Kyoto's Caps on Emissions Hit Snag in Marketplace U.N. Mulls How to Fix Pollution-Credit System; 'Expecting Too Much'

By JEFFREY BALL. Wall Street Journal, December 3, 2007; Page A1

The Kyoto Protocol was supposed to harness market forces to solve global warming. It slapped caps on greenhouse-gas emissions and set up a complex market for companies to trade permits to pollute.

But it hasn't yet ignited the green-energy revolution its architects were expecting. The cap-and-trade system has brought about useful projects targeting a few especially potent greenhouse gases. It hasn't, however, forced the industrialized world to meaningfully curb what scientists say is the biggest problem of all -- the growing consumption of fossil fuels.

Today, diplomats at a big United Nations global-warming conference in Bali, Indonesia, will begin looking for a fix as they open debate on a new global-warming agreement. Also this week, a Senate committee in Washington is scheduled to debate a proposed cap-and-trade system for greenhouse gases in the U.S., which opted not to ratify the Kyoto treaty.

The Kyoto treaty requires the industrialized countries that ratified it to reduce their overall emissions by 5% from 1990 levels. The caps, which expire in 2012, will not go into effect until next year. But participating nations have spent several years scrambling to get ready. The European Union has already instituted caps on its member nations. This has fueled a nascent carbon-permit trading system: Countries and companies that can't meet the new requirements can buy emissions permits from others that can. Trading in permits hit $30 billion last year, according to the World Bank.

Yet problems with the system loom large. The world's two biggest energy users, the U.S. and China, aren't subject to emissions caps. Countries that face the caps have been reluctant to push their industries too hard. And industry itself has proved adept at fulfilling its obligations without cutting down much on fossil fuels such as oil, coal and natural gas. It is doing this largely by funding projects in the developing world that destroy potent but uncommon greenhouse gases.

"What has happened is, markets work as markets will do, to find the lowest-cost alternative," says Michael Zammit Cutajar, a Maltese diplomat who during the Kyoto talks was head of the U.N. body that gave birth to the carbon market. The cap-and-trade system was "a brilliant idea," he says, but implementing it has exposed the "tension between the market approach and the sustainable approach."

The big question now is how to structure a carbon-trading system that's palatable to the U.S. and to developing countries such as China. The U.S. and China together account for about 40% of emissions of carbon dioxide from fossil-fuel combustion, which scientists say is the most common source of man-made greenhouse-gas emissions. That alone dwarfs the 28% share from the countries that did sign up for Kyoto caps, among them Canada, Japan and the nations of the EU, according to the Paris-based International Energy Agency.

The politicians face a dilemma: They want emissions constraints to be tough enough to matter, but loose enough to persuade the U.S. and China to play greater roles. European nations have expressed a willingness to cut emissions deeply, but only if the U.S. does too. The U.S. and China are calling on one another to play ball.

The broader question is whether a cap-and-trade system targeting industry is enough to meaningfully curb greenhouse gases. Some favor the introduction of carbon-emission taxes, such as an added tax on gasoline, saying that would push consumers to trim their energy use. Others say even blunter tools are needed, such as tougher government rules on the energy-efficiency of cars and buildings. Industry long has resisted such steps.

The current carbon-trading system is producing modest environmental benefits. In Europe and Japan, where the Kyoto emissions caps are set to kick in next year, some companies have begun changing their operations as the effective cost of burning fossil fuel rises. If governments toughen emission caps in coming years, as is expected, the cost will rise further.

But progress has been much slower than Kyoto's architects hoped for. Japan's emissions are rising, Canada has backed away from its target, and the EU says it will meet its goal only if member nations get tougher. Scientists say far bigger cuts than those called for in the treaty are needed. But global energy use is expected to rise by 50% by 2030.

The U.S. pioneered the concept of harnessing markets to solve environmental problems. In 1995, it imposed a cap-and-trade program to curb power-plant emissions of sulfur dioxide, a pollutant that causes acid rain.

Under that program, the federal government gives power plants yearly allocations of permits to emit sulfur dioxide. Power plants that are over the limit have a choice: cut their emissions or buy pollution permits from plants that don't need their entire allocations. The system has reduced U.S. sulfur-dioxide emissions from power plants by about 40% from 1990 levels. It's widely viewed as an environmental and economic success.

In the talks leading to the Kyoto treaty, the U.S. argued successfully for using the cap-and-trade model to fight greenhouse gases. But because global warming involves many countries and many gases, solving the problem is far more complicated than addressing acid rain.

The Kyoto treaty sets emissions limits for industrialized countries and for the EU, which decided itself how to divide the burden among member countries. Developing nations face no caps. Diplomats decided that it wasn't fair to burden their economies right away with pollution controls, given that the industrialized world had faced no restrictions during decades of growth.

It's up to each participating nation to determine which companies to slap restrictions on. After a government sets an emissions limit for a company, it gives that company just enough permits to cover it. Companies that reduce emissions below their caps can sell excess credits to companies that don't have enough. Each company must decide how much to cut emissions and how many permits to buy from others.

The EU's cap-and-trade system has been in effect since 2005. It's a dry run for the Kyoto treaty's emissions caps, which go into effect next year and run through 2012.

Holcim Ltd., a Swiss cement maker, faces caps. In 2005 and 2006, it didn't need all its permits, so it sold a total of about one million of them for an average of about €11, or about $16, apiece, says Bruno Vanderborght, Holcim's vice president for environmental strategy. This year, Holcim increased cement production and needed to buy about 100,000 permits. Mr. Vanderborght says the company has improved its energy efficiency "slightly" and is looking to improve further. It has also been buying permits from another source: developing nations.

The treaty includes a unique mechanism for involving the developing world in the process. Carbon-reduction projects in developing nations generate emissions permits, or credits, which can be sold to companies in industrialized nations facing emissions caps. In effect, these companies can fulfill some of their emission-reduction obligations by financing pollution-control projects in the developing world.

The troubles with the system began even before it went into effect. In 1997, the U.S. Senate passed a resolution urging President Clinton not to embrace the Kyoto treaty, and soon after President Bush took office in 2001, he announced he wouldn't support emissions caps because they would be too costly for the economy. That made it tougher for the EU to force stringent emissions caps on its industry. Tough caps would make it harder for European companies to compete against American ones.

In 2005, when Europe introduced its first round of caps, it kept them soft. As an added shock absorber, governments and companies began looking hard in the developing world for cheap emissions credits.

Kyoto's architects now say they didn't anticipate how the projects in the developing world would suppress efforts to cut back on fossil-fuel use.

Under the treaty, projects targeting more potent gases generate more credits than projects targeting carbon dioxide. The treaty covers six kinds of greenhouse gases. At one end of the spectrum is carbon dioxide. It accounts for 77% of all man-made greenhouse-gas emissions, the U.N. says, but it's also the weakest.

At the other end is HFC-23, a byproduct of the manufacture of a common refrigerant. Every ton of it is 11,700 times as damaging to the atmosphere as a ton of carbon dioxide, according to the U.N. But despite its high potency, the gas accounts for less than 1% of the effect of man-made greenhouse-gas emissions, the U.N. says.

Under the Kyoto trading system, each credit represents one "carbon-dioxide-equivalent" ton of avoided emissions. So a project that eliminates one ton of carbon-dioxide emissions generates one sellable credit. A project that gets rid of one ton of HFC-23 emissions generates 11,700.

Installing machinery on a refrigerant plant to incinerate HFC-23 is cheap. According to the World Bank, generating one carbon credit through an HFC-23 project typically costs less than $1. Generating a credit from a renewable-energy project -- erecting a wind turbine or a solar panel -- can cost $5 to $10, the World Bank says. Such credits currently sell for as much as €17, or about $25. So the economic incentives to undertake HFC-23 projects have far exceeded those for fossil-fuel reduction projects.

During the Kyoto talks, there wasn't much discussion about whether such disparities might focus too much activity on eliminating gases that aren't a big part of the overall problem, according to Mr. Cutajar, the Maltese diplomat who headed the U.N. body. The provision that allows industrialized countries to obtain credits in the developing world was "an add-on" late in the talks, he notes. "The general impression was that low-carbon development was about clean energy," Mr. Cutajar says. "It sounded good. It smelled good. It was only later that the details got worked out."

Between 2002, when credits generated in developing countries began trading, and the end of last year, HFC-23 projects accounted for 46% of all developing-world credits traded -- by far the biggest chunk of that market, according to the World Bank. All told, at least 70% of developing-world credits traded during that market's first five years came from projects targeting gases other than carbon dioxide, the World Bank says.

At present, most eligible plants that emit HFC-23 have been signed up for carbon-credit projects. As a result, projects targeting less-potent gases are getting more funding.

One such gas is methane. It's emitted when animal dung decomposes on farms and when trash rots at landfills. Ton for ton, it's 21 times more damaging to the atmosphere than carbon dioxide, the U.N. says. That's provided an incentive for two types of popular carbon-credit projects: putting tarps over animal-waste lagoons, and putting pipes in landfills to tap and burn off the methane. Burning methane produces less-potent carbon dioxide.

Programs to reduce the burning of fossil fuels -- a far bigger environmental problem -- accounted for less than one-third of the developing-world credits traded between 2002 and last year, the World Bank says. But they have begun getting more attention.

The trading system has given birth to an industry of middlemen who arrange projects in developing countries to produce credits. Natsource LLC, a New York-based asset-management firm, manages a roughly $700 million investment fund through which companies, including many Japanese and European utilities, buy carbon credits. Most come from projects targeting the potent but ancillary gases such as HFC-23 and nitrous oxide, a byproduct of nylon production. "Of course the market is going to do the cheaper thing first," says Jack Cogen, Natsource's chief executive officer. "That's what markets do."

The World Bank has put together some of the biggest emissions-reduction projects. Karan Capoor, a senior financial specialist at the World Bank, says "it's expecting too much" to think the Kyoto treaty could significantly curb fossil-fuel consumption without long-term caps and the participation of big countries such as the U.S.

Some investors in the carbon market cite another reason for the scarcity of clean-energy projects: a panel of U.N.-sanctioned officials who meet periodically in Bonn, Germany, and decide which proposed carbon-reduction projects will get to sell credits. The panel approves only environmental projects it determines wouldn't happen without the sale of the credits.

Clearing that bar can be difficult for clean-energy projects. Those related to potent gases such as HFC-23 and methane have an easier time, because they rarely make economic sense without the carbon-credit revenue. U.N. officials say that to keep the system honest, it's important not to subsidize projects that would happen anyway.

In 2006, the European Commission, the EU's governing body, reported that the European industry ended 2005 with more permits than it needed to meet caps under the EU's system. That caused the price of European credits to plummet.

The commission now is pressuring member governments to tighten their emissions caps, which has pushed prices back up. Eight countries have sued or threatened to sue, arguing the commission is being too stringent.

At the U.N. conference in Bali, the price issue is likely to color debate over whether to award carbon credits to projects that preserve forests, which consume carbon dioxide. Kyoto's architects authorized credits for planting new trees. But they declined to allow credits for preserving existing trees. They worried, among other things, that nations might seek credits to preserve trees they have no intention of destroying. Heavily forested nations such as Indonesia and Brazil want to reverse that decision.

On Capitol Hill, companies anticipating a U.S. carbon cap are gunning to make it as loose as possible. Duke Energy Corp., the nation's third-biggest coal burner, is one. In October, Duke joined the heads of other big emitters in writing to the head of a Senate committee on the environment. Their letter declared it "critically important" for any cap-and-trade system to set an upper limit on the market price of a carbon permit. That ceiling would rise over time.

A system without price controls might force utilities to switch to fuels that are cleaner but costlier than coal. "While a lot of people started down the road romanticizing" the use of emissions caps to fight global warming, says Duke's chief executive, James Rogers, in an interview, they're "now coming to grips with the cold reality of the economics."

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