How to Buy a Cleaner Planet | Feature | Chicago Reader

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How to Buy a Cleaner Planet

It's so crazy, it just might work: letting industry pay for the right to pollute.


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By Harold Henderson

It seems like global warming means doomsday no matter what. If we keep on burning coal and oil and gasoline, carbon dioxide will continue to build up in the air and change the climate, setting off an environmental plague of droughts, floods, and extinctions. But if we cut back on fossil fuels, we may well set off a worldwide economic depression.

Your money or your life? Financial-market inventor Richard Sandor, who runs the Loop-based firm Environmental Financial Products, thinks that's a false choice. He believes we can reduce carbon dioxide pollution for as little as a nickel a gallon of gasoline--cheap enough that we can avoid both catastrophes at once.

To achieve this historical double play, Sandor would like to see worldwide emissions trading established--a kind of environmental market in which companies buy and sell the rights to emit a certain amount of carbon dioxide. If the market were set up properly--and that's the catch--it would enable everyone to reduce the total amount of carbon dioxide (and other greenhouse gases) released into the atmosphere at the lowest possible cost. And it would promise windfall profits to any ingenious inventor who could make reductions even more cheaply.

Economics professors have long dreamed of putting a price on pollution. But that dream has only just begun to affect reality. Most environmental laws still simply say, "Don't put out more than two million tons of crud a year" or "Install a catalytic converter on every car." These laws do reward ingenuity--the kind of ingenuity that enables a company to put out exactly two million tons of crud and not a pound less, or the kind of ingenuity that installs the cheapest catalytic converter you can get away with. Sandor argues it would be better to write laws that would reorient the game by building a set of incentives that reward businesses for cleaning up more rather than less.

Making a market to save the world is just the sort of idea you'd expect Sandor to have. He's worked in and around the Chicago Board of Trade for decades, serving as a vice chairman in 1997-'98. In the 1970s he devised a futures market in interest rates, which became an enormous success when rates began fluctuating wildly. These days he describes himself as "a professional inventor in the broadest sense of the word....I create ownership rights for what were previously free resources." In other words, he devises new ways to buy and sell stuff.

Tinkering with markets puts Sandor in a Chicago tradition that goes back to the 1850s, when members of the Board of Trade figured out a way to grade wheat and trade it as a standardized bulk commodity instead of haggling over individual bags of wheat from particular midwestern farms (a process William Cronon describes in riveting detail in his book Nature's Metropolis). It may not sound like much, but this innovation rationalized prices, revolutionized farming, enabled Chicago to outstrip Saint Louis, and permanently altered the landscape of the midwest. It also did wonders for the Board of Trade, which before this had often been unable to get anyone to show up to trade, even when it offered free refreshments.

A market in pollution rights, aka emissions trading, could involve even higher stakes. It's also trickier to start up, because it can't create itself. It depends on a judicious combination of government intervention and government neglect. First the government would have to set an overall cap on a particular kind of pollution, then it would divide up that cap so that trading could begin, and finally it would enforce the cap by monitoring actual emissions at each plant. Then the government would stand aside and let trading work its magic within this framework. The market is a powerful tool because it focuses people's ingenuity on a single purpose, just as a radial-arm saw focuses electricity on the job of cutting. But the saw just makes noise unless someone installs the right blade and puts a two-by-four under it.

"You'd think this idea made so much sense, perhaps, that no one could possibly object," Fred Krupp of the pro-trading Environmental Defense Fund told a Northwestern University audience last fall. "But unfortunately there are still some companies that want to pollute for free, and there are still some bureaucrats that want to micromanage and overregulate."

Sorry, Fred, but to understand emissions trading is not necessarily to love it. Advocates often overstate its virtues. Like gearheads who can discuss the fine points of horsepower, trading advocates are fascinated by detailed market mechanisms, but they tend to gloss over the unavoidable ethical dilemmas those mechanisms pose. For instance, well-designed markets can accomplish social goals and make everyone better off, but they don't make everyone equally better off. Many environmentalists and many developing countries agree with the Indian daily the Hindu, which on March 10 condemned carbon dioxide emissions trading as an attempt by the U.S. to "bind [us] in environmental colonialism in order to protect its own luxury interests."

The easiest way to understand emissions trading is to check out the four-year-old federal Acid Rain Program to control sulfur dioxide. A recent UN report calls it "the largest and most successful emissions cap and allowance-trading program in the world." Though it's smaller and simpler than carbon dioxide emissions trading would be, Sandor and other advocates of emissions trading agree that it's the best working model we have.

In 1990 Congress wanted to reduce the sulfur dioxide pollution being spewed out by electric utilities (which contributes to acid rain). To accomplish this goal, it could have told each plant what to do and how to do it ("Cut your sulfur dioxide emissions in half by installing scrubbers"). Command-and-control regulations like this ensure that some cleanup gets done, but they don't ensure that it gets done in the most efficient way, especially given how fast new technology comes along. President Bush wanted to try a more flexible approach, and Congress was eventually persuaded to pass the Clean Air Act Amendments of 1990.

This law set a nationwide cap on sulfur dioxide emissions from coal-burning utilities. Phase I of the cap began in 1995 for the 110 dirtiest power plants in the country; Phase II will start next year, setting a lower cap for all plants. It will limit sulfur dioxide emissions to no more than 8.95 million tons per year, a nifty 10 million tons less sulfur dioxide per year than we had to breathe in 1980.

But a limit is also an entitlement. Just as "Don't go in the deep end of the pool" also means "You can play in the shallow end," so too "Don't emit more than 8.95 million tons of sulfur dioxide" means "We won't hassle you for emitting 8.95 million tons of sulfur dioxide." In passing this law, Congress in effect said that utilities as a group have the right to emit 8.95 million tons of sulfur dioxide every year. (Conventional regulations too imply some "acceptable" level of pollution, because any given required technology will clean up only so much.)

Think of the cap as 8,950,000 "Get Out of Jail Free" cards. Each card, called an "allowance," is good for one ton of sulfur dioxide coming out of a smokestack. Every year the U.S. Environmental Protection Agency deals the cards to each plant for free. The plants can then buy and sell the cards however they choose. The EPA monitors how much sulfur dioxide comes out of each plant, and at the end of the year each plant must give the EPA one card for every ton of sulfur dioxide it put out or face a stiff automatic fine. The EPA doesn't care where those cards come from or how long the plants have held them.

This trading game works for the environment because Congress set the cap low: there aren't enough cards to allow plants to keep polluting as they did in 1980. Each plant gets a share roughly proportional to, but less than, the tonnage it used to emit. Bad actors get lots of cards, good actors get fewer--and somehow everyone has to have enough cards to give the EPA at the end of the year.

As a power-plant manager, you have three choices: you can make less sulfur dioxide so that the cards the EPA has dealt you will cover the amount you produce, or you can keep on polluting and try to buy additional cards, or you can do a combination of both. If you choose to make less sulfur dioxide, you can either install scrubbers to clean sulfur from your coal or you can buy cleaner coal in the first place. Every plant is different. Some are set up so that it's easier to scrub. Some are closer to western clean-coal deposits. If your plant can be cleaned up cheaply, you may then find yourself holding more cards than you'd need to satisfy the EPA at year's end. You can hang on to them for future years, or you can sell them for whatever the market will bear.

If instead you decide to keep on polluting and get more cards to cover the total, then you have to buy them from someone else, another power plant or a broker. This sounds like cheating, but it's not. Everyone's trying to get under the cap, so no one can afford to sell you any allowances unless they've already cut their sulfur dioxide output by so much that they have cards to spare. In other words, the fact that anyone is offering cards for sale guarantees that someone, somewhere, is getting the job done. And by buying their excess cards you're helping them do it.

The cheaper it is for you to clean up, the more money you can make selling your extra allowances. So the way to get rich is to do as much as possible, not just a grudging minimum. Suddenly the market is working for environmental protection instead of against it. No command-and-control regulation or pollution tax can produce this self-fueling result.

The politics behind the Acid Rain Program have been questioned, in particular the decision to give, not sell, allowances to existing polluters. Was this fair? Shouldn't they have had to pay something? Maybe, but making them freebies may have been the political price for getting emissions trading through Congress. In his forthcoming book Emissions Trading: Environmental Policy's New Instrument, Richard Kosobud, an economist at the University of Illinois at Chicago, says that the electric utilities might not have agreed to emissions trading in 1990 if they hadn't been assured of getting free allowances to start with.

Nevertheless, the Acid Rain Program has worked as an environmental program. Sulfur dioxide emissions from Phase I plants were just 5.4 million tons in 1996--well under the EPA's cap.

The program also seems to be working as a market. In 1998 more than 5 million allowances were traded between utilities in a $1.6 billion market. (That's an order of magnitude smaller than the U.S. corn market but well above the Board of Trade's threshold for considering establishing a futures contract.) Allowances are now selling for around $200 apiece, a reasonable figure given that it roughly corresponds to engineering calculations of what it costs to get rid of a ton of sulfur dioxide. But when trading began, the market was thin, and the price of allowances fluctuated. In 1996 allowances were selling for as little as $66, apparently due to mistaken plans and growing pains. If the cost of getting rid of a ton of sulfur dioxide had really dropped that low, that would have been good news for pollution control. But it was too good to be true.

What about Sandor's most important claim for environmental markets--that they will bring down the cost of pollution control? Has emissions trading made it cheaper to control sulfur dioxide? Yes, though advocates often exaggerate both the savings and the role of trading in creating them. Clinton administration officials, following their boss's lead on veracity, have claimed a 15- fold savings, but they base that figure on apples-and-oranges cost comparisons. The truth is more modest. The most careful studies back in 1990 predicted that during Phase II it would cost between $225 and $500 to get rid of a ton of sulfur dioxide. Today, on the eve of Phase II, the cost is about $200 a ton--a significant but not astronomical savings.

Moreover, the fact that we're now getting cleaner air for less money doesn't prove that emissions trading had anything to do with it. Three big changes have hit the electricity-making business since 1990. Railroad competition has made western coal cheaper to ship to the midwest. Utilities have found better ways to mix coals of varied qualities in their boilers. And scrubbers have become cheaper to install and run, and more efficient at removing sulfur.

All these things might have happened whether or not Congress had passed the Acid Rain Program in 1990. But trading advocates believe that they happened sooner because emissions trading created a demand for them. Dallas Burtraw of the Resources for the Future think tank writes in a recent paper, "What were previously independent factor markets supplying services to utilities (coal mining, rail transport, and scrubber manufacturing) were thrown into competition with each other by the program's flexible implementation. This unleashed competitive pressure to find ways to reduce costs in all these markets." At the very least, Kosobud adds, the Acid Rain Program allowed utilities to take advantage of these new options more easily once they appeared. So Illinois Power was free to cancel its order for scrubbers when it saw lower clean-coal prices.

This is all plausible--and a bit vague. The Acid Rain Program offers a chance to test an assumption at the heart of modern economic theory--that free markets lower costs. And this is no classroom exercise. If the assumption doesn't check out, then Richard Sandor and the Environmental Defense Fund aren't likely to be able to save us simultaneously from global warming and global depression. But this test has yielded no quantitative proofs, little evidence, and hardly even any anecdotes--just a restatement of the assumption. Researchers write that costs have fallen "no doubt in response to competition" and that the program "gives an incentive" to improve efficiencies. One trader says research just can't quantify the dynamics of an open market, but he doesn't mind: "I have no such obsession with quantitative proofs." You just gotta believe.

If we're satisfied with faith, then a world carbon dioxide market should be set up to work like the Acid Rain Program. Companies whose products are closely connected to fossil-fuel burning would get to trade rights to emit carbon dioxide under a cap, and those that find a way to allow less fossil fuel to be used to do the same amount of work would make money selling their extra carbon dioxide allocations. That way they could profit from marketing such things as fuel-efficient and alternative-fuel cars, high-efficiency lightbulbs, energy-saving appliances, solar cells, fuel cells, and natural-gas generators. If and when some new energy-saving invention arrives, everyone would seize on it to make even more money, rather than wait for legislators to write it into new regulations.

Trading carbon dioxide allocations might work even better than the Acid Rain Program, because anything that takes carbon dioxide out of the air and "sequesters" it as carbon--long-lived trees, undisturbed farmland--has the same effect as not emitting a corresponding amount of carbon dioxide. That means that people could create allowances by planting trees or plowing their fields less. This opens up a possibility that Sandor has been quick to exploit--trading sequestered carbon rights as well as emissions rights, thus enabling third-world farmers to be paid for preserving trees instead of logging them.

So much for the good news. The bad news is that the details of carbon dioxide emissions trading have proved harder to work out than the details of the Acid Rain Program. Here's a sampling of the problems:

Who would be in charge? In the Acid Rain Program the problem was largely within the U.S. and was dealt with by the U.S. government. But since carbon dioxide is a global pollutant and there's no global government, where will the authority come from to cap, allocate, and enforce? The leading candidate is the Kyoto Protocol, an international treaty negotiated at Kyoto in December 1997 and now in the process of being refined in follow-up meetings. However, the Kyoto Protocol is disdained by developing countries because it asks too little of the U.S. and by Senate Republicans because it asks too much. (Under the protocol, the Clinton administration has agreed to reduce U.S. carbon dioxide emissions to 7 percent below 1990 levels, but it has left the actual work to be done by whoever holds office in 2007.)

Even worse for would-be carbon traders like Sandor, the Kyoto Protocol takes a much narrower view of emissions trading than they do. It allows wide-open trading only among developed countries (provisions for developing countries involve a complex bureaucracy). It has no clear provision for trading between companies; only countries are allowed to trade. And it says that trading should only be "supplemental to domestic actions"--in other words, each country should make most of its promised reductions on its own, not through trading. The Acid Rain Program places no comparable restrictions on participating utilities, and there's little doubt that such restrictions would have crippled the program.

Who would get the allowances to start with? In the Acid Rain Program, Congress gave away allocations to existing polluters, the utilities. With carbon dioxide, that would mean giving most allowances to big multinational companies. Developing countries won't accept that, and it might not even be economically efficient. Last summer University of Maryland economists Peter Cramton and Suzi Kerr argued in a Resources for the Future publication that carbon dioxide allowances should be auctioned off to the highest bidder. That way polluters would at least pay for the right to pollute. Even more egalitarian is the radical idea floated by Peter Montague in "Rachel's Environment & Health Weekly" (December 10): issue an equal share of the greenhouse-gas allowance cap to every person on earth, to sell or retire as he or she chooses.

Who would be held accountable for meeting the cap? This is actually a separate technical problem from who would get the allowances to start with, though the Acid Rain Program's politically expedient solution lumped the two together. But the Acid Rain Program affected only a few hundred smokestacks belonging to a few dozen utilities. Carbon dioxide comes from fossil-fuel burning, which is ubiquitous, making it impossible to hold every source, from cookstoves to airplanes, directly responsible. Ideally, the entities chosen to do most of the trading and to be monitored would be the biggest sources of emissions, be few enough in number to keep track of, and yet be numerous enough to set up a robust market that no one player could dominate. Obviously, picking these entities would be a politically challenging task even if you had a well-accepted set of institutions within which to do so.

Who would benefit from trading? In the Acid Rain Program no one utility stands out as dramatically impoverished compared to the rest. But a carbon dioxide program would span the full global range, from appalling poverty to obscene affluence. From a trader's point of view, that's great. Poor countries can plant trees, insulate buildings, or switch fuels much more cheaply than rich ones can--so they could generate low-priced allowances for U.S. companies to buy. That's why advocates of trading want all countries to be in the same wide-open carbon dioxide market, something the Kyoto Protocol doesn't envision.

But many environmentalists and third worlders suspect that carbon dioxide emissions trading will somehow leave them holding the dirty end of the stick. And mainstream economic analysis shows that their suspicions aren't altogether idle. In an October 1998 paper, "Analysis of Post-Kyoto CO2 Emissions Trading Using Marginal Abatement Curves," issued by MIT's Joint Program on the Science and Policy of Global Change, A. Denny Ellerman and Annelene Decaux found that "the distribution of the gains from trading [would be]...highly skewed in favor of those who would face the highest costs in the absence of emissions trading"--in other words, in favor of the U.S. and other developed countries.

In one key scenario Ellerman and Decaux suppose that a worldwide system like the Acid Rain Program were adopted for carbon dioxide. Developed countries, which would mostly be buying allowances, would save an estimated $94 billion over what it would have cost them to make the reductions on their own. Developing countries, which would mostly be selling allowances, would gain $10 billion from those sales. Everyone would be better off, but not equally. Trading would make both the rich richer and the poor richer, but, as is often the way with capitalism, the rich would get richer faster.

It's a question of values. If you see global warming as a problem to be solved, then this result sounds great. But if you see global warming as a chance to punish evil polluters, then it doesn't satisfy. If you would like to see a world where poor countries can realize an extra $10 billion a year--in other words, if you're primarily concerned about relieving absolute poverty--then it sounds great. But if you want a world where everyone's income converges toward equality--if you're primarily concerned about relieving relative poverty--then it does sound a lot like environmental colonialism.

All these headaches would drive most of us to some other line of work, but they just make Sandor want to start tinkering and trading. He doesn't criticize the tedious, brain-crunching meetings that created the Kyoto Protocol and that are now refining it--work in which the Environmental Defense Fund has taken the lead. But he doesn't care to set up a new market that way, from the top down. The concluding line of his company's slide show, "Market-Based Solutions to Climate Change," says it all: "Imperfection is inevitable: start now, improve as we go."

"Every time I've seen somebody try to develop some national grand scheme, particularly for a market, it falls flat on its face," Sandor told a forum on climate change for local business leaders held at Northwestern's Kellogg Graduate School of Management last November. "If you start small, you can at least learn." The Acid Rain Program itself grew out of a number of smaller emissions-trading schemes the EPA began trying back in 1975. For carbon dioxide, Sandor says, "We need a pilot program and a demonstration project." (He's been urging this on Congress and the Clinton administration for years without success.) "You don't start building a 747. You start with a couple of guys with spit and glue off North Carolina flying for seconds....You don't start with a Worldwide Web. You start with Steven Jobs and a garage."

Sandor knows that any carbon dioxide emissions market will require some kind of governmental authority to cap, allocate, and enforce. But he's not going to wait around for all the i's to be dotted, or even written. He knows there are speculators and companies out there willing to buy and sell in the expectation that a framework of authority will grow up around them.

One of Sandor's "garages" is Costa Rica, where he has helped devise a way for that country to market carbon dioxide allowances as "certified tradable offsets." Each CTO equals one ton of sequestered carbon, and it's backed by the preservation of enough Costa Rican rain forest to sequester 1.7 tons, which provides a large but necessary margin of error. To guarantee this, the Swiss-based international standards firm Societe Generale de Surveillance (SGS) was hired to ascertain what would have happened to a given patch of rain forest in the absence of the program. (If the purpose is to reduce carbon dioxide and not to produce flimflam, a CTO can't be based on forests that have already been preserved or on the planting of trees that would have been planted anyway.) SGS also took account of uncertainties along the way--landslides or hurricanes that would kill trees and eventually liberate their carbon, for instance. Finally it approved a number of CTOs for Costa Rica to sell on the international market. "What we got," says Sandor, "would be an AAA instrument in terms of carbon sequestration. The science could be off by 40 percent, but the investor was assured there would be a sufficient amount of carbon."

Because SGS has done the certification work up front, a carbon trader who buys CTOs need not visit Costa Rica to make sure the trees are there--just as a wheat trader at the Chicago Board of Trade need not visit a farm in downstate Ford County to check on the crop before buying a contract for wheat deliverable in July. CTOs have become commodities like grain, and it no longer matters where they're from.

How is this new commodity selling? The Norwegian government and a consortium of three Norwegian companies bought 200,000 CTOs in 1997 for $10 apiece. Sandor's firm bought 1,000 in May 1997 at an undisclosed price, presumably in hopes of someday selling them at a profit. Last spring SGS certified 1 million CTOs in Costa Rica, and Reuters reported that Sandor had brokered an $80 million sale. Who bought them? How many? At what price? He won't say.

Sandor is by no means the only inventor-trader trying to find the 1999 equivalent of Thomas Edison's electric-lightbulb filament. "The International Petroleum Exchange has developed a carbon-trading market," he told the Northwestern University audience last November. "Sydney [Australia] has just announced a new market. OM, the Swedish exchange, is setting up an environmental exchange in Edinburgh. The Chicago Board of Trade, with its sulfur [dioxide] trading, is looking at that. There are eight other exchanges around the world that are already setting up these infrastructures." The March 1998 issue of the "Global Greenhouse Emissions Trader" newsletter listed ten recent trades, among them 100,000 metric tons of carbon dioxide reductions that Canadian Suncor Energy bought from Niagara Mohawk, which was to create them by generating electricity from solar, wind, and biomass rather than from fossil fuels.

Deals like this, in Sandor's view, will "ultimately evolve into a system for efficient markets." But right now--with no legal framework for trading--they're good only for corporate PR and buyers' speculation that they'll be worth more down the road if some countries institute legal controls on carbon dioxide emissions. In August the Australian Greenhouse Office warned traders in "carbon credits" that they're taking real chances. "The government has not established any formal mechanisms for recognising or crediting their trades. Those contemplating such speculative trades should seek legal advice about the risks involved." CTOs may be commodities like wheat, but if the market collapses you can't eat them.

And with no overall carbon dioxide cap in place, there's no guarantee that deals like this will do the environment any good--just as there was no guarantee that the Wright brothers' flight would ever do transatlantic travelers any good. In the absence of a cap, Greenpeace International can plausibly criticize unregulated trade in CTOs as "a mechanism for allowing continued growth in pollution" in developed countries--though Sandor could plausibly reply that experimental trading shouldn't be criticized for not being perfect from the beginning.

Sandor takes these early carbon dioxide trades seriously. Not only does he expect them to evolve into a real market, but he believes they already show that global warming will be cheap to fix. "What we see as a market participant and as market inventors from a bottom-up approach, are prices that range from $1 to $30 a ton [of carbon dioxide removed]," he said at Northwestern. "This is nowhere near the Charles River Associates [estimate that it would cost] $213 a ton or [economist] Rob Stavins at Harvard at $150 a ton." Between $20 and $30 a ton, he says, "is where willing buyers and sellers are meeting."

Sandor's attitude is refreshing. Let the cost of preventing global warming be decided not by dueling studies commissioned by interested parties, but in the trading pits, where hard-nosed buyers and sellers strike their best bargains. Unfortunately there's no trading pit, no cap, no allocation, no enforcement--only a few dozen speculators scattered across the globe. So the current low price may not mean what Sandor says it does. When sulfur dioxide allowances were selling for $66 three years ago in the Acid Rain program--one-third the actual cost of cleanup--it was for reasons that had little to do with real-world costs. And the sulfur dioxide market was far better developed than the carbon dioxide market is now.

More likely, carbon dioxide "allowance" prices are low now because traders are just buying insurance--figuring that greenhouse-gas restrictions might never be imposed but will cost something like $200 a ton if they are. So it would make sense to pay $20 now in order to have some allowances on hand just in case. This was the view expressed by General Motors' chief economist G. Mustafa Mohatarem at Northwestern in November: "As long as there is uncertainty about whether Kyoto will ever become a binding agreement, the price you'd be willing to pay [for greenhouse-gas allowances] would be a lot less, because you are essentially buying insurance rather than a certain commodity."

You won't hear carbon dioxide market trends reported on the radio anytime soon, but they could change our future--depending on what they really mean. If we can get rid of a ton of carbon dioxide for only $20, that would amount to just "three to five cents a gallon of gasoline at the retail level," Sandor told the executives gathered at Northwestern. "We don't think the problem is as large as people contend it is."

Art accompanying story in printed newspaper (not available in this archive): illustration/Mike Werner.

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