Abstract
Capitalist societies matured from trading manufactured goods to commoditizing interest rates, bank debt, and home equity. Now financial pioneers are literally reaching for the sky. But in monetizing Earth's atmosphere, has the omnipotent market finally met its match?
When a group affiliated with the Chicago Climate Exchange came by Terry Davis's downstate Illinois farm four years ago, Davis learned that corn and soybeans weren't all his farm could yield. Because Davis is a no-till farmer–leaving corn and soybean stalks untouched after harvest–his land could produce carbon credits, too.
In no-till farming, carbon that otherwise would be released into the atmosphere when the soil is churned up remains stored in the soil. And that carbon might be useful, in the form of an offsetting credit, to a power plant or other industrial enterprise that cannot meet its obligations to reduce the carbon dioxide gas it pumps into the air. “I didn't realize until the [exchange] came along that I was doing no-till farming for the atmosphere, too,” said a delighted Davis, who employs no-till primarily because it reduces erosion, cuts fuel and fertilizer use, and can even produce higher crop yields. For Davis, there is also a financial benefit: He can earn about $1,500 a year selling carbon credits.
From Midwestern farms to landfills in India, to new Chinese power plants, to replanted Amazonian rainforests, people around the world are learning that they can play surprisingly active and sometimes profitable roles in the global effort to combat climate change. But there are serious questions about whether activities such as Davis's farming should qualify for carbon credits.
Davis began using no-till methods in 1980. Simply by continuing his practices, he is creating no “additional” emissions reductions. There also is no guaranteed “permanence” to the carbon he stores in the soil. Another farmer might decide to plow the land every spring and fall. Furthermore, continuing no-till practices on his acreage doesn't guard against conversion of nearby fallow acres into crop land, which could “leak” as much carbon as Davis stores. Added together, Davis's farm falls short of three qualities experts consider essential when assessing the legitimacy of carbon credits.
“Of course the farmer wants to sell the credits. He's not doing anything wrong,” said Anja Kollmuss, an environmental scientist at the Stockholm Environment Institute, a leading research organization focused on sustainable development. The problem, according to Kollmuss, is that the Chicago Climate Exchange allows him to sell those credits. “People wind up selling offsets that aren't really offsets,” she said.
Welcome to the complex and controversial world of carbon credits. At a time when people worldwide are increasingly obsessed with mitigating climate change, carbon credits are one of the most talked about tools. And as Congress moves toward adoption of a cap-and-trade approach to emissions reduction, perhaps yet this year, carbon credits seem set to become a key component of U.S. climate policy.
Since their inception in 2002, credits have been a subject of vigorous debate. Environmentalists feared polluters would readily buy credits rather than make costly improvements that would cut emissions from their plants. And the controversy has only intensified. There have been charges of manipulation in the markets where credits are traded, lax enforcement of standards, and outright fraud. Scientists have raised questions about the legitimacy and permanence of certain credit-generating activities. And, in a new strain of debate, some economists are beginning to ask if enough credits will be available to satisfy demand as government-mandated emissions caps in Europe and elsewhere become increasingly steep during the next few years.
Global warming is a threat, not just to the environment, but also to human society. Rising tides, melting polar ice, droughts, and landslides are among the side effects scientists expect from rising temperatures. Tropical diseases are migrating into more temperate zones, and crops are threatened by pests and pathogens that are jumping climate barriers, too. Violent tribal or cross-border disputes over arable land and water are not inconceivable in the near future.
Carbon credits are one of the major tools policy makers have developed to reduce the greenhouse gas emissions that are contributing to global warming. Under the 1997 Kyoto Protocol, which ushered in the largest system for carbon emissions regulation, power plants and other big companies in industrialized countries that can't meet mandated reduction targets have another option: They can make offsetting investments in projects in less-developed countries that reduce emissions or even absorb greenhouse gases.
A power plant that exceeds its limit by 100 tons of carbon dioxide or equivalent greenhouse gases can purchase credits representing 100 tons of emissions reductions. The source of those reductions? Perhaps installing machinery to capture methane from a landfill in India, or replanting rainforest in Madagascar, or installing thousands of high-efficiency light bulbs in a village in Kenya.
The United States has not signed the Kyoto Protocol, of course. But a leading bill in Congress, sponsored by Independent Sen. Joseph Lieberman of Connecticut and Republican Sen. John Warner of Virginia, typifies the cap-and-trade approach that seems likely to become law. Such a system would introduce rules that would cap the tonnage of greenhouse gas emissions that industrial companies and other entities are allowed to emit. Those that can't meet the targets would need to purchase carbon credits, which would be used to offset their excess emissions.
In the absence of action from the federal government, some states–California, as well as a group of northeastern states–have imposed their own limits. California's first major deadline for its plan to reduce emissions to 1990 levels by 2020 hits next year, as do those set by the Regional Greenhouse Gas Initiative's cap-and-trade standards for 11 New England and Midatlantic states.
For emitters not affected by such rules, there is an alternative: “voluntary” emissions credits. Emitters set voluntary targets in order to promote a “green” image, or perhaps to prepare for the seemingly inevitable emissions limits soon to be imposed by government.
The foremost market for voluntary credits in the United States is the Chicago Climate Exchange (CCX). The CCX requires members to commit to reducing their emissions. Companies that cut emissions by more than their required amount are awarded allocations that they can sell on the exchange. Those that cannot meet their goals must purchase offsets on the exchange.
Credits have become a big business. Those developed according to the standards of Kyoto's Clean Development Mechanism (CDM) result in 155 million tons of emissions reductions each year, and by the time Kyoto expires in 2012, they are expected to reduce global emissions by some 2 billion tons of carbon dioxide-equivalent gases. The cumulative value of CDM credits traded between 2002 and 2006 was $7.8 billion, according to a World Bank report.
Voluntary trading comprises a far smaller, but still important, sphere of activity. Globally, the voluntary market produced 65 million tons worth of offsets for carbon dioxide-equivalent gases in 2007, a 165 percent increase in volume over the prior year's activity, according to a study by New Carbon Finance. That figure is expected to reach 400 million tons by 2010, according to data from The Climate Group, former British Prime Minister Tony Blair's nonprofit leadership coalition.
Even though credits over time could help to prevent billions of tons of carbon dioxide, methane, and other greenhouse gases from reaching the atmosphere, both voluntary and mandatory credit programs attract considerable criticism and scrutiny. Mandatory programs, critics say, have created perverse incentives that prompt uneconomic or even environmentally harmful behavior. Exhibit A in the perversity argument is the hydrofluorocarbon trifiuoromethane (HFC-23), a by-product of the hydrochlorofluorocarbon refrigerant chlorodifluoromethane (HCFC-22)–itself a gas that became popular because of its usefulness as a replacement for refrigerants harmful to the ozone layer. HFC-23 is one of the world's most potent greenhouse gases, with 11,700 times the climate impact of carbon dioxide.
Its potency made it a rich target for emitters seeking low-cost offsets. Research by Stanford University professor Michael Wara established that $6 billion in CDM credits could be generated with a mere $100 million investment in equipment needed to produce, then capture and destroy, HFC-23. This created an incentive, and may even have prompted construction of HCFC-22 plants, the chief purpose of which was to produce the potent greenhouse gas by-product.
At one point, according to Wara's research, applications for credits arising from destruction of HFC-23 represented 35 percent of the applications in the CDM pipeline. Once officials on the CDM executive board, which approves credit applications, became aware of the lopsided impact of HFC-23 destruction, they sought to close down the loophole, with mixed results.
Just as important, flaws in the CDM system allow for some projects to qualify for credits even if the projects would have gone ahead without a credit system in place. To wit, critics focus much attention on credits derived from power projects in China, a country that is the source of more than half of the current CDM credit applications. The world's fastest-growing major economy is building a new power plant every week by some estimates. Although most of the new plants will take advantage of China's abundant stores of coal, the Chinese are installing state-of-the-art technology in many new plants and are keenly interested in carbon capture and even coal gasification technologies. The new, high-efficiency coal plants and the many hydro, wind, natural gas, and nuclear power plants under construction in China all qualify for credits. Although the construction is part of a national growth program enshrined in China's 11th Five-Year Development Guidelines, scores of plants have become the subject of a CDM credit application.
David Victor, a Stanford economist who has studied the CDM system, is wary of the way it's functioning. And the idea that certain projects would have been undertaken even without credits–a phenomenon derisively dubbed “anyway credits”–underscores just one of the paradoxes of the CDM credit program. Unless anyway credits are blocked, he said, the program risks becoming “a big transfer of wealth to the developing countries without much impact on emissions.”
The CDM executive board invited criticism early by approving virtually every application that passed its way–the board approved 95 percent of proposed projects in 2004 and 2005. Such permissive vetting contributed to a phenomenon of carbon profiteers known broadly as “carbon cowboys.”
Today, the “cowboy” firms–which sell outright fraudulent credits resulting from nonexistent construction programs, concoct actual projects that provide little environmental benefit, or double-sell credits to more than one emitter–are thought to be in retreat thanks in part to more sophisticated and ambitious oversight and regulation. Last year, the CDM board approved only 57 percent of credit applications. It rejected outright some 9 percent of project applications, double the rejection rate in 2006.
Tougher enforcement has pressured even some of the largest firms marketing carbon offsets, such as market leader EcoSecurities Ltd., which saw its share price drop more than 75 percent after announcing it had to write off a quarter of the credits in its portfolio because it couldn't find enough approved projects for its customers. Competitor Cameo International Ltd. has acknowledged having projects delayed, and a third big player, AgCert International PLC, has delisted from the London Stock Exchange after filing for protection from creditors.
Price volatility and unpredictable trading volume have been other acute problems. The most notorious example came about in Europe in April 2006, when prices on credits generated by the European Union's Emissions Trading System dropped by 30 percent in a week's time. Market experts explained that a price bubble prompted by speculation that emitters would not meet their mandated caps quickly burst when a report that month on the progress of 12,000 companies in the European program indicated most would hit their targets. After that initial, hair-raising experience, the market stabilized.
Still, hairy times for the carbon markets are just around the bend, according to an important new working paper by Wara and Victor of Stanford's Program on Energy and Sustainable Development. With the volume of CDM applications expected to explode in coming years, the CDM approval process may become a bottleneck that imperils the effectiveness of the entire system. “The CDM executive board will likely have to respond to between 5 and 10 thousand issuance requests, depending on whether they come annually or bi-annually over the next five years,” the economists write. “This is between 20 and 40 times the rate at which issuance has been occurring.”
If the mandatory carbon markets have their challenges, the so-called voluntary markets have many more. Voluntary markets range widely. They include the carefully constructed architecture of the CCX and the collective wisdom of “Gold” credit certification, which incorporates input from 51 nongovernmental organizations. Other voluntary credits, though, exist in an unregulated and sometimes opaque netherworld, where the demands of “greenwashing” and public relations can trump the need to protect the atmosphere and mitigate global warming. In fact, the wide variation in the quality of voluntary credits has prompted a cottage industry of credit-rating experts. In a July 2007 report on the voluntary carbon offset market, the audit committee of the British House of Commons systematically portrayed the voluntary marketplace as a virtual rogues' gallery of misguided offset projects.
The stories of failed credits are legion: The rock band Coldplay offset emissions of its 2002 concert tour by planting thousands of mango seedlings in southern India, only to have more than half of them die for lack of water. A British company called Climate Care distributed high-efficiency light bulbs in a ramshackle neighborhood of Cape Town, South Africa, only to see a local utility sweep through the same neighborhood a few months later with a redundant replacement program of its own. A Los Angeles program to junk highly polluting old cars proved to be a boondoggle that made payments of $600 per car, many of which were already inoperable vehicles that had a scrap value of only $50.
The voluntary market has motivated all manner of creative–some might say opportunistic–thinking. One of the most dramatic ventures was Plank-tos, Inc., a private company that spent nearly $4 million, much of it investor money, on a plan to seed the ocean with iron filings that would promote algal blooms, thereby absorbing tons of carbon dioxide. Environmental groups, wary of the scientific credibility of the idea in the first place, revolted when Planktos announced the site of its first experiment: just off the heavily protected Galapagos Islands. Planktos ceased operations in February and sold its assets, including an ocean-going research vessel called Weatherbird II. But the idea is not dead. The company's chief rival, Climos, has raised $3.5 million to fund research into oceanic iron fertilization.
“Our objective is to take off where the science has left us,” said Dan Whaley, founder of Climos, who considers Plank-tos's demise a self-inflicted disaster. “There is now a price on carbon. If you can prove an emissions reduction, you can sell that carbon on the open market.”
If Climos ever succeeds in verifying and selling carbon credits, it's possible that the marketplace will be the CCX, the largest player in the voluntary carbon market in the United States. The brainchild of economist Richard Sandor–who embraces the title “the father of financial futures” because he designed the first interest-rate futures contract on the Chicago Board of Trade in 1975–the CCX is at once the most successful and most controversial participant in the U.S. carbon credit markets. Sandor declined to be interviewed for this article, though the author has interviewed him and heard him speak about the CCX on other occasions.
In the CCX, Sandor has created an innovative and largely successful experiment in a voluntary cap-and-trade system. Modeled after an approach used successfully by the U.S. Environmental Protection Agency during the early 1990s to encourage power plants and other polluters to drastically reduce emissions that create acid rain, the CCX requires member companies, cities, universities, and other entities to make legally binding commitments to reduce their emissions by 1 percent per year. A second phase of the CCX program, which commenced in 2007, requires participants to reduce emissions 6 percent before 2011, for an annual reduction rate of 1.25 percent. As with the CDM system, those that can't hit their targets can purchase credits created by certain approved activities, for example, capturing methane from coal mines, landfills, and hog lots; storing carbon in the ground through no-till farming; or preserving forests.
The CCX's member rolls include industrial luminaries ranging from Ford Motor Company to Monsanto, to utility giant American Electric Power (AEP). Many cities and universities have committed to emissions reductions as CCX members, as well. Dozens of CCX-approved aggregators comb the countryside in the United States, Canada, and Mexico, finding farmers who won't till their land, for example, or ranchers and coal miners willing to install methane-capturing equipment, thereby producing offsets that can be traded on the CCX. Credit-generating projects are dutifully verified by independent firms approved by the exchange as scientifically sound. These firms send people into the field to provide independent audits of emissions-reducing activity.
A natural salesman whose intelligence and enthusiasm for the CCX are infectious, Sandor sees the exchange as more than just a dry run for industrial players who want to practice cap-and-trade before Uncle Sam takes over. Besides that, Sandor sees the CCX serving a higher purpose: promoting experimentation that just might help cool the planet. A favorite yarn, told during countless lunches, conference panels, newspaper interviews, and television appearances, is about MIT chemical engineer Isaac Berzin. Thanks to the CCX, Sandor says, the professor took an idea–growing algae in cooling ponds outside power plants to absorb the plant's carbon dioxide emissions and collecting it when it dies to use as a renewable fuel–and built a business by selling credits on the exchange.
To loyal CCX backers such as Bruce Braine, vice president for strategic policy analysis at AEP, Sandor's brainchild is accomplishing multiple objectives. It is prompting big polluters such as AEP to reduce their emissions–by 46 million tons of carbon dioxide-equivalent gases over eight years, in AEP's case. CCX membership is also encouraging AEP to help fund emissions-reducing activities elsewhere. Because it cannot meet its emissions-reduction commitments on its own, AEP is funding a program to capture and destroy methane from 400,000 head of livestock on 200 U.S. farms, generating 4.6 million CCX credits worth roughly $35 million at today's prices.
A TON OF CARBON SAVED IS A CARBON CREDIT EARNED
Braine, who is also a CCX board member, bristles when he hears some of the criticisms leveled at the CCX: that the system is not transparent to outsiders; that the industrial companies that dominate the organization set easy-to-achieve targets and only lightly scrutinize members' efforts to meet their goals; that the system is a closed loop filled with conflicts of interest between, say, verifiers who rely on the CCX for business, or board members who set the rules that they, as members, must adhere to.
“When you talk about a closed loop, realize you've got utilities and cities and states and public sector organizations and NGOs among the membership. The fact that those groups are very well represented on the committees and in making rule changes makes it hard to say that the CCX is just a set of companies developing the rules for their own benefit,” Braine said. He added, “It's really not the case that it's just a country club or a set of big companies trying to greenwash their reputations.”
Outside the green halo of the CCX, though, criticisms and questions continue to mount. “States and cities should not join the Chicago Climate Exchange,” reads the opening line of an August 2006 manifesto published by a cohort of environmental groups including the Natural Resources Defense Council and Public Interest Research Group chapters in several states. The document cites loopholes in the CCX system and the exchange's lack of transparency to outsiders among its reasons.
A report by Environmental Defense Fund, which purchased the exchange's $495 rule book issued in 2003, offers up the most detailed critique of the CCXs alleged shortcomings. The picture that emerges is one filled with loopholes, exceptions, and carefully crafted codicils that give member companies broad leeway when it comes to counting their emissions reductions and other emissions impacts.
For example, according to the report, member companies may exempt up to 895,495 metric tons of emissions from any plant built after 2002. Despite its claims to “cap” member companies' emissions, the CCX allows members experiencing growth in their underlying businesses to exceed emissions targets without penalty in some circumstances. Inviting leakage of emissions from operations outside the United States, the CCX allows member companies to exclude their operations in Canada and Mexico when reporting their total emissions. The exchange also allows member companies to claim reductions even if the activities that create them are mandated by law.
“A lot of their projects, businesses are doing anyway, but they're still going to generate CCX credits,” said Tejas Ewing, author of an Environmental Data Service report that tallied shortcomings of the CCX system including measurability and verification.
Illinois farmer Davis is one who benefits from the CCX's loose definition of additionality. He's also an example of a potential conflict of interest regarding independent credit verification: He is a director of the Warren County Soil and Water Conservation District–the very organization charged with verifying the integrity of his no-till farming practices.
Backdating is another questionable practice that comes into focus with a review of materials available on the CCX website. According to the project guidelines, methane digesters that were installed beginning in 1999 can qualify for credits; so can stands of trees planted as far back as January 1,1990. Grass plantings going back to 1999 are eligible, too.
Some who follow the price of carbon credits say the CCX's lax standards are apparent in the value of CCX contracts that trade on the exchange. Prices have more than tripled so far this year, to around $7 per ton of carbon, but that figure is less than one-fifth the current price for credits generated under the European Union's Emissions Trading Scheme–a gap that represents in part a lack of confidence in the quality of CCX credits, critics say. The CCX has argued that trading volume, nearly triple last year's levels, is a sign of market acceptance.
Perhaps more important, to some climate experts, the track records of the existing credit-generating systems raise questions about the absolute effect of carbon markets on our mounting greenhouse gas problem. After all, total global emissions are still rising–even faster than the Intergovernmental Panel on Climate Change predicted in the late 1990s. And efforts to measure the impact–or the folly–of offset systems can be heavily influenced by what story a given evaluator wants to tell. Kollmuss, of the Stockholm Environment Institute, said it's virtually impossible to gauge if or how much emissions have slowed on account of the CCX, the CDM, and the European Union Emissions Trading System. “It's impossible for us to measure a world that doesn't exist, and the estimates are probably influenced by peoples' preconceptions,” Kollmuss said. “People get so tied down in the details, they forget we're going to lose our environment as we know it.”
Back on the farm, Davis nevertheless believes strongly in the importance of environmental consciousness. He is already trying to do what's right for the environment by practicing no-till farming and pays scant attention to debates about the value of the carbon credits it generates or the role they play in combating climate change.
“Carbon is carbon,” Davis said. “It doesn't matter if it was a dinosaur that walked into a bog 10 million years ago and is just being pumped out as a barrel of oil, or whether it's stored in an ear of corn.”
Carbon is carbon. No doubt about that. But carbon credits? They may be traded like commodities, but no two carbon credits are exactly alike.
Supplementary Material
S. 139: Climate Stewardship Act of 2003
Supplementary Material
S. 309: Global Warming Pollution Reduction Act
Supplementary Material
H.R. 1590: Safe Climate Act of 2007
Supplementary Material
Kyoto Protocol to the United Nations Framework Convention on Climate Change