The Pitfalls of Pollution Allowance Trading

Managing POWER magazine

By Kennedy Maize
Although Congress killed the Obama administration's plans for a cap-and-trade program for controlling power plant emissions of carbon dioxide, many advocates of that policy approach, …continue to push for allowance trading. The argument is that trading mechanisms are more efficient than conventional command-and-control. But a new policy analysis from the environmental think tank Resources for the Future (RFF) highlights the problems cap-and-trade programs have faced in regulating emissions of sulfur dioxide and oxides of nitrogen. According to the analysis, changes in just one program—the sulfur dioxide rules—have wiped out some $3 billion in the value of utility-held emissions allowances.

Image via Wikipedia…[Says] the RFF analysis—"Banking on Allowances: The EPA's Mixed Record in Managing Emissions Market Transitions" —cap-and-trade programs have suffered from declining credibility and market support. Say Arthur Fraas and Nathan Richardson, "…[Changes] by regulators in the rules governing the use of allowances can significantly affect the certainty and credibility of the emissions-trading programs and the value of allowances. Such changes may lead to undesirable market behavior, including an emissions increase as sources use up or dump their banked allowances."

… The prototype trading programs for SO₂ and NO_x have all allowed utilities to bank excess pollution reductions, giving the allowance owners flexibility in timing and financing their reductions. But all of the programs changed substantially as time passed—particularly as the Environmental Protection Agency (EPA) has sought to tighten caps over the years. ...

Image via Wikipedia"Because emissions allowances convey certain rights," says the RFF discussion paper, "it is important that emissions-trading programs maintain clear and consistent rules of the use of allowances in order to limit uncertainty and assure a smoothly functioning market." But that has not been the case, …

Pushed by internal and external policy and political dynamics, the EPA has repeatedly ratcheted down emissions targets, or caps. …[Says] the RFF discussion, "If banked allowances are used in the new, stricter program, emissions will be greater than desired in the short term until those banked allowances are drawn down. … [This] delay before the new caps 'bite' will be perceived as problematic and will create pressure to reduce or eliminate these 'excess' allowances."
"Striking the right balance" between the need for greater reductions and the value of banked allowances "is not easy," says the RFF paper, … "Though the problems have been consistent, the EPA's response has not” …
The damage to cost-effective reductions can be significant, says the analysis. … In the policy tug-of-war over new emissions reductions, environmental groups and their allies have pushed to eliminate the use of banked allowances, while business interests have argued for preservation of the value of the emissions.

Image via WikipediaPart of the problem is that the government has specifically avoided treating banked allowances as property; … Both Congress and the EPA have insisted through the law and implementing regulations that an allowance "does not constitute a property right." The RFF paper says the best way to understand the emissions allowances is to see them as "carrying some (but not all) of the rights in the property bundle. For example, holders can exclude others from using allowances they hold. But the statutory provisions and government agency decisions that create allowances limit allowance holders' rights." One of the problems in the property "bundle" is "the extent to which banked emissions allowances hold value as emissions caps decline and new programs are created."

… Although the EPA historically has sought to preserve the value of banked allowances during program shifts, most recently the agency proposed to wipe out banked allowances from the CAIR program to apply its successor "Transport Rule" regulatory regime. This EPA move, says the RFF paper, "represents a shift" in the EPA's traditional approach "that can only be detrimental to the overall efficiency of the EPA's cap-and-trade programs." …
—Kennedy Maize is MANAGING POWER's executive editor.

Climate Change - Building a Green Economy

Photograph by Yoshikazu Nema; Artwork by Yuken Teruya

NYTimes.com

By PAUL KRUGMAN

Published: April 5, 2010

If you listen to climate scientists — and despite the relentless campaign to discredit their work, you should — it is long past time to do something about emissions of carbon dioxide and other greenhouse gases. If we continue with business as usual, they say, we are facing a rise in global temperatures that will be little short of apocalyptic. And to avoid that apocalypse, we have to wean our economy from the use of fossil fuels, coal above all.

But is it possible to make drastic cuts in greenhouse-gas emissions without destroying our economy?

Like the debate over climate change itself, the debate over climate economics looks very different from the inside than it often does in popular media. …[There] is widespread agreement among environmental economists that a market-based program to deal with the threat of climate change — one that limits carbon emissions by putting a price on them — can achieve large results at modest, though not trivial, cost. There is, however, much less agreement on how fast we should move, whether major conservation efforts should start almost immediately or be gradually increased over the course of many decades. …

Environmental Econ 101 If there’s a single central insight in economics, it’s this: There are mutual gains from transactions between consenting adults. … More than that, some careful analysis shows that if there is effective competition in the … market, so that the price ends up matching the number of widgets people want to buy to the number of widgets other people want to sell, the outcome is to maximize the total gains to producers and consumers. Free markets are “efficient” — which, … means that nobody can be made better off without making someone else worse off.

Now, efficiency isn’t everything. …[There] is no reason to assume that free markets will deliver an outcome that we consider fair or just. … But the logic of basic economics says that we should try to achieve social goals through “aftermarket” interventions. That is, we should let markets … [make] efficient use of the nation’s resources, then utilize taxes and transfers to help those whom the market passes by.

But what if a deal between consenting adults imposes costs on people who are not part of the exchange? … When there are “negative externalities” — costs that economic actors impose on others without paying a price for their actions — any presumption that the market economy, … will do the right thing goes out the window. So what should we do? Environmental economics is all about answering that question.

One way to deal with negative externalities is to make rules that prohibit or at least limit behavior that imposes especially high costs on others. That’s what we did in the first major wave of environmental legislation in the early 1970s: cars were required to meet emission standards for the chemicals that cause smog, factories were required to limit the volume of effluent they dumped into waterways and so on. And this approach yielded results; America’s air and water became a lot cleaner in the decades that followed.

But while the direct regulation of activities that cause pollution makes sense in some cases, it is seriously defective in others, because it does not offer any scope for flexibility and creativity. …

Enter Arthur Cecil Pigou, an early-20th-century British don, whose 1920 book, “The Economics of Welfare,” is generally regarded as the ur-text of environmental economics.

… What Pigou enunciated was a principle: economic activities that impose unrequited costs on other people should not always be banned, but they should be discouraged. And the right way to curb an activity, in most cases, is to put a price on it. So Pigou proposed that people who generate negative externalities should have to pay a fee reflecting the costs they impose on others — what has come to be known as a Pigovian tax. The simplest version of a Pigovian tax is an effluent fee: anyone who dumps pollutants into a river, or emits them into the air, must pay a sum proportional to the amount dumped.

…[With] the rise of environmental regulation, economists dusted off Pigou and began pressing for a “market-based” approach that gives the private sector an incentive, via prices, to limit pollution, as opposed to a “command and control” fix that issues specific instructions in the form of regulations.

The initial reaction by many environmental activists to this idea was hostile, largely on moral grounds. Pollution, they felt, should be treated like a crime rather than something you have the right to do as long as you pay enough money. …[There] was also considerable skepticism about whether market incentives would actually be successful in reducing pollution. Even today, Pigovian taxes as originally envisaged are relatively rare. The most successful example I’ve been able to find is a Dutch tax on discharges of water containing organic materials.

What has caught on instead is a variant that most economists consider more or less equivalent: a system of tradable emissions permits, a k a cap and trade. In this model, a limited number of licenses to emit a specified pollutant, like sulfur dioxide, are issued. A business that wants to create more pollution than it is licensed for can go out and buy additional licenses from other parties; a firm that has more licenses than it intends to use can sell its surplus. This gives everyone an incentive to reduce pollution, because buyers would not have to acquire as many licenses if they can cut back on their emissions, and sellers can unload more licenses if they do the same. …[Economically], a cap-and-trade system produces the same incentives to reduce pollution as a Pigovian tax, with the price of licenses effectively serving as a tax on pollution.

In practice there are a couple of important differences between cap and trade and a pollution tax. One is that the two systems produce different types of uncertainty. If the government imposes a pollution tax, polluters know what price they will have to pay, but the government does not know how much pollution they will generate. If the government imposes a cap, it knows the amount of pollution, but polluters do not know what the price of emissions will be. Another important difference has to do with government revenue. A pollution tax … imposes costs on the private sector while generating revenue for the government. Cap and trade is a bit more complicated. If the government simply auctions off licenses and collects the revenue, then it is just like a tax. Cap and trade, however, often involves handing out licenses to existing players, so the potential revenue goes to industry instead of the government.

Politically speaking, doling out licenses to industry … offers a way to partly compensate some of the groups whose interests would suffer if a serious climate-change policy were adopted. This can make passing legislation more feasible.

…[The] Waxman-Markey bill, a cap-and-trade setup for greenhouse gases that starts by giving out many licenses to industry but puts up a growing number for auction in later years, was actually passed by the House of Representatives last year; it’s hard to imagine a broad-based emissions tax doing the same for many years. …

In any case, experience suggests that market-based emission controls work. Our recent history with acid rain shows as much. The Clean Air Act of 1990 introduced a cap-and-trade system in which power plants could buy and sell the right to emit sulfur dioxide, leaving it up to individual companies to manage their own business within the new limits. …[Over] time sulfur-dioxide emissions from power plants were cut almost in half, at a much lower cost than even optimists expected; electricity prices fell instead of rising. Acid rain did not disappear as a problem, but it was significantly mitigated. …

…The emission of carbon dioxide and other greenhouse gases is a classic negative externality — … . Textbook economics and real-world experience tell us that we should have policies to discourage activities that generate negative externalities and that it is generally best to rely on a market-based approach.

Climate of Doubt? …[It’s] worth establishing three things about the state of the scientific debate.

The first is that the planet is indeed warming. … [If] you look at the evidence …­— taking averages over periods long enough to smooth out the fluctuations — the upward trend is unmistakable: each successive decade since the 1970s has been warmer than the one before.

Second, climate models predicted this well in advance, even getting the magnitude of the temperature rise roughly right. …So the fact that climate modelers more than 20 years ago successfully predicted the subsequent global warming gives them enormous credibility. …

…[My] third point: models based on this research indicate that if we continue adding greenhouse gases to the atmosphere as we have, we will eventually face drastic changes in the climate. …[We’re] talking about massively disruptive events, like the transformation of the Southwestern United States into a permanent dust bowl over the next few decades.

… Is a cap-and-trade program along the lines of the model used to reduce sulfur dioxide the right way to go?

Serious opposition to cap and trade generally comes in two forms: an argument that more direct action — in particular, a ban on coal-fired power plants — would be more effective and an argument that an emissions tax would be better than emissions trading. … There’s something to each of these positions, just not as much as their proponents think.

When it comes to direct action, you can make the case that economists … are too ready to assume that changing people’s financial incentives fixes every problem. In particular, you can’t put a price on something unless you can measure it accurately, and that can be both difficult and expensive. So sometimes it’s better simply to lay down some basic rules about what people can and cannot do. …

Is there a comparable argument to be made for greenhouse-gas emissions? My initial reaction, which I suspect most economists would share, is that the very scale and complexity of the situation requires a market-based solution, whether cap and trade or an emissions tax. … Reducing emissions of those gases will require getting people to change their behavior in many different ways, some of them impossible to identify until we have a much better grasp of green technology. … Econ 101 tells us … that the only way to get people to change their behavior appropriately is to put a price on emissions so this cost in turn gets incorporated into everything else in a way that reflects ultimate environmental impacts.

… A market-based system would create decentralized incentives to do the right thing, and that’s the only way it can be done.

That said, some specific rules may be required. James Hansen, … has argued forcefully that most of the climate-change problem comes down to …burning coal, and that whatever else we do, we have to shut down coal burning over the next couple decades. …[A] market-based system might turn out to have loopholes — and their consequences could be dire. So I would advocate supplementing market-based disincentives with direct controls on coal burning.

What about the case for an emissions tax rather than cap and trade? There’s no question that a straightforward tax would have many advantages over legislation like Waxman-Markey, which is full of exceptions and special situations. … The question is whether the emissions tax that could actually be put in place is better than cap and trade. There is no reason to believe that … a broad-based emissions tax would make it through Congress.

To be fair, Hansen has made an interesting moral argument against cap and trade, one that’s much more sophisticated than the old view that it’s wrong to let polluters buy the right to pollute. What Hansen draws attention to is the fact that in a cap-and-trade world, acts of individual virtue do not contribute to social goals. If you choose to drive a hybrid car or buy a house with a small carbon footprint, all you are doing is freeing up emissions permits for someone else, which means that you have done nothing to reduce the threat of climate change. … But altruism cannot effectively deal with climate change. Any serious solution must rely mainly on creating a system that gives everyone a self-interested reason to produce fewer emissions. …

The bottom line, then, is that while climate change may be a vastly bigger problem than acid rain, the logic of how to respond to it is much the same. What we need are market incentives for reducing greenhouse-gas emissions — along with some direct controls over coal use — and cap and trade is a reasonable way to create those incentives. …

The Cost of Action Just as there is a rough consensus among climate modelers about the likely trajectory of temperatures if we do not act to cut the emissions of greenhouse gases, there is a rough consensus among economic modelers about the costs of action. That general opinion may be summed up as follows: Restricting emissions would slow economic growth — but not by much. The Congressional Budget Office, relying on a survey of models, has concluded that Waxman-Markey “would reduce the projected average annual rate of growth of gross domestic product between 2010 and 2050 by 0.03 to 0.09 percentage points.” … Over all, the Budget Office concludes, strong climate-change policy would leave the American economy between 1.1 percent and 3.4 percent smaller in 2050 than it would be otherwise.

And what about the world economy? In general, modelers tend to find that climate-change policies would lower global output by a somewhat smaller percentage than the comparable figures for the United States. …

Such figures typically come from a model that combines all sorts of engineering and marketplace estimates. …

There are, … a number of ways this kind of modeling could be wrong. Many of the underlying estimates are necessarily somewhat speculative; … There is also reason to doubt the assumption that people actually make the right choices: many studies have found that consumers fail to take measures to conserve energy, like improving insulation, even when they could save money by doing so.

But while it’s unlikely that these models get everything right, it’s a good bet that they overstate rather than understate the economic costs of climate-change action. That is what the experience from the cap-and-trade program for acid rain suggests: costs came in well below initial predictions. …

… Even if you do not fully trust the models — … history and logic both suggest that the models are overestimating, not underestimating, the costs of climate action. …

The China Syndrome … China, which burns much more coal per dollar of gross domestic product than the United States does, overtook us by that measure around three years ago. Over all, the advanced countries — the rich man’s club comprising Europe, North America and Japan — account for only about half of greenhouse emissions, and that’s a fraction that will fall over time. In short, there can’t be a solution to climate change unless the rest of the world, emerging economies in particular, participates in a major way.

Inevitably those who resist tackling climate change point to the global nature of emissions as a reason not to act. Emissions limits in America won’t accomplish much, they argue, if China and others don’t match our effort. … Indeed, emerging economies feel that they have a right to emit freely without worrying about the consequences — that’s what today’s rich countries got to do for two centuries. It’s just not possible to get global cooperation on climate change, goes the argument, and that means there is no point in taking any action at all.

…Carrots, or positive inducements, are one answer. Imagine setting up cap-and-trade systems in China and the United States — but allow international trading in permits, so Chinese and American companies can trade emission rights. By setting overall caps at levels designed to ensure that China sells us a substantial number of permits, we would in effect be paying China to cut its emissions. Since the evidence suggests that the cost of cutting emissions would be lower in China than in the United States, this could be a good deal for everyone.

But what if the Chinese (or the Indians or the Brazilians, etc.) do not want to participate in such a system? Then you need …carbon tariffs.

A carbon tariff would be a tax levied on imported goods proportional to the carbon emitted in the manufacture of those goods. Suppose that China refuses to reduce emissions, while the United States adopts policies that set a price of $100 per ton of carbon emissions. If the United States were to impose such a carbon tariff, any shipment to America of Chinese goods whose production involved emitting a ton of carbon would result in a $100 tax over and above any other duties. Such tariffs, if levied by major players — …— would give noncooperating countries a strong incentive to reconsider their positions.

…Keeping world markets open is important, but avoiding planetary catastrophe is a lot more important. …[You] can argue that carbon tariffs are well within the rules of normal trade relations. As long as the tariff imposed on the carbon content of imports is comparable to the cost of domestic carbon licenses, the effect is to charge your own consumers a price that reflects the carbon emitted in what they buy, no matter where it is produced. …[The] World Trade Organization, which is charged with policing trade policies, has published a study suggesting that carbon tariffs would pass muster. …

The Costs of Inaction …[Climate] modelers themselves have grown increasingly pessimistic. What were previously worst-case scenarios have become base-line projections, … . Underlying this new pessimism is increased concern about feedback effects — for example, the release of methane, … from seabeds and tundra as the planet warms.

At this point, the projections of climate change, assuming we continue business as usual, cluster around an estimate that average temperatures will be about 9 degrees Fahrenheit higher in 2100 than they were in 2000. That’s a lot — equivalent to the difference in average temperatures between New York and central Mississippi. … And the troubles would not stop there: temperatures would continue to rise.

Furthermore, changes in average temperature will by no means be the whole story. Precipitation patterns will change, with some regions getting much wetter and others much drier. Many modelers also predict more intense storms. Sea levels would rise, with the impact intensified by those storms: coastal flooding, already a major source of natural disasters, would become much more frequent and severe. And there might be drastic changes in the climate of some regions as ocean currents shift. …

While there may be some benefits from a warmer climate, it seems almost certain that upheaval on this scale would make the United States, and the world as a whole, poorer than it would be otherwise. How much poorer? If ours were … [an]agricultural society, extreme climate change would be obviously catastrophic. But we have an advanced economy, the kind that has historically shown great ability to adapt to changed circumstances. …[The] same flexibility that should enable us to deal with a much higher carbon prices should also help us cope with a somewhat higher average temperature.

…[It’s] not just a matter of having warmer weather — many of the costs of climate change are likely to result from droughts, flooding and severe storms. The other is that while modern economies may be highly adaptable, the same may not be true of ecosystems. The last time the earth experienced warming at anything like the pace we now expect was during the Paleocene-Eocene Thermal Maximum, … when temperatures rose by about 11 degrees Fahrenheit over the course of around 20,000 years (which is a much slower rate than the current pace of warming). That increase was associated with mass extinctions, which, to put it mildly, probably would not be good for living standards.

So how can we put a price tag on the effects of global warming? The most widely quoted estimates, like those in the Dynamic Integrated Model of Climate and the Economy, known as DICE, used by Yale’s William Nordhaus and colleagues, depend upon educated guesswork to place a value on the negative effects of global warming in a number of crucial areas, especially agriculture and coastal protection, then try to make some allowance for other possible repercussions. Nordhaus has argued that a global temperature rise of 4.5 degrees Fahrenheit … would reduce gross world product by a bit less than 2 percent. But what would happen if, as a growing number of models suggest, the actual temperature rise is twice as great? Nobody really knows how to make that extrapolation. For what it’s worth, Nordhaus’s model puts losses from a rise of 9 degrees at about 5 percent of gross world product. Many critics have argued, however, that the cost might be much higher.

Despite the uncertainty, it’s tempting to make a direct comparison between the estimated losses and the estimates of what the mitigation policies will cost: climate change will lower gross world product by 5 percent, stopping it will cost 2 percent, so let’s go ahead. Unfortunately the reckoning is not that simple for at least four reasons.

First, substantial global warming is already “baked in,” as a result of past emissions and because even with a strong climate-change policy the amount of carbon dioxide in the atmosphere is most likely to continue rising for many years. So even if the nations of the world do manage to take on climate change, we will still have to pay for earlier inaction. As a result, Nordhaus’s loss estimates may overstate the gains from action.

Second, the economic costs from emissions limits would start as soon as the policy went into effect and under most proposals would become substantial within around 20 years. If we don’t act, meanwhile, the big costs would probably come late this century … So how you compare those costs depends on how much you value costs in the distant future relative to costs that materialize much sooner.

Third, and cutting in the opposite direction, if we don’t take action, global warming won’t stop in 2100: temperatures, and losses, will continue to rise. So if you place a significant weight on the really, really distant future, the case for action is stronger than even the 2100 estimates suggest.

Finally and most important is the matter of uncertainty. …The recent doubling of many modelers’ predictions for 2100 is itself an illustration of the scope of that uncertainty; … Beyond that, nobody really knows how much damage would result from temperature rises of the kind now considered likely.

… As Harvard’s Martin Weitzman has argued in several influential papers, if there is a significant chance of utter catastrophe, that chance — rather than what is most likely to happen — should dominate cost-benefit calculations. …

Still that leaves a big debate about the pace of action.

The Ramp Versus the Big Bang …On one side are economists who have been working for many years on so-called integrated-assessment models, which combine models of climate change with models of both the damage from global warming and the costs of cutting emissions. … Thus Nordhaus’s DICE model says that the price of carbon emissions should eventually rise to more than $200 a ton, effectively more than quadrupling the cost of coal, but that most of that increase should come late this century, with a much more modest initial fee of around $30 a ton. Nordhaus calls this recommendation for a policy that builds gradually over a long period the “climate-policy ramp.”

On the other side are …[those] who work with similar models but come to different conclusions. …Nicholas Stern, an economist at the London School of Economics, argued in 2006 for quick, aggressive action to limit emissions, which would most likely imply much higher carbon prices. This alternative position doesn’t appear to have a standard name, so let me call it the “climate-policy big bang.” …

The policy-ramp advocates argue that the damage done by an additional ton of carbon in the atmosphere is fairly low at current concentrations; the cost will not get really large until there is a lot more carbon dioxide in the air, and that won’t happen until late this century. And they argue that costs that far in the future should not have a large influence on policy today. …

The big-bang advocates argue that government should take a much longer view than private investors. Stern, … argues that policy makers should give the same weight to future generations’ welfare as we give to those now living. Moreover, the proponents of fast action hold that the damage from emissions may be much larger than the policy-ramp analyses suggest, either because global temperatures are more sensitive to greenhouse-gas emissions than previously thought or because the economic damage from a large rise in temperatures is much greater than the guesstimates in the climate-ramp models. …

The Political Atmosphere …[The] House has already passed Waxman-Markey, a fairly strong bill aimed at reducing greenhouse-gas emissions. It’s not as strong as what the big-bang advocates propose, but it appears to move faster than the policy-ramp proposals. But the vote on Waxman-Markey, … revealed a starkly divided Congress. … And the odds are that it would not pass if it were brought up for a vote today.

Prospects in the Senate, where it takes 60 votes to get most legislation through, are even worse. …

So the immediate prospects for climate action do not look promising, despite an ongoing effort by three senators — John Kerry, Joseph Lieberman and Lindsey Graham — to come up with a compromise proposal. (They plan to introduce legislation later this month.) Yet the issue isn’t going away. …

Paul Krugman is a Times columnist and winner of the 2008 Nobel Memorial Prize in Economic Science. His latest book is “The Return of Depression Economics and the Crisis of 2008.”

How companies manage sustainability

Most companies are not actively managing sustainability, even though executives think it’s important to a variety of corporate activities. Those that do are reaping benefits for themselves and for society.

McKinsey Quarterly

March 2010

More than 50 percent of executives consider sustainability—the management of environmental, social, and governance issues—“very” or “extremely” important in a wide range of areas, including new-product development, reputation building, and overall corporate strategy, according to the latest McKinsey survey.¹ Yet companies are not taking a proactive approach to managing sustainability: only around 30 percent of executives say their companies actively seek opportunities to invest in sustainability or embed it in their business practices, for example.

This survey explored how companies define sustainability, how they manage it, why they engage in activities related to sustainability, and how they assess as well as communicate this engagement.

Companies are defined as being most engaged with sustainability if their executives say that sustainability is a top-three priority in their CEOs’ agendas, that it is formally embedded in business practices, and that their companies are “extremely” or “very effective” at managing it.² … Energy companies, not surprisingly, also take a more active approach.

Why companies engage in sustainability

One potential reason so many companies don’t actively address sustainability despite the attention paid to it by the media and some consumers and investors is that many have no clear definition of it. … Among those that do, the definition varies: 55 percent define sustainability as the management of issues related to the environment … In addition, 48 percent say it includes the management of governance issues …, and 41 percent say it includes the management of social issues … .Fifty-six percent of all the respondents define sustainability in two or more ways.

Executives in business-to-business companies are likelier than their counterparts in consumer-facing companies to seek new growth opportunities through sustainability activities (20 percent, versus 14 percent).

Even with this range of definitions, most respondents see sustainability as creating real value…

The difference in views on short- and long-term value creation may be explained in part by the fact that building reputation is in a class of its own when compared with other, more immediately financial reasons for engagement such as alignment with the company’s business goals or improving operational efficiency. Indeed, 72 percent of respondents say considering sustainability is “extremely” or “very important” for managing corporate reputation and brands. In addition, 55 percent agree that investment in sustainability helps their companies build reputation, and 36 percent see building reputation as a top reason for addressing sustainability issues (Exhibit 1).

…But companies consider sustainability in a wide range of other business activities as well (Exhibit 2). …

Given sustainability’s importance, it’s surprising that only 27 percent of respondents say their CEOs or other C-level executives run their companies’ sustainability initiatives on a day-to-day basis.³ …

Uneven management efforts

Despite sustainability’s importance to various corporate activities, only a quarter of executives say it’s a top-three priority on their CEOs’ agendas. The lack of weight in leadership’s top agenda shows in the relatively small number of activities companies actually pursue related to sustainability… (Exhibit 3).

Companies where sustainability is a top-three priority on the CEOs’ agendas are likelier to pursue sustainability due to alignment with business goals (38 percent) than for building reputation (27 percent).

By contrast, senior executives in the energy industry take an active approach to managing sustainability, likely because of the potential for regulation and increasing natural-resource constraints. … Further, energy executives are much likelier than others to be active in seeking opportunities to invest in sustainability (40 percent versus 28 percent), to integrate it into their companies’ business practices (43 percent versus 29 percent), and to shape regulation actively (29 percent versus 16 percent).

Except among energy companies, reporting practices are relatively poor, considering the impact executives say sustainability has on business. Particularly in light of the role of sustainability in reputation-building efforts, for example, it’s surprising that companies do not take an active approach in communicating their initiatives externally (Exhibit 4). Indeed, 62 percent of respondents say their companies do not report sustainability metrics to investors or are unaware of their companies’ sustainability-reporting practices—even though more than 50 percent keep track of the value created by sustainability in terms of reputation building and cost savings (Exhibit 5).

The picture is again different for energy executives: 74 percent of energy executives incorporate sustainability when developing their companies’ regulatory strategies, compared with 53 percent of respondents overall. Similarly, 54 percent of respondents in the energy industry say their companies embed sustainability data in communications with investors, compared with 35 percent overall.

What the proactive do differently

Just over 6 percent of executives say that sustainability is a top-three priority in their CEOs’ agendas, that it is formally embedded in business practices, and that their companies are “extremely” or “very effective” at managing it. These engaged companies actively seek opportunities to invest in sustainability: 88 percent of the respondents in this group say so, compared with 23 percent of all others (Exhibit 6). …

Other findings indicate how much sustainability is a part of the fabric of these companies. Their executives, for instance, are more aware than executives at other companies of the metrics their companies track. … More importantly, among the group that is aware of what’s being tracked, the engaged companies are far more likely to be tracking relevant sustainability indicators such as waste, energy and water use, and labor standards for their suppliers and consumers.

In addition, these engaged companies do more than others to communicate externally the impact of their sustainability programs (Exhibit 7).

Dealing with regulation

Regulation, particularly environmental regulation, can have a very strong effect on companies’ sustainability activities. However, only about 35 percent of executives say their companies have quantified the potential impact of environmental and social regulation on their businesses; only 40 percent feel prepared to deal with regulation in the next three to five years and are personally confident about handling climate change issues. …

Looking ahead

• Seventy-six percent of executives say engaging in sustainability contributes positively to shareholder value in the long term. Companies that manage sustainability proactively are much likelier to seek and find value creation opportunities.
• Companies where sustainability is a top item in their CEOs’ agendas are twice as likely as others to integrate sustainability into their companies’ business practices. This suggests that senior executives who want to reap the benefits of incorporating sustainability into their companies’ overall strategies must take an active role in the effort.
• A first step to gain recognition and improve the impact of sustainability activities could be to communicate better with investors and other stakeholders.

Notes

¹ The survey was conducted in February 2010 and received responses from 1,946 executives representing a wide range of industries and regions.

² Energy companies, which are overall more engaged in sustainability activities than are companies in other industries (likely as a result of potential regulation and natural-resource constraints), were excluded from this group.

³ Also surprising, 11 percent of respondents say “no one” coordinates initiatives on a daily basis, and 5 percent are unsure.

About the Authors

Contributors to the development and analysis of this survey include Sheila Bonini, a consultant in McKinsey’s Silicon Valley office, Stephan Görner, a principal in the Sydney office, and Alissa Jones, a consultant in the Copenhagen office. They would like to acknowledge the contributions of their colleague Michaela Ballek.

A new look at carbon offsets

Carbon markets will continue to play a role in pricing—and limiting—emissions, but the opportunity in developing markets may be less promising than once expected.

McKinsey Quarterly

FEBRUARY 2010 • Marcel Brinkman

Source: Climate Change Special Initiative

In This Article

• Exhibit: Based on current proposals, the world will achieve only half of the emission reduction required to limit global warming to 2 degrees.

The CFOs of any company that uses or produces energy were naturally interested in the outcome of the recent Copenhagen round of global climate negotiations, for both the potential new costs and new opportunities. Although the conference did not lead to the legally binding global carbon reduction treaty that a lot of climate watchers had hoped for, many are still watching closely as regional (rather than global) carbon markets continue to evolve. For despite the uncertainty in Copenhagen, current global carbon market arrangements will probably survive. The pricing that these markets set for carbon emission allowances will continue to be increasingly important for businesses—in particular, those facing the cost of buying allowances (so-called carbon credits) or developing projects for which carbon credits are anticipated sources of revenue.

Emission caps and related carbon trading in developed nations are a very effective way to reduce carbon emissions if supported by other forms of regulation, such as energy-efficiency standards. …

However, the role of carbon markets in developing nations (through offset financing) is still unclear and might be relatively limited compared with their role in developed nations. … Indeed, if carbon markets do not take off in developed nations in a major way, companies could be left holding credits for which there is no demand.

The economics of offset markets

Even though a global deal remains elusive, domestic and regional carbon markets will continue to grow—from slightly less than €100 billion in 2008 to around €800 billion in 2020, according to recent McKinsey estimates. The European Union, for example, already has a domestic carbon market—currently the only one of its size, with trading volumes expected to increase as the market matures and liquidity increases. The United States is poised to establish one, with climate change legislation awaiting action this year. And a number of other countries … are considering the introduction of domestic carbon markets. At the same time, multiple regional markets exist (within the United States, for example) or are being considered (as in China), mostly voluntary in nature.

Companies in these markets have a choice of reducing their own emissions to stay within their caps, buying credits from other companies, or buying international offsets. … Without a mechanism linking the various domestic carbon markets, prices, driven by local market conditions, will probably vary significantly.

The offset market plays a key role, as it is the de facto international carbon price mechanism, in the absence of direct market linkage. In theory, an originator of offset credits—say, an offset project developer—can sell its credits to a government in an Annex I country¹ (which will use these credits to offset its carbon reduction commitments) or to a company in a domestic carbon market. These activities can create price arbitrage between various domestic carbon markets and the international carbon market.

Two factors hamper price equalization among the offset market, domestic carbon markets, and the global market as envisioned by the assigned amount units (AAU) established in the 1997 Kyoto Protocol on climate change.

• On the one hand, countries have limited the amount of offsets that can be imported into domestic carbon markets. For instance, the European Union will allow only 1.6 metric gigatons² (GT) of offset credits to be imported into its market from 2008 to 2020, or on average 0.1–0.2 GT per annum. …
• On the other hand, the demand for offsets from Annex I countries is less certain, as the global market is oversupplied with “hot air,”³ which limits the need to buy offset credits. …

Offset market supply also plays a key role in offset market prices. … As the market matures, more expensive sources of abatement, often requiring an upfront investment, will be pursued. Supply will also be determined by the offset market’s future structure. …There are also concerns about the so-called additionality of project-based offsets.⁴

Multiple proposals have been put on the table to scale up offset markets. …The eventual supply of credits and their relative cost will be determined by the choice of mechanism, as well as the type of offset credits allowed (for example, whether they include carbon capture and storage, nuclear power, or efforts to cut emissions by reducing deforestation and the degradation of forests).

McKinsey has developed a carbon market model based on the firm’s most recent greenhouse-gas-abatement cost curve.⁵ … The “hard” demand for offsets is expected to be around 1.4 GT by 2020—adding up demand from domestic carbon markets, including the European carbon market and the expected US one. …

The model calculates that 2020 carbon prices in the EU emission-trading system (around €29 a ton) will be well above the price in the offset market (around €13 a ton, which reflects the exhaustion of the system’s offset quota). The US carbon market price (€16 a ton) is much closer to the offset market price. The difference results from the offset discount factor proposed in the American Clean Energy and Security Act of 2009.⁶

Abatement: A modest role in developing countries

The Intergovernmental Panel on Climate Change (IPCC) suggests that the global community needs to limit emissions to 44 GT in 2020 in order to limit global warming to two degrees.⁷ That goal would require global cuts of up to 17 GT of emissions by 2020. A large share of this decline will have to take place in developed nations, but their potential is limited to 5 GT by 2020. Faster-growing developing nations have more room to make low-carbon choices in energy efficiency and power (6 GT by 2020), as well as most of the emission reduction potential of preserved forests (roughly another 6 GT by 2020).

McKinsey’s carbon market model offers a view on the likely outcomes of the global regulatory debate, and in particular the role played by carbon markets. To do so, the model assesses the effectiveness of existing and proposed climate change regulations, including those outside the emissions directly capped by carbon markets. …

A detailed assessment of all proposals from Annex I and non–Annex I countries currently on the table⁸ shows that the world will be able to realize only about half of the emission reduction potential required to limit global warming to two degrees (exhibit). Of this emission potential, three GT of reductions will be achieved as domestic abatements in Annex I countries, up to two GT will be international offsets (which count toward the domestic abatement of Annex I countries), and a further three GT will be achieved by autonomous action from developing nations, potentially with financial support from Annex II nations.⁹

Actions currently envisioned by developing countries include a 70 percent reduction of deforestation in the Amazon rainforest by 2017 (which Brazil has proposed) and the increase of renewable power in China to 15 percent of its energy mix in 2020. … South Africa, for instance, proposes to let its emissions peak in 2025 before reducing them after 2035.

Offset demand of up to 2 GT represents significant growth compared with 2008, when 140 megatons of offset credits were issued. Yet 2 GT is a relatively modest amount in light of the up to 17 GT of abatement required to limit global warming to two degrees.

We need to be critical of this assessment, however, as the scenario modeled is only one possible outcome of ongoing discussions. … Japan has already announced a target of reducing emissions 25 percent below 1990 levels by 2020. Although that goal is conditioned on the willingness of other countries to take similarly bold action…

Furthermore, developed nations proposed substantial financial support for developing ones in the nonbinding political Copenhagen Accord: $30 billion in the period from 2010 to 2012 and up to $100 billion a year by 2020. … However, it might not be possible to achieve the recommended environmental outcome even given a more ambitious scenario with stricter national targets.

As a result of this uncertainty, companies are likely to move away from projects—such as the capture of gases other than carbon dioxide and the reduction of emissions from cooking stoves,¹⁰ which are responsible for up to 18 percent of global warming—that rely completely on offsets as their income stream. Instead, they will look for projects that also have other income streams, such as power market revenues and government subsidies, even if these projects require significantly more investment.¹¹

About the Author

Marcel Brinkman is an associate principal in McKinsey’s London office.

Notes

¹ Under the Kyoto Protocol, Annex I countries are those 37 industrialized nations that committed themselves to a reduction of greenhouse gases.

² Metric tons: 1 metric ton = 2,205 pounds.

³ Russia, Ukraine, and various other Eastern European nations have emission caps above their current emission levels, because of the 1989 collapse of the Soviet Union. The result is a significant overhang of credits.

⁴ In other words, some projects might have been undertaken without any revenue from carbon credits and therefore may not have any “additional” environmental advantages.

⁵ McKinsey’s global greenhouse-gas-abatement cost curve assesses the technical potential to reduce carbon emissions and the cost by country, industry, and lever. For a full description, see “Pathways to a low-carbon economy,” available free of charge on mckinsey.com.

⁶ Sponsored by US Representatives Henry Waxman and Edward Markey, the act includes provisions on clean energy (and the transition to an economy based on it), energy efficiency, global warming, and agriculture- and forestry-related offsets.

⁷ This scenario assumes that carbon content in the atmosphere is reduced to 450 parts per million (ppm) by 2100, with an overshoot to 510 ppm in the intermediate period.

⁸ The proposals in the assessment include the recent submissions to the United Nations Framework Convention on Climate Change (January 31, 2010), the European Union’s commitment to reduce carbon emissions to 20 percent below the 1990 level by 2020, and the targets in the American Clean Energy and Security Act of 2009, passed by the US House of Representatives in 2009 and awaiting consideration by the Senate.

⁹ An Annex I subset of nations that have made a commitment to pay the incremental cost of mitigation and adaptation for developing (non–Annex I) nations. Annex II nations are Australia, Austria, Belgium, Canada, Denmark, the European Union, Finland, France, Germany, Greece, Iceland, Ireland, Italy, Japan, Luxembourg, the Netherlands, New Zealand, Norway, Portugal, Spain, Sweden, Switzerland, the United Kingdom, and the United States.

¹⁰ See Elisabeth Rosenthal, “Third-world stove soot is target in climate fight,” New York Times, April 15, 2009.

¹¹ A company can claim offset income, however, only if a project is not otherwise expected to make a hurdle rate of return. The upside of such investments is therefore capped.

Carbonflow-The Salesforce.com for Carbon Offset Transactions

Semantic Seed
on Thursday, 29 October 2009
by Janice Williams Oliver

“The World Bank, says Neal Dikeman, co-founder/CEO and Chairman of the Board for Carbonflow™, reports approximately $126 billion dollars in carbon offset transactions have occurred, of that only $500 million were in the USA.”  Carbon offset trading is very active internationally and at some point will gain greater traction in the USA because this year, [both the House and Senate are considering bills to reduce global warming pollution and transition to a clean energy economy].  …
The United Nations Framework Convention on Climate Change (UNFCCC) says “the central feature of the Kyoto Protocol is its requirement that countries limit or reduce their greenhouse gas emissions. … To help countries meet their emission targets, and to encourage the private sector and developing countries to contribute to emission reduction efforts, negotiators of the Protocol included three market-based mechanisms – Emissions Trading, the Clean Development Mechanism (CDM) and Joint Implementation.”
“CDM offsets comprise 90% of all carbon offsets traded worldwide,” says Richard Barber, Chief Technical Officer/VP of Engineering at Carbonflow™.   The UNFCCC further states, “CDM allows emission-reduction (or emission removal) projects in developing countries to earn certified emission reduction (CER) credits, each equivalent to one tonne of CO2.  These CERs can be traded, sold, and used by industrialized countries to meet a part of their emission reduction targets under the Kyoto Protocol.  The mechanism stimulates sustainable development and emission reductions, while giving industrialized countries some flexibility in how they meet their emission reduction limitation targets.”  …
“The projects must qualify through a rigorous, public registration and issuance process designed to ensure real, measurable and verifiable emission reductions that are additional to what would have occurred without the project.  … It is the first global, environmental investment and credit scheme of its kind, providing a standardized emissions offset instrument, CERs,” says the UNFCCC.
CDM uses three auditing companies in its approval process.  They are Det Norske Veritas (DNV) of Norway, SGS United Kingdom Limited and TÜV SÜD in Germany.  …
“Carbonflow™ provides unique browser-based products and services that empower any organization to manage and monitor greenhouse gas reduction projects on a secure multi-party platform. Employing HOpE™ (Hybrid Operating Environment) principles, Carbonflow™’s solution provides accessible technology to everyone – including those in developing countries with limited online access.”  … It takes 2 years for a project to receive approval using the current CDM process; Carbonflow™ predicts that using their software will cut the CDM process down by six months to a year.
Why does the future for Carbonflow™ look bright?  It is the only company working with CDM’s auditors to automate their process. It is likely the CDM system will be expanded to include the USA.  Or, the USA will create a separate CDM system.  In both instances, the CDM auditors will be consulted/used and Carbonflow™ will definitely benefit.
At first I thought Carbonflow™ was an enterprise carbon accounting company like … Verisae who includes Walmart as one of its customers.  There are over 40 carbon software companies in the marketplace today.  Large companies like SAP and Microsoft are purchasing them to get into the carbon accounting business.  Carbonflow™ appears to be ahead of the curve.  Neal says “Carbonflow™ has no competition.”  The existing carbon accounting software companies are used in-house for carbon measurement purposes.  Carbonflow™ provides a multi-party platform that coordinates CDM activities internationally.
What are the opportunities for entrepreneurs specifically in carbon software management/accounting and/or Cleantech?  “Cap and Trade will put a new cost in everyone’s supply chain.  It will be a 10 year exercise,” says Neal.  Multiple green jobs and opportunities will be created to satisfy this demand. …