How I see it – Richard Sandor

Beyond Kyoto: some thoughts on the past, present and future

“A thousand-mile journey always starts with the first step” Lao Tse, Chinese Philosopher, 6th Century BC

“We cannot cross the sea merely by staring at the water” Rabindranath Tagore, Indian thinker and Nobel-prize winner

It’s been a long journey, spanning more than a dozen years and four continents. The first steps were taken in Rio de Janeiro. Five years later an international treaty emerged in Kyoto. Six years later the first rules-based, multi-sectoral marketplace began in Chicago and a mere two years later the EU Emissions Trading System (ETS) got started. This pilot has been extraordinarily successful in a short time but the future task of successfully implementing the Kyoto Protocol is formidable. The post-Kyoto period presents an even greater set of challenges. But all of these hurdles look less daunting in view of our experiences over the past 13 years.

In 1992 during the Earth Summit, we presented a paper on a framework for a global emission trading system at a ‘side show’ in a tent overlooking the beautiful beaches of Rio; the idea was received with great scepticism. Concern over climate change was limited to a few scientists and environmentalists. The concept of emissions trading was but a theoretical chapter in economics textbooks.

Fifteen years later, the situation is quite different. From corporate leaders to academicians to the common person, we seem to be taking a more serious look at global warming. Market-based mechanisms such as emissions trading have become widely accepted as a cost-effective method for addressing climate change and other environmental concerns. Environmental issues are fast moving out of the confines of corporate EH&S departments into the realm of corporate financial strategy.

The pace of this transformation has left few unaffected: cities managing their greenhouse gas (GHG) emissions; equity and debt analysts paying close attention to climate liability; peasants in Cambodia exploring the possibility of linking to the global GHG marketplace.

However, the sceptics are still around. They question the effectiveness of climate action without the big three: the US, China and India. They question the survival of Kyoto after 2012. They cite lack of harmonisation in international climate action and argue that there is little direction and much uncertainty on a post-2012 framework. They complain about too many ‘hot air’ reductions and a lack of infrastructure for the Clean Development Mechanism (CDM) to be able to take off.

In this article, we would like to address some of these concerns by attempting to look at what lies ahead. By no means is this a prediction of future events or a market forecast. We, like everyone else, have no crystal ball to predict the future. This is merely a vision statement that this student of markets would like to share with you. We begin by looking at our journey thus far.

The road so far

The short history of global climate efforts paints a positive picture of things to come. Last February, the Kyoto Protocol entered into force, signalling that the international community was serious about climate change. In Europe, the start of the EU ETS has given a boost to the global efforts to manage climate change.

Australia, Japan and Canada also seem to be aware of the need for action. The Australian states are looking into setting up trading schemes, without federal support. Canada recently released a proposal for honouring its Kyoto targets that include provisions for offsets projects. Japan has plans to first reduce emissions domestically, then invest in sinks through CDM and Joint Implementation (JI).

In the US, a wide variety of policy initiatives are evolving. The Regional Greenhouse Gas Initiative (RGGI), organised by nine northeastern states, and climate proposals by Washington, Oregon and California, are good examples. At the federal level, congressional interest in climate change action has been on the rise, as indicated by a significant increase in the number of climate related legislative bills over the years in Congress. The US private sector is also showing greater sensitivity to climate change. Major corporations, including recently General Electric, have announced intentions to manage their GHG emissions.

The CDM process, though painfully slow and plagued by bureaucratic hurdles, is making progress. Only 15 projects have been so far registered, mostly confined to landfill gas, renewable energy and small-scale hydroelectric projects. However, the CDM Executive Board seems to have made progress in other areas. Notably, the first version of the CDM registry is now operational and progress is being made on linking this with the International Transaction Log.

Private interest in the marketplace has also been tremendous. The Chicago Climate Exchange (CCX), a voluntary programme for GHG reduction and trading in North America, has seen membership rise from 16 founding members to more than 100 in less than two years. Recently, two big Brazilian corporations, which are non-binding members under Kyoto, have signed up to take on the binding CCX emissions reduction commitment. This is one case that demonstrates that private action against climate change knows no geographic or regulatory boundaries.

Our analysis of the story up to this point has been one of cautious optimism. The market is surely still in its evolutionary stages but the 'baby' is growing fast and healthy.

The road ahead

So where do we go from here? We think the future state of climate action will be based on a well-integrated plurilateral system. The major components will likely be:

- regional trading systems;

- the CDM; and

- voluntary markets.

Adding to these important variables in the form of participation from China, India and the US, and the potential role of carbon sinks, especially from forestry and agriculture, and we may have the essential components for our analysis.

It is inevitable that the numerous regional trading initiatives will move towards some form of harmonisation and uniformity to reap the full benefits of a globalised environmental market. This is necessary for the success of the carbon market . both from a financial viewpoint and as an environmental policy. We are already seeing early signs of harmonisation in, for example, procedures and quantification methods, as indicated by the GHG Protocol. The RGGI system will potentially be open to EU ETS and Kyoto allowances. Many corporations, which are increasingly members of multiple climate initiatives, will serve as catalysts to this convergence.

The CDM has tremendous potential, but there is need to simplify the process. The mechanism is an important vehicle for forging political consensus between the industrialised and developing countries, thereby expanding the comprehensiveness of the Kyoto Protocol. As early as 1998,we shared with the public our suggestions for a “simplified” CDM at the annual UN climate change meeting, in Buenos Aires.

In that paper, we discussed the need for standardisation and the development of a rules-based CDM system. This would help reduce transaction costs associated with establishing emission baselines and project additionality on a non-standardised, project-by-project basis, thereby promoting sustainable development.

Here it is important to note that the pace of CDM reform has huge implications for the cost of compliance. In fact, a failure to address this could undermine the EU ETS and the Protocol itself by sending a signal that compliance costs will be too high to be practical. Eventually, the CDM process will have to respond to market demand, and standardisation and simplification is expected to occur.

Meanwhile, the voluntary markets provide opportunities to link regulated and unregulated sectors of the global carbon marketplace. There is a growing interest among entities unregulated by Kyoto to participate in some form of climate action. These constituents, including numerous cities, office-based organisations and universities, are redefining their roles by taking a pro-active stance with respect to climate change. A global trading regime among such voluntary entities has tremendous potential to be viable on its own.

China, India and the US

There is also a great deal of debate about the US, China and India participating in a binding form of emissions reductions. The US has rejected entry into any agreement that excludes China and India. However, despite the fact that these latter face significant risks from climate change, they have argued on moral and ethical grounds against taking reduction targets. China and India base their exclusion on the carefully developed principle of common but differentiated responsibility included in the UN Framework Convention on Climate Change (which spawned Kyoto) and the reality that per capita emissions are far below those in the developed world.

Sadly, the fact remains that the sheer size of US emissions (accounting for about 23% of the global total) and tremendous economic growth in China and India, fuelled by coal, will undermine any efforts by the rest of the world. The uncertainty of US, Chinese and Indian participation in global climate action is imposing considerable costs to the shape of future climate policy.

Assuming that the trigger point for US participation is entry by China and India, we focus our attention on the latter two. The principles of equity and fairness are useful guideposts. Economic and environmental indicators in these two nations provide a good starting point. The facts speak for themselves. China and India account for 14% and 5.6% of global GHG emissions respectively. Rapid increases in electrification, burgeoning transportation sectors and rising industrial production, primarily based upon fossil fuels, all point to higher GHG emissions from emerging Asia. China and India are also the fastest growing economies in the world today. The figure below indicates China will surpass the US as the world’s largest emitter in 2014. India, on the other hand, having surpassed Germany’s emissions in 1998, is expected to account for 6.8% of global emissions in 2014. China’s and India’s shares of world GDP in 2014 are expected to be 17% and 9% respectively. The issue of equity and fairness post-2012 may dictate that these countries take some responsibility for their emissions.

Finally, we turn to the inclusion of a broad-based set of carbon sinks, especially from forest and agricultural sectors.There has been a quiet transformation in these sectors over recent decades. From being just providers of food, fibre and wood, parts of agriculture and forestry have redefined their roles as providers of environmental goods and other multi-functional benefits. Parallel developments in international trade agreements such as those in the World Trade Organisation necessitate reductions in domestic commodity price support policies. The desire to provide income support and meet environmental goals is likely to increase the level of coordination between these two societal objectives.

This opens great opportunities for agriculture and forestry to participate in carbon trading. For example, the total carbon sequestration from US crop land alone is estimated to be around 75 million–208 million tons of carbon annually, valued at $1 billion–3 billion at current carbon prices. On the other hand, total commodity subsidies in 2003 were in the order of $11.5 billion. An agricultural carbon sequestration programme could therefore provide for 10–27% of all expenditures on commodity subsidies. The vision is clear. The challenge of global warming dictates a new direction to the way farming has been practised.

Conclusion

Many analysts feel that the current GHG market is merely at the beginning of what could be the biggest financial market in the world. I am as excited about this development as I was when I was involved with the birth of financial futures in the 1970s. There is no doubt that the idea is still new and the challenges immense. But I believe we know our destination and this will lead to continued growth in the environmental marketplace.

It is hard to believe it has been six years since we started to write this column. In these pages we have covered topics ranging from the rise of sustainability indexes to the potential use of market-based solutions to address water quality and quantity problems and as a potential source of conflict resolution. We have commented on the state of negotiations and the design of mechanisms for a global framework for emissions trading; made the economic case for the prominence that coal will continue to have in our economy; and advocated the use of futures markets to price global oil shocks. Many of our predictions and statements have been confirmed or are now becoming a reality. For others, time will tell.

This magazine shares the same title as a class we taught at the business school at Columbia University in 1991. At that time the words ‘environment’ and ‘finance’ were still far apart. We now live in a world where they are forever intertwined.

Richard Sandor is chairman and chief executive of the CCX.

Thank you to Murali Kanakasabai, Claire Jahns and Rafael Marques for their assistance in the preparation of this article. I would like to thank the staff of the Chicago Climate Exchange for their intellectual input and support over the past six years and all the individuals from business and academia who have provided their expertise in our articles. Many thanks to Graham Cooper for the invitation to share our thoughts with the readers. Special thanks to my wife Ellen, my children and grandchildren for their support throughout this journey. To all of the readers of Environmental Finance who have supported us over the past six years,“au revoir mes amis” and “hasta luego”.