Climate Change  Monitoring International Greenhouse Gas Emissions Trading

By Ruth Greenspan Bell

Advocates of international emissions trading would be wise to reflect on
recent U.S. accounting and trading scandals. The Kyoto Protocol
establishes an international greenhouse gas trading system. Emissions
trading clearly can save society money, but international planners must
put safeguards into place to keep the mission of traders on track with 
the goal of reducing greenhouse gas emissions. If international policymakers
wait until a scandal erupts, it will be too late. Who will be the
international Securities and Exchange Commission of emissions trading?
Ruth Greenspan Bell directs Resources for the Future's program for
International Institutional Development and Environmental Assistance,
helping institutions in societies without strong legal systems to become
more effective in implementing natural resource management and
environmental protection policies and laws. Her current projects include
efforts involving public participation in environmental decision making 
in the Danube region and in Thailand. Before joining RFF, Bell spent almost
17 years in management positions in the Office of General Counsel at the
Environmental Protection Agency.

Sham trades reported by Reliant Resources, Dynergy, Enron, and CMS
Energy to pump up trading revenue and volume in California, the out-and-out
balance sheet fraud committed by WorldCom, and the most recent revelations
about seemingly reputable bankers who intentionally structured transactions to
allow Enron to hide $125 million in debt, seem, at first
glance, to have only a remote connection to global climate change policy.

But advocates of international emissions trading would be wise to reflect
on these scandals.The cornerstone of the approach to climate change management
taken by the administration of former U.S. President Bill Clinton is a complex
international greenhouse gas trading system. The administration of
President George W. Bush has pulled out of the Kyoto Protocol process, but
it has not slammed the door shut on an emissions trading scheme in the future.
Emissions trading allows firms and countries that can control pollution
more cheaply to accumulate credits for their efforts. They may then sell
these credits to others for whom the cost of pollution reduction is
greater. Variations of this technique were written into the Kyoto
Protocol's "clean development mechanism." The Pew Center for Climate
Change calls emissions trading the "policy of choice," and the theory has
been endorsed by many economists, including several Nobel laureates, and
now even by many environmental advocacy groups.
The purpose of trading is to harness market forces in the reduction of
greenhouse gases. The main opposition has come from proponents of the view
that emissions trading would allow the developed world, and in particular
the United States, to escape responsibility for its energy-intensive
lifestyle by funding reductions in other parts of the world.

Sulfur Dioxide Trading in the United States
The sturdiest working examples of emissions trading can be found in the
United States--the same examples cited by the proponents of a global
trading scheme. The United States has achieved significant reductions in
sulfur dioxide from electric generating plants by setting a permanent
emission ceiling and allocating utilities allowances to emit 1 ton of
sulfur dioxide during or after a specified year based on their historic
fuel consumption and a specific emissions rate. For each ton of sulfur
dioxide emitted in a given year, one allowance is retired and can no
longer be used. The market kicks in because allowances may be bought,
sold, or banked.
An international trading system would work in basically the same way. Some
sort of limit would be set. It could be met either by reducing greenhouse
gas emissions or by purchasing reductions from pollution sources in other
parts of the world that can more easily and cheaply reduce their
greenhouse gas emissions. Economic theory says the environment will
improve while the overall price tag of cutting greenhouse gas emissions
goes down.

Examples of Trading Abuses
But in the past six or so months, a number of warning bells have sounded
for those who care to listen. Examples of trading abuses have cropped up
in the United States, meaning within the context of a well-developed legal
and oversight system and a free press--an important issue that will be
discussed further below. The basic message of each of these incidents is
that even in a mature, capitalist democracy, the invisible hand needs
plenty of highly visible oversight and management. Without strong
institutions to police the participants in the market, markets can be
captured and distorted. The losers from the frauds reported in today's
press have been investors and consumers. In the future, if greenhouse gas
trading is not backed up by effective institutions, the environment will
be the loser.
The first of these incidents involved New Jersey's emissions trading
system. PSEG Fossil LLC, the biggest player in that state's system,
apparently had not installed necessary pollution controls or obtained
proper permits. The U.S. Justice Department discovered this and brought an
enforcement action, which was resolved in the form of a consent decree.
PSEG, without admitting any wrongdoing, agreed to stop selling its credits
to other firms and to stay out of the trading system. When PSEG was forced
to withdraw, its sheer size and status as one of the largest "suppliers"
of credits in New Jersey brought that state's system close to collapse.
 
In addition, according to the Aug. 5, 2002, issue of the Electricity
Daily, the South Coast Air Quality Management District (SCAQMD) in
California and the regional office of the U.S. Environmental Protection
Agency are looking into charges that a Pasadena broker cheated several
firms who paid for emissions credits that were never delivered. The SCAQMD
manages emissions trading for the Los Angeles region.
A similar example from the United Kingdom was reported in the April 12,
2002, edition of the Electricity Daily, in an account of a
government-sponsored auction in which participating companies bid by
offering greenhouse gas reductions. An independent review by Environmental
Data Services noted strong grounds to suspect that at least half of the
claimed emissions reductions were not real, and blamed the inaccuracies on
shortcomings in the Department of Environment, Food, and Rural Affairs
regulatory controls and "poorly thought through rules."

The New Jersey and U.K. situations attracted little public notice. But
more recent events have attracted a great deal more attention. This past
spring, several energy trading companies admitted to having made sham
electricity trades. In addition to the well-known activities of Enron,
Duke Energy Corp. reported that it had included about $1.1 billion of
energy trades that had no economic benefit in financial statements over a
three-year period, and the chief executive of CMS Energy was forced to
resign when it was disclosed that the company had inflated revenue by 28
percent over two years. A former Reliant executive was quoted as saying,
"The same circuit got traded back and forth. The idea was to book more
transactions and get a market going."

All of the above failures and near failures, including the Enron and
WorldCom debacles, took place in countries where law and law enforcement
are relatively well developed. The news media paid close attention and so,
therefore, did the public and government officials. The nongovernmental
organizations are vigilant and know how to bring lawsuits or how to
complain to Congress.

Will Trading Work in Developing Countries?
The question for global planners is, if market incentives are fragile
here, how would they work in developing countries where strong
institutions to protect markets against fraud and corruption simply do not
exist?
Emissions trading systems must be tested against the difficult conditions
found in the real world, where there will always be people who cut corners
or outright cheat. If it was not clear before these recent events, it
certainly is now: some countries and some people will not follow the
rules. And the rules are particularly hard to enforce when what is being
traded is a highly intangible commodity, as are carbon emissions.
The difficulty of the proposed global emissions trading system is that it
rests on a foundation of carbon reductions in each country. The actual
in-country reductions can be achieved any number of ways, using
traditional command-and-control or market-based environmental instruments,
but they must be continuous, that is, there must be a reliable continuing
stream of carbon reductions over time. It is these reductions that are
sold or traded. In addition, if the Kyoto regime holds up, the reductions
will be calculated after a baseline is established; the greenhouse gas
emission reduction for which a credit can be obtained must be incremental
to each country's baseline, defined as that would occur in the absence of
the certified project activity.

In other words, the commodities being traded are difficult to identify, to
keep track of, and to count. The European Union has recognized this fact
by attaching an explanatory note to its proposed directive on greenhouse
gas emissions trading that allows the EU to enter into separate agreements
with non-EU countries for trading, but emphasizes that such agreements
will depend on whether there are adequate monitoring, reporting, and
verification programs in place so that the carbon allowances would be
demonstrably related to actual emissions reductions.

Verification Notoriously Difficult
But verification can be notoriously difficult and rests on domestic
systems of environmental enforcement. Participants in these transactions
in the West know they can rely on a viable legal system or some analogous
set of institutions to ensure the integrity of trades and to act in a timely manner
to protect wronged parties.
But many places where the "cheapest" carbon reductions are to be found  do
not have reliable rule of law traditions or the resources and policies
that would discourage cheating. For example, a power plant can change its
fuel entirely, or use cleaner coal, or install control technology.
Verification of each of these approaches is quite different. It is
relatively easy to determine whether the plant is fired by coal or natural
gas, but harder to know, on a continuous basis, whether the coal used is
cleaner or the control technology has been turned on and continuously
maintained.

The EU may have the best of intentions, but its actual ability to monitor
what is going on in Russia, Ukraine, Bulgaria, and Romania, to choose four
examples, will be quite limited.
Verification and oversight procedures in the developing world and the
countries of the former Soviet bloc, where reside many of the big
potential sellers in this market, have been notoriously ineffective. In
many cases, these are countries that have adequate laws on the books, but
they have done a very poor job of controlling their domestic pollution.
We could not be sure how much pollution each of their plants would send in to
the atmosphere when they do not have the expensive monitoring equipment
that is required in the United States.

The court systems may move too slowly, giving life to the adage, "justice
deferred is justice denied." Or the judiciary lacks independence, and
sometimes judges get their pay checks and social benefits from the same
body that owns polluting industry.
In addition, rampant, or even institutionalized, corruption may mean that
public officials who oversee such programs will make policy decisions on
the basis of personal connections or illegal payments rather than whether
the trade involves true reductions in greenhouse gas emissions.
Independent nongovernmental organizations, where they exist, do not have
the tools available to their counterparts in the United States. Indeed,
many of these countries cannot produce accurate figures on basic data such
as population and economic production, let alone the highly esoteric
information for greenhouse gas emissions.

Policing Trades Across Borders
Critically, verification must be in the countries of origin of the
emissions. There are no international institutions to police trades across
borders and keep them honest, although some level of oversight is planned
through the Conference of the Parties and an executive board supervising
the clean development mechanism.
Nevertheless, we know through examples--such as the difficulty of policing
arms reduction and nuclear proliferation treaties--how hard verification
can be and how many resources they can absorb.
Climate change verification should be even harder, and the incentives to
do it fewer. This is because reducing greenhouse gas emissions can require
supervision of potentially thousands of domestic reduction projects in each country.
Historically, governments have typically given far less weight and
attention to supervising international environmental treaties than they do
to agreements that involve arms and world trade. And the sanctions
available, even when governments are alert to violations, are limited in
number and often severe. Negative trade measures, unilateral sanctions,
membership sanctions, and other economic and political measures are rarely
or reluctantly used because of their political consequences.
What if we set up a worldwide system and later find fraudulent record keeping
or industries that sell phony reductions? Who will enforce the rules?
What body would prosecute false accounting schemes and assure
the basic integrity of the regime? There are at least two possible outcomes.
The best solution would be if countries with currently weak enforcement
and compliance regimes could be inspired to make improvements so they can
share in the considerable benefits that global trading might bring them.
The other possibility is the temptation toward cheating.
Either way, trading itself will not solve the problem of greenhouse gas
emissions in the absence of substantial domestic commitment to making real
emissions reductions.
Proponents are quick to point out the undeniable successes of the sulfur
dioxide emissions trading scheme, but they are less likely to mention its
reliance on the many unique safeguards built into the U.S. program.
No less an authority than The Economist magazine has published a spate of
articles trumpeting market-based instruments as the salvation of the
environment (in the same issues that report the details of the WorldCom
scandal).
But their exhibit No. 1, emissions trading, alone is not a solution to resolving
works relatively well, these same solutions are far less likely to succeed
where institutions are much weaker.

No Substitute for Domestic Institutions
What does this mean for protecting the world from global warming? The
dazzle of trading, and its undeniable benefits, should not blind
policymakers to the need for fashioning a reality-based system with real
greenhouse gas reductions. They must be sure that the rewards from trading
do not tempt traders to manipulate the system for their own enrichment.
This requires countries in the developing world and countries in
transition to develop institutions that can control emissions and expose
cheating before, during, and after trades are made.
The role of the developed world must be to face this challenge the old
fashioned way--by providing assistance and working patiently to develop
laws, monitoring systems, and property rights, as well as respect for
those requirements.

The governments running the system, through the Conference of the Parties,
must build confidence through an institutional structure that is capable
of managing these very difficult problems.
The bottom line is integrity must be developed and insured.
Emissions trading clearly can save society money. But international
planners must put safeguards into place now, not later, to keep the
mission of traders on track with the goal of reducing greenhouse gas
emissions. If international policymakers wait to act until a scandal erupts,
it will be too late. The United States, with 200 years of experience in financial regulation,
has just acknowledged the urgent need to step up enforcement through the
Securities and Exchange Commission. Who will be the international SEC of
greenhouse gas credit trading?
________________________________________
1 United States v. PSEG Fossil LLC, D. N.J., No.
02CV340, 1/24/02.
2 "Energy Trades Echoed in Broadband Market," The
New York Times, May 17, 2002, Section C, p 1.
3 E.g., "The Invisible Green Hand," The Economist,
July, 6, 2002, A Survey of the Global Environment, p. 15. <<..

Copyright A9 2002 by The Bureau of National Affairs, Inc., Washington 
D.C