For sale: pollution
As climate worries heat up, U.S. firms are experimenting with the greenhouse gas trade. Is this a good idea?
NEW YORK (Fortune) -- Along the shores of the sleepy Ohio River, deep in West Virginia's "megawatt valley," the twin smokestacks of American Electric Power's Mountaineer coal plant rise 1,000 feet, a shade higher than the Eiffel Tower. Here coal is burned to heat water to make steam that drives the giant turbines that make the power - a grossly inefficient process that has barely changed since the days of Edison.
"You throw away a lot of heat to make that electrical energy - about 40 percent," says the plant manager, Charlie Powell. And it is dirty. AEP (Charts) is America's single largest emitter of greenhouse gases - sending as much out from its stacks as Canada. That's a statistic the company wants to change, and it's hoping that membership on the Chicago Climate Exchange can help.
The 206 members of the CCX buy and sell rights to emit greenhouse gases (carbon dioxide, methane, and four others), just as if they were pork bellies or wheat. When AEP joined the CCX, for example, an independent auditor established its baseline emissions; AEP made a contractual commitment to cut that figure by 1 percent a year (total U.S. emissions are rising more than 1 percent a year). Then the company was granted credits that equalled its target.
AEP can use these in three ways. If its emissions are below its allowance, it can sell the difference, meaning the company has an incentive to emit as little as possible. If it needs to emit more, it can buy the difference from another member. Or AEP can invest in an offset program - say, planting carbon-sucking trees - that would earn the company new credits. The goal of the CCX is to create a market for pollution that, in effect, becomes a mechanism for reducing it.
Do-nothing days are over
Companies are taking action now because doing nothing is a strategy that is running out of steam. Recently the U.S. Supreme Court agreed to consider a suit that would require the U.S. Environmental Protection Agency to regulate car and truck emissions. And the U.S. Senate is about to consider, for at least the fourth time, imposing mandatory national caps on greenhouse gas (GHG) emissions - a step that is unlikely to go far this year, but signals momentum towards regulation.
Like it or not, U.S. industry is beginning to accept that the issue of climate change is not going away. Many companies, including AEP, believe that a cap-and-trade setup is the most economical way for business to deal with it.
Trading pollution rights on a virtual commodity exchange is not the stuff of mad green wonks. The U.S. already runs several environmental markets, including the highly successful SO2 framework to combat acid rain, and Europe and Canada also have carbon markets. (The CCX has subsidiary exchanges that operate in both those places.)
What makes the CCX distinctive is that it is based in a country that did not ratify the Kyoto Protocol, the international treaty to reduce emissions of greenhouse gases. The U.S. has accepted no limits on its emissions (by contrast, the EU agreed to cut emissions by 8 percent from 1990 levels, and Canada by 6 percent).
Though no one has to join, the CCX has managed to attract a broad array of members, including industrial giants like Rolls-Royce, Motorola (Charts), DuPont (Charts) and IBM (Charts); six cities; and even a U.S. Senator, Richard Lugar (R-Indiana), who owns a 600-acre farm.
It's difficult to know exactly what percentage of U.S. emissions CCX members account for - on this and other details, the operations can be murky - but AEP alone accounts for about 10 percent of the nation's stationary source (i.e., not cars) emissions. Most members have pledged to reduce their baseline emissions by 1 percent a year.
A voluntary system, says Richard Sandor, the brains behind the CCX and a former chief economist of the Chicago Board of Trade, helps companies clean up their operations and learn the basics of trading.
"Our job is to inform the debate, build core competency, prove that we could develop a common protocol, and to implement it," says Sandor. "One should never underestimate the training-wheel phenomenon."
On those modest terms, the CCX works. Its members have traded a total of 11 million metric tons of CO2e (carbon dioxide equivalent, the basic unit of GHG trading) since the exchange opened for business in 2003. In 2003-04, according to the CCX, its members reduced the amount of CO2e they emitted by the equivalent of taking 15 million cars off the road.
But fundamental questions remain: Can a voluntary system that includes only a small fraction of polluters ever result in robust trading? Is the CCX really helping the environment, or just adding pages to sustainability reports? And since companies can make efficiency gains on their own, why do they need the CCX at all?
Getting the jump on federal regulation
Besides green bragging rights, the reasons for joining the exchange almost always start with the belief that Congress will eventually force some sort of action.
"It is probably before its time," says Michael Morris, CEO of AEP and a board member of the CCX. "But it will be a very effective tool." As carbon matures as a commodity, companies in the CCX see a value in being ahead of the game.
AEP says it has bought and sold a million tons of CO2e. International Paper says it saw roughly $6 million in revenues in 2005 from all its environmental markets (including SO2). That's not chump change, but those are big companies.
Imagine that AEP needed to buy credits to increase Mountaineer's emissions by 10 percent. At today's CCX prices that would cost $4 million - peanuts for the $12 billion company. The same purchase on Europe's exchange, where a continent-wide law drives demand for credits, would cost about $18 million.
"Voluntary action goes only so far," cautions Andrew Ertel, president of environmental trading firm Evolution Markets. "Until we, and big business, live in a world of regulatory certainty, we are not going to see a thriving carbon market in the U.S."
The lack of a nationwide, mandatory emissions cap limits the action on the CCX, which sees only about 200 trades a month. Trading volume is volatile, ranging from as little as 37,000 metric tons in January to as much as three million in May. And until recently, prices on the CCX struggled to top $2 per ton. By comparison, Europe's exchange, supported by mandatory caps, can see volumes of three million tons a day, and prices peaked at $39 in March.
Sandor is confident that the differences in participation between the U.S. and Europe will narrow. In April, he noted, a roster of companies, including Shell and GE, told the Senate they were ready for federal limits. Within a few weeks CCX prices shot up to $5, and volume picked up too.
"We're the indirect beneficiary of $70 oil, or maybe Katrina refocused everybody," Sandor says. "There's suddenly a greater interest in everything that has to do with reduced greenhouse gas emissions."
Sustainability depends on big players
Whether those prices are sustained may depend on how well the design of the exchange suits the large industrial players that need it most. One difficulty: Many CCX members are retail consumers of energy - cities, colleges, states - for whom participation is sometimes a political statement. Portland, Ore., for example, will retire rather than trade its credits. Nice for the environment, bad for market liquidity.
In this sense, the CCX has more ambition than action. Unlike the SO2 market, which is limited to power plants, or the European carbon market, which is limited to big plants and manufacturers, the CCX allows just about anyone to join (feel free to apply). But companies like AEP need other big firms to trade with, and right now they make up less than 15 percent of the 206 members.
Still, the recent spike in prices on the CCX has gotten the attention of AEP. "If the price is $1 a ton, it's not going to result in a lot of activity," says Chuck Zebula, AEP's senior vice president for fuel and emissions. But valued at $5 a ton, what comes out of the smokestack is worth enough to offset upgrades and influence decisions.
Last year the Mountaineer plant generated 10.5 million megawatt-hours of electricity, and a corresponding 8.6 million tons of CO2e. That would make its emissions, in CCX terms, a $39 million cost. If improvements yield just a 1 percent cut, the plant has almost $400,000 of emissions to sell. Looked at another way, the emissions are suddenly 20 percent of the cost of Mountaineer's fuel.
Back inside the plant, Powell shouts over the deafening roar of machinery. He points out a crooked valve in the main steam line that slows the flow on the way to the generator. This year, based partially on the economics of the CCX, Powell will replace the bend with a straight valve, a change he thinks will save 30,000 tons of CO2.
Company-wide such small changes could save AEP 1.3 million tons of CO2e a year. It goes to show that it's the big polluters that have the best opportunity to make a real dent in GHG reductions. And if training wheels are needed to make that happen, well, it's a start.