Green Tea and Greenhouse Gases

“The targets can’t be revised and we must work resolutely to reach them.”

That’s what Chinese Premier Wen Jiabao said in March 2007, at the fifth full session of the tenth National People’s Congress. It was in the context of a vow that the government would meet previously established energy-saving and pollution control targets by 2010 despite recent setbacks.

The statement reflected growing concern about pollution, especially greenhouse gas (GhG, the culprit in global warming) emissions globally and in China: in April 2007 the U.S. Supreme Court ordered the federal government to revisit regulating carbon dioxide emissions from cars (emissions were previously considered unregulated pollutants; in the same month China’s National Coordination Committee for Climate Change (NCCCC) was expected to announce new policies for reducing GhG. These were especially important because China’s unprecedented recent economic growth has resulted in significant environmental damage: GhG emissions are expected to surpass those of the US by 2010; China has eight of the ten most polluted cities globally; air pollution is estimated to contribute to over 1.5 million years of life lost annually in the country.

Against this backdrop is presented an analysis of opportunities for and barriers to capitalizing on global emissions trading markets to institute a domestic emissions trading program in the People’s Republic of China.


A Primer on Greenhouse Gases

First, some basics on GhG. All objects emit electromagnetic radiation, with its intensity based on a given object’s temperature. Some of the radiation earth emits is absorbed by molecules in the atmosphere which reradiate the energy, some toward space and some toward earth. The latter radiation causes earth’s temperature to increase at the surface, also known as the “greenhouse effect.” The key issue, then, is that the more molecules in our atmosphere that can absorb long wavelength radiation, the greater the greenhouse effect.

And we are adding many such molecules to our atmosphere, through GhGs including carbon dioxide (CO2), the largest contributor to the greenhouse effect. Combustion of fossil fuels including coal, natural gas, and petroleum products (e.g., gasoline) always releases CO2 as a byproduct. There is a strong link between recent changes in atmospheric CO2 concentrations and increases in average global temperature, which have been especially evident since about 1900. Consequences of this trend include the disappearance of low-lying coastal land due to the melting of polar ice caps, along with the warming/drying of low-latitude regions and more extreme global weather patterns.

What are the major sources of GhGs? Energy consumers (e.g., for transportation and electricity/heat) represent the largest emitters of GhG, with residential buildings and road-based transportation as the largest specific sources. Thus measures such as more effective insulation and fuel efficiency can limit these sources’ impact. Note, however, that deforestation nearly equals these two sources in GhG output, suggesting the potential for an emissions trading system: you can offset the GhGs your car produces by encouraging someone else to reduce their automobile use or to plant a tree.


The Ins and Outs of Emissions Trading

Emissions trading is a market-based mechanism for environment protection and pollution control whereby an entity can choose either to undertake emission reduction or purchase emission credit on the open market through private negotiated transactions or a climate exchange. In 1997, to illustrate emissions trading’s benefits, MIT’s Global Change Joint Program developed aggregate supply and demand curves for emissions permits; the models revealed the astonishingly low cost of reducing global CO2 to target levels: $11 billion, versus $120 billion with no emissions trading.

Emissions Trading Markets
Two main emissions market types were studied: (1) cap and trade markets and (2) credit/project-based markets.

Cap and Trade
The cap and trade system sets an overall maximum amount of emissions per compliance period (typically annual) for a given entity, by allocating a fixed number of emissions allowances. If the entity is below this cap at the period’s end, they have allowances to sell; if above, they must purchase allowances from companies with a surplus. Credits are traded either on exchanges (European Climate Exchange or Chicago Climate Exchange; ECX or CCX) or through non-public over-the-counter markets.

According to the Kyoto Protocol, signatory countries must reduce total GhG emissions to 1990 levels by 2012. Reduction credits may be obtained through (1) Clean Development Mechanism (CDM), UN-approved GhG-mitigation projects in developing countries (e.g., China) that generate Certified Emission Reduction (CER) credits that can be traded with developed nations and (2) Joint Implementation (JI) projects, or UN-approved GhG-mitigation projects that developed nations can undertake to generate credits tradable with other developed nations.

As part of the EU Trading System (EU ETS), EU allowances (EUAs) can be traded on the ECX, with each EUA representing one ton of CO2 (right-to-emit). In 2006, 452 million tons were traded in ECX CFI Futures Contracts, with an underlying value of EUR 9 billion. CERs from CDM projects can potentially be used in the EU ETS; credits from JI projects can also be used, as of 2008. Specific types of both credits are excluded (e.g., those from large dam projects).

Project-Based
Companies that have committed to voluntary reduction targets may seek to obtain emissions credits directly from another company or through a broker. The California Climate Action Registry (CCAR) registers entity-wide emissions but has no current mechanism for registering/trading project-based emissions reductions; this mechanism is currently being developed.

The Chicago Climate Exchange (CCX) is an emission registry, reduction, and trading system for all six GhGs. CCX is a self-regulated, rules-based exchange wherein members make voluntary but legally binding GhG-reduction commitments, as measured in metric tons of CO2 equivalent. Each CFI contract represents 100 metric tons of CO2 equivalent. All CCX members were expected to have reduced direct emissions 4 percent below a baseline period (1998-2001) by the end of 2006, with a 6 percent reduction by 2010. As with the ECX, the CCX allows offset projects (e.g., CDM-eligible), but the trade volume of these is minimal. The CCX runs an internet-accessible marketplace with a clearing and settlement platform that processes all transaction information.

Trading Regulation
Regulation of the European market is conducted by each member state. Compliance is achieved by surrender to the member state a number of allowances equal to the total verified emissions from that entity during the preceding calendar year. The CCX, on the other hand, has contracted with the SEC-supervised National Association of Securities Dealers (NASD) as its regulatory body. The NASD admits new entities to the CCX, reviews annual compliance, and oversees the CCX trading model. For example, CCX-member Amtrak reports emissions to NASD, which audits these through random sampling (e.g., total diesel fuel used in a given location) and outside verification.


Emissions Trading Systems and China

Regulatory efforts for GhG in China are led by the National Development and Reform Commission (NDRC). At present, CDM projects considered a priority in China include energy-efficiency efforts, development/utilization of renewable energy, and recovery/utilization of methane. A National CDM Board, comprising stakeholders including the NDRC and Ministry of Science and Technology (co-chairs), Ministry of Agriculture, and China Meteorological Administration, reviews CDM projects on multiple dimensions (e.g., qualification, methodology, monitoring plan). Revenues from the transfer of CERs are owned jointly by the project owner and the Chinese government, with the government using its share to support activities on climate change. China leads the world in supplying CDM credits: 50 percent market share in 2006.

Timelines for Emissions Trading Systems
Despite this, a one-size-fits-all approach to reducing GhG will not work in China. Thus a customized emission trading system would be in order, as would be segmentation of industries in question along several dimensions.

Because cap and trade systems require extensive inventorying, regulatory/monitoring, and reporting frameworks, designing such a system for China will take significant time and effort. Thus a long-range timeline is suggested for instituting such a program in China, with an initial promotional/educational phase, followed by enhanced capacity-building and maturity of regulation/enforcement longer-term.

A more detailed timeline is recommended for Chinese project-based programs: in the short-term, CERs generated by CDM-related projects will be candidates for trading on the ECX platform; mid-term, establishing a self-regulating structure for voluntary climate exchange in China would be a challenge, given the government’s involvement in most regulatory activities, so market/non-market-based drivers will move project-based trades forward (e.g., non-CDM projects as candidates for trade on the CCX voluntary market); long-term, an in-country cap-and-trade program may diminish the volume of trades with EU-ETS, but CCX-based opportunities (related to emissions reductions from mid- and small-scale sources) may increase.

Market Segmentation
Chinese sectors can be segmented into those most likely to focus on CDM and non-CDM projects. CDM projects typically have a high technology component, a proven reduction capability, and a higher market value. Thus natural target industries for such projects are electricity, transportation, and steel. Buyers and sellers for CDM-related CERs use ECX as their primary platform. Chinese industries most likely to generate CDM-related CERs were analyzed along several dimensions including technological changes, efficiency improvements, and policy shifts to present several opportunities in these sectors: specialty equipment (e.g., catalytic converters) to improve coal quality and reduce emissions; moving plants to less polluted regions; using factory power in a load-balanced manner to distribute emissions over a longer period.

Smaller-scale Chinese industries may emit significant GhG, but cannot afford expensive CDM projects. Thus it is suggested that some of these sectors/projects (e.g., landfills, university projects) could leverage voluntary markets like CCX for their carbon reduction.


Global Climate Change and Business Opportunities

The increased focus on global climate change creates a large pool of potential business opportunities that serve the goal of protecting and improving the environment. These include:

• Consulting: As China and the rest of the world enter this potentially huge environment-related market, there will be many opportunities for experts/consultancies to provide support in areas including reduction technologies, pricing analysis, forecasting, and auditing. Start-up and established firms could serve these needs.
• Verification: Just as the NASD regulates the CCX, there are opportunities for regional market verification, with revenue derived from membership fees.
• Technology/Monitoring Tools: Technology-related opportunities exist in several linked areas: emissions-reducing technology; technology to help make the switch to clean technology; monitoring of all emissions-related technology. For example, there is major opportunity for the development of an affordable pollution-monitoring device.
• Global Clearance/Settlement: The need for seamless clearance and settlement of trading units is expanding with the number of market participants. Currently there is little fungibility between markets, and the over-the-counter market is cleared manually. This is a lucrative area of opportunity.
• Insurance/Guarantee Products: There are ample opportunities for entities to insure or create hedging products allowing the risk of projects in this area to exist away from the producer or credit purchaser.
• Financial Derivative and Data Products: Large financial intermediaries can create financial products/hedges that track not only the underlying emissions products but also the value of the company supplying or purchasing credits.
• Private Equity and Venture Capital: With over $100 billion of private equity aimed at investment in China, funds/resources could be directed toward carbon/emissions reduction opportunities and technology.

Despite these opportunities it is unlikely that China will have a domestic climate exchange in the near future. Nonetheless, as China introduces and enforces more stringent emissions standards, opportunities to help make the country one of the largest contributors to global GhG-reductions will not only grow, but be more crucial than ever.