Trading Solutions for Lowering Air Pollution: Trading of Greenhouse Gas Emissions Allowances Can Lower the Cost of Regulatory Compliance and Create Business Opportunities
Annala, Christopher, Howe, Harry, Strategic Finance
Thanks to innovative trading in greenhouse gas emissions allowances, complying with air pollution regulations isn't the same for all firms all the time. In this rapidly growing field, a company--be it an electric utility, a dry cleaner, or an auto body shop--can, in effect, buy a real option from another company to legally pollute more than regulations permit.
In essence, this market-based approach to pollution compliance gives companies a flexible and cost-effective alternative to installing pollution-lowering technologies, changing energy sources, or building an entirely new plant.
Let's look at an example. Companies A and B emit 1,000 tons of methane per year each, and new regulations permit a maximum output of 900 tons per year. Company A reduces its emissions to 800 tons. Under environmental regulations that incorporate an emissions trading approach, Company A can sell an allowance from the U.S. Environmental Protection Agency (EPA) or a state air pollution regulator that would let the buyer emit an additional 100 tons of methane. Managers for Company B have a choice: reduce emissions by 100 tons by investing in pollution-lowering equipment and technology or purchase the 100-ton permit from Company A.
MARKET APPROACH TO COMPLIANCE
It all began in the 1960s with theoretical work on emissions trading, but the development of active emissions trading (ET) markets is relatively recent, beginning in 1990 with the Clean Air Act, which established a trading approach for sulfur dioxide emissions under Title IV of its Amendments. Adding a market-based approach to complying with air pollution regulations jump-started the trading in EPA pollution allowances and augmented government-dictated solutions. Lawmakers reasoned that markets in tradable emissions allowances would be another way to help companies figure out themselves the best way to meet lower pollution standards, and it worked. Sulfur dioxide allowances began trading at prices much lower than had been anticipated while achieving emissions reductions at levels far greater than expected.
Today there are ET markets for pollutants such as sulfur dioxide, nitrogen oxide, particulate matter, volatile organic compounds, and wastewater, among others. In Europe and other industrialized nations, ET markets are more advanced than in the U.S. because those countries are adhering to the Kyoto Protocol, which the U.S. withdrew from in 2001. The Kyoto Protocol is an agreement to reduce the greenhouse gas emissions believed to cause climate change. It was initially negotiated in Kyoto, Japan, in 1997 and to date has been ratified by about 122 countries.
Carbon trading under the Kyoto Protocol, for example, has the potential to create a new global commodity market valued at $9 billion annually by the Financial Times. Other studies put the figure higher, at $18 billion to $36 billion, and, if derivatives are included, at least twice as high.
In the U.S., greenhouse gas emissions allowances trade on the Chicago Climate Exchange, the Chicago Board of Trade, Cantor Environmental Brokerage, and by over-the-counter intermediaries (see sidebar, p. 43). Also, regional U.S. programs such as RECLAIM (Regional Clean Air Incentives Market) in Southern California administer ET programs.
There are important issues that affect all the trading programs. One is the problem of the initial allocation of tradable permits, which are based on historical production of pollution. Newer sources of pollution, therefore, are subject to more stringent regulations. Also, most of the trading programs come with a cap on the total number of allowances issued. The cap is then lowered in subsequent years to achieve lower overall pollution levels.
Beyond compliance flexibility, market solutions offer companies lower costs, strategic business opportunities, preparation for potentially tougher greenhouse gas emission standards, preemption of environmentalists' attacks, and new knowledge and experience about using ET to solve compliance problems. …