Transforming Risks into Opportunities

TRANSFORMING RISKS INTO OPPORTUNITIES

We are at a point in history at which companies and individuals must pay attention to climate change, whether or not they believe the science. Sustainability is of necessity a key part of any viable corporate strategy. The carbon markets are an important piece of the global climate puzzle. The need to comply with regulations and the demands of consumers makes an understanding of the carbon markets prudent. This article is designed to provide the background that sophisticated market participants need to evaluate what opportunities make sense.

Energy-intensive manufacturers and power generators are facing carbon-reduction mandates by regional, national and international regulators. Multi-national manufacturers and even retailers are requiring "voluntary" carbon footprint reports from vendors throughout their supply chains. In response, affected companies are purchasing and even "manufacturing" their own "carbon offsets" as a strategy for demonstrating voluntary carbon neutrality and for mitigating the costs of mandatory carbon-emission limits. The World Bank reported that the 2008 global demand for offsets in the compliance market reached $ 6,813 million and IN the voluntary carbon offset market reached $ 397 million . Assuming enactment of a U.S. cap and trade system or U.S. Environmental Protection Agency ("EPA") rules setting mandatory carbon limits, the global demand for carbon offsets is expected to skyrocket within the next decade. Accordingly, planning and development of offset projects will be a strategic opportunity for early adopters and a cost-management lifeline for many.

I. Background

Because the carbon offset market is new to many, it is important to start from the basics: a carbon emissions offset is a marketable commodity which represents a unit of reduction, removal, or avoidance of greenhouse gases ("GHG") emissions. Emission[s] offsets are used to compensate for excess GHG emissions that occur elsewhere. Offset purchasers buy offsets to comply with emissions targets as though the entity had made the reduction itself.

One offset credit represents one metric ton of carbon dioxide equivalent that has been eliminated or avoided by implementation of one or more renewable energy technologies, energy efficiency improvements, industrial and agricultural gas capture, or land use or forestry changes.

Figure 1 below exemplifies an offset transaction.

Figure 1:

Currently there are two basic types of markets for offset credits: voluntary and mandatory. In voluntary markets, such as the Chicago Climate Exchange, corporations and individuals interested in reducing their net GHG emissions purchase offsets optionally and without the need to meet a cap. The European Union Emission Trading Scheme ("ETS") is a mandatory cap-and-trade system created as a result of the Kyoto Protocol. In mandatory cap-and-trade schemes such as the ETS, companies, governments or other entities to which the scheme applies may buy carbon offsets from entities to which the scheme does not apply. The tool that presently allows entities to purchase and sell carbon offsets in mandatory markets is called the Clean Development Mechanism ("CDM"), applicable to entities whose countries have ratified the Kyoto Protocol. Figure 2 shows a simplified transaction of the CDM.

Figure 2:

Emitter A is regulated under a mandatory cap-and-trade system with an overall cap of 300 tons. If offsets are permitted under the program, an entity whose emissions are not regulated under the cap (Emitter B) can make emissions reduction of 100 tons, creating 100 credits that can be purchased by Emitter A to offset a 100 ton increase in A's emissions. Although emissions from Emitter A total 400 tons, which exceeds its capped limit, Emitter B has reduced total emissions by 100 tons, so that, on net, the targeted emission reductions are achieved.

Several carbon markets, including the U.S. Regional Greenhouse Gas Initiative ("RGGI") and the ETS, accept carbon credits created through offset projects. The post-2012 requirements for offset projects in these schemes have not been finalized so the article will focus on the current CDM established by the Kyoto Protocol, which, if not adopted in its entirety by other nations in the future, will certainly be resembled in its main characteristics.

Under the Kyoto Protocol, which came into force in 2005, the countries listed under its Annex B - (generally speaking, so-called "developed countries") committed to reduce their GHG emissions to 1990 emission levels. Although emission caps were not imposed on the developing countries which ratified the Protocol, it has become clear that some form of emission reduction measures by developing countries will be essential to implement the mission of the Kyoto Protocol, as increase in GHG emissions is directly correlated with economic growth. An example would be China's pledge to curb the growth of the country's carbon dioxide emissions by a "notable margin" by 2020 from their 2005 levels, which was announced last September 22 by President Hu Jintao. Although China did not put a figure on the cuts, it indicated at the U.N. General Assembly that the curbs would be measured by unit of gross domestic product, in line with China's concerns about preserving its rapid economic growth.

The CDM mechanism was designed with the dual purpose of funding emissions control efforts in developing countries and to assist the industries in developed countries to smoothly transition to the lower carbon levels required under the ETS cap and trade system.

Under the CDM, countries not listed in Annex B or economic entities located in such countries can develop emissions reduction or removal projects in their territories. The reductions or removals from these projects must be "additional" to reductions that would occur in its absence, and the projects must demonstrate concrete, long-term, measurable, and permanent environmental benefits. That is, the project must demonstrate that it is not required by regulation, that it is not common practice, and that the offset funding helps overcome financial, technological, or implementation barriers. For that purpose, the candidate project must be approved by the Designed National Authority ("DNA") and then validated by a third party agency called a Designated Operational Entity ("DOE"). If a project meets all DOE requirements, the project may then be registered