The (Very Profitable) Economics of Emissions

For decades, Wall Street has seen environmentalism as a pest—but no longer. With the emergence of emissions markets in America, manufacturers are turning greenhouse gases into cold, hard cash.

In 1985, the rugged Colorado town of Telluride faced a nasty air-pollution problem created by the smoke from its wood-burning devices. To clear it away, city officials passed a clever ordinance. They handed out permits to all current stove and fireplace owners but declared that anyone installing a new stove or fireplace had to acquire two permits from preexisting owners first. And so, the market for trading permits was born. With every two-for-one transaction, the number of wood-burning devices decreased, as did the pollution. The town solved its environmental problem without fancy technology or harsh regulations—just pure and simple economics.

Two decades later, Telluride's idea is going national. A growing number of policy makers, economists, and environmentalists agree that the most efficient, least expensive way to reduce carbon dioxide emissions is with an "emissions market" where firms and brokers can trade shares of pollution just like they trade shares of stocks.

Caps and Commands

A national emissions market would work like this: The federal government decides that the whole United States can only emit X amount of carbon dioxide per year. (Currently, X equals about 6.5 billion tons.) Factories then get a certain number of permits for their emissions, each worth 1 ton. Instead of looking for ways to dump pollution, companies "own" their emissions output and can trade it like a commodity. For instance, if a business has 25,000 permits but only needs 20,000, then it can sell the extra shares for cash. Or, if a company unexpectedly exceeds its pollution limit, it can buy extra permits to cover itself.

The result is a "cap-and-trade" market, which allows the government to screw down maximum emissions levels and lessen pollution by taking shares out of circulation. When shares disappear, the supply goes down, and the remaining shares become more expensive. Eventually, it costs companies too much to simply buy extra permits and prompts them to invest in cleaner technology.

Supporters believe this system far surpasses the government's current approach, which is based on "command-and-control" regulations. Rather than punishing companies for bad environmental behavior, emissions markets encourage good deeds by financially rewarding those who get by with fewer shares. Under today's command-and-control scheme, if the limit on pollution is set at 1,000 tons of CO2, then a factory has no incentive to reduce pollution below that. The market scheme, on the other hand, entices factories to get that figure as close to zero as possible.

The government's current approach also requires plants to install expensive devices whenever they upgrade or build new facilities. Rather than pay ghastly installation and construction costs, managers often do nothing, which allows high-polluting plants to persist. By contrast, the market approach encourages factories to take baby steps if they can't take big ones, because even small investments in curbing pollution pay off in the form of extra shares.

Emissions markets have another big thing going for them—a successful track record. Remember acid rain? Believe it or not, an emissions market largely helped eliminate it as a major environmental threat. When Congress passed the Clean Air Act in 1990, it established a market for trading the sulfur and nitrous oxides that cause acid rain. Trading went live in 1995, and in three years, emissions had dropped by 3.9 million tons—70 percent more than expected. Within a decade, acid rain was a forgotten curiosity.

Bursting the CO2 Bubble

Unfortunately, dealing with greenhouse gases is trickier than acid rain, because every industry releases at least some carbon dioxide. Still, the carbon-market solution is making headway. Most prominently, there's the Chicago Climate Exchange, a mini-market for companies that want to trade pollution now in anticipation of tougher environmental regulations in the future. There's also the Regional Greenhouse Gas Initiative—a coalition of 10 states in the Northeast—which will begin trading emissions for power plants in 2009. And in California, a carbon market is part of an ambitious greenhouse-gas reduction scheme known as The Global Warming Solutions Act.

But governments have to be careful when setting up emissions markets, as Europe proved a couple of years ago. Environmental markets are prone to the same irrational exuberance as any capitalist market. In 2005, the European Union began mandating emissions trading, and analysts predicted prices wouldn't rise much higher than
$10 per share. One year later, however, they'd jumped to $38. The carbon dioxide bubble popped, and in two weeks, shares had dropped by two-thirds—the green equivalent of Black Tuesday.

Scared away by Europe's experience, some economists are promoting alternatives, such as "carbon taxes," which tax emissions just like personal incomes. (The more you pollute, the more you pay.) The problem is that carbon taxes set no cap on emissions. In other words, the world's biggest manufacturers could pollute all they want as long as they pay up, and global warming might actually get worse.

Going to Market

Still, most economists believe the United States can sidestep problems by following a few simple rules. First, future markets must issue a reasonable number of permits. The European Union handed out way too many credits initially, making everyone feel rich enough to take risks. A year later, when pollution reports came out, many countries had emitted far less than expected, leading to a glut of shares. With high supply and low demand, prices plummeted.

Also, U.S. markets will need to distribute their credits wisely. Some market proposals "grandfather" in firms, giving companies credits based on past pollution patterns. But that system punishes companies that have been controlling pollution and rewards those that were flouting the rules. Distributing credits via a good old-fashioned auction, however, could generate extra revenue for the government.

It's a good thing the Europeans are showing us how to stomach the ups and downs, because carbon markets will receive a big boost when the Kyoto Protocol goes into effect in 2008. Emissions markets are at the core of that agreement, allowing entire countries to trade pollution shares as though they were businesses. In other words, someday, people all over the world could be getting rich off pollutants once regarded as worthless.

This article was written by Sam Kean and originally appeared in mental_floss magazine.