How to Prepare For Cap & Trade

After years of stable energy prices, consumers and business are now faced with dramatically escalating costs with no sign of abatement. While government officials bemoan the high prices, they are simultaneously preparing to take actions that are designed to add additional upward pressure. Due to concerns regarding man-made global warming, the US is in the early stages of adopting a cap and trade system for CO2. The US Senate recently debated a proposed bill but tabled the measure for the time being. President-elect Obama supports cap and trade legislation and is quoted as favoring the toughest limits anywhere. At this time, the European Union (EU) has just completed Phase 1 and is beginning Phase 2 of their version of cap and trade. Results to date on CO2 emissions, energy prices and GDP have been negligible. But, Phase 2 is designed to be tighter and more impactful.

In this article we try to provide background on what cap and trade is and the experience to-date in the EU. At the conclusion of the article, we offer some points on what business can do to prepare and even thrive in this new environment.

To begin with, cap and trade is a process under which the government sets a limit – a cap – on the amount of CO2 that can be discharged into the atmosphere. This cap would then be associated to emitters of CO2 through some mechanism, either by government direction, auction or a combination of the two, to specific industries (exactly which industries is an open question but electric utilities and other heavy manufacturing industries such as steel production Are likely candidates). Businesses in these industries would then need to limit their CO2 emissions to the allocated cap amount. If they are able to emit less than their allocated amount, they would then be free to trade the excess allowance to other businesses that are emitting more. Each year the cap would be lowered to drive the desired behavior which is greater investment and utilization of so called green technologies. Overtime, the total CO2 emissions would in theory fall and the effects of human activity on the atmosphere and global warming would be mitigated.

Regardless of the theoretical impacts, our belief is that a practical real world impact will be an increase in cost. What is today free, the right to emit CO2 into the atmosphere, will tomorrow have a cost associated with it. For industries included in the cap and trade schema, electric utilities being a prime example, this will be a direct production cost increase. For other industries, the cost increase will come in the form of higher energy prices and raw material costs as suppliers are forced to pass on their costs.

On the positive side of the ledger, businesses in the directly affected industries that have already made investments in green technologies will be able to recover some of this investment by selling their excess allowances and will be able to be more competitive in the market. In addition, businesses that produce equipment or provide services associated with green technologies will find their markets and opportunities expanding.

Simply put, there will be winners and losers. But, more importantly, regardless of what business you are in, there will be an impact that needs to be prepared for.

Since the US cap and trade scheme is still on the drawing boards, a look at what the EU has done is helpful. IN 1997, the Kyoto Protocol (Kyoto) created a framework and a set of rules for a global CO2 market. The nations of the EU are signatories to Kyoto and have established the European Union Emission Scheme (EU ETS) The EU ETS is the largest multi-national, greenhouse gas emissions trading scheme in the world and is currently the world's only mandatory CO2 trading program .

Within the EU, national allocation plans (NAPs) determine for each member state the cap on the total amount of CO2 that installations covered by the EU ETS can emit, and set out how many CO2 emissions allowances each plant will receive.

The EC's (European Commission) task is to scrutinize member states' proposed NAPs against 12 allocation criteria listed in the emissions trading directive. The criteria seek, among other things, to ensure that plans are consistent with reaching the EU's and member states' Kyoto commitments, with actual verified emissions reported in the EC's annual progress reports and with the technological potential to reduce emissions. Other criteria related to non-discrimination issues, EU competition, state aid rules and technical aspects. The EC may accept a plan in part or in full.

The EU just finished Phase 1 which began under Kyoto's Voluntary Trials program which took effect on February 16, 2005. Phase 2 began in January 2008. Under Phase 1 it appears that the associated CO2 emission allowances were higher than actual emissions. Carbon credits fall in price on the open market from a high of approximately $ 40 / ton at the early 2006 to less than $ 1 / ton in late 2007. Lower allocations have been made under Phase 2.

To facilitate the market, the EU determined to accept Kyoto flexible mechanism certificates (Emissions Trading, The Clean Development Mechanism, and Joint Implementation) as compliance tools within the EU ETS.
Companies within the EU may trade or reassign their allowances the following ways
Operatively, moving allowances between operators within a company and across national borders
Oover the counter, using a broker to privately match buyers and sellers
Otrading on the spot market of one of Europe's climate exchanges (the most liquid being the European Climate Exchange).

Like any other financial instrument, trading consistors of matching buyers and sellers between members of the exchange and then settling by depositing an allowance in exchange for the agreed financial consideration. Much like a stock market, companies and private individuals can trade through brokers who are listed on the exchange.

When each change of ownership of an obligation is proposed, the national registry and the European Commission are informed in order for them to validate the transaction. In Phase 2, the UNFCCC will also validate any change that alters the distribution within each national allocation plan (NAP) in the EU.
With the creation of a market for mandatory trading of CO2 dioxide emissions within the Kyoto Protocol, the London financial marketplace has established itself as the center of the CO2 finance market, and is expected to have grown into a market valued at $ 60 billion in 2007.

In addition to procuring additional credits in the marketplace, companies may create new credits through the Clean Development Mechanism. In these situations, companies invest in green energy projects, including projects in other countries. Projects must meet strict guidelines in terms of both the emissions resulting / avoided and the financial impact of the investment. Projects that would have been financial viable without the investment are not certified and do not generate the additional credits.

Given all of this process, what has happened so far? Basically, not much, at least as it relates to reductions in CO2 emissions. A recently published article in the Wall Street Journal showed there has been no discernable impact on CO2 emissions in the EU.

From a GDP perspective, results are also unclear. As shown in the table below, EU real GDP growth rates after an initial dip in 2005 have rebounded beyond 2004 levels, the year before the introduction of the EU ETS. Inflation has remained fairly constant at 2.3-2.4% over this same period.

Year Real GDP Growth Inflation
2004 2.7% 2.3%
2005 2.1% 2.3%
2006 3.3% 2.3%
2007 3.1 2.4%
Source: EU Fact Sheet compiled by the Market Information and Analysis Section, DFAT

Given this data, one might be inclined to assume a cap and trade system has no impact on GDP or prices, positive or negative. This may turn out to be true in the aggregate, but a tighter cap that actually achieves the stated goal of reducing CO2 emissions first has to be in place before this hypothesis can be tested. Further, while GDP numbers are good for measuring overall prosperity, they do not measure individual industries or businesses. Here results can be significantly different.

Therefore we stand by our hypothesis of higher cost and believe it is prudent to prepare for the worst and hope for the best.

What then should this preparation entail? First, think conservation. A general reduction in energy consumption will lead to lower energy costs regardless of any impacts from cap and trade. Given all of the variables associated with energy cost in the future it is difficult to evaluate investments that may be required to facilitate preservation. In those cases, we recommend doing multiple scenarios analysis with a variety of optimistic and pessimistic assumptions.

Where can some of this conservation come from? Certainly adjusting thermostats and turning off unnecessary lighting is easy and probably already being done. More creative ways include reviewing green computing opportunities (more energy efficiency hardware, virtualization, data center outsourcing), reviewing production and shipping processes (reduced material handling, manufacturing steps, LTL shipments, etc.), shifting energy intensive activities to off peak periods, Telecommuting, and modified work schedules are but a few areas to explore.

In addition to conservation, businesses are also finding creative ways to get more revenue by unbundling services. Customers may react negatively to a price increase but if the service offered includes multiple components, say delivery as one component, they may react more favorably if the product / service is unbundled and priced separately. Care must be given here to ensure that each component is priced at its fair market value. Artificially hiding costs in the price of one service to cover issues with another will only distort customer reactions and can negatively affect the bottom line.

Finally, companies should look for creative ways to infuse green technologies into their products and services. For example, if your business is construction, offering energy efficient technologies and expertise to your customers will provide you a competitive advantage over those who do not.

In conclusion, the energy landscape is changing and going through a period of great dislocation. Companies will need to adapt to this changing environment to survive. More importantly, as with all change, tremendous opportunities will present them to companies ready to seize them.