Copenhagen: what to look for…
One of the most exciting things occurring in the world today, from both an economic and environmental perspective, is the development and implementation of cap and trade regulations that create economic incentive to do the right thing by the environment.
In simplest terms, the cap and trade regulations under the Kyoto Protocol (the driving force behind greenhouse gas emission reductions internationally), and those regulations under debate in the legislative process in the US, create a shortage of instruments that commercial and industrial emitters must surrender at the end of each year against their total greenhouse gas emissions in the previous year. If emitters do not reduce their emissions within the proscribed amounts, they must purchase instruments from another emitter that has done so, or create new instruments through narrowly defined and closely monitored project activities that reduce emissions elsewhere. The free trading of these instruments provides price signals for the cost of compliance that can be used by those of us seeking to invest in technologies or project activities that reduce emissions.
The issue being addressed is vast – with global greenhouse gas emissions from human activity totaling above 36 billion tonnes of CO2 equivalent a year and a target of total emissions of less than 7 billion tonnes a year by 2050. The potential market size is vast – with the chair of the CFTC Energy and Environmental Markets Advisory Committee “…estimating carbon markets could be worth $2 trillion in transaction value – money changing hands – within five years of trading (starting)…” (CNBC Carbon Challenge Series 2009)
Therefore, as we look forward to the negotiations that will be held next month in Copenhagen, it’s worthwhile to keep an eye on what we need to see for the potential of the market forces created by carbon regulation to be realized.
The entire goal of cap and trade mechanisms is to create a market dynamic in which capital will flow to new technologies that reduce greenhouse gas emissions (without a commensurate reduction in productivity) and to project activities that will reduce greenhouse gas emissions. For the market forces to reach maximum potential, the negotiations must result in signals to investors that warrant and support investment.
Investors, innovators, and entrepreneurs need to see clarity around only a few key issues to spur investment and activity.
TERM – the first stages of regulation have been short, primarily to work the kinks out of the underlying processes. That’s fine, but the types of investment required to seriously address the long-term nature of the problem need certainty around how long the regulations will be in force. The longer the term and the more certainty that can be provided, the stronger the incentives will be to deploy risk capital. The short duration of the current phases of regulation actually preclude large investments in technologies and in infrastructure changes in the large emitter communities because implementation in most cases requires a longer time period that current regulations cover. For example, typical venture capital and private equity return horizons last five to ten years.
REDUCTION COMMITMENT – the projected price levels for compliance going forward (and therefore the inputs to models used by investors to calculate their return – and risk) can only be modeled if there is some level of certainty around total emissions, required reductions, etc.
Unfortunately, many of the folks leading the discussions in Copenhagen, while seeking to leverage the prospective benefits of market forces to inspire capital investment are often less focused on the market benefits and more focused on political or moral objectives. While keeping an eye out on TERM and REDUCTION COMMITMENT, also keep an eye out for those things coming out of Copenhagen that might seem out of place when thinking about implementing a program to save the world from the threat of global warming. Watch for anything that reduces incentives to reduce emissions!!! There will be discussions about limiting project activities that reduce emissions. This makes little sense to us, but there will be groups whose primary focus is shutting down commercial and industrial sectors rather than reducing overall global emissions. Also watch out for discussion points seeking to reduce the amount of money that can be made by reducing emissions – some politicians and environmentalists seek to exploit market dynamics but simultaneously will want to put caps on the reward entities can reap without a commensurate reduction in the risks associated with undertaking the investments.
All in all, Copenhagen will be interesting to watch…. Let’s just make sure we’re all watching for the right things…!
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