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 CO2e^SM Trade Cycle (Figure 2) incorporates
these actions and illustrates one approach to managing the risks and opportunities
arising from climate change.

Figure 2 – CO2e^SM 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.

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.