This entry will provide some background on carbon credits and try to address the question of whether carbon credits are really “just a license to pollute.” I also want to discuss what I see as a potential pitfalls for companies seeking to get into the carbon trading market. Many companies are being asked to sign complex, long-term contracts that obligate them to sell their carbon credits through exclusive and potentially lucrative (for the broker) brokerage arrangements. But first, some background.

There are at least three ways to regulate greenhouse gases. First, these emissions can be regulated in the same manner as other regulated pollutants. A governmental regulator would condition the issuance of operating permits on the requirement that certain greenhouse gas emission limits would not be exceeded. If a permit holder exceeded those limits the permit could be revoked and fines could be levied. This method has been criticized because it does not encourage innovation, as witnessed by many existing industries that are slow to adopt new technologies for fear that they will trigger permit reviews and even stricter standards.

The second method that has been explored would be to simply tax the excess emissions. This method has also been criticized on the same grounds as a regulatory approach — it does not encourage innovation. Also, there is no assurance that the tax revenues would be used to offset the hypothetical damage that the environment would incur from the excess emissions.

The third method, and the method encouraged by the Kyoto Treaty and most often used in proposed federal legislation, involves a cap on the total annual emissions that is lowered over time with the market being allowed to assign a monetary cost to any shortfall through the ability to purchase “credits” or “offsets” generated by companies that have voluntarily reduced their greenhouse gas emissions. Because carbon dioxide is the most easily recognized of the greenhouse gases, it is common for people to use the term “carbon credits” when refering to these offsets.

As an overly simple illustration, lets assume that Emitter Inc. is allowed to emit 1 million tons of greenhouse gases each year but instead emits 2 million tons per year. In order to make up the shortfall, Emitter Inc is allowed to purchase 1 million tons of carbon credits from Green Inc. This is where the “license to pollute” charge comes in. As an analogy, I would sure like to get to work faster by driving faster than the speed limit. What if I could do that by paying an extra fee? That is what drives the critcism of this program.

But lets look at the whole picture. Green Inc. has purchased emission controls that reduce its emissions from 3 million tons per year to 1 million tons per year. The cap for Green Inc. happens to be 2 million per year. Therefore, Green Inc. has reduced its emissions by 1 million tons “too much.” Although these controls cost Green Inc. $5 million, it can sell these carbon credits to Emitter Inc. for 6 million dollars. It makes one million dollars in “profit.” This is also a great deal for Emitter Inc. if its engineers estimate that it would cost $10 million to achieve the same level of reduction. Perhaps $10 million makes it uneconomical for Emitter to stay in business. So, does this really “give polluters a license to pollute?” That is true only if we ignore the cost and the benefits to both companies and the environment. The cost to Emitter Inc. is $6 million. The benefit is gained by Green Inc. which is rewarded for doing something that it did not have to do and presumably would not have if it had not been given this financial incentive. Another benefit is that Green Inc.’s engineers had an incentive to come up with innovative ways to reduce emissions. This storehouse of knowledge can be used with other similar industries to the same effect. Therefore, as this new-found knowledge is passed around there would (theoretically) be an amplified effect of greenhouse gas emission reduction. A third benefit is obviosly the $4 million that Emitter Inc. saved. Finally, the environment has been spared 1 million tons of emissions that would have been generated had it not been for the carbon trading program.

There is yet another “market based” control that will eventually kick in. As the cap is lowered each year, there will come a time when Green Inc. and other similar companies can no longer sell their credits. Green Inc. needs those credits for its own use. Emitter Inc. will join an increasing number of buyers in a seller’s market. As the price increases for the credits, Emitter’s engineers may eventually reach the point where they decide that it will cost less to reduce the company’s emissions than it will cost to purchase offets. In the meantime, it is hoped that advances in technology will lower the cost for Emitter Inc. to reduce its emissions as well.

Now, lets look at the marketplace of carbon credits. Keeping with the Emitter and Green Inc. model we have already discussed above, it is easy to overlook the fact that these two companies are not likely to make a direct trade between each other. Future regulations will likely require that before Emitter Inc. can use the credit against its emissions reduction shortfall that it must be able to prove that the credits it is purchasing are real. This means that there must be a regulated marketplace where the carbon reduction created by Green Inc. can be verified. There are currently several such markets, both here and abroad. Europe has a highly sophisticated market for the trading of carbon credits. The lynchpin of any such market is verifiability. Proving that the emissions reductions are real is vital to a successful marketplace. As economists say, bad money chases out good money. The same thing would happen to any market where there is a perception that some companies are selling credits that are not as real or as verifiable as others. The entire market can be devalued by that perception. Another analogy might be a food market. If one market was known to sell contaminated food mixed in with the good food, then the volume of sales and the prices of that food would plummet. Hence, there is a strong incentive by both regulators and the participants in the market that there be strong control over the quality of the credits.

Another feature of these markets that is currently developing is the marketing of potential emission reductions by brokers. Some of the contracts that I have read have very long terms (ten years) and are difficult to terminate. Also, the commissions can be extremely high, as much as 40 to 50 percent of the sales price of the carbon credit. Because this is a fairly new market, it is important for companies to carefully review these brokerage commissions before agreeing to a long-term contract. Fortunately, there are a number of new companies entering the market and the variety of contracts should increase.

— James Pray