Environmental Economics: An update on the Chicago Climate Exchange

From the NYTimes (Capital Pollution Solution* $$$):

The exchange, also known as CCX, opened for business in December 2003, after raising $25 million in a public offering on the Alternative Investment Market, a part of the London Stock Exchange. By May of this year, more than six million carbon allowances had been traded on the exchange, and the price for the allowances was hovering between $3 and $5 per metric ton of carbon dioxide. CCX now has more than 175 participants, including corporations like American Electric Power, Ford, Motorola, DuPont and I.B.M., as well as the state of New Mexico and six American cities, including Portland, Ore., and Oakland and Berkeley, Calif. Sandor says that in 2004, the members of CCX reduced carbon emissions by 30 million metric tons, roughly equivalent to the yearly emissions of two big coal plants. “CCX is growing,” the energy trading consultant Peter Fusaro told me recently, “but compared with mature exchanges like the New York Mercantile Exchange, the volumes are still minuscule.”

4th Try: According to the EIA, the U.S. generates almost 6000 million metric tons of carbon emissions each year. At $4 per metric ton, the cost of reducing carbon emissions by 70%, about what scientists say needs to be cut to avoid climate change problems, is $16.8 billion, about 0.14% of annual GDP. Not too costly with the help of market forces, right? My guess is that this is a case of low hanging fruit and the marginal cost is increasing.

Am I missing something here (i.e., please check my math)?

Here is some background on the Chairman and CEO of the CCX, Richard Sandor**, along with a brief history of the EPA's Acid Rain Program and the concept of emissions trading:

Sandor began his career as an academic, teaching economics at the University of California at Berkeley in the late 60’s. Inspired in part by a credit crunch that hit California in those years, he came up with the idea of interest-rate futures, a financial instrument that would allow banks and investors to hedge against future changes in interest rates. In 1972, he left academia and joined the Chicago Board of Trade as an economist. In 1982, he followed the financial boom to Wall Street, taking a job at Drexel, where he worked developing futures markets in insurance and other fields. By 1990, however, Drexel was in bankruptcy, and Sandor turned his attention elsewhere: to environmental problems and how market mechanisms might be used to solve them.

Sandor’s interest was sparked by the Environmental Protection Agency’s 1990 Acid Rain Program, which sought to reduce sulfur dioxide emissions from coal-burning power plants in the United States. The design of the program was ingenious but simple. Instead of trying to regulate sulfur dioxide emissions the usual way, by dictating a certain kind of emissions-control technology on each power plant, the E.P.A. employed what is known as a cap-and-trade program. The agency set an overall limit, or cap, on the amount of emissions permitted from all power plants combined. Then it allotted a certain number of pollution allowances to each emitter and let the operators of individual plants figure out how they wanted to proceed. A company might install scrubbers or switch to lower sulfur coal in order not to exceed its quota, but if the company determined that polluting beyond its quota was necessary, it could buy additional allowances from companies that had not used up their allotments. Companies that reduced their emissions could bank their credits for later use or sell them for a profit.

Fascinated, Sandor joined the E.P.A.’s Acid Rain Advisory Committee, which was charged with helping to implement the new law. Among other things, Sandor persuaded the E.P.A. to hold the annual auction for sulfur dioxide allowances on the exchange run by his former employer, the Chicago Board of Trade. In the end, the cap-and-trade program reduced pollutants more quickly, and far more cheaply, than anyone anticipated and became the model for market-based environmental success. Best of all, it helped transform the problem of reducing pollution from a moral issue into a pragmatic one.

Not long after the acid-rain program began, Sandor and other economists began thinking about how to apply the same market-based strategies to an even bigger problem, with an even bigger potential market: global warming. Whereas sulfur dioxide is a pollutant emitted from a measurable number of specific smokestacks, greenhouse gases, which are commonly measured in metric tons of carbon dioxide equivalent, are emitted from millions of diverse sources, including cars, jets, farm animal waste, factories and power plants. And unlike sulfur dioxide, which is a regional pollutant, greenhouse gases are a global problem: a metric ton of carbon dioxide emitted in Russia has the same impact on the atmosphere as a metric ton emitted in Ohio.

Despite these critical differences, in principle the same market-based approach could be used. First, set the overall limit of greenhouse gases that countries are collectively permitted to emit, then distribute (or auction off) allowances among various pollution sources within each country and sit back and watch the emitters trade those allowances as their needs and market strategies dictate. There would even be room for speculators to join in the market: if you think next summer is going to be a scorcher, you might buy up allowances on the theory that in hot weather, coal plants often run at maximum capacity to meet the power demand, dumping more carbon dioxide into the atmosphere and thus raising the demand (and the price) for carbon allowances.

A key innovation in the design of carbon markets was the idea of offsets. The basic concept was that polluters could earn emissions credits not only by cutting their own carbon emissions but also by assisting in efforts to reduce emissions from other sources elsewhere in the world: for instance, by paying farmers to reduce the emission of methane, a potent greenhouse gas, from animal waste. Another example of an offset was the so-called natural carbon sink — something like a forest, which absorbs carbon dioxide through photosynthesis. If you increase the absorption of carbon dioxide with plants, you create the same net effect on the atmosphere as cutting emissions from your car — so why not allow polluters to earn credits for, say, investing in reforestation?

*Sorry for the link to a pay site, I received the entire article, which isn't all that congratulatory, via email. And here is some interesting trivia, we reviewed the review of the article's author's book (say that 3 times fast without spilling your beer).

**Sometimes I feel just like Richard Sandor who says: