RICHARD L. SANDOR
says that emission trading is the cheapest and most effective way to fight climate change and outlines how a market should be set up
It is no wonder that we have managed fundamentally to alter the chemical composition of the atmosphere. For we have treated it as an unlimited resource, available to all in unlimited quantities, at no charge.
Nobody owns the atmosphere, so nobody takes account. Respectfully treating it as the limited resource it really is requires limiting its consumption, and instituting a process for treating it responsibly. The zero price now being charged for its use means there is no direct reward to those who might supply carbon abatement and sequestration services. Private capital is not being mobilized. The market is missing. It must be introduced.
Emission taxes, command-and-control regulations and other non-market policies are likely to be part of the policy mix needed to achieve the Kyoto targets, but they fail to exploit cost efficiencies and may not yield the desired emission reductions. An international, market-based, emission allowance trading regime can help solve the climate change problem while offering a dynamic flexibility that translates into cost-effectiveness. Keeping environmental protection affordable is critical to maintaining public support.
Understanding how markets evolve makes it possible to identify specific steps to establish one in greenhouse gases. There are, admittedly, few well-designed environmental markets, but the dramatic success of America's sulphur dioxide allowance market in combating acid rain, for example, strongly argues in favour of managing climate change by promptly establishing a greenhouse gas emissions trading programme.
Environmental markets did not appear spontaneously any more than did the commodity, equity, and bond ones that preceded them. Like any other good or service, they are responses to latent or overt demand. Specific legal and institutional infrastructures have to be developed if they are to evolve successfully.
A seven-stage process
History suggests that markets evolve in seven stages:
1. A structural economic change that creates the demand for capital.
2. Creation of uniform standards for a commodity or security.
3. Development of a legal instrument which provides evidence of ownership.
4. Development of informal spot markets (for immediate delivery) and forward markets (non-standardized agreements for future delivery) in commodities and securities where 'receipts' of ownership are traded.
5. Emergence of securities and commodities exchanges.
6. Creation of organized futures markets (standardized contracts for future delivery on organized exchanges) and options markets (rights but not guarantees for future delivery) in commodities and securities.
7. Proliferation of over-the-counter markets/deconstruction.
There have been many examples of this. The seven-stage process holds true, for example, for the evolution of the equity-capital market beginning with the need to finance the Age of Discovery that brought Columbus to the Americas; for the evolution of trading in agricultural commodities in America in the 19th century; and for the refinement of markets for instruments that support the housing finance system in the United States in the 20th century.
Similarly, increased pollution by sulphuric emissions accompanied increased electricity demand and output. Latent demand became effective demand as public concern over human health and environmental damage motivated legislators to pass the Clean Air Act Amendments of 1990.
These set an overall national limit on sulphur dioxide emissions, ultimately requiring a 50 per cent cut. Under a command-and-control regime, coal-fired utilities would have had little choice but to purchase expensive pollution control technologies to meet the lower targets. Instead, a market-based 'cap-and-trade' system was adopted. Utilities could either reduce emissions directly or purchase allowances from others that cut emissions below their targets. They were motivated to reduce emissions because they could sell their unused allowances. Those that did not make cuts had to buy more allowances or face stiff fines. All rules protecting local air quality remained in force.
In a single stroke, the Clean Air Act performed three functions: it standardized an environmental commodity (a legally authorized allowance to emit 1 ton of sulphur dioxide); it produced the 'evidence of ownership' necessary for financial instruments; and it established the infrastructure to transfer title efficiently. An informal forward market emerged even before the Act required compliance. Options followed. Organized exchanges arrived when the Chicago Board of Trade (CBOT) competitively won the right to conduct the annual allowance auctions on behalf of the Environmental Protection Agency (EPA); it continues to provide this service pro bono.
The overwhelming success of this programme, and others like it, may help to motivate the international community to accelerate the establishment of a pilot phase for greenhouse gas emissions trading. Before the United States sulphur programme was launched, most forecasters predicted that compliance costs would range from $300 to $900 per ton. The first trades were executed in 1992 at around $300 per ton; but the price at the first EPA/CBOT auction was $131 per ton. In 1998 it hovered from $115 to $160. Meanwhile, total emissions came down ahead of schedule: between 1995 and 1997, aggregate emissions were more than 33 per cent below sanctioned levels. As The Economist put it: 'Overall, this [programme] has cut sulphur emissions faster and more cheaply than anyone predicted.'
This major success interests both the environmental and business communities because it reflects the win-win possibility of emissions trading. Turning this possibility into a probability includes such conditions as strictly limiting and precisely measuring pollution levels, and enabling industry to comply with the law using flexible and creative instruments.
Other less well-known programmes involving resource permitting and emissions trading helped phase out lead from gasoline in the United States and have been introduced in such diverse nations as Poland, New Zealand and Chile. Internationally, the Montreal Protocol on Substances that Deplete the Ozone Layer allows the use of market-based tools, and these have contributed to its success in cutting the production of ozone-depleting substances.
Policy makers continue to debate alternative tools to restrict greenhouse gas emissions. Emission taxes have an unpredictable effect on the level of emissions and carbon taxes are politically unfeasible in many countries. But in just a few short years, the idea of using tradable permits to combat global warming - which I first articulated in preparation for the 1992 Rio Earth Summit - is gaining widespread acceptance.
As the Kyoto agreement is implemented, a wealth of lessons is available from the seven-stage process and from other examples of inventive activity ranging from aircraft to computers. The evolutionary development pattern of many international agreements, such as the World Trade Organization and the European Community, is also pertinent: most of the expansive, large-scale, multilateral institutions started as targeted, small-scale, plurilateral protocols.
History suggests that the best approach to realizing a large-scale greenhouse gas trading system would be to begin with an early, no-frills, limited-scale, voluntary carbon dioxide pilot programme. Participating national governments would agree to enforce a system where their domestic emission sources can reach emission limits jointly by trading with emission sources in other participating countries. Non-member governments could choose a more limited 'opt-in' by agreeing to monitor emissions and certify emission reductions for industries or individual firms that voluntarily choose to participate in the initial phase. Provisions must be made for new members, and to address unregulated gases and uncovered emission sources and sinks. In this way, the market would be flexible and resilient enough to assure its structured evolution.
A limited-scale greenhouse gas trading programme is an essential step on the path to a larger international system. Pioneers will be needed to face the challenge of innovation, and it is in the interest of the major emission sources to assume this role. Some companies (such as Suncor in Canada and Niagara Mohawk in the United States) and countries (like Costa Rica) have taken up the mantle of leadership in the nascent market.
The inclusion of the Clean Development Mechanism in the Kyoto Protocol was extremely encouraging. If properly designed, it can help realize the remarkable capability of tradable emission permits to deliver a 'double dividend' - helping to lower the cost to the public of addressing climate change and acting as a powerful mechanism for transferring clean energy technologies and financial resources from industrialized to developing countries.
Impressive economic benefits flow from driving down the cost of cutting greenhouse gas emissions. The industrialized world can take very meaningful steps to bring down emissions at a cost of about one tenth of 1 per cent of GDP, if market-based methods are used. Many of the early transactions have occurred at prices that would imply even lower overall costs, and my firm has directly observed very large reductions in emissions being offered at similar levels.
The first step in developing the missing greenhouse gas market is to define the commodity. Kyoto provided a cap on total emissions and delineated the basis for creating the property right, or commodity. Other key ingredients now needed include participants' baseline emission rates, initial allowance allocations, and protocols for monitoring emissions and calculating the benefits of emission avoidance or sequestration programmes.
Drawing on the lessons from the introduction and evolution of new markets, there are 12 steps to implementation. They could be called the 'clean dozen':
- Clearly define the tradable commodity for greenhouse gas emissions.
- Establish a market oversight body.
- Establish emission baselines.
- Clearly specify allocation and monitoring procedures.
- Establish uniform, non-segmented allowances.
- Launch an international allowance clearing-house and registrar.
- Employ existing exchange and trading systems.
- Use allowance auctions to assist the market.
- Develop standardized trade documentation.
- Require cooperation among trade forums, including provisions for information sharing and mutual offset.
- Use existing expertise to design book-keeping and accounting systems.
- Provide assistance to market forums in emerging economies.
Emissions trading is an environmental and economic winner. The seven-stage process enables us to describe a common dialectic of how markets evolve. My colleagues and I - and myriad other advocates of market-based environmentalism - have been building a market architecture for a greenhouse allowance trading pilot programme and are working diligently for its practical implementation. Such a regime can target emission levels directly (which carbon taxes cannot do) and it is likely to be the most cost-effective option. So it must be near the top of the menu of policy options needed to prevent the costly threat of climate change. In the words of The Economist: 'There is reason to think that global emissions trading might work. And if, in the end, it does not? Little harm would have been done. The risks are negligible, and the potential economic benefits very large.'
We must act now to take the vital first step to implement a voluntary trade regime with binding emission limits. This needs to provide sufficiently flexible incentives so that the private sector taps into an unparalleled wealth of specialized knowledge and entrepreneurial creativity. Stated positively, we must 'learn by doing'. Stated negatively, we must not follow the fallacious rhetoric of the status quo that offers a map down a road with no outlet: 'Do not initiate a programme until you learn all the drawbacks. And you cannot learn about the drawbacks until you initiate the programme.'
Innovative private entities and non-governmental organizations - and leading governments - possess unique sets of knowledge and skills. Only when these are brought to bear individually and collectively on the problem of climate change will the risk be appropriately managed.
An international greenhouse gas emissions trading programme has already moved from a possibility to a probability. The time has come for the public and private leaders of the world community to make it a reality.
Dr. Richard L. Sandor is Chairman and CEO of Environmental Financial Products L.L.C., United States of America.