The Economist: Trading thin air
May 31st 2007
From The Economist print edition
The carbon market is working, but not bringing forth as much innovation as had been hoped
EVERY year the average sow and her piglets produce 9.2 tonnes of carbon-dioxide equivalent through the methane emissions from their effluent. In the past, that has been a problem both for the environment and for pig-farmers. In developing countries the pig-effluent collects in open lagoons which smell bad and get infested with flies. Sometimes it flows straight into nearby water systems.
Now this problem has become an opportunity. Bunge, an agricultural-commodities business based in America, builds lined and enclosed pools to collect the effluent and captures the methane that it emits. The farmer can use the gas to generate electricity. By preventing methane from escaping into the atmosphere, Bunge creates a credit which it can sell on the carbon market. The farmer gets to keep 20-30% of the value. Bunge has 40 such projects operating in Brazil and is planning to expand into Mexico, Guatemala, Peru and the Philippines.
The carbon market is truly innovative. Although it works like any commodity market, what is being bought and sold does not exist. The trade is not actually in carbon, but in not-carbon: in certificates establishing that so many tonnes of carbon dioxide (or the equivalent in other greenhouse gases) have not been emitted by the seller and may therefore be emitted by the buyer.
The purpose of setting up the market was, first, to establish a price for carbon and, second, to encourage efficient emissions reductions by allowing companies which would find it expensive to cut emissions to buy credits more cheaply. It has had some success on both countsâ€”some would argue too much on the second.
A carbon price now exists, established by the European Emissions-Trading Scheme (ETS). In its first phase it has been volatile (see chart 2) because information about Europe’s industrial emissions was poor, so the market got a shock in early 2006 when it emerged that the European Commission had been too generous with the allowances it handed out to industry. Phase one allowances (2005-08) are now virtually worthless. But the commission has learnt its lesson and got meaner with allowances, thus pushing up the price in phase two.
The supply of carbon credits comes principally from two sources. The first is the allowances given to companies in the five dirty industries covered by the ETS (electricity, oil, metals, building materials and paper). The second source of carbon dioxide lies outside Europe. The European Commission linked the ETS to the â€œclean-development mechanismâ€ (CDM) set up under the Kyoto protocol. This provides for emissions reductions in developing countriesâ€”such as those on the Latin American pig farmsâ€”to be certified by the UN. Such â€œcertified emissions reductionsâ€ (CER) can then be sold.
The demand for carbon credits comes mostly from within the ETS, from polluters who need certificates allowing them to emit carbon. There is some demand from Japan, which has a voluntary scheme, and from companies and individuals elsewhere in the world who want to offset their emissions for moral reasons, or to make themselves look good.
The trade is now sizeable. Some â‚¬22.5 billion-worth ($30.4 billion) of allowances were traded last year, according to Point Carbon, a data-provider, representing 1.6 billion tonnes of CO2â€”a huge increase on the â‚¬9.4 billion traded in 2005. Europe’s ETS made up about 80% of the total value.
Developing-country CERs accounted for about â‚¬4 billion of last year’s trade: 562m tonnes of CO2. According to New Carbon Finance, a research company, carbon funds worth $11.8 billion have been raised so far. Half of that total is managed from London. Climate Change Capital, a niche investment bank, raised $130m for its first carbon fund, launched in July 2005; its second, launched a year later, is now worth around $1 billion. According to Tony White of Climate Change Capital, all the money for the first came from hedge funds, which like risk. By the time the second fund was established, more cautious investors, such as pension funds and banks, were prepared to put money into it.
The money has gone mostly into projects in developing countries to produce CERs. Bunge’s Brazilian pig-farmers are making CERs out of their animals’ effluent. But the bulk of the investment has gone into greenhouse-gas capture in China.
Cheap and cheerful
The most potent greenhouse gas is HFC-23, a by-product of HCFC-22, a chemical used in, among other things, fridges. It is now mostly banned in the developed world. Its global-warming effect is, tonne for tonne, 11,700 times greater than that of carbon dioxide, so it is good to get rid of it, and cheap, too; capturing it and burning it off costs less than â‚¬1 for the equivalent of one tonne of carbon dioxide. These days China produces most of the world’s HFC-23. Thatâ€”along with the fact that the Chinese government is efficient to deal withâ€”explains why 53% of the total volume of CDM projects in 2006â€”worth around â‚¬3.5 billion in totalâ€”went to China.
The very cheapness of cutting emissions of HFC-23 makes the trade controversial. Credits costing less than â‚¬1 to produce have been sold on the market for up to â‚¬11. Factories have found that their damaging by-product, HFC-23, can be more valuable than their main output. The Chinese government, realising how much money there is in this business, has imposed a tax of 65% on revenues from it, and in February this year it launched its own $2 billion CDM fund. So European consumers, who are paying for greenhouse-gas abatement through their electricity and other bills, are contributing billions of dollars to the Chinese government’s coffers via the CDM.
Easy optionsâ€”HFC-23 and other fabulously dirty (ie, profitable) industrial gasesâ€”will soon run out. Guy Turner at New Carbon Finance reckons that the days of the CER that costs less than â‚¬1 to produce are over, and that the range is now more like â‚¬1-5. But there is plenty of scope at that level. China’s industrialisation is a fast and dirty business, and there will be no shortage of greenhouse gases produced there for rich-country money to clean up.
That is part of the problem. Of the 65% of companies surveyed by Point Carbon earlier this year which claimed that the ETS had led them to abate their emissions (up from 15% the previous year), most were planning to buy credits rather than cut their own emissions. Yet the ETS was intended to cut European emissions as well as Chinese ones.
This is happening on a small scale. At times the carbon price has made it worth power companies’ while to switch from dirty fuels to cleaner gas. â€œWe massively reduced our lignite production when the CO2 price was at its height,â€ says Alfred Hoffmann, head of portfolio management in Scandinavia and Germany for Vattenfall, a Swedish power company. Lignite is dirtier than black coal. But then gas prices rose, making switching less attractive.
Bringing home the methaneThe carbon price has delivered some of the innovation that it was supposed to generate. Shell, for instance, is pumping CO2 from a refinery in the Botlek area of the Netherlands into 500 greenhouses producing fruit and vegetables, thus avoiding emissions of 170,000 tonnes of CO2 a year and saving the greenhouse owners from having to burn 95m cubic metres of gas to produce the CO2 they need.
Alcan, an aluminium company, is planning to use the heat from one of its smelters to increase the efficiency of its power-generation plant at Lynemouth in Northumberland in Britain. Wyn Jones, managing director of Alcan’s British smelting and power-generation operations, says this will save 150,000 tonnes of CO2 a year (â‚¬3m if the price of CO2 is around â‚¬20 a tonne, as Alcan expects) and 60,000 tonnes of coal (Â£2.1m, or $4.2m, at around Â£35 a tonne). He is not sure how much the project will cost, but is reckoning on a payback period of around five years.
But European emissions overall are not falling, which suggests there may not be as much switching out of coal, or as much technological innovation, as had been hoped. Chinese CERs are too cheap and the carbon price is too low and too volatile. Even when it was bouncing around at â‚¬15-25, it did not seem to encourage much new investment. According to Bjoern Urdal of Sustainable Asset Management, who took a detailed look at the effects of the carbon price on the German electricity market last year, replacing old coal-fired power stations with gas-fired ones became worthwhile only at a carbon price of â‚¬33. He has not done the sums since last November, when the European Commission chucked out Germany’s â€œtransfer ruleâ€ (which would have exempted new coal-fired stations from the ETS for 14 years), but reckons the break-even point will have come down to more like â‚¬25.
That helped raise the carbon price. So did the commission’s decision to slash national governments’ planned allocations to industry for the period 2008-12. The price of phase two allowances has risen to a level high enough to get some power generators to switch from coal to gas at the margin when the gas price is moderate; but not high enough to get them to replace coal-fired power stations with gas-fired onesâ€”nor to encourage much of the innovation that carbon trading had been expected to spawn.