Rob Day | November 7, 2008 at 5:10 AM

The challenges and hopes for a U.S. carbon trading market

We’ve been digging even deeper into carbon trading topics lately, for obvious reasons (self-promotion alert).  And then I had the pleasure of participating on a “cap-and-trade vs. carbon tax” panel yesterday sponsored by the New England Clean Energy Council (and very well executed by Panel Intelligence).  So I thought it might be useful to put down a few thoughts on the subject.

Conventional wisdom says that we should be expecting a cap-and-trade scheme sometime during Obama’s first term in office.  We discussed this possibility in a post on Wednesday.

In thinking about how such a scheme might impact U.S. cleantech startups and investors, it’s important to look at the examples of existing trading markets:  EU ETS, US regional markets, and voluntary markets like the Chicago Climate Exchange (CCX).  The devil’s of course in the details, but if a U.S. federal cap and trade system is enacted we can draw a few operational conclusions:

1.  Any system is likely to overtly encourage energy efficiency adoption, but with unknown effectiveness. There is general agreement around the concept that encouraging energy efficiency is a good thing, naturally, and we’ve heard discussions about “carve-outs” for energy efficiency as a source of offsets in a U.S. cap and trade scheme (see Karla Bell’s great blog for good discussions on these and other related topics).  And even if it does, the administrative overhead associated with getting carbon credits validated and acknowledged as financial/ regulatory instruments can be quite costly, if not prohibitive.  At least the way it’s done right now, concerns about “additionality” (ie: was the energy efficiency improvement really in addition to what would have been done under “business as usual”) and the need to validate and verify actual carbon emissions reductions from a lot of small energy efficiency improvements is difficult even at the utility level.

That’s one of the reasons we like CarbonFlow, as they’re developing scalable solutions to this challenge, so that energy efficiency gains can more easily and cheaply be accredited for trading. As it stands right now, cleantech startups would really have to partner up with bigger players (ie: utilities, or oil refiners) in order to gain any advantages to their value proposition as a result of a high-level cap and trade scheme.  That’s somewhat daunting…

2.  Something’s gotta give in the current carbon offset accreditation process. In a system like RGGI where it’s basically just utilities trading emissions credits with utilities it’s less important.  But in Europe, the inclusion of carbon offsets from overseas ( for the most part, the so-called Clean Development Mechanism, or CDM) has allowed for very economic emissions reductions and significantly reduced the negative economic impacts associated with limiting carbon emissions.

So you want to include CDM-like elements into a U.S. system.  But then you’re bumping up against a very labor-intensive, expensive, and time-intensive process to get such projects approved.  A typical landfill gas capture project in an emerging economy, for instance, might take 7 months and $100k in fees (mostly to consultants, etc.) to gain validation as a “credit”—and only then can the project developer sell those credits.

There’s been an entire industry that has grown up around the creation and selling of these kinds of credits, whether into official systems like the EU ETS/ CDM, or just for voluntary markets.  Everything from growing trees to fuel-switching projects to growing plankton for deep ocean carbon sequestration is being planned with strong dependency, at some level, upon this value creation path.  I’ve seen numerous business plans where entrepreneurs are counting on gaining such credits as an important part of their future revenue streams.  But for this to be feasible, the bottlenecks and high transaction costs associated with accreditation have to be greatly alleviated.  That 7 months and $100k can be hard to make work for a number of these opportunities…  That’s another reason we like CarbonFlow, because they’re working directly with leading validators to come up with smart solutions to these challenges.

3.  In an ideal world, these carbon offsets become highly liquid, fungible commodities. If you’re an energy trader, you love the concept of trading carbon offsets, because they become another way to play around geographic inefficiencies.  Think about it—carbon is a global issue, not a local issue.  So a carbon offset from one place is the same as a carbon offset from another place.  But meanwhile, energy traders are used to working in a market where energy supplies are very geographically determined.  The interplay between, say, temporarily turning off a power plant in one place, getting carbon credits from that, and applying them toward turning on a peaker plant somewhere more capacity constrained, is just one example of how commodities traders might find a lot of arbitrage opportunities… if we can create a truly global carbon trading market.

However, for this to happen, for offsets to be readily traded multiple times per day, we need to have a strong understanding of where each credit came from.  After all, it’s not like other commodities—it’s the ABSENCE of a negative, so it’s tough to prove the asset is real unless there’s a lot of transparency around where it came from, how it was derived, how it’s being verified, etc.

And not all carbon offsets will be created equal.  To the consumer product company seeking “carbon neutrality” for marketing purposes, it might be worth paying more for a carbon offset created by protecting a wildlife preserve, than for a credit created by capturing previously released coolants at an obscure chemical plant somewhere unphotogenic.

In all these cases, we need a lot more information about the credits, and this information needs to follow the credits around as they change hands over and over again.  Industry participants like New Energy Finance will typically project a “churn” per offset of around 4x (meaning that each credit will change hands an additional 3 times per year after its initial sale), but I suspect that would really be on the low end if we can figure out answers to all of these challenges.

If we can figure out solutions and put in place a cap and trade system that encourages simplicity, transparency, and inclusiveness, then such a system could be very encouraging to the growth of the cleantech industry in the U.S. and elsewhere.  If we design it to be too onerous and limited, however, not only will we find the system to be costlier than hoped, we’ll also not see much positive impact for young startups and small businesses where most of the jobs growth is typically seen.

So get on it, Obama team!

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