Hog Wild Pollution Trading*

COMMODITIES

Hog Wild for Pollution Trading

Why environmental markets are becoming a very big deal.

FORTUNE

Monday, September 2, 2002

By Cait Murphy

"Two offers at 150."

"Where was the last trade?"

"147."

"640 for NOx 2002s."

"75 cents for 165s in September."

"Anyone want Texas Grill?"

It's the conventional chatter of a trading desk, this one at the offices of commodities broker Natsource in downtown Manhattan. But these brokers--mostly young, mostly male, mostly dressed in jeans or khakis--are buying and selling an unconventional commodity: pollution. Or more precisely, the right to emit pollutants like sulphur dioxide (SO2), nitrogen oxide (NOx), particulate matter (PM), and the ever popular volatile organic compounds (VOCs). [Playing a cat-and-mouse game, cap and trade brokers are pollution pimps, to wit, I'll trade you three dirty whores for a clan virgin.--RSB]

Is this some shady Enronesque development? Hardly. There have been government-backed pollution-trading programs since the 1970s. But only in the past few years has the market for pollution--a term participants wince at, preferring "environmental market" or "emissions market"--burgeoned. Now there are markets for everything from dirty water to methane from hog manure. And pollution trading is about to become a much bigger deal, for good reason: When it comes to cleaning up the earth, air, and water, trading works.

Perhaps the best example is the SO2 cap-and-trade system, set up by Congress and the other Bush administration in 1990. The Environmental Protection Agency gave each of the nation's 200 or so largest power plants the right to emit a specific number of tons of SO2 every year (the "cap"); the plants also had to install technology to track their emissions. At the end of the year the EPA determines whether each plant's emissions exceeded its allowances. Slackers are punished--through heavy fines, reduced allowances, or both--and the number of allowable emissions is reduced every year. The novel twist: The EPA set up a trading system enabling companies to buy or sell allowances to meet their requirements.

Let's say a coal plant facing unexpectedly high demand [Bullshit. Billion dollar industries employing hundreds of analysts don't have "unexpectedly high demand. The writer of this article is a reality fabricator. Belongs on reality tv.--RSB] realizes that it is using its SO2 quota too quickly. It has a number of options: It can install scrubbers, burn lower-sulfur coal, or switch to natural gas. Alternatively, it can go to the SO2 market and buy allowances from a plant that reduced emissions more than it was required to do and therefore has SO2 to spare. The buyer saves money, the seller makes money, and because the EPA gradually lowers the cap, pollution recedes.

By limiting the output of SO2, the EPA was in effect creating a value for a commodity that had been free. Therefore, thinking went, companies would reduce emissions when and where it was cheapest to do so. They would also have an incentive to reduce their emissions faster than required, because they could sell the surplus. The emphasis was on achieving a specific goal (less acid rain) not on dictating how to do it ("thou shalt install scrubbers").

The result? SO2 emissions have fallen faster, further, and at less cost than anyone dared expect, and the system has been extended to more than 2,000 power plants. Even as the economy has grown, SO2 emissions are on track to fall to half their 1980 levels by 2010 (see chart below). The cost to industry is about $1 billion a year; the EPA figures the benefits, just in terms of less sickness and fewer premature deaths, will reach $50 billion by 2010.

The market for SO2 isn't as frenzied as that for, say, oil or pork bellies, because companies need to prove compliance only once a year. At Evolution Markets, one of the larger emissions traders, an average day sees perhaps a half-dozen trades. But the $4-billion-a-year market is already sophisticated enough to feature swaps, forwards, puts, calls, and options. SO2 allowances are used as collateral, loaned, or swapped for other pollutants. They can even be bought and then retired--the perfect gift for the environmentalist who has everything. "I don't think Congress envisioned all these types of transactions," laughs Gary Hart, manager of emissions trading at Atlanta-based Southern Co. "But if you give an incentive, people will get creative."

The success of the SO2 program has convinced almost everyone that trading can be useful environmental policy. The U.S. already trades wetlands, water pollution, and fishing rights; in what could be a huge expansion of the environmental market, the Bush administration's proposed clear-skies legislation would stiffen requirements for SO2 emissions and create national markets for mercury and NOx (there are already regional NOx programs). And this isn't just an American idea. China and Slovakia have SO2 cap-and-trade programs. Chile trades total suspended particulates. Australia has a renewable trading market. Canada trades SO2, NOx, and VOCs.

Put it all together, though, and pollution is still a boutique market. "It's small compared with almost any other commodity," says Jack Cogen, president of Natsource. "But this is going to grow and grow. I think it will be the dominant thing we do in five years." That's because there is about to be a significant new entry to the field: greenhouse gases (GHGs).

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