By Bill Van Amburg, Automated Credit Exchange, Pasadena, CA, USA

If you are not yet well educated on emissions trading, here’s a tip: it’s time to learn. Perhaps no other tool to help reduce environmental emissions will emerge as being as important as emissions trading over the coming decade.

At the same time, perhaps no other tool is as misunderstood. At its core, emission trading is not about deals, brokers or the trade itself. It is not about making money on the margins. It is definitely not about “buying your way out” of environmental responsibility.

Rather, at its best emissions trading is a way of giving businesses greater flexibility to meet environmental standards in the most cost-effective way possible, while adding the environment to the bottom line. In the language of economists, this is known as incorporating environmental “externalities” into the cost of doing business.

Figure 1. Expiring NOxRTC prices since 1999
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These attributes are starting to bring regulators and industries together in common programmes worldwide, from the proven Regional Clean Air Incentive Market (Reclaim) efforts in southern California and the emission allowance markets of the US Midwest, to the emerging NOx trading programmes under development in the Netherlands and elsewhere in Europe. On the immediate horizon is the emerging climate change framework for trading Greenhouse Gas (GHG) emission credits.

The Automated Credit Exchange (ACE) came into being specifically to make these markets economically sustainable and environmentally effective. ACE designs, develops and operates neutral environmental emissions exchanges using advanced economic software that allows companies to cost-effectively trade and execute their compliance decisions.

From experience gained in these existing and emerging markets, some of the savviest “traders” are often those from the power industry. Partly due to experience in energy trading spawned from deregulation, partly a result of corporate skills at long-range investment and planning, power industry companies generally fare well. Because they are able to project future options, they can make trading decisions that allow them to meet objectives, reduce risks and optimize costs.

Beginnings and lessons

A prime example of emission trading benefits— and challenges— exists in the ground-breaking Reclaim programme implemented by the South Coast Air Quality Management District (SCAQMD) of the Los Angeles region of California.

When conceived in the early 1990s, the programme was an effort by both industry and regulators to redefine the relationship and find a new way to meet aggressive emission reduction needs while not driving businesses out of the Los Angeles region. Driven by this recognized twin need, the desire was to find a way to achieve maximum environmental benefit at the least cost. A flexible approach based on declining emissions allocations was the solution. The benefit, according to SCAQMD, has been an estimated 40 per cent reduction in the cost of compliance to date, compared to a “command-and-control” approach.

Of course, using a market structure is not a replacement for taking action. Rather, the market provides an indicator of the aggregate value of those actions— and sometimes there is a greater “temporal” value of those credits. Meaning: a price spike.

This summer saw one of the most dramatic price run-ups in the history of Reclaim. Prices increased from around $5/lb ($11/kg) NOx in May to over $40/lb ($88/kg) by mid August. While ACE had forecast significant price increases for some time, this increase was nevertheless unprecedented.

Looking at it objectively, there were several contributing factors:

  • First was the allocation “crossover”. The emissions allocation had been steadily reducing to the point where the allocation had dropped below actual emissions.
  • Second was the lack of planning by many companies. Historically, these companies had been relying on excess credits that had previously been available at year’s end. Because of the initial over-supply of credits, prices were kept unrealistically low and a number of companies failed to recognize the impending shortfall.
  • Third was the fact the economy had been growing steadily for a number of years. When Reclaim launched, the region had been suffering through a deep recession. That, in fact, was the reason for the initial over-supply of credits, but economic growth more than caught up.
  • Fourth was that the south coast experienced a long and hot summer that required utilities to operate their peaking units and use up their remaining emissions allocation to avoid creating rolling brown-outs throughout the region.

Added to this, the remaining credits likely represent higher control costs. All these factors combined to drive the prices through the roof before stabilizing at around $13/lb ($29/kg) by the end of the August.

Was this “unpleasant” for some companies? No question. At the time, ACE senior vice president Verne Wochnick noted, “There were some understandable reasons why credit prices rose. And there was some plain panic out there.”

Figure 2. ACE allows companies to stucture sophisticated bids in simple ways
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But rather than highlighting a problem, this summer’s peaking showed the market at work. Credits were never meant to represent the only option. Rather, as an indicator of relative value, the credit market was making it clear to companies who had yet to act that it was time to implement their control strategies, and indeed that is starting to happen. The market was working mostly as planned.

Not that it had been that easy getting to this point. Industry was the initial motivator of this market approach in southern California, as it looked for ways to flexibly meet environmental reduction goals. To create a workable programme— economically and environmentally— took several years of activity, both by the regulating agency and the industries who would be subject to those regulations. Additionally, environmental advocates, community groups and others also had input into the outcome.

In many ways, while contentious, setting the emissions goals may have been the easier job. Once established, each company emitting over four tons of two specific pollutants— nitrogen oxides (NOx) and/or sulphur oxides (SOx)— were assigned an “allocation” of emissions credits. That allocation represented a “cap”, or limit, on the individual companies and on the overall group of companies (roughly 380) affected. That allocation also declined, before flattening out to a minimum level in the year 2003.

Instead of being told what control devices to use and where and when to implement them, companies were given the flexibility to meet that declining allocation in almost any way they wanted (short of violating toxic and other emission rules). Altering production processes, staggering control options, even reducing production, were all options available.

Of course, the other option is the market. As a “cap-and-trade” programme, companies that emit less than their allocation can trade that reduction as a credit to companies that emit more than their allocation.

That’s the benefit of the market structure. Given enough companies with different cost structures for their control options, there will be credit price differences that they can “trade”. Ideally, this allows companies flexibility on timing of controls, or the ability to accommodate a rapid production increase before controls can be installed.

However, making that market work— and giving companies the real tools to make use of those opportunities— was the more difficult side of the programme.

Enter ACE technology

The Automated Credit Exchange came into being to provide this function. In fact, the principals of ACE were some of the key, early advisors helping to design and launch Reclaim. From their efforts, came the recognition that the companies involved should be split into two groups whose yearly reconciliation periods, or cycles, were six months out of phase. The reason: it would keep credit purchase “crunches” from being worse. While the 2000 credit price rise has been steep, imagine if all 380 companies needed to purchase at the same time, rather than just half that number.

Reclaim received the value of leading-edge economic design and testing from a team at the California Institute of Technology (Cal Tech), including Dr. Anne Sholtz. This team helped devise the concept of “cycles”, among other contributions.

A new technology also being developed at Cal Tech caught Anne Sholtz’s eye. Originally designed for advanced resource allocation functions on a NASA project, it was sophisticated software that allowed members of the science team to “bid” for power and mass “credits” on the project, and came up with solutions that maximized overall gain to the “system”.

Dr. Sholtz, ACE’s president and CEO, realised the application to emission credit trading: companies could design confidential offers to buy or sell exactly the kinds of credits they wanted, setting prices based on their control cost structure. The advanced software would then find any combination of offers or portions of offers that could fill the order and increase the economic “surplus” for buyer and seller. Neutral, optimizing, transparent for price but confidential for execution— the concept for ACE was born.

Figure 3. Allocation crossover was partly to blame for large price increases in Reclaim this year
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ACE licensed, customized and has since enhanced the system for the environmental emissions market. The ACE technology makes it possible for market participants to structure sophisticated bids in simple ways. For instance, using the technology’s “combinatorial” (the ability to bundle, or package, multiple items) and contingent (the ability to set up “or” bids) functionality, a user can set up several business scenarios in his offer and allow the ACE system to decide the one with the “best” economic result. This could involve structuring “build-controls-or-buy-credits” scenarios, letting the results determine the best path.

Additionally, because the system uses special optimizing algorithms to deliver trade results that balance the “surplus” created between seller and buyer, the system is unbiased; and because the exchange takes no market position in the trades, it is neutral. Those multiple benefits, combined with confidential matching and settlement, make the system highly attractive.

There is a triad that supports ACE’s success: leading-edge economic technology; assistance and involvement with the creation of the instrument; and understanding of the needs of the client, in this case the industry. One of ACE’s principals was a key player from the industry group that led the original charge for Reclaim.

This combination of economic and technology expertise, policy savvy and customer knowledge is why ACE transacts a high percentage of third-party trades in the Reclaim system.

Emerging markets overseas

As the pressures to reduce emissions stretch the traditional regulatory regimes, emission trading is being considered more broadly than ever before. While debates over

trading carbon and greenhouse gases continue and are dominating the views of many people, there are several other efforts that are making considerable progress toward creating emission markets around the world.

One of the most notable is the work that is underway by the government of the Netherlands and its Ministry of Housing, Spatial Planning and the Environment. Faced with the need to reduce national and regional NOx emissions, the Ministry engaged ACE to help it design an emissions market based on a novel concept: an enhanced rate-based structure.

The Netherlands programme would be different to a “cap-and-trade” system in several key ways. It establishes a Performance Standard Rate (PSR) rather than a “cap”. This rate— which would be expressed as a unit of emissions per unit of energy— sets the performance standard to meet. A company’s emission allocation, therefore, is not “fixed” or pre-set, but is rather determined by its energy use, multiplied by the PSR. This allocation is then compared to actual emissions. A company exceeding the PSR would need to reduce emissions or buy credits.

Such a system provides flexibility to accommodate growth or company movement and changing economic conditions, an important requirement for the EU. At the same time, it provides an important incentive to implement new, cleaner technology. Under the proposed Dutch model, a new company could establish business and generate credits from its first year, if it performed better than the PSR. Also, increasing or decreasing production (as with power generators) would not necessarily affect compliance, as long as a company met the performance standard rate.

Several other countries in Europe and elsewhere are now also reviewing these emerging programmes and establishing market-based approaches to criteria pollutant emissions reduction.

Whether cap-and-trade or rate-based, what matters most is establishing a market structure that has a well-defined instrument to be traded, including the time frame of the credits, allocation mechanism, trading rules and the like. Additionally, to maximize the effectiveness of the market function, a centralized, neutral and unbiased exchange structure can provide both the market meeting point and the tools for effective trades.

It is critical to have a mixture of economic knowledge, political and industry leadership and heavy “domain” expertise to make these programmes and marketplaces successful.

At its basis, then, emissions trading programmes provide participants two critical pieces of flexibility:

  • They allow companies to look at all possible options to achieve emissions goals (from process efficiencies to fuel switching to controls); and
  • They allow companies to use the marketplace to find out if their costs to achieve those results are “competitive”.

If a company’s compliance costs are less expensive than the cost of credits, then the company can take its control actions, and potentially even sell credits to others. If a company’s control costs are higher than the price of credits for the same amount of reductions, it then makes more sense for a company to buy the surplus emissions of other companies. Either way, a company that has thoughtfully assessed its options and cost structure is far better able to use this tool to its benefit than a company with less advanced planning. And if you take away no other lesson on emissions trading, make sure it’s this: be prepared. Market structures are coming.