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Trading Greenhouse Gas Emissions? Trade for Profit While Still Benefiting Society
by: Gail Osten
The Chicago Climate Exchange will become a futures exchange later this year; its “airborne” commodity is just as unusual as when financial futures made their debut some 30 years back.
Editor’s Note: Sometimes concepts are so new that it pays to put them into the simplest of terms, and this is one of those times. The newly launched Chicago Climate Exchange draws some of the same quizzical looks that financial instruments did when they appeared on the scene. But the exchange is breaking some new ground, and trading in greenhouse gas emissions becomes even more fascinating when stripped of its high-sounding buzzwords; it is actually pretty simple to understand. For traders, it will be even easier to digest once it becomes a futures market later this year. And, just maybe it will offer traders the ability to feel that they’re part of a bigger environmental objective. Who knows?]
Years ago it was very simple to identify a commodity – basically, you could touch it. Gold, cattle, wheat, oil, coffee. The list goes on. To make a long story short, that necessity of being tangible ended in the early to mid-1970s with the introduction of financial futures – foreign currency, GNMA, T-bond and T-bill futures. And in the ‘80 and ‘90s, Eurodollars, the S&P 500 and Dow index futures, and options on a slew of products, took root.
The chasm between the “old world” – commodity futures – and the new, hip world – financial futures – was perceptible in some crowds. Cocktail party goers were wowed by the Master of the Universe who announced that he was now raking in big bucks trading bonds (ala The Bonfire of the Vanities) or the brave Wonder Woman who knew the ins and outs of making money in the S&Ps. No more the sexy tale of trading pork bellies.
The fact is, however, that the investment world has changed for good, and the lines between cash, futures and OTC are blurring rapidly. Commodities are bubbling up to become a very enticing bull market, even if financial futures do command the lion’s share of trade. It doesn’t matter any more. It’s dollars and cents that count, not cocktail party banter.
Are There Any Good Markets Yet to Be Discovered?
Yet, many less-than-forward-thinking pessimists express that new (and good) product ideas are at a premium – maybe because it takes guts and a boatload of money to develop new markets when there’s no guarantee that the investment will pay off. And, with but a few exceptions, the investment world has never been considered one that is particularly charitable, nor has it broadly exhibited much outward social consciousness.
Let’s for a moment blend social consciousness with a market that is, in a way, part commodity and part financial instrument. And let’s explain it so that a normal mortal can understand, because it’s truly a very appealing concept. Enter the Chicago Climate Exchange (CCX), whose purpose is to be a self-regulatory exchange that manages a voluntary (but legally binding) pilot program for reducing and trading greenhouse gas emissions (GHGs) in North America. That sounds very noble, and it is. A few paragraphs down, we’ll explain why. But for the sake of this magazine’s readership, here’s the bottom line. Let’s call these emissions carbon financial instruments (CFIs), because that’s what they are. An individual trader will use this all-electronic market to speculate on the price of a right to emit 100 metric tons of greenhouse gasses – CO2, methane, nitrous oxide, hydrofluorocarbons, etc. – in future “vintages” (in other words, in a particular future year). Once you get past the initial terminology, which admittedly is a bit new to most traders, it really should be quite simple. Remember, if it’s gradable, it’s tradable.
Take it from Richard Sandor, creator of CCX, and one of the first people to illustrate how to monetize the intangible. As the mastermind behind the first interest rate futures contract ever – GNMA futures (on mortgage-back securities) – he knows all too well that introducing totally new concepts has its challenges. Remembers Sandor, “When Ginnie Maes began trading back in 1975, people were having a very difficult time figuring out what factors affected supply and demand. Certainly, no one knew, for example, what housing starts were or how they impacted price.”
He believes that with education, interested market participants will raise their emissions IQs in the same way as traders did when financial instruments made their debut, and this new market can be as big or bigger than the energy markets. “This concept is as radical as when financial futures began,” says Sandor, and he should know.
But, can you trade for a profit and still benefit society? Sandor thinks the answer is yes. After all, a market needs buyers and sellers to work; some might be socially responsible, others not. But without the two sides, it’s a lopsided equation.
The Ins and the Outs
One of the solutions to this potential imbalance is a category of exchange members that includes market makers, and CCX has a decent number of those. As in so many other markets, it’s the market makers’ job to make sure that markets are kept liquid so buyers and sellers can get in and out of the market without difficulty. That’s one key dimension of a successful market, and its importance is not lost on those who have played the game of entering a market and learning that it’s like the Roach Motel – you can come in, but you can’t get out.
The Big Guns – Companies That Emit Gasses, But Want to Cut Back
But who are other members of this exchange, and what kind of commitment have they made? It’s voluntary, after all. Each group of members has its own reason for being involved. One of the core groups includes companies, municipalities and other entities that actually emit greenhouse gasses. And here’s where the green part comes in: Each member commits to decrease its GHG emissions one percent each year from 2003 to 2006 relative to a baseline of its average emissions from 1998 to 2001. The CCX determines these baselines, and the National Association of Securities Dealers (NASD to you investors) audits and monitors those emissions, verifying CO2 absorption. Everything is on the up and up.
These members, which Sandor says are just the tip of the iceberg in terms of participants in the pipeline or on the “prospect list,” are household names – Ford Motor Co., Dow Corning, DuPont, Motorola, Waste Management, International Paper, Amtrak, the City of Chicago, and more. This is hardly a group that the general public would recognize as card-carrying environmentalists, but companies are becoming increasingly concerned about the short- and long-term effects of global warming, even as the U.S. government has questioned the validity of research that highlights its negative impacts.
So, from a pure dollars-and-cents perspective, why should any company care? Frankly, the insular and recently much-maligned little world of stock analysts occasionally busts out of its bottom-line, green-shade bounds (actually, for legitimate purposes). More and more, they are asking companies what their plans are for cutting down on emissions of CO2. Seem odd? Well, so goes the new world, and like it or not, we’re dealing in the present. So, wouldn’t the smart firm that is “an emitter” want to be in the forefront of this rush? Yes. In fact, Sandor says he would not be at all surprised to see a couple thousand members down the line, though now there are just more than 50.
Outside of the ecological benefits of participating in this voluntary cap-and-trade program through CCX, there are some rather obvious positives that come from reducing emissions. Companies that hit their reduction targets receive credits that can be traded. For example, a company that has emitted an average of 100,000 metric tons of CO2 from 1998 to 2001 agrees to reduce that by one percent in 2003 to 99,000 tons, by another one percent in 2004 to 98,000 tons, to 97,000 tons in 2005, and finally down another one percent to 96,000 metric tons in 2006. The company receives credits for 4,000 metric tons that can be sold on CCX to companies that exceed their targets.
The Marginal Emitter/Good Corporate Citizen
Another group of CCX members includes companies that contribute either a very small amount or no direct emissions; yet, they still commit to offset all emissions associated with business-related travel and energy usage. And, yes, there is a way to measure this. Part of the beauty of Sandor being the main driver behind this market is that his 30-some years of being an economist of note – especially as related to standardized markets – makes the measurement and quantification part of the scenario a necessary and realistic component of the concept. We’re not just talking blue skies here. It has to be practical.
So, how does it work? Take note, readers who also are corporate CEOs, COOs or, generally, big cheeses that make an impact at the board level. Let’s say you are the CEO of Eco, Inc. (a made-up name, of course), or even of ProfitAboveAllElse, L.L.C. (an even more preposterous name), and many of those on your management team have somewhat of a passion for a healthy environment. Some of them know that state legislatures have passed 29 bills in the last three years addressing climate change. Others know that the stratospheric ozone layer is being compromised, and along with that, it’s damaging vegetation and trees and probably their skin and the skin of their children and grandchildren. And you know that, eventually, the Democrats and Republicans in Congress will actually agree that there should be some federally mandated cap system on emissions; you might as well make the commitment now while you understand the rules of the marketplace, as the government may use a free-enterprise exchange as a model. And so on.
Whatever the case – pick your own personal reason – you would like to be proactive in taking a stand, however small, on behalf of the environment. Eco, Inc. and ProfitAboveAll Else, L.L.C. can become members of CCX, too; then they agree to offset their company’s GHG footprint as regards electricity usage and company travel. A calculator helps them figure out how much energy they are using and the extent of their indirect gas emissions. Once determined, they can purchase that amount on the market and “retire” those emission credits. What a company can do, in essence, is mitigate their company’s impact on the environment by keeping their net CO2 emissions at zero. This is one way to make a statement about the importance of being an environmentally responsible corporate citizen.
And, by the way, the market prices of CO2 emissions currently range between $0.80 and $1.00 a ton, with the minimum contract unit at 100 metric tons. It’s not inconceivable that even the guy off the street who is alternately pumped up about ecology and hacked off about the general public’s ignorance about environmental challenges can become part of the solution. Organizations that are so inclined have already begun to make their mark.
Third Parties That Facilitate Others Taking Advantage of the Market
Without going into drill-down detail, CCX has another category of members who facilitate projects that remove carbon from the environment. They typically do it as an “aggregator,” which means that they, not the Exchange, are dealing directly with a number of entities. The simplest example is probably farmers who use a no-till process of farming (environmentally friendly, capturing natural resources) to trap carbon in the soil, working through an “offset aggregator” like a state farm bureau. The Iowa Farm Bureau is one of those aggregators that recently traveled from county to county telling farmers how they could realistically raise one crop above the ground… and one below the ground, too. Aggregators will become increasingly important as more individual projects seek to mitigate carbon from becoming environment-bound.
Where Is CCX Going…and How Fast?
Unquestionably, starting a new market is a crapshoot. But after just five months of operation, Sandor says the Chicago Climate Exchange is more than meeting his expectations. “We expected to have about 20 members at this stage, but we have a couple more than 50. And we thought trading volume would be between one and two thousand metric tons daily, but we are doing between eight and nine thousand.”
That early success, he indicates, is what pushed the time frame up for becoming a futures exchange later this year. Because of CCX’s airtight economic justification, it should be in perfect position for approval by the Commodity Futures Trading Commission when it makes its submission. Certainly Sandor’s background as chief economist of the Chicago Board of Trade in the ‘70s and subsequent high level positions make him understand what regulators are looking for in market transparency and all-important rules, potential fungibility with emerging “pollution” markets in other world centers – and the whole ball of wax that makes a market appealing for individual traders to enter.
Still, there will be a learning curve, and Sandor says that in the next month, the exchange will be putting out more information on factors that affect supply and demand and, in turn, price. Exchange officials also currently are in discussions with quote vendors so that price dissemination will be much broader than just on the exchange’s website.
But first things needed to be first. And, interestingly, Sandor admits that although he knew the concept of CCX would make it in the real world, there was a time when he wondered what else could possibly block its path to launch. “During the last three years, we faced 9/11, the stock market bubble bursting, the Bush Administration walking away from the Kyoto Accord, war in Afghanistan, a recession, and war in Iraq. All of these things could have been near-fatal body blows. But we made it.”
If CCX continues to gain steam, it could encourage sizable reductions in greenhouse gas emissions without onerous governmental intervention, although realistically it will not solve global warming. Nonetheless you have to start with baby steps, and someone had to build the institution that laid the groundwork for this market. Free market forces, in the end, may be the best way to get businesses to control pollution on an ongoing basis, and credit trades are the payoff. But even if the federal government does eventually get into the act (as it doubtlessly will sooner or later), CCX will have eased the transition. That could make its procedures fairly “golden” and the standard by which government will abide. And success brings success. 