Oil Energy Money

In the first sale  of its kind, $39m worth of carbon credits (or allowances) were sold at an open auction last Thursday.  The auction, run by the Regional Greenhouse Gas Initiative (RGGI, or ReGGIE) a coaltion of ten North Eastern states, was expected to attract 20 bidders but a surprise 59 participated, ranging from power companies to environmental groups.  12.5 million credits, each of which allows 1 ton of carbon to be emitted, were sold and the selling States intend to invest the money raised in environmentally friendly developments.  That’s the good news.

Before we get to the bad news, lets discuss what exactly happened last Thursday. 

In response to President Bush walking away from the Kyoto Protocols, many states have taken it upon themselves to reduce emissions on a national level.  One solution is a cap-and-trade system where a cap on carbon emissions is put in place.  If a company produces less carbon than its allowance, it can sell credits to a company which has exceeded its allowance.  This should encourage producers to curb emissions in the hope of selling their credits for a profit.  

For a cap-and-trade system to work, the price of each allowance (one ton of carbon output) must be higher than the price of reducing emissions by one ton of carbon.  If the cost of reducing carbon emissions is higher than the cost of buying credits, no one will bother reducing their carbon output and simply buy a credit for each ton they exceed their allowance.  

For example, if a company is allowed to emit 100 tons of carbon and it currently emits 110 tons, it has the choice of either:

• Spending, say, $10m to buy 10 carbon credits, or
• Spending $20m to install carbon reduction technology which will reduce output to 100 tons.

 It will obviously choose to buy credits.  This won’t help the environment much.  

Further, the cap must be low enough that companies face the risk of exceeding their allowance.  These two ideas lead us to the bad news.

Firstly, the futures market expected credits to be sold for $4 each.  They fetched $3.06 at the auction.  By comparison, credits trade for about $37 in a similar European scheme.  An Australian study estimated that credits must cost $25 before they cover the cost of injecting carbon emissions underground.  This disparity in prices hinders a truly global carbon trading market which is necessary to attract liquidity, investors and attention.

Secondly, the cap was set at  188m tonnes, while figures from 2007 estimate a total output in the ten states of 168m tonnes.  The cap is set to decrease by 10% increments between 2015 to 2018 so companies will be forced to reduce output in the future.  Right now however, producers have little motivation to invest in credits.   

Keith Johnson at the WSJ is equally skeptical about the scheme, suggesting that it is too cautious and lenient.  But Thursday’s auction may be useful as a blueprint for larger, national initiatives taken in the future.  Once pricing and supply are hammered out there should be a bright future in carbon credits, encouraging companies to improve emissions without taxpayer subsidies.  And that should be good news for everyone