June 17, 2003

Carbon Trading

Most of the people I talk to think that we will trade carbon. It is just a matter of when. I think that I agree with them.

I also get general agreement when I say that I think that it is likely that leadership in the development of carbon trading will come from the private sector. This is actually an interesting development. Most of the thinking about carbon trading is based on an analogy with the trading of sulfur permits in the US. Sulfur trading is part of the framework that was put in place to address issues associated with acid rain. In that framework the US government sets a total amount of sulfur that can be emitted into the atmosphere and sells rights to emit that much material. The price of the right to emit a unit of sulfur is then set by market mechanisms.

There are two ways for a company (say an electric utility) to manage the sulfur that it produces as atmospheric waste. First it can modify it practices so that there is less atmospheric sulfur waste. Modification might include switching to lower sulfur coal or developing new combustion technologies that trap sulfur before goes up the stack. Second it can buy permits to allow the needed sulfur emissions. In a market system, companies will choose which ever option is cheaper. Because the total amount of sulfur that can be emitted is limited and declining, there is incentive to develop new processes in order to avoid having to buy increasingly scarce permits.

Sulfur trading has been fairly successful. The total amount emitted has steadily decreased and, surprisingly, so has the price of permits. Prices have dropped because, the process changes that were encouraged by the structure of the framework have been very successful.

The story is a little more complicated because at the same time as sulfur permits were being implemented, railroads were being deregulated. Railroad deregulation had the effect of lowering the price of lower sulfur coal from the western states.

The sulfur system is called a "Cap and Trade" framework. The total amount of sulfur emissions is "capped" and companies then trade to account for differences in their needs and capacities. The price is initially set by the imposition of the Federal government of the cap. At the implementation point of the system an initial set of property rights is established. Setting the initial level and the initial distribution of property rights is a tricky political problem, but one that was solved in the case of sulfur.

Carbon is different from sulfur. In the case of sulfur and acid rain, the problem could be usefully addressed within the confines of a single nation-state; although there are interesting conflicts with Canada. The time and space scales of the sulfur problem are such that costs and benefits could be assessed and results could be seen in manageable time frames. None of these is true for carbon. Carbon mixes fairly quickly on a global scale and has a time scale in the atmosphere of centuries; thus no single nation can unilaterally address the problem and the benefits may take decades to accrue. Furthermore the details of the carbon cycle are much more complex than those of acid rain.

In some ways the Kyoto Protocol can be thought of as a cap and trade system. It attempts to put limits on the total amount of carbon that can be emitted into the atmosphere and it attempts to allocate initial property rights to those emissions. In this way the Kyoto Protocol would establish a framework in which the value of a ton of carbon could be established.

In a classical sense, some form of capping is necessary to establish a market for carbon, but it doesn't look like people are waiting for that to happen. The price of a ton of carbon is currently somewhere between $3 and $30. Some people I have talked to say the range is much smaller than that. It appears that a growing number of forward thinking companies expect that carbon will be managed in some way in the future. Those companies believe that first movers with respect to the capacity to trade and manage their carbon will have competitive advantage when that day comes. There are enough of those companies that there is a group associated with the Chicago Board of Trade that has established the Chicago Climate Exchange to handle the expected market in carbon trading. There are also large companies such as BP and DuPont that trade carbon internally.

Thus the capacity to trade is being developed in the absence of a regulatory framework. That capacity reflects the expectation by large, globally distributed, firms and groups of firms that carbon emissions are a liability that needs to be hedged. I expect this to continue to develop and that those who are hedging now will come out ahead of the game.