Impact of Greenhouse Gas Regulation: The Next Ten Months – The Next Ten Years by Chris Trayhorn, Publisher of mThink Blue Book, January 15, 2002 Introduction Climate change has arrived — physically, politically and economically. The debaters no longer argue if climate change is real, they debate how quickly it is coming upon us and the level of urgency with which we must implement a solution. Industries, once skeptical, are now the leaders in seeking a solution. The companies that once comprised the anti-Kyoto Global Climate Coalition1 are increasingly appearing on the flagship Business Environmental Leadership Council of the Pew Center on Global Climate Change,2 acknowledging that the threat of climate change is serious enough to warrant concrete action to reduce greenhouse gas (GHG) emissions. Businesses increasingly realize the jeopardy of awaiting a political solution. Political discount rates3 are out of sync with those of capital-intensive businesses. Companies investing in billion-dollar power plants or manufacturing facilities wish to minimize the uncertainties affecting the 20- to 30-year economic lifetime of these facilities. Companies realize they cannot avoid being part of the greenhouse gas solution, delaying the debate and implementation of the solution increases risk, not decreases it. It is better to take some short-term pain than to lose your core business down the road. Companies building large emitting facilities today should examine the history of the tobacco industry4 to realize the perils of accepting short-term political shelter. Utilities, many with annual GHG emissions in the order of millions or tens or millions metric ton carbon dioxide equivalent,5 potentially face additional annual operating costs in the tens or even hundreds of millions of dollars. They will be in the front line of the GHG solution once it occurs.6 Prudent management demands that utilities prepare for the advent of a greenhouse gas constrained future. Proactive utilities (and other industries) are going beyond preparing for the future and are actively participating in shaping this new field. The next ten years will see the introduction of mandatory GHG constraints and the growth of a global market for GHG instruments. Utilities need to understand and shape emerging policies to safeguard their industry. Background: Origins of Climate Change Policy Climate change was put firmly on the international agenda by two international events during the 1990s. The 1992 Earth Summit in Rio de Janeiro was attended by a host of world leaders, including the former President Bush, and alerted the world to the geophysical dangers of climate change. The 1997 Kyoto Protocol is an international treaty that when ratified will place binding emissions constraints on industrialized nations. These international gatherings demonstrated that climate change, until then largely seen as an environmental issue, was in fact a financial issue with potential multi-billion dollar impact on emission intensive corporations. The Kyoto Protocol itself is part of a wider international process, and arose from the United Nations Framework Convention on Climate Change that was opened for signature at the 1992 Earth Summit. The Convention sets an ultimate objective of “stabilizing atmospheric concentrations of greenhouse gases at safe levels.” It currently has 180 governments as parties. The first Conference of Parties, held in Berlin in 1995, initiated a new round of talks that sought to achieve stronger and more specific emissions reduction commitments. The subsequent agreement negotiated at “COP3” in 1997, the Kyoto Protocol, bound industrialized nations to reduce greenhouse gas emissions by an average of 5.2 percent below 1990 levels by the first commitment period of 2008 to 2012. This treaty is groundbreaking — largely because it uses a market-based mechanism (emissions trading) to achieve an environmental goal.7 The application of emissions trading represents a new approach to controlling pollutants. In the past, pollution has largely been controlled using “command and control” regulations or the use of financial disincentives, generally taxation. The Kyoto Protocol process has come under strain recently, with the United States threatening to walk away from the process. This followed a highly visible disagreement at COP6 (the Hague, November 2000), involving the extent to which the flexibility mechanisms (emissions trading) can be used to meet reduction targets. Europe has consistently demanded harsh limits on trading while nations that favor market-based approaches such as the United States, Canada, Australia and Japan argued for maximum flexibility to minimize the cost of achieving the reductions. Despite the U.S. withdrawal from this process in early 2001, the rest of the world reached agreement at the so-called COP6.5 in Bonn in July 2001 (the continuation of the failed COP6 in The Hague). The Kyoto Protocol is expected to be ratified in the near term, albeit without U.S. participation. However, while the Kyoto Protocol is a major driving force for achieving emissions reductions globally, it is not the only route. Initiatives to reduce greenhouse gas emissions at the regional, the national, and even the corporate level are increasing in tempo. It would be a mistake to assume that any future slowdown in the pace of international negotiations means that binding emission reductions are off the policy radar screen — particularly in Europe. Current and Future Market Developments Despite the disagreements at the international level, moves to control GHG emissions are emerging in a variety of spheres. Governments have three broad policy options to control pollutants (GHG emissions in this case): • “Command and control” style — the regulator defines minimum environmental standards and all emitters are required to meet these requirements irrespective of cost. There is no financial benefit for over-complying. • Taxation — financial penalties are applied to GHG emissions. Firms have a financial incentive to reduce emissions only up to the point where the cost of reduction is lower than the per unit level of the tax. • Market-based mechanism — regulation sets emissions targets and lets the market decide how to allocate the right to emit among polluters. Historically, regulators have mostly utilized the command and control or taxation approach. However, GHG emissions trading provides the most robust opportunities for a manageable transition to this new carbon constrained world. The U.S. experience in SOx (acid rain precursor) and NOx (smog precursors) “cap and trade programs”8 have shown the economic advantages to emissions trading. GHG emissions trading offers an additional benefit of allowing utilities to reach beyond their own set of solutions to capture reduction opportunities in other sectors that are considerably less expensive. Mandatory programs are emerging today. Governments are coming under severe pressure from the public to act on climate change. European governments, having embraced the concept after their initial skepticism, are beginning to establish national emissions trading schemes. The Danish Government has implemented a binding emissions trading scheme applied to electricity generators. The United Kingdom is in the process of establishing a voluntary emissions trading scheme that offers corporations significant financial incentives to take on emissions reductions. Several other European nations are examining the feasibility of introducing national trading schemes (e.g., The Netherlands and Norway). In addition, there are plans in the European Commission to implement a regional emissions trading scheme by 2005. These schemes will involve genuine transfers of financial value and potentially place significant financial obligations on emission intensive firms. The sidebar describes several government and corporate emissions trading schemes in more detail. In 10 years, the first environmental markets (U.S. SOx and NOx) have been transformed from experimental programs to liquid and sophisticated commodity markets. The embryonic GHG market is likely to develop the same level of sophistication in a similar timeframe, but on a global scale. The Incentive for Utilities to Act Now Why would a utility be interested in spending its own money to pay for emissions reductions in other industries? Once resigned to the inevitability of a GHG-constrained future, utilities quickly realize they are in the front line of responsibility and implementation. Intra-utility emissions trading undoubtedly can reduce the cost of reduction compared to historic command and control regulation. Expanding trading to other fossil fuel industries with more diverse emissions reduction cost curves will produce even more savings. However, the real cost savings come from capturing available reductions that lie outside the usual businesses, such as offsets from forestry, agriculture, and from developing nations. While much of the ‘low-hanging fruit’ may be of limited availability, it can provide a lifeline of reductions sufficient to carry the utility industry to implement the next generation of lower emitting technology. Classic lobbying defense would have utilities argue that they need time for an orderly transition to the next generation of low-GHG technology. They would argue for time to develop and implement the new technologies. However, this tactic will not work in the current situation. First, the public perceives it as socially irresponsible, and increases pressure to force them to do “the right thing.” Second, it creates a strong short-term economic incentive for companies to put off the development of those new technologies; the longer one can demonstrate technological difficulty the longer the postponement period. Third, the status quo continually compounds the ultimate dislocation that the industry will be forced to undertake; the longer the delay the higher the emissions levels one must cut from and the steeper the cuts one must make.12 GHG Trading Programs — Design and Reality A properly-designed GHG trading program addresses these issues. It demonstrates that the industry is willing to immediately address its environmental responsibility but asks for the flexibility to reach beyond its own boundaries for the solution. This provides access to the “low-hanging fruit” available in other sectors that are unlikely to get direct regulation. It creates a significant direct short-term economic incentive for innovation in creating GHG efficiencies, thereby unleashing the creativity of the market to develop GHG reduction and mitigation opportunities. It also creates a budget line item for emissions within the company, unleashing similar forces within the institution that would not be nearly as effective if GHG reductions remain an academic interest.13 Early Involvement is Required The picture painted above is one of accelerating government and corporate activity, despite slower progress at the international level. Real money is being spent today. Scheme participants expect that national, regional and even corporate schemes will begin to link together in order to drive down GHG reduction costs. Corporations entering the market at this early stage are gaining valuable experience, adapting their corporate infrastructure, and in some cases, accumulating low-cost emission reductions. Utilities need to be involved at early stages of policy development; otherwise they risk being saddled with unfavorable policies. Figure 1 – Impact of Delay in Acting How Can Utilities Seize Opportunity and Mitigate Risk in this New Market? Utilities are easy targets for GHG regulation. They are large, stationary emission sources that can’t escape offshore. They represent easy targets for special interest groups and politicians who wish to lay the blame for climate change at business’ door, conveniently forgetting that the only reason electricity generators exist is to satisfy domestic and business demands for energy. The first step any company needs to take is to get its own shop in order. Information must be collected, risk assessed and opportunities analyzed within a meaningful framework. Given the likelihood of emissions trading, this information needs to be developed in a manner in which internal reduction opportunities can be readily compared to external opportunities and acted upon. Waiting for the rules to be developed before taking action is like starting to train the week before a marathon. Many companies underestimate the time and effort it takes to effectively participate in a new market. During the transition to a deregulated energy market, it has taken utilities three to five years to develop effective trading businesses in an area that they had previously regarded as their core competence — the buying and selling of electricity. Furthermore, an understanding of internal capabilities means that companies can pro-actively participate in the creation of the regulatory framework to ensure it develops in a favorable direction (i.e., into an effective and efficient mechanism). How Should Utilities Manage the Threat from Greenhouse Gas Regulation? This question may be answered at different levels. At the industry level, utilities have a history of successfully lobbying governments to achieve specific policy outcomes in respect of climate change issues. A prime example is the United Kingdom, where the government introduced a tax on energy use (the Climate Change Levy) at the customer level, rather than at the generator level. However, it is important to note that climate change regulation will affect different utilities in different ways. GHG emissions constraints are positive for low-emission generation plants, such as renewables and closed cycle gas-fired plants. Consequently, the utility lobby is fragmenting along sub-industry lines. Industry associations that represent coal-fired power stations take a very different position than renewable and gas-fired generators do. Climate Change — An Issue of Strategic Importance At the level of the individual company, climate change must be treated like any strategic issue. Senior executives responsible for strategy, risk management and finance must understand the background and implications of climate change policy for their business. Key steps include: • Understanding the issues. Understand the policy development process at the international and national level. Understand where this policy process is likely to lead and be in a position not just to predict, but to influence policy. Assess scenarios for GHG regulation in the regions in which the business operates. If emissions trading schemes are likely to be introduced, what level of targets are expected? • Quantifying current and future emissions from your business. Measurement and forecasting are critical in order to understand the possible impacts on the business. What are current GHG emission levels? How are emission levels likely to change in the future? How will acquisition and divestment plans influence forecast emissions? What is the emission intensity of production (per unit of output), how will this vary in the future, and how does this compare with your competitors? • Assessing internal abatement options. What actions can the business take internally to reduce GHG emissions? Assess the risk-adjusted cost of taking these actions. This is often not a trivial activity because internal emission mitigation actions are typically significant projects in their own right involving upfront capital cost, potentially uncertain reduction benefits and uncertain cashflows over a number of years. How will technology affect internal abatement costs in the future? How will current and future legislation treat early action taken to reduce GHG emissions? Should the business wait to generate maximum legislative benefit from reductions? Do your internal data collection and analytic processes promote effective use of external markets when they develop? • Investigating external emission reductions options. The international pre-compliance market offers the opportunity to secure low-cost emission reductions early. • Developing a comprehensive carbon management strategy. The information collected in earlier steps allows an organization to identify a range of potential future scenarios, the financial and operational implications for the business and consequently develop firm plans for mitigating the risks and taking advantage of opportunities. • Adopting corporate infrastructure. Does corporate decision making recognize the potential impact of emissions on operations, planning and finance? Is the required information being collected? Does the management reward system create incentives for emissions mitigation or inadvertently penalize it? Does the incentive structure reach those parties that can directly impact emissions (e.g., plant operators)? Do they have adequate information to make prudent decisions? The CO2eSM Trade Cycle (Figure 2) incorporates these actions and illustrates one approach to managing the risks and opportunities arising from climate change. Figure 2 – CO2eSM Trade Cycle Copyright 2001 CO2e.com LLC A firm that understands internal abatement costs and current market pricing is in a position to develop a strategy that balances internal and external action. Individual corporations will be at different stages of responding to climate change, and will tailor this general approach to their individual circumstances. The next section describes some of the concrete actions that leading corporations in this field have undertaken. Emission Trading Programs — Government and Corporate The early emissions trading schemes promise to be fraught with practical difficulties. For example, the embryonic Danish program places mandatory emission caps on large generators only, and those generators unable to meet their emissions targets pay a fine equal to DKK40 per MWh (USD 4-5/ MWh). Shortcomings include lack of diversity in the marketplace,9 and the fact that the supply and demand for permits is governed by factors10 that overshadow the financial penalty for failing to meet targets. Consequently, there has been little trading activity thus far. The U.K. scheme consists of a complex array of interrelated policies involving emissions trading, energy taxes, and renewable energy policies. While the scheme is expected to be a success, it imposes a very steep learning curve for prospective participants. National governments are also introducing market-based renewable energy trading programs. The Australian program began in April 2001 and requires electricity suppliers to purchase a specified proportion of electricity from renewable sources, using renewable energy certificates, rather than necessarily purchasing the physical electricity. A similar scheme will start in the United Kingdom during 2002 and further schemes are expected to emerge throughout Europe in the near future. “Green trading schemes” place additional financial obligations on utilities. It is critical that utilities play a cornerstone role in the development of these schemes in order to ensure that policy develops in a favorable direction. A number of major corporations have taken on voluntary emissions reduction commitments, including BP, Shell, DuPont, Ontario Power Generation and, most recently, Entergy. Some of these corporations have acquired emissions reductions in the marketplace. Total market activity has reached between 100 and 160 million metric tons of carbon dioxide equivalent transacted11. In addition, entities such as governments (The Netherlands) and fund managers (World Bank Prototype Carbon Fund) have entered the market to acquire emissions reductions on a commercial basis. Two multinationals (BP and Shell) have instituted internal trading programs where business unit managers are assessed on meeting emissions reduction targets, and may meet these targets through internal actions or trading in an internal marketplace. Other groups of corporations have also announced initiatives, such as establishing broad-based emissions reduction targets and emissions trading schemes. Practical Steps Already Being Taken by Emission Intensive Firms Various multinationals and utilities have developed sophisticated carbon management strategies. Specific actions taken include: • Appoint a climate change manager. Appointment of a central, cross-disciplinary GHG resource (individual or team) to design and implement corporate climate change strategy. The responsibility extends from defining and managing the collection of physical emissions data, working with business unit managers to identify abatement costs and developing a strategic carbon management approach. • Technical and financial analysis of internal abatement costsAnalysis goes beyond simply measuring and forecasting emissions to using advanced project analysis methods to estimate the risk-adjusted cost of undertaking internal emissions reductions. This requires sophisticated project analysis techniques to measure the impact of uncertain future cashflows, together with operational and policy risk factors on a par with those already used to assess fuel diversity and load uncertainty. • Establish internal emissions trading. In the same way that a national emissions trading scheme allows a country to achieve emissions targets at lowest cost, an internal corporate trading scheme allows a firm to identify the most efficient reductions. A well-structured scheme will provide proper financial incentives to encourage business unit managers, plant managers, scientists and engineers to identify and implement cost-effective emissions reduction projects. It will also create the internal awareness of the utility emissions profile throughout the firm essential to effectively react to the inevitable evolution in GHG regulations. The BP scheme (see the sidebar) achieves this by linking GHG performance to business unit manager remuneration. • Enter the marketEnter the pre-compliance market to acquire emission reductions from third parties. The firms who are active (largely North American and Japanese utilities) hope to gain experience and build a war chest of potentially valuable reductions while the market price is still low. In addition, they will shape the embryonic marketplace by helping establish the business practice that other entrants will follow. More sophisticated players take a portfolio approach and acquire emissions reductions from a variety of project types and geographical locations. Corporations who enter the external market at this stage typically do so in concert with other activities. For example, an assessment of internal abatement costs14 is critical to determine if a firm will be either a net buyer or a net seller. In either case, external market activity is valuable to diversify a portfolio of emissions reductions. External emissions reductions can complement an internal GHG trading system, whereby a business unit manager is permitted to achieve emission reductions through internal or external action. An internal trading scheme is extremely valuable to a organization with diverse emissions sources. The foundations of such a scheme must be solid. All aspects of the scheme, ranging from basic elements, such as the currency (carbon dioxide equivalent) and measurement and verification to the technology that facilitates trading, must be developed with the external marketplace in mind. Consistency is critical. The endgame for an internal trading scheme is linkage with external marketplaces — national, regional, and even other corporations. The quest is to use the market to identify and acquire good-value emission reductions. Summary Emission reduction policies are rapidly developing at the international, regional and national level. In the past decade, emissions trading has grown from a mad glint in an environmental economist’s eye to an accepted method of controlling pollutants. Over the next 10 years, the current experimental GHG emissions trading program will grow to form a unified international commodity market for GHG instruments. Utilities, who face potentially crippling financial exposures, need to act now. Climate change must be approached like any other long-term key strategic issue. Utilities can mitigate future risks and take advantage of opportunities. Importantly, they can learn from early movers to maximize the likelihood of undertaking the most suitable actions. Climate change is a long-term issue that will increasingly become a defining issue of the power generation industry. The solutions under debate today are but the first step in addressing the problem. How a company positions itself today will determine if it is part of that evolving future or a business-school case study of a failure to adapt. Footnotes 1 The Global Climate Coalition has taken a strong position against mandatory greenhouse gas constraints and the Kyoto Protocol in particular. 2 The Pew Centre on Global Climate Change works with industry and government to educate stakeholders on the risks, challenges and solutions to climate change. 3 The high discount of any benefit or action that is not recognized by the public prior to the next election — antonym: statesmanship. 4 A once federally-subsidized industry now subject to class-action suits by those same states. 5 Carbon dioxide equivalents (CO2eq) provide a universal standard of measurement against which the impacts of releasing (or avoiding the release of) different greenhouse gases can be evaluated. For example, the ‘climate impact’ of the release of one ton of methane in greater than the release of one ton of carbon dioxide. However, the impact of the release of methane can be expressed in terms of the impact of the release of a certain volume of carbon dioxide (the carbon dioxide equivalent). 6 Utilities are among the largest emitters of GHG in virtually every nation, are already highly regulated, and pose the least threat of flight. 7 Market mechanisms can harness the creativity of business people, scientists and engineers to identify and realize the lowest cost emission reductions available globally. The market-based approach recognizes it is irrelevant from a global warming perspective where the reduction occurs or who makes the reductions. This realization frees emitters to look for reductions to offset their emissions beyond their own operations. 8 Cap and Trade is a type of emissions trading program in which participants have their emissions measured and surrender an emission allowance for each unit (e.g., one ton) of their emissions during a designated time period. The number of available emissions allowances is constrained, thereby limiting the quantity of allowable emissions. The participants are allowed to trade the available pool of emissions allowances in a secondary market, presumably continually reallocating this scarce commodity to its highest value uses. 9 The small number of market participants share very similar internal abatement cost curves. 10 The overall balance of supply and demand for electricity in Northern Europe drives the production decisions made by the Danish generators. Consequently the market participants are all expected to be buyers or all sellers. 11 CO2e.com estimate. 12 First, most utilities are facing emissions growth, so any cuts will be initiated from a higher emissions level. Second, because climate change is a problem of accumulation, industry will be forced to offset all of the emissions that were contributed prior to implementation of the cuts resulting in a lower end-point emissions target than would otherwise occur. This argument holds true on both the micro and macro level. 13 Any utility manager who believes they receive the same quantity and quality of information regarding reduction capability by asking their planning divisions and operations managers in answer to memorandum opposed to making emissions a budgetary line item should consider career counseling. 14 When assessing internal abatement costs, it is important to perform the analysis on an equitable basis. Consider all risks, operational and policy, associated with the project. Also, consider the likelihood that early reduction activity will be credited under a future mandatory scheme. Filed under: White Papers Tagged under: Utilities About the Author Chris Trayhorn, Publisher of mThink Blue Book Chris Trayhorn is the Chairman of the Performance Marketing Industry Blue Ribbon Panel and the CEO of mThink.com, a leading online and content marketing agency. He has founded four successful marketing companies in London and San Francisco in the last 15 years, and is currently the founder and publisher of Revenue+Performance magazine, the magazine of the performance marketing industry since 2002.