The eco-nomics of carbon markets

Did you find carbon offsets under your tree on Christmas morning?

For $99, a website called sells offsets for 50,175 lbs of carbon—roughly the carbon footprint of the average American. For $29, Terrapass offers the “Around Towner,” which, the company says, funds the reduction of 6,000 lbs of carbon. (According to Terrapass’s carbon calculator, that’s how much I need to offset a year of emissions from driving my 1994 Volvo 850 the 6,000 miles or so that I travel.)

This trade in voluntary, feel-good and largely unregulated carbon offsets remains relatively small and a little sketchy. See, for instance, this Business Week story from last March that criticized Terrapass. You can feel better about dealing with The Carbon Fund, a nonprofit with an impressive list of partners.

Several people I know buy offsets. Katy Goldstein, the daughter of my college roommate Warren Goldstein, bought some for her brother. Al Gore and his business partners, John Doerr and David Blood, told me last fall that they buy carbon credits to offset the emissions they create by driving, flying, consuming and the like. Companies like News Corp. and Allstate buy offsets to reduce their carbon footprints. Hey, it can’t hurt.

But offsets are only small slice of a big, fast-growing market in carbon emissions. In fact, the business of buying and selling emissions in places where they are regulated, predominantly the EU and Japan, is the one that really matters. About 1.2 gigatons of CO2e with a value of about Eu15.8 billion was traded in the first half of 2007, according to Point Carbon, a company that analyzes and consults on carbon emissions markets. This business will get a whole lot bigger if, as expected, the U.S. enacts mandatory controls on carbon emissions. That's why most of the world’s big financial firms—Barclay’s, Goldman Sachs, Morgan Stanley, Merrill Lynch, J.P. MorganChase, etc.—are getting into emissions trading in a big way. Carbon emissions trading is dizzyingly complex but important, so, to learn a bit more about it, I recently went to see Veronique Bunion, who runs Point Carbon’s Washington office.

Veronique lives and breathes carbon emissions. (No, not literally.) She has a PhD in climate physics and chemistry from MIT, as well as a masters in environmental and energy policy. She worked at Goldman and at Constellation Energy before opening Point Carbon’s office in Washington in 2006. The company, which was started in Oslo in 2001, has about 140 employees and 15,000 clients. J.P. MorganChase is an investor, as is private equity firm Oak Capital.

“We’re a bunch of carbon nerds,” Veronique tells me, cheerfully. “We can quote from the Kyoto Protocol. We’ll read 250 pages of the Lieberman Warner bill for fun on a Saturday night." Turning serious, she explains, "This is the most complicated problem out there. If I’m going to look for a challenge in life, this might as well be it.”

Like all markets, the carbon emissions market is driven by supply and demand. The demand for emissions credits comes from regulated companies, mostly electric utilities and industrial firms in Europe and Japan, which need carbon allowances to burn coal or to produce steel or chemicals. The supply can come from many places—other European or Japanese companies that are able to reduce their emissions, and thus have allowances to spare, or from what are called Certified Emissions Reductions (CER) projects in the developing world under a scheme called the Clean Development Mechanism (CDM).

Carbon emissions currently trade for about 22 euros a ton on the European market, according to Point Carbon. The voluntary offsets sold by The Carbon Fund and Terrapass are much cheaper - $4 a ton and $10 a ton, in the examples cited above.

The Clean Development Mechanism is controversial. CDM projects cover a variety of areas—capturing landfill gas, developing wind turbines or hydropower, plugging leaks in gas lines and, most commonly so far, capturing powerful greenhouse gases, called HFCs, that are generated by factories, mostly in China, that produce refrigerants. By some estimates, more than half of the first 800 CDM projects involved HFCs, which are such potent gases that the factories made more money by trapping them and selling emissions credits than they could by selling refrigerants. An article in the journal Nature (referenced here) call this a $6 billion distortion in the carbon market.

Veronique defends the CDM against its critics. “Overall, it’s a very good thing,” she tells me. “The hurdles to get a project qualified are stricter than people realize. Yes, there were some very cheap, very lucrative reduction opportunities. The classic examples are the refrigerant projects in China and India. Those are off the table now. They’ve all been done.”

That’s the idea behind the cap-and-trade approach to reducing emissions. Because the market is efficient, at least in theory, it will seek out the cheapest, easiest carbon reduction projects first, and then move on to projects that are more costly and difficult. (When it comes to climate change, it doesn’t matter where a ton of carbon or carbon-equivalent gases comes from.) The sticky question, though, is whether the carbon reductions bought and paid for under CDM would have taken place anyway, without the sale of credits—a concept known as “additionality.” You don’t want to pay someone to take an action that makes economic sense without the credits, like capturing methane gas from a landfill and burning it to generate electricity.

Carbon markets raise a slew of other issues, including whether to allocate or auction the allowances, whether to regulate emissions upstream (at a wellhead or oil refinery) or downstream (at the gas pump), where the markets will be located, who will oversee them, and how transparent they will be. These will all be part of the debate next year as Congress debates climate change legislation.

Yes, all this is complicated—but getting the carbon market right is absolutely vital, if we want to reduce emissions in a way that makes economic sense. I didn’t buy any offsets for the holidays, but my winter reading list includes books and articles on environmental markets. It's at times like this that I wish I’d taken more economics courses in college.

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