Reducing greenhouse gases has become a major international objective. While the international community debates the Kyoto protocol, a number of countries have already announced that they will reduce greenhouse gases. The November 1998 Buenos Aires meeting on the Kyoto Protocol helped advance the trading approach as one means for reducing greenhouse gases. Because carbon dioxide is a major greenhouse gas, creating a market for carbon emission reductions is under consideration. A market solution would be far less costly for society than a command and control system. Should a carbon market evolve, the U.S. natural gas industry could be a winner.

Even though some in the scientific community do not believe that carbon emissions contribute to global warming, everyone agrees that carbon emissions are increasing rapidly. Because it is possible that carbon emissions increase the likelihood of significant climate change, a market should be at the top of the list of policy options to cost-effectively manage our emissions budget. In effect, a carbon-trading system may be cheap insurance against potentially large societal problems.

Sulfur Emissions Trading Paves the Way

Emissions allowance trading with firm emissions limits, or a cap, is a straightforward concept that is already operational in a national scale. The U.S. sulfur dioxide emissions market is a primary example. Other examples are trading rights to produce leaded gasoline in the United States during the leaded gasoline phase-out and the trading of production rights for chlorofluocarbons (CFCs) under the Montreal Protocol.

Firm emissions limits, along with monitoring requirements and strict noncompliance penalties, both ensure that the environmental result will be reached and that it will create financial value for the allowances. Thus, the environmental and financial integrity of the system are mutually supportive.

In the sulfur dioxide program, Congress placed an overall restriction on power plant emissions natiowide, a permanent cap set at 50 percent below 1980 levels. The program effectively allows power plants to comply by either (1) investing in cleaner fuels, pollution control technologies, more efficient equipment, improved dispatch, demand-side management, transmission improvements, or any other direct means; or (2) buying extra emissions rights from another power plant that has made extraordinary emission cuts. Buying excess rights from a more efficient power plant allows the older and less-efficient power plant to meet its obligations at lower cost to consumers.

In short, trading emission permits allow industry to meet emissions goals in a least-cost manner. It also permits maximum flexibility in how companies comply and provides a financial incentive for cost-effective technical innovation.

Title IV of the 1990 Clean Air Act Amendments established trading in sulfur emissions among 110 power plants. During the debate on this legislation, experts estimated that these emission rights would command a very high price. Some intial estimates ran as high as $1500 per ton. Hahn and May report several pre-1992 estimates of forecasted prices for sulfur emission allowances, ranging from $309 (Resource Data International) to $981 (United Mine Workers). In seven annual auctions at the Chicago Board of Trade (CBOT) since 1993, the average spot market price of allowances has been $128. In recent months, allowances have traded at close to $200 a ton. Carlson et. al. Argue that many factors, in addition to trading of emissions rights, created low prices of sulfur emission allowances: improved technologies for burning low sulfur coal, improvements in electrical generating efficiency, and lower prices for low sulfur coal.

Evaluations of the sulfur emissions trading program suggest that the program has been a success. The program has achieved 100 percent compliance. By 1998 actual sulfur emissions were 30 percent below the allowable level. This can be attributed to the "banking" provisions of the trading system, by which excess allowances can be saved and used at any future date.

There has also been steady growth in the interutility trading of allowances, from 700,000 ton in 1995 to 2.8 million tons in 1997. The market has now reached the level of approximately $2 billion each year in registered trades. Environmental Financial Products estimates that, in addition, there is on the order of $2 billion a year in derivatives such as options, forwards and others unregistered trades.

Nonetheless, the full effects of the trading have not been realized, as the market is still adjusting to this new innovation. Carlson et. al. Estimate that this innovation will save $784 million annually beginning in the year 2000. They estimate the net cost of the cap-and-trade system is 43 percent of the estimated costs under a command-and-control system.

The benefits of the program appear to far outweigh the costs. Current annual compliance costs are estimated to be in the $1 to $2 billion range. A recent study prepared for the Environmental Protection Agency indicates a central estimate of the value of benefits from the program to human health alone is $10 billion a year.

Critics had said that the sulfur trading program would not work because it involved a new commodity and because of the monitoring and reporting challenges, regulatory uncertainties, and regulated structure of the utility industry. In spite of these hurdles, the program has been a resounding success. The continuous emissions monitoring systems are working and their cost has fallen substantially. The market functioned well from the beginning under a highly regulated industry structure and is thriving now in the midst of utility industry deregulation. Further, the market has been successful despite regulatory uncertainty and even disincentives to trading from rulings of the FERC and some state public utility commissions.

As the market for greenhouse gas emissions continues to evolve, switching to less carbon-intensive fuels will be an important means to reduce carbon emissions. Natural gas is the least carbon-intensive fossil fuel. Per unit of energy, combustion of natural gas results in 42 percent less carbon dioxide emissions than coal and 29 percent less than residual fuel oil. Significant reductions in carbon dioxide emissions could be made through fuel switching, for example, from residual fuel oil to natural gas. The value of carbon emission reductions resulting from a trading and regulatory regime will also favor cofiring of natural gas with coal and might lead to an early retirement of coal-fired boilers or a repowering to use natural gas.

When the value of carbon reductions is added to the value of SO2 and NOx reductions that also result from a switch to natural gas, the financial premium associated with the environmental benefits of the switch will be even greater. The market in carbon reductions will motivate technological improvements to reduce emissions. For example, if price signals provide incentives for increased use of natural gas, the market would respond with new technologies. Price incentives will encourage technologies that produce, distribute, and combust natural gas more efficiently and effectively.

Each pound of noncombusted methane that escapes to the atmosphere is 21 times more potent as a greenhouse gas than carbon dioxide. Minimizing pipeline leakage in production could become very valuable by generating carbon reductions. These opportunities are especially large in countries, such as some in the former Soviet bloc, where pipeline infrastructure is substandard. The increased capture and utilization of coal-bed methane will also provide opportunities for the natural gas industry.

Some developed-country emitters of carbon may be willing to pay others in developing countries or to invest in projects in developing countries to reduce carbon dioxide or methane emissions. This would be done to create offsets to domestic emissions, or as a means of buying time to invest in technologies needed to reduce emissions at home, the carbon market would provide a more efficient solution. U.S. firms would likely use a combination of reductions in domestic emissions and domestic and international carbon trades. This provides increased opportunities for U.S. companies in the natural gas industry to expand their international activities in exploration and development and building infrastructure.

Estimates of the value of carbon emissions allowances range from $348 per ton of carbon ($95 per ton of carbon dioxide) to $15 per ton of carbon ($4 per ton of carbon dioxide) according to other estimates. Based on early market signals, Environmental Financial Products is using market values between $20 and $30 per ton of carbon ($5 to $8 per ton of carbon dioxide). Without a market to trade carbon emissions, the lower prices (and the lower mitigation cost to society) will not be possible.

A number of factors must be considered when designing a market for carbon emissions. In contrast to the sulfur market, carbon emission sources are less concentrated. They include electric utilities, oil and gas production and refining, transportation, and the commercial and residential sectors. In addition, sulfur could reduced only by cutting emissions. A carbon market, on the other hand, may work through both direct reductions and through the capture of carbon dioxide in forests and soils (sequestration).

Low-cost systems to measure and monitor direct emissions of methane, as well as carbon dioxide from the combustion of methane, are available. As the market develops, new technologies should emerge to make this task economically feasible. Methane emissions from landfills and coal mines need to be mapped more carefully. Opportunities will emerge for companies to provide monitoring and measurement services.

Dr. Richard Sandor, chief executive officer of Environmental Financial Products, has been heavily involved in finding a number of new markets. He postulates a simple seven-stage process for market development:

• Structural economic change that creates a demand for new services
• Creation of uniform standards for a commodity or security.
• Development of a legal instrument that provides evidence of ownership.
• 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.
• Emergence of securities and commodities exchanges.
• 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.
• Proliferation of over-the-counter markets.

Based on this experience, Sandor is developing recommendations for implementing an international pilot program for carbon emissions trading. An international pilot is in keeping with the Kyoto Protocol, which, during the first phase, puts the burden on developed economies. With trading, those in developed countries would also have the option of involving developing countries by funding low-cost emission reduction projects and by helping developing countries finance their efforts to prevent destruction of existing forests.

An effective carbon emissions market must have a clearly defined tradable commodity for greenhouse gas emissions. The standard measure to be traded must be agreed to by all parties. An oversight body is needed, along with emissions baselines and clearly specified allocation and monitoring procedures. Once these standards are in place, existing exchanges and trading systems can be used to facilitate trades. Widely accepted standards will increase the credibility of the trades and help standardize the legal mechanics more quickly. All of these steps will lower the transaction costs in the new market.

With standardization and use of existing exchanges and trading systems, a carbon emissions market is very feasible. If we can trade corn on the Chicago Board of Trade, we can trade carbon. A system of quotes, hedging, and options will evolve. The market for carbon trades is already evolving. Niagara Mohawk (an electric power company in New York State) and Arizona Public Service completed a swap of carbon offsets for sulfur dioxide emission allowances in 1996. Environmental Financial Products purchased rainforest protection carbon offsets from the Republic of Costa Rica in 1997. This 1.1-million-acre program also includes assurance form the Costa Rican government that the area will be placed in a national preserve. In 1998, the Japan-based Sumitomo began converting coal-fired electric power plants in Russia to natural gas to earn carbon offsets as part of a transaction.

The road to price discovery is being built. A market for carbon reduction services is now emerging. Carbon markets are being designed in the United Kingdom on the International Petroleum Exchange and in Australia at the Sydney Futures Exchange. Major companies such as United Technologies, British Petroleum and Royal Dutch Shell have also committed to large and early reductions in their own greenhouse gas emissions.

Early reduction credit legislation has been recently introduced in the U.S. Senate (S. 547). The proposed legislation has been cosponsored by a bipartisan group of 12 senators. It would allow companies to enter into early-action agreements to recognize greenhouse gas emissions reductions with the executive branch of the government. These agreements would focus on companywide reductions made between 1999 and 2007. Credits would be recognized in any future regulatory regime in the United States that limits greenhouse gas emissions. These credits would be subtracted from the first U. S. allocation under the Kyoto Protocol (2008 to 2013), if it is ratified by the United States and enters into force. Passage of this bill would provide a regulatory framework and clear incentives for companies to reduce greenhouse gas emissions and begin trading.

Therefore, regardless of whether the United States approves the treaty, it may soon be possible to provide important market opportunities to the natural gas industry. Firms in other countries may even be willing to pay to make greenhouse gas emissions reductions in the United States. U.S. action to limit net carbon emissions or to create early reductions credits would help make the benefits and incentives even greater.

Carbon trading is not only feasible, it is emerging even in the absence of government regulation. New investments are being made in technologies and research needed to monitor and standardize carbon measurement. Active trading of carbon could prove an inexpensive insurance policy against the unknown, but potentially catastrophic, problems that may emerge because of the rapid increase in global carbon emissions. An effective and efficient market-based solution will become even more important as governments around the world tighten restrictions on carbon emissions.

The U.S. natural gas industry is well-positioned to help in reducing carbon dioxide emissions. While helping to clean up the air, the benefits to the industry could be substantial. Income and asset values should both increase. All the while, carbon trading could also make the natural gas industry more resilient to other forces that have persistently created business cycles in the energy sector.

Notes

1. This article emerged from two presentations by Dr. Sandor at Monsanto and the University of Kentucky; and one by Ms. LeBlanc at a meeting of the International Association of Energy Economists in Houston. Another article by these authors about this subject has been published in Choices Magazine, a publication of the American Economics Association, in the first quarter of 1999.

2. Hahn, Robert W., and Carol A. May, "The Behavior of the Allowance Market:

Theory and Evidence," The Electricity Journal, March 1994, 7:2, 28-37.

3. Carlson, Curtis, Dallas Burtraw, Maureen Cropper, and Karen L. Palmer. "Sulfur Dioxide Controls by Electric Utilities: What are the Gains from Trade?" Resources for the Future Discussion Paper, July 1998:98-44.

4. Chestnut, Lauraine G., "Human Health Benefits from Sulfate Reductions under Title IV of the 1990 Clean Air Act Amendments," EPA Contract No. 69-D3-0005 (November 10, 1995).

5. Energy Information Administration, "What Does the Kyoto Protocol Mean to U.S. Energy Markets and the U.S. Economy?" (October 1998)

6. Sandor, Richard L. "The Role of the United States in International Environmental Policy." Presentation to the White House Conference on Climate Change. Washington, D.C. 6 Oct. 1997.

"Money to Burn?" The Economist. 344(1997): 86.

Article published in Natural Gas, June 1999 , page 6