The Obama Agenda: Eagerly awaiting cap-and-trade
With future bottom lines at stake, carbon traders are anxiously watching and waiting as Congress works on a cap-and-trade bill. The prospect of the creation of a new nationwide carbon market has dealers, bankers, venture capitalists and private equity firms eyeing every nuanced provision of the legislation. Each provision, from price controls to market regulation to carbon offset caps will affect the profits that environmental investment firms could reap from the cap-and-trade legislation – if it is passed.
Cap-and-trade is a regulatory structure in which the government sets a limit – or cap – on overall emissions of pollutants. The system then allows manufacturers, utilities and other emitters to trade pollution permits, or allowances, amongst themselves. The cap on emissions would become more stringent over time, raising the price of emission allowances, and presumably coercing industry to find more environmentally friendly ways of producing energy.
“We're just asking for market-based, science-based rational rules,” said David M. Williamson, a lobbyist and counsel to the Carbon Offset Providers Coalition. “And if we have those, we're going to deliver literally billions of dollars of stimulus investment into low-carbon technologies over the next ten years. And we can get going tomorrow, if we had a sufficiently clear signal from Congress.”
In the program, companies would also be permitted to buy offsets as an alternative to reducing emissions. Offsets allow emitters to avoid cutting their own emissions by instead investing in projects such as tree planting, capture of livestock-manure gases, and methane-capture programs at landfills that take pollutants out of the atmosphere.
“There are good investment opportunities out there because these projects make sense,” Williamson said. “They make sense from an environmental standpoint and they make sense from a financial standpoint. So the idea is to let the marketplace find the best cost-benefit point and to put investment money in there, and of course the folks who invest in these technologies are going to make, we hope, some reasonable return on that money. That’s exactly what a market-based approach should encourage.”
In June, the House of Representatives passed its version of a cap-and-trade bill, the American Clean Energy and Security Act, by a vote of 219 to 212. The bill would require U.S. emissions to decline 17 percent by 2020 and 83 percent by 2050 from 2005 levels.
To reach those emission reduction goals, the bill sponsored by House Energy and Commerce Committee Chairman Henry A. Waxman, D-Calif., and Rep. Edward J. Markey, D-Mass., allows emitters to acquire up to 2 billion tons of carbon offsets annually, with half of those credits coming from domestic carbon-reducing projects and half coming from international carbon-reducing projects. However, the legislation allows for more international offsets when there are insufficient domestic offsets available.
In the Senate, Sens. John Kerry, D-Mass., and Barbara Boxer, D-Calif., have drafted similar legislation to the Waxman-Markey bill, but the entire Senate will not start debating the issue until 2010 – after the health care debate and most likely after the chamber takes on the issue of financial reform.
Meanwhile, Kerry, along with Sen. Lindsey Graham, R-S.C., and Sen. Joe Lieberman, a Connecticut independent, are working on another bipartisan climate change bill, the details of which have yet to be released. The Senators have stated that they plan to mix a market-based system with more provisions for nuclear energy and environmentally sensitive onshore and offshore oil and gas exploration.
Should some version of a cap-and-trade bill become law, a large domestic market in carbon offsets would be created.
“We want a very large carbon market where we have prices put on carbon emissions,” Williamson said.
Two privately-owned, New York-based environmental investment firms that trade carbon assets – Natsource and Equator – are watching Congress’ negotiations closely.
These firms and hundreds of other environmental investment firms have a lot to gain from the legislation.
Environmental investment firms conduct business in different ways. Natsource creates and manages carbon funds, advises clients and lobbies on their behalf. Equator invests in forest carbon and other environmental commodities in addition to investing in Latin American forests and timber. Still other environmental investment firms develop offsets through landfills, wind power and numerous other projects.
Even without a nationwide carbon market, environmental investment firms are already trading carbon through a voluntary carbon market, the European Union Emission Trading System and through the northeast’s Regional Greenhouse Gas Initiative - the first mandatory, market-based carbon emissions reduction program in the United States.
California lawmakers and regulators are also ironing out the details of a statewide cap-and-trade program that is close to fruition. Still, a nationwide cap-and-trade program would be a game-changer.
“If Europe continues along the same path that they have been on, and you have just added basically an economy larger than Europe, yes, of course, the market will grow,” Eron Bloomgarden, president of environmental markets at Equator said.
Milo Sjardin, an analyst with New Energy Finance, a firm that tracks the carbon trading market, agrees.
“These types of firms are going to be hugely affected by any climate change legislation,” Sjardin said. “The main reason is that offsets are going to play a very large role in any bill that might be passed. So if offsets are going to play a big role, then naturally the firms that have a lot of experience in that space and know where to get the emission reductions and how to achieve those most cost effectively will be in a very good position going forward.”
Natsource was one of the first and is one of the biggest and companies in the environmental investment industry. The company had approximately $800 million in assets under management as of March 31, 2009 according to its Web site. Natsource has sold carbon credits to entities like the government of Portugal and large European energy companies. New Energy Finance ranked Natsource as the world’s largest purchaser of carbon credits.
Equator is another prominent player in the industry.
In October, Equator announced a partnership with Sierra Pacific Industries – the second largest lumber producer in the United States – to develop offsets by sequestering 1.5 million tons of carbon dioxide. Lumber companies can create carbon offsets by pledging to keep the numbers of trees in the project forest area above a certain level. Bloomgarden said that Equator would sell some of the credits gained in the partnership and would hold onto some of the credits as well.
“[Firms] can either sell offsets directly onto an exchange or, for example, they could leverage the contacts they've already got – oil and gas companies or utility companies – to sell those offsets directly for their compliance needs,” Sjardin said.
If the House cap-and-trade proposal was enacted, the Environmental Protection Agency found that carbon prices would range from $13 to $17 per ton in 2015. Carbon costs would reach $17 per $22 per ton, five years later, by 2020.
Under the Waxman-Markey bill, approximately 85 percent of carbon credits would be given away for free by the government and about 15 percent of the carbon credits would be auctioned off at the start of the program.
The government would give out some of the credits to industries that would be regulated under the new legislation. These businesses include: high energy demanding industries like iron and steel, oil refineries, and electric utilities.
Other credits would be given to businesses that would not be directly affected under the bill. These businesses would sell the credits and use the profits for mandated, specific purposes like energy efficiency, new technology and holding down consumer energy prices. These businesses include: local electricity distribution companies, state governments, local natural-gas distribution companies and the automobile industry.
All credits given away under the legislation would essentially be gifts worth significant money, but environmental investment firms will be unaffected monetarily by the carbon credit giveaways.
Still, they are tightly monitoring the rules that Congress is writing.
“You have got to minimize costs on customers,” Rich Rosenzweig, Natsource chief operating officer said. “And one of the ways you do that is with allocation. So there are a lot of people that like big auctions of credits. We don't. We prefer providing some of the allowances to the companies and letting them figure out how best to reduce their costs.”
But many details in the proposed United States cap-and-trade scheme still have to be determined – among them are price controls, market regulation and offset caps. The rules that Congress creates will help to determine the profits that the environmental firms could reap.
Price Controls
If the House and Senate bills are any indication, it is likely that price controls – a price floor and a price ceiling on the price of carbon – will be put into the legislation to allay fears of huge price fluctuations.
A price floor would be a clear signal to investors that credits that they purchased would not decrease in price. In fact, both bills incorporate an escalating price floor, which would ensure that carbon credits would appreciate in value over time. Because of these guarantees, the government is essentially making certain that there will be demand for the credits.
A price ceiling would be a welcome sign to polluters that the prices of allowances would not skyrocket and become unaffordable.
“If you look at the European carbon market, it's three times as volatile as the stock market,” economist Steven Stoft, author of “Carbonomics,” said. “Price controls make carbon a safer investment because you know the price can't go too high or too low. It's quite helpful on the volatility question.”
The House and the Senate legislation looks pretty similar in terms of price floors and ceilings. The House legislation provided a $10 per ton price floor for carbon permits in 2012 and a “strategic reserve” of permits to be held by the government and auctioned off if prices for carbon permits rise very high. The $10 floor rises at five percent plus inflation in subsequent years.
The Senate legislation provides for an $11 floor for carbon permits and a $28 ceiling in 2012, with both increasing over time.
“Theoretically, it would be better not to restrict the price,” Bloomgarden said.
He said that restricting the price would mean that the price of carbon would not truly reflect the actual cost of the environmental objective that the cap-and-trade program was driving towards.
Still, Bloomgarden said that he was willing to compromise.
“Can we live with a fairly broad price band? Sure. I think what we're seeing at the moment is a fairly broad range which I don't think will be too restrictive on the market.”
Market Regulation
Another detail of the legislation to be worked out is how and where carbon offsets can be traded. The question is whether all trades must be brokered at an exchange or whether transactions can be completed on the side – or “over-the-counter,” a form of derivative trading.
After the financial crisis – which was intensified by derivative deals – there has been hesitancy in Congress to allow unregulated over-the-counter, derivative trading of carbon.
“I know the Wall Street crowd can't wait to sink their teeth into a new trillion-dollar trading market in which hedge funds and investment banks would trade and speculate on carbon credits and securities,” Sen. Byron Dorgan, D-N.D., said in an opinion piece in the Bismarck Tribune. “In no time they'll create derivatives, swaps and more in that new market. In fact, most of the investment banks have already created carbon trading departments. They are ready to go. I'm not.
“For those who like the wild price swings in the oil futures market, the unseemly speculation in mortgage-backed securities, or the exotic and risky financial products like credit default swaps that pushed our economy into the ditch, this cap-and-trade plan will be the answer to their prayers.”
Bloomgarden said that due to the nature of carbon offsets, environmental investment firms needed the ability to trade carbon over-the-counter and away from exchanges. Bloomgarden said it would not make sense to have all carbon trading done on exchanges.
“There are some proposals to trade carbon only over exchanges and you know it's a reaction to credit derivatives, and I think it sort of misses the point,” Bloomgarden said. “When you have an exchange trade requirement, it means that every contract has to fit a specific mold, a specific structure and that just doesn't necessarily work when you are talking about carbon. It doesn't give the flexibility that the market participants would need.
“It would be as if you were saying, if you wanted some corn, you could go to the farmer down the street and agree with him on a price and buy his corn, but then you would have to bring the corn to an exchange and buy it there.”
Bloomgarden said that over-the-counter carbon trading is often used as a hedge to mitigate risk. He cited an example of a small-scale farmer who developed offsets by investing a certain amount of money in a methane reduction offset project.
Bloomgarden said the farmer would not have the sophistication or experience with these types of projects to bring his offsets to an exchange, but the farmer would have an easier time selling his offsets to an experienced aggregator or environmental investment firm as an over-the-counter trade. By selling the offsets to the aggregator, the farmer and the aggregator could mold their trade on their terms and the farmer could lock-in a return on his original investment. Bloomgarden said that an exchange deal would not allow for this kind of flexibility.
Dirk Forrister, Natsource managing director and head of International Emissions Trading Association’s market oversight committee, acknowledged that it was a tough time to be promoting derivative transactions.
“The word derivative has become a bit of a boogey man,” Forrister said. “And part of that is just because of the alarm bells all around credit default swaps and other types of derivatives involved in the mortgage markets. In emissions markets, there haven't been any instances of real problems with derivatives – any maybe it's because we're small and new – but really it's a problem that carbon markets should not encounter.”
The Waxman-Markey bill would require all derivatives trades – including carbon derivatives trades – to be handled on an exchange that would be registered with the Commodity Futures Trading Commission. This provision in the House legislation would do away with the over-the-counter trading market. In addition, when Congress takes up financial reform legislation in 2010, it may try to drive more over-the-counter transactions onto exchanges.
Still, Natsource is not giving in.
“We want to have access to both exchanges and over-the-counter markets because we see a role for both,” Forrister said. “Right now, some of the legislative initiatives have been tilting the table toward exchanges, and we don't think that that is wise just because certain types of carbon products, the contracts that trade aren't standardized enough to go on an exchange. It wouldn't work.
“You really need a contract that is tailored to the specific needs for the project itself and the developer involved. So we've been trying to educate on Capitol Hill about how these markets have evolved and the importance of the flexibility that over-the-counter markets bring for offset projects.”
Offset Caps
Another legislative provision that needs to be decided upon by Congress is the amount of offsets permitted in the cap-and-trade system.
In both the Waxman-Markey and Kerry-Boxer bills, carbon offsets are capped at 2 billion tons per year, but the Waxman-Markey bill allows for more international offsets than the Kerry-Boxer bill does.
The House bill caps international offsets at 50 percent of total offsets allowed (except when there are not enough domestic offsets available) while the Senate bill caps international offsets at 25 percent of total offsets allowed.
“We think that the House provisions make more sense,” Rosenzweig said. “Although people would naturally want to do more domestically, the fact is that there's going to be probably more available internationally.”
Williamson’s clients do not want any caps. Although he said they may be willing to compromise.
“We don't think there's any rational policy justification for any caps,” Williamson said. “But the caps are sufficiently high that if there were clear market rules that we could actually get projects approved, then we'd be willing – as a political compromise – to live with the caps that are in the bills.”
Sjardin said that the higher the offset caps were set at by Congress, the better off the environmental investment firms would be. More caps would mean more trading for the firms.
With provisions in each bill that he likes, Rosenzweig stressed that the most important thing was just to get a cap-and-trade program up and running.
“If you want to address climate change, delay can be costly,” Rosenzweig said. “So what's important is to get a workable program that provides a price signal on carbon and provides markets so companies can figure out the cheapest way to comply over time. As caps get more stringent, new technology will come online and you can achieve more of your objectives.”
A cap-and-trade system would be new to the United States, but Europe introduced its own system, the European Union Emissions Trading Scheme, in 2005. If Europe is any indicator, Natsource and Equator and the other environmental asset managers are in prime position to reap benefits from the new legislation.
Sjardin said that some environmental asset firms profited a great deal from Europe’s cap-and-trade system by creating and trading international offsets.
“Firms did very well because offsets were a key component of that scheme as well,” Sjardin said. “They made investments all over the world in China, Brazil, Mexico and India, creating a lot of offset projects and trading on the back of those.”
Even if Congress cannot pass a cap-and-trade bill in 2010, Sjardin said the issue would likely reemerge in the near future.
“The whole cap-and-trade issue is not going to go away,” Sjardin said. “So even if the bill fails next year, we're likely to see legislation back in 2011.”
