market:

Industrialized countries can simply purchase emission reduction credits from other industrialized countries. A developing country may also engage in this form of emission trading if it voluntarily adopts an emissions target.

The Joint Implementation (JI) program means that investment in projects that reduce emissions in industrialized and Eastern European countries can earn emission reduction credits. These credits may then become available for international trading.

The Clean Development Mechanism (CDM) is not yet clearly defined but is intended to provide emission reduction credits for appropriate project investment in developing countries. Investors earn credits provided the relevant projects provide "benefits" to the host country. However, crediting is only allowed up to a certain percentage of the investor’s own overall emission target. On the positive side, and in contrast to the above systems, CDM emission reduction credits accrue for the whole period of 2000-2012 (not just for the commitment period 2008-2012).

These three mechanisms provide the basic menu of options available to businesses for trading in emission reductions. Each option carries different transaction costs and risk factors. For example, at present, the price of credits purchased through a CDM approach may well be cheaper than credits purchased on the open market between industrialized countries. This difference is primarily due to greater risk and uncertainty associated with the CDM process. In a perfect market the price of all credits will tend to equalize.

Firming up market rules

The greenhouse gas market has been established in principle, with a new commodity - the metric ton of CO2 equivalent emissions. We have a good idea of how the market should develop and transactions are taking place on that basis. But it is clear that a good deal of work still needs to be done to fill some of the gaps and reduce the remaining uncertainty under the Protocol. Business likes to know all the rules of the game before it gets right out on the pitch and there are a few major clarifications that would make the players a good deal more comfortable.

First of all, business needs clarity on the timeframe for GHG emission reductions. The Kyoto Protocol has effectively specified an emissions cap for each industrialized and Eastern European country that will enter into force across 2008-2012. In order to prepare to meet this limit domestic action now needs to be taken in the short term to structure national emission targets and time frames and decide on the national level initial allocation of allowances. The legislative wheels are already turning in the US and in Europe to give companies regulatory "credit" for early action to reduce greenhouse-gas emissions, but this process must be sped up. Business leaders recognize that regulations requiring emissions reductions are probable over the next decade and the sooner the outline of an early trading framework is established, the sooner they can start engaging the market to meet their compliance requirements.

Second, the design of the trading system must be clarified. Who is responsible for the integrity of emission reduction credits? In the US SO2 market the seller is held liable for the integrity of the permits sold. If such a seller liability system were established for international GHG emissions trading, a business purchasing allowances would not have to worry whether the business selling the allowances actually met its commitments. Under such a scheme all permits would be worth the same regardless of who sold them and the market would be likely to have good liquidity. Under a buyer beware system of shared liability, allowances would have different risks and thus different prices depending on the seller’s reputation. These uncertainties would be likely to reduce market liquidity. Further design issues are the ability to bank credits forward, and the ability to borrow credits from future compliance periods to meet temporary compliance shortfalls.

Third, implementation issues must be firmed up. A reporting system must be established to track both emissions monitoring results and emissions trading activity. Transparency should be promoted and ensured through public availability of the relevant data. For example, the successful US SO2 emission trading program uses a publicly open Allowance Tracking System that is posted on the Internet. This level of transparency allows close scrutiny of transactions and contributes to high compliance levels.

Certification of emission reduction credits must be standardized and the criteria made widely available. This is necessary to ensure that credits are homogenous and that the tradable unit is therefore clearly defined. In the case of investment in emission reduction projects, advance certification must clearly specify the intended emission reductions, but there is an additional need to verify that the project proceeded as planned and the reductions were indeed made.

Given the uncertainty in verification, a liability system to deal with "bad trades" must be developed. In the US sulfur dioxide trading system, the seller is liable if they oversell their credits or the credits are worthless. Under a GHG trading system it has been suggested that the buyer and the seller share liability. It’s argued that in many cases the buyer may be in a better position to scrutinize the integrity of the credit. Opponents to a shared liability system argue that the buyer is in less of a position to ensure the integrity of the credit and should not be liable for the seller’s irresponsibility.

Early birds catch the worms

In advance of final legislation on mandated greenhouse gas reductions, business is preparing to hedge against future price and liquidity risk in emissions credits. However there are several other major benefits of early entry into the greenhouse gas emissions market:

• Trading allocates scarce business resources efficiently; not just financial resources but management capacity and technical expertise.

• Trading captures innovation and creativity, and energizes staff.

• Trading promotes the early development of emission reducing technology.

• Trading provides early experience in using markets to meet compliance requirements.

• Trading provides an opportunity for positive public relations and a strong image of environmental responsibility

In view of these incentives, several trades have already taken place.

For example, in early 1998, the Canadian firm Suncor Energy Inc. purchased 100,000 tons of CO2 credits with an option to purchase a further 10 million tons of reductions over a 10 year period from Niagara Mohawk Power Corporation. The deal has a potential value of $10CDN million. In late 1997 Canada's Ontario Hydro bought 10,000 tons of CO2 credits from a pool of credits belonging to Edison International's Southern California Edison Co. In addition, an example of an inter-pollutant transaction took place when Arizona Public Service Company swapped 25,000 tons of SO2 emission allowances for 1.75 million tons of greenhouse gas emission credits from Niagara Mohawk Power.

In addition to independent trades, industry is working with local and federal governments to promote pilot early trading systems. A key incentive of these pilot trading systems is the recognition of trades by government as credit for early action. For example, in Canada the Greenhouse Gas Emission Reduction Trading Pilot (GGERT) credits verifiable early action to reduce greenhouse gas emissions against any further obligations. The pilot system helps the development of the technical and administrative infrastructure required to support full-scale emission reduction trading and gives business a valuable opportunity for practical experience.

The media coverage of UNFCCC COP4 at Buenos Aires and the growing recognition across the business community of the need for action has meant that an increasing number of firm bids and offers are being tendered. This trading activity will grow rapidly as clarification of trading rules in the FCCC process continues.

The role of the honest broker

The greenhouse gas market environment is fast evolving in response to domestic and international regulatory developments. The broker plays a crucial role in devising market solutions that allow business to comply, at minimal cost, with the new regulations. The broker also provides the avenue for well placed business to seize greenhouse gas market opportunities and capture new sources of revenue to complement core business activities.

Since the greenhouse gas market is young and exceptionally flexible there is a considerable need for brokers to play a creative role in matching buyers and sellers. It’s up to the broker to develop innovative transaction structures, serve as a vital source of price information, and advise on the changing regulatory environment.

Transaction Structures

Through a variety of deal structures, smart brokering helps firms hedge their risk and capture opportunity:

Immediate Settlement: Payment is made within 3 to 5 business days of the confirmation that title to the reductions has been transferred to the buyer.

Forward Settlement: May be structured as pay now (discounted) receive later or as pay later, receive later. The second transaction type is often restricted to those with investment grade credit. Credit problems often may be solved through negotiation

Streams: Both immediate and forward settlement is available for streams of allowances of consecutive vintages.

Call Options: Options provide a level of flexibility and risk management that can not be provided through other types of transactions, by giving the purchaser of the option the right but not the obligation to buy at a specified price for a for a specified premium.

Inter-pollutant and Inter-commodity Swaps/Bundling: This structure includes the exchange of SO2 and NO_x allowances for Greenhouse Gas Emissions Reduction Credits. These structures may enable a company to avoid capital gains or losses, for example in the US, if the IRS rules that these transactions will be treated as "like kind". GHG transactions may also be structured by bundling reductions with other commodities such as coal or wholesale power.

Doing the right thing

First of all, emission trading lowers the cost of attaining the Kyoto greenhouse limits and gives business the incentive to use resources as efficiently as possible. This is good for the environment.

Second, the cost savings from emissions trading may be considerable, depending on the amount of gains from trade that can be captured as international markets are explored. This gives compliance flexibility as well as revenue opportunity to business.

Third, international emissions trading separates who pays for emission reductions from who undertakes the reductions. Countries with lower abatement costs and higher emission ceilings will generate a valuable commodity to export. Developing countries will have the opportunity to sell emission reductions to developed countries and generate badly needed investment capital. This is good for development and global economic efficiency.

Emission trading provides smart business the opportunity to compete in a dynamic new market place.

Natsource, Inc. is the leading broker in existing environmental emissions markets for SO2, NOx and VOC Allowances, brokering close to $1 billion in emissions transactions. This market position has led to Natsource representing several companies interested in the fast emerging greenhouse gas market. Natsource is a full service energy brokerage company with expertise throughout the energy industry and the ability to bundle transactions across different commodities. Natsource has established a specialized greenhouse gas trading desk that stands ready to help clients both manage risk and capture revenue opportunities in the emerging global GHG marketplace.