Josephine V. Yam

By 2023, a Changed World in Energy

“When it comes to energy, the rule of the game is to expect the unexpected,” observed energy historian Daniel Yergin in the New York Times article, “By 2023, a Changed World in Energy”.

Yergin noted: “So much effort is going into research, development and innovation all across the energy spectrum, 10 years from now we may well see the next game changer.”

Writer Clifford Krauss recalls that, in 2003, American natural gas fields were thought to be depleting rapidly such that expensive terminals for natural gas importation, not exportation, were being built. U.S. oil production was likewise declining at rapid rates.

Now, ten years later, the U.S. is well on its way to become energy independent, thanks in no small part to new drilling technology that has made its oil and natural gas fields much more productive. In fact, in its latest World Energy Outlook, the International Energy Agency (IEA) reported that the U.S. will overtake Saudi Arabia and Russia as the world's top oil producer by 2017. This will have massive geopolitical consequences, as the U.S. will no longer depend on undemocratic regimes like Venezuela or Nigeria for obtaining its oil supply.

So what will the energy world look like in 2023? It will be a different energy world where there will be widespread adoption of electric cars, solar panels by business and households and trains and trucks guzzling on natural gas. It will be a world where renewable energy sources will become dominant, accounting "for 32 percent of the overall growth in electricity generation through 2040.”

According to the IEA, the emerging market economies, like China, will still be reliant on fossil fuels through 2035. Yet, it reports that China’s new government has committed to investing more than $70 billion a year in clean energy projects, in recognition of the imperative sustainability path that it must undertake to quench its still growing energy appetite.

“Much of the future of energy will depend on government policy, of course,” noted Krauss. And indeed, a clean energy world will only be possible if governments around the globe arm themselves with the solid political will and foresight to bravely implement policies that support sustainable growth that is so crucial in this carbon-constrained decade.

U.S., China Forge Historic Deal on Climate Change

"Groundbreaking" is the appropriate word to describe the United States - China deal recently forged to jointly combat climate change. Being the world’s two biggest economies and greenhouse gas (GHG) emitters, their monumental “call to action” to reduce GHGs will be undertaken "by advancing cooperation on technology, research, conservation, and alternative and renewable energy."

The National Post article reported that this deal was reached during U.S. Secretary of State John Kerry's visit to China this weekend. Kerry is known to be a staunch advocate for advancing U.S. policies on GHG reduction and climate change.

The U.S.-China joint statement forcefully enunciated that both countries “consider that the overwhelming scientific consensus regarding climate change constitutes a compelling call to action crucial to having a global impact on climate change.” Moreover, they recognize that an “urgent need to intensify global efforts to reduce greenhouse gas emissions… is more critical than ever” and believe that “such action is crucial both to contain climate change and to set the kind of powerful example that can inspire the world.”

Noted Alden Meyer, representative for the Union of Concerned Scientist in the United States: By “pledging to set the kind of powerful example that can inspire the world," both countries "raise expectations" that they "will move more forcefully to confront the threat of climate change."

Yet, as we all know, the devil will surely be in the details. So we wait in anticipation as the U.S. and China discuss the details of this historic deal in an upcoming Strategic and Economic Dialogue meeting later this July.

US is Global Leader in Cutting Greenhouse Gas Emissions

In his New York Times article, "A Model for Reducing Emissions", Eduardo Porter reports that the US has cut its CO2 emissions by almost 13 percent since 2007. The Americans have reduced their total energy use in the past 5 years by 5 percent. Surprisingly, this reduction is likely the most substantial GHG cut among developed countries and even more than what Europe has achieved.

The most compelling driver for the incredible decline in CO2 spewing is neither regulation nor increased citizenry initiatives to combat climate change. It is simply the interplay of market forces: low energy prices and technological innovation. In other words, the reasons are economic, not political.

Undeniably, the depressed economy has caused the lower production of goods and services, which in turn has decreased the Americans' use of energy. But a breakthrough in hydraulic fracturing of shale rocks has also produced massive amounts of cheap natural gas, which is significantly cleaner than coal. This in turn has caused electric utilities to switch from coal to natural gas, increasing the latter's overall proportion from 21 percent to 30 percent of total electricity produced from power plants.

Will these market forces continue to bring into fulfillment President Obama's goal of cutting CO2 emissions by 17 percent by 2020? Maybe. But until there is a carbon price that internalizes the escalating environmental damage and climate threat that carbon imposes on humanity, only then will there be a genuine driver that effectively dampens massive CO2 spewing.

Time to Confront Climate Change

The New York Times editorial “Time to Confront Climate Change” recalls that during his first term, President Obama described climate change as one of humanity’s most pressing challenges. He pledged an all-out effort to pass a cap-and-trade bill that would limit greenhouse gas (GHG) emissions. Unfortunately, during that period, many political obstacles blocked Mr. Obama’s administration from successfully passing a cap-and-trade bill.

Since his re-election in November 2012, President Obama identified climate change as one of his top priorities in his second term. In his interview for TIME’s Person of the Year award, he cited the economy, immigration, climate change and energy at the top of his agenda for the next four years.

The article then raised a very important question: Will President Obama bring the powers of the presidency to bear on the climate change problem?

President Obama has strategic “weapons” within his reach to tackle climate change and reduce emissions while reasserting America’s global leadership, the article notes.

One weapon he has is to ensure that natural gas, which is hugely abundant in the U.S., is extracted without risk to drinking water or the atmosphere. Indeed, the U.S. has natural gas in abundance, a boon considering that it emits only half the GHG emissions as coal does. This can be undertaken by the Obama administration through national legislation to replace the inconsistent, patch-work requirements of various state regulations.

Another weapon President Obama has is to enact and implement policies both in well-known clean energy technologies (i.e. wind power and solar power) as well as in basic research, next-generation nuclear plants and promising technologies that could lead to a low-carbon economy.

Moreover, another weapon within President Obama’s arsenal is to call on the Environmental Protection Agency (EPA)’s authority under the Clean Air Act to limit emissions from stationary sources, mainly coal-fired power plants. The EPA has already proposed strict emission standards for new power plants that can only be built when they have installed carbon capture and sequestration technologies. The problem that the EPA will need to deal with is what to do with existing coal-fired power plants, which still generate about 40% of U.S. electricity power.

At the Copenhagen climate meeting back in 2009, President Obama committed that the U.S. would reduce its GHG emissions by 17% below 2005 levels by 2020. With the abundant supply and strong demand for cheap natural gas as well as the EPA’s newly established fuel standards and mercury rules, among others, the U.S. is now on its way to achieving a 10% GHG reduction by 2020.

Thus, it appears that reaching President Obama’s 17% goal is within the realm of the possible after all. That is, if he courageously uses the powers of his presidency to wield the strategic weapons he has to tackle climate change.

5 Steps for Business-friendly Climate Agenda

Eric Pooley provides five steps that President Obama should take to address climate change in his second term. In his Harvard Business Review article, “A Business-Friendly Climate Agenda for Obama's Second Term”, Pooley outlines how the president can fulfill his promise to ensure that America "isn't threatened by the destructive power of a warming planet". He emphasizes that the following 5 steps can only be successful with the active support and participation of private industry.

1. Feed the conversation. President Obama can start by simply by talking about the issue and helping Americans see the relationship between emissions, climate change and extreme weather. This conversation is crucial as it engages the voices from private industry, including insurance companies, pension funds, banks and small business. To be politically viable, climate solutions must be economically sustainable.

2. Reduce climate accelerants. President Obama can take immediate steps to reduce potent greenhouse gases other than carbon, such as methane and fluorinated gases used in refrigerants and industrial applications. Although carbon is most ubiquitous, these substances are "climate accelerants", which means that they accelerate global warming the same way gasoline fuels a fire.

3. Start a clean energy race. President Obama can reduce subsidies for fossil fuels, continue tax credits for renewable energy while increasing R&D funding. Congress should pass national clean energy standards, which would require states to get more energy from renewables. Obama should also encourage private capital to invest in low-carbon energy by removing barriers to investments in efficiency and renewables.

4. Use the Clean Air Act. President Obama should use the Clean Air Act to reduce greenhouse gas emissions, under authority confirmed by the U.S. Supreme Court in Massachusetts v. EPA. This means vigorously defending the clean-air rules that his administration has already put in place, including the historic higher fuel economy standards for new cars and trucks and restrictions on the emission of mercury and other toxic air pollution for power plants. His administration should also set CO2 emission standards for new and existing power plants through flexible and economically efficient approaches.

5. Put a price on carbon. President Obama should heed the call of economists from across the political spectrum that believe that the most economically efficient way to cut carbon pollution is by imposing a price via a carbon tax or through cap and trade. Either would be a powerful incentive to produce cleaner power and could be accompanied by lower taxes on labor or capital, easing the impact on working families and business. As the U.S. moves toward a fiscal cliff, there is slew of discussions in Washington about raising revenue through a carbon fee. It could be in the form of a carbon tax starting at $20 per metric ton and rising at 6% a year that could raise $154 billion by 2021.

Energy and Climate Change in Obama's To-Do List

In the New York Times article, “A To-Do List for the Next For Years”, Carol Browner proposes the need for President Barack Obama to finally execute on a climate change agenda. Ms. Browner was former director of the White House Office of Energy and Climate Change Policy from 2009 to 2011 and the administrator of the Environmental Protection Agency (EPA) from 1993 to 2001.

“Energy and climate change, two issues that deeply divide the country, stand out as major pieces of unfinished business for the Obama administration,” she notes. Nevertheless, she points out that President Obama has unequivocally stated that “even for those who don’t believe climate change is real, the benefits of clean energy -- cleaner air, energy independence, American jobs and enhanced global competitiveness -- are just too important to ignore.”

How then can President Obama execute on a climate change agenda? By using his executive authority and by leverage existing energy laws.

The U.S. Supreme Court has affirmed the EPA’s authority to limit greenhouse gases that endanger public health. Browner recalls that during his first term as president, Obama used an energy bill signed by George W. Bush to reach an agreement on cleaner, more fuel-efficient cars. Car manufacturers had business certainty, consumers saved money at the pump and the environment became cleaner. She notes that President Obama can use this existing authority to work with the electric utilities to reduce carbon pollution and secure greater energy efficiency while providing business certainty.

Ms. Browner also recommends that given the abundance of natural gas, the Obama administration must ensure that “fracking” is done in accordance with strong public health standards. Also, instead of 20 to 30 different state regulations that are imposed on fracking businesses, the Obama administration should just develop one set of national requirements based on the best available science and technology while leaving the oversight and enforcement up to the states.

Indeed, by executing on a strong climate change agenda in the next 4 years, President Obama can ensure that the U.S. moves steadily and unconditionally towards a sustainable, clean energy future.

New Sustainability Metric: Total Return on Resources

The Boston Consulting Group (BCG)'s recent report stated that, in order to succeed in this new world of sustainability, companies will need to treat "resource management" as essential to their business. To do this, companies must focus on their “total return on resources” in order to optimize their inputs and outputs to maximize profits.

For inputs, companies will need to monitor the payback from natural resources in order to minimize the consumption of scarce supplies. Thus, power companies, for example, put a lot of money in improving the efficiency of their generating plants to reduce how much coal or natural gas they need in order to produce each megawatt of electricity.

For outputs, companies will also need to manage the "putback", which is the effect of their actions on the future supply of natural resources and on the climate so as to limit damage to the larger ecosystem. In such cases, for example, power companies put a lot of money in scrubbers and other processes to reduce the harmful emissions they release into the air.

The BCG report cites many stellar examples of companies focusing on their “total return on resources”. One of them is the Florida Ice & Farm, a Costa Rica-based beverage company. Its highly visionary CEO, Ramón de Mendiola Sánchez proclaimed that 40 percent of the variable portion of executive pay would be dependent on the company’s performance on environmental and social measures. He established a framework of strict measurements and strong managerial focus on environmental metrics, such as solid waste, water use and carbon dioxide emissions. The company set very lofty goals of achieving zero net solid waste by 2011, becoming water neutral by 2012 and carbon neutral by 2017. Thus, it comes as so no surprise that one of its bottling plants has become the most efficient in the world in terms of water usage. At the same time, the company’s revenues and market share have continued to grow through a tough economy. Mendiola firmly believes that this commitment to sustainability is the only way to achieve continued growth and to sustain Florida’s position as one of the most influential and admired companies in Costa Rica.

Indeed, the BCG report notes that, as resource supplies fail to keep up with burgeoning demand, companies will start treating sustainability as a central part of management rather than thrust it to the amorphous office unit of corporate social responsibility. The world as a whole is on the verge of a new wave of innovation in resource management, the report observes. And, as with all innovation, this will create opportunities for companies to teach others how to thrive in a carbon-constrained, resource-constrained world.

Carbon Finance: To Trade or Tax?

There are a lot of features of a Carbon Tax that make it an effective economic-incentive approach to address climate change:

  1. Carbon taxes lend predictability to energy prices. This allows for strategic decision-making involving energy to be made will full awareness of the carbon–appropriate price signals, whether it is design of new electricity generating plants to the purchase of the family car.
  2. Carbon taxes will provide quicker results. The taxes themselves can be designed and adopted quickly and fairly.
  3. Carbon taxes are transparent and are easier to understand than Cap & Trade. The government simply imposes a tax per ton of carbon emitted, which is easily translated into a tax per kWh of electricity or gallon of gasoline.
  4. Carbon taxes address all sectors and activities producing carbon emissions. They target carbon emissions in all sectors such as energy, industry and transportation.

Indeed, the three-letter word called “tax” can spell political suicide for some governments, especially in the midst of this global financial crisis. Thus, some governments may not be bold enough to espouse it as a strategic policy tool to fight climate change.

Written: 2011 November
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The Issue of Double Counting in the Monitoring and Reporting of Greenhouse Gas Emissions (MRG)

There is a complexity inherent in MRGs, especially in respect of consistency of reported information. One related issue relates to international offsets and double counting.

The issue revolves around the following questions:

How will offsets be accounted for in reporting and reviewing countries’ progress toward meeting their emission-reduction targets under the Cancun Agreement? Will both developed (buyer) and developing (seller) countries be able to count emission reductions from offset projects towards their respective pledges? Or will only the buyers get to count them, as is currently the case under the Kyoto Protocol and domestic emissions trading systems?

Currently, there is uncertainty in the existing agreements. Most countries have not taken an official position on what they would be doing.

A Stockholm Environment Institute paper and policy brief entitled “The Implications of International Greenhouse Gas Offsets on Global Climate Mitigation” addressed this issue when the paper was presented at a carbon markets and accountability seminar hosted by the OECD and the International Energy Agency in April 2011.

The paper concluded that the use of international offsets, if counted both by the supplying (developing) and buying (developed) country, could effectively reduce the ambition of current pledges by up to 1.6 billion tons CO2e in 2020. It suggested that the current pledges could significantly fall 10% lower than the total abatement required to stay on a path consistent with limiting warming to 2°C. The paper assumed that each ton of offset credit represents a ton of emissions benefit. To the extent that offsets do not represent real, additional reductions, then the effective dilution of pledges could be even greater.

It would be highly beneficial if this double counting issue of international offsets is settled uniformly across the EU and globally in order to preserve the environmental integrity of the EU ETS and the upcoming emission trading systems around the world.

Written: 2012 March
Reference: Stockholm Environment Institute, “The Implications of International Greenhouse Gas Offsets on Global Climate Mitigation (2011)

What are the advantages and disadvantages of catastrophe bonds?

Advantages

  • Catastrophe bonds have less credit risk because the total amount of funds which can be called by the (re)insurer if a catastrophe occurs are placed in trust. In contrast, reinsurers do not hold funds equal to their maximum exposure, and thus reinsurers have insolvency risk.
  • Catastrophe bonds also reduce agency costs relative to equity capital, because the funds raised from the bond issue are placed in trust and cannot be used by managers unless a specified catastrophe occurs.
  • Catastrophe bonds involve lower tax costs than equity capital, just as debt financing in general has a tax advantage relative to equity financing.
  • The catastrophe bond structure reduces financial distress costs relative to traditional subordinated debt, because the contingent payments are based on readily observable variables (the occurrence of a catastrophe) and the payments are agreed upon ex ante. Additional debt financing generally involves greater financial distress costs.
  • Catastrophe bonds have a moderating effect on reinsurance prices and prevent reinsurance prices from increasing any faster than they did. By presenting an alternative to traditional reinsurance, the development of cat bonds has forced reinsurers to become more competitive with pricing.
  • Investing in catastrophe bonds could be recommended since they have presumably low or zero correlation with other currently traded assets and are therefore a promising instrument for portfolio enhancement. Also, cat bonds have attractive risk/return characteristics, especially for those large, sophisticated investors they are designed for, such as mutual funds/investment advisors, proprietary/hedge funds, and (re)insurers.
  • Returns on catastrophe bonds are proven to be less volatile than either stocks or bonds.

Disadvantages

  • The use of catastrophe bonds is hindered by regulatory constraints that generally require that the bonds be issued by an offshore special purpose vehicle. As a result, catastrophe bonds can involve substantial transactions costs. Transaction costs indeed represent approximately 2 percent of the total coverage provided by a catastrophe bond (for example, $2 million for a security providing $100 million in coverage). These costs include: underwriting fees charged by investment banks, fees charged by modelling firms to develop models to predict the frequency and severity of the event that is covered by the security, fees charged by the rating agencies to assign a rating to the securities, and legal fees associated with preparing the provisions of the security and preparing disclosures for investors. The price of a reinsurance contract would not typically include such additional fees.
  • Others institutions avoid purchasing catastrophe bonds altogether because it would not be cost-effective for them to develop the technical capacity to analyze the risks of securities so different from the securities in which they currently invested.
  • Catastrophe bonds are available only to institutional investors.
  • The market in cat bonds generally suffers from lower levels of liquidity relative to mainstream bonds.
  • The dramatic recent growth in the catastrophe bond market has in turn spurred the launch of some new insurance related businesses which could potentially undermine the long term growth prospects of the cat bond market.

Written: 2011 October
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Inclusion of Airline Emissions by European Union Emissions Trading System (EU ETS) triggers International Law Dispute

The brewing international controversy of airline emissions being included in the European Union Emissions Trading System (EU ETS) highlights one of the risks of the EU unilaterally imposing a carbon market on its member countries while China, US and other major economies do not have their own carbon markets.

The Law

The European initiative, effective January 1, 2012, involves folding aviation into the six-year-old emissions trading system, in which polluters can buy and sell a limited quantity of permits, each representing a ton of carbon dioxide. The law requires airlines to account for their emissions for the entirety of any flight that takes off from — or lands at — any airport in the EU bloc. While airlines landing or taking off in Europe are included in the EU ETS beginning January 1, 2012, they do not have to start paying anything until April 2013.

The goal of this European initiative is to speed up the adoption of greener technologies at a time when air traffic, which represents about 3 percent of global carbon dioxide emissions, is growing much faster than gains in efficiency.

Consequences of the Law

Airlines will have to buy 15 percent of their emissions certificates at auction. Carbon emissions from planes will initially be capped at 97 percent of the 2004-2006 levels. The emissions rules apply from the moment an aircraft begins to taxi from the gate, either en route to or from a European airport, and they cover emissions for the flight from start to finish — not just the portion that occurs in European airspace.

Why the EU went ahead with the Law

Governments and airlines have been in negotiations for more than a decade over the creation of a global cap-and-trade system under the auspices of the International Civil Aviation Organization, an arm of the United Nations. The organization’s 190 member states passed a resolution in 2010 committing the group to devising a market-based solution, though without a fixed timetable.
Impatient with the pace of those talks, the European Commission moved ahead with its own plan, which was passed two years ago with the support of national governments and the European Parliament.

Airline arguments

Some 26 countries, including China, Russia and the United States, formally showed their dissatisfaction with the European system — a move that heralds a possible commencement of a formal dispute procedure at the International Civil Aviation Organization (ICAO), a U.N. agency that handles global aviation matters. They have questioned whether this EU directive is invalid. Their arguments include the following:

  1. Why the requirements apply to emissions from the entire flight, not just the portion that occurs within EU airspace?
  2. In applying its environmental legislation to aviation activities in third countries' airspace and over the high seas, the E.U. has violated fundamental and well-established principles of customary international law.
  3. The EU's actions infringe on the notion that each nation has sovereignty over its territory, a universally recognized principle of international law.
  4. By acting unilaterally, the European Union also breached international obligations that require such matters to be resolved by consensus under the auspices of the International Civil Aviation Organization (ICAO), a U.N. agency that handles global aviation matters.

In fact, China recently announced that its carriers would be forbidden to pay any charges under the European emissions system without Beijing’s permission.

EU Response to China and the other countries

The EU posits that the ETS is not a charge or a tax but a cap-and-trade system. Its defense includes the following claims:

  1. The purpose of our legislation is to reduce emissions, not make money.
  2. Including aviation in the ETS is "fully consistent with international law" because the EU is not seeking to extend its authority outside of its airspace.
  3. However, given the complaints of China and other countries, the EU could suspend parts of a new law requiring airlines to account for their greenhouse gas emissions if countries were to make clear progress this year toward establishing a global emissions control system.

Written: 2012 February
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Why was there an over-allocation of allowances in the European Union Emissions Trading System (EU ETS)?

One reason why there was an over-allocation of allowances in the European Union Emissions Trading System (EU ETS) was because of national self-preservation. The EU gave its member states the authority to determine their specific allocation of allowances. In the name of protecting national economic self-interest, the member states over-allocated allowances to themselves, especially France, Germany and Italy. With no ability to bank allowances into the second phase because of their expiration dates, the allowance price of a Phase I allowance dropped to zero in 2007.

Written: 2012 February
Source: PriceWaterhouseCoopers (PWC). (2009). Carbon Taxes vs. Carbon Trading: Pros, cons and the case for a hybrid approach

What are the two main conditions that make emissions trading systems feasible in the European Union Emissions Trading System (EU ETS)?

Condition 1 - the participants covered by the program must be sufficiently varied for there to be potential gains from trading allowances. If all firms were the same, then they would all face the same abatement costs and so they would all be either net buyers or net sellers. Hence no trade would occur. In the European Union Emissions Trading System (EU ETS), the coverage includes power plants and five major industrial sectors (including oil, iron and steel, cement, glass, and pulp and paper) that together produce nearly half the EU’s CO2 emissions.

Condition 2 - there should be a sufficient number of polluters included in the scheme in order to ensure a reasonably liquid market. This increases the amount of trades that occur, hence allowing a clear price signal to emerge. In turn, this reduces the uncertainty that participants face when making long-term investment decisions because the expected gains from investing to abate are much clearer. Furthermore, the risk of any one participant holding extensive market power, which would restrict trading, is reduced. In the European Union Emissions Trading System (EU ETS), approximately 12,000 facilities in the 25 EU member states are covered.

In successfully meeting these two conditions, the EU ETS’ massive scale and breadth has enabled it to build a very robust emissions trading market in a short period of time. For example, in 2007, over 100 million allowances per month were traded. Moreover, rates of compliance amongst participants were encouragingly high.

Written: 2012 February
Source: PriceWaterhouseCoopers (PWC). (2009). Carbon Taxes vs. Carbon Trading: Pros, cons and the case for a hybrid approach”