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12/30/2010 01:53 PM

Dealing in Hot Air

The Pitfalls of Europe's New Emissions Trading System

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The next stage in the world's CO2 emissions-trading scheme will begin in two years. Everyone agrees that the rulebook is complicated and that the costs for industry will be enormous. But nobody knows if the system will really help the environment -- or merely create a burdensome bureaucracy.

Peter Scur used to spend a lot of time outdoors, converting old quarries into fertile habitats and making sure that bats remained undisturbed while making their nests in limestone caverns. It was the sort of effort one might expect from the environmental officer at a cement company.

Overburdened by paperwork these days, Scur doesn't have much time left for such activities.

Scur, a tall man with strong hands, is sitting in his office at a plant belonging to the German unit of Mexican cement-maker Cemex in Rüdersdorf, 30 kilometers (19 miles) east of Berlin, poring over files marked "CO2," or carbon dioxide.

"We are being literally inundated with laws," he says. Scur has no choice but to address the new regulations.

Now that he is the company's so-called carbon manager, Scur has to be prepared for a new era that is about to begin, not only for Cemex and the cement sector, but also for the rest of German industry.

CO2 a Cost Factor for First Time

When the third stage of the European emissions trading program starts in 2013, it will actually cost companies real money when their plants emit large amounts of carbon dioxide. The invisible greenhouse gas, which flows out of chimneys by the ton, will become a cost factor for the first time. Businesses are beginning to prepare for the new reality, and it's high time that they did, following the establishment of key parameters shortly before Christmas by the EU executive, the European Commission.

It set upper limits of how much CO2 a company will be permitted to emit at no charge in connection with the production of a product. In addition, the entire range of industrial goods was concentrated into 53 products, like roof tiles, steel beams and aluminum sheets, and an emissions limit was defined for each product. The limits are based on the average emissions levels for the most efficient 10 percent of industrial plants in Europe.

In the case of cement, for example, a plant can emit precisely 766 grams of CO2 for each kilogram produced. Companies that exceed the CO2 emissions limits will be required to buy pollution certificates in the future. Other emissions limits are 1,328 grams for steel production, 1,514 grams for aluminum and 144 grams for roof tiles. It's a relatively straightforward system, at first glance, but the devil is in the details:

The lobbyists spent months making the rounds in Brussels and Berlin, proposing changes, additions and exceptions to the 76-page draft document, wrestling over every single value. It was a fierce competition that led to one overriding outcome: It made emissions trading even more complicated and contradictory, and ultimately more unfair.

The blame can be assigned to neither government officials nor industry associations. The problem lies in the system. The closer we come to the next stage, a few fundamental questions are being posed more seriously: Is emissions trading, the way it is being structured today, even feasible? Can it truly be an instrument that achieves its goal in an efficient way, namely to effectively reduce CO2 emissions and slow down climate change? Or is a bureaucratic monster being created here?

Transforming CO2 into a Currency

The idea is undoubtedly fascinating, and logical enough: Scarce environmental assets are assigned a price, giving companies an incentive to use them sparingly. Canadian economist John Harkness Dales invented the "cap and trade" principle more than 40 years ago, and it was later applied to the CO2 problem.

Under this concept, the government sets an upper limit for pollution rights. The limit is reduced each year and the market takes care of the rest, with companies buying the certificates at auction and trading them with one another. As a result, CO2 becomes a currency of sorts, which is bought and sold on special exchanges. The right to emit a ton of CO2, for example, currently costs about €15 ($20).

EU Climate Commissioner Connie Hedegaard is enthusiastic about the clever mechanism. Emissions trading is the best solution the world has seen, the Danish national said recently, "despite some problems and challenges in the beginning."

In the first phase, from 2005 to 2007, governments were still generous in providing companies with free certificates -- far more, in fact, than they needed. At the time, no one had to take the system very seriously, and the energy industry even had the audacity to bill its customers for the rights it had received free of charge. It was practically a money-making machine.

This changed with the second trading period, which began in 2008 and will continue until 2012. Now companies are required to buy at least some of their emissions rights at auction, but they still receive the majority for free.

Pollution Rights to Become Scarce Commodity

In the third and final phase, pollution rights will finally become a scarce commodity, marking the beginning of what is probably the biggest economic experiment since the end of socialism. Electricity producers will be especially hard-hit.

Starting in 2013, they will have to purchase all pollution rights. Power plant operators were responsible for some 338 million of the roughly 428 million tons of CO2 emitted in Germany last year came, or more than three-quarters of the total. RWE is in an exceptional position among the utilities.

The Essen-based electric power company emits about 149 million tons of CO2 a year, more than any other company in Europe. Based on current prices, the certificates would cost the company more than €2 billion in 2013. RWE Chief Executive Jürgen Grossmann calls it the "beginning of a new calendar in the energy economy," and the dawning of an uncertain future.

Other industrial sectors get off more lightly, including lime producers, refinery operators and steelworks. They are allocated the majority of the rights they need free of charge, but there is usually a residual amount they have to buy outright or at auction. Of course, every euro spent on CO2 rights reduces profits, which explains why companies are already complaining so loudly today.

The lime industry, for example, estimates that companies will have to buy an additional 20 percent of their certificates. Not all companies can afford this, which is why some could shut down production every year in October in the future, says Werner Fuchs, head of the German lime industry association. "Then they'll be forced to take a winter break." The German steel industry is also painting the future in gloomy colors.

"We are disappointed by this outcome," says Hans Jürgen Kerkhoff, president of the German Steel Federation. "The decision completely ignores industrial realities." The limit value for steel, 1,328 grams, is "technically unattainable," says Kerkhoff, noting that producers will have no choice but to buy costly certificates "on a large scale."

It's possible that some processes are largely exhausted in steelmaking, and that hardly any efficiency gains can be achieved anymore. Otherwise, however, producers still have room to increase reserves and reduce waste, using optimized control technology and cogeneration, for example.

A Growing Bureaucratic Burden

But what will be hard to avoid are the bureaucratic costs generated by emissions trading. Every industrial operation is required to carefully document how much carbon dioxide its plants emit. "They like to underestimate the cost of this," says Christian Günther.

Günther is in charge of innovation at Saarstahl in Völklingen, an industrial town steeped in tradition in Germany's western state of Saarland. The company has been forging metal for more than 120 years.

The manager, wearing a protective suit and safety goggles, is standing in the factory building, at a safe distance from the converter, a fireproof container filled with 165 tons of golden yellow, molten crude iron. A special vehicle drives up and dumps molten ferromanganese into the vat, followed by a dozen other materials, including boron, aluminum and anthracite coal. Every type of steel has its own recipe. "A steel plant is like a huge kitchen," says Günther.

The composition plays a key role in determining CO2 emissions. The engineers cannot simply insert a measuring device into a smokestack, because the result would be much too imprecise. Instead, they weight every load of raw materials delivered to Völklingen by truck or railcar, and then determine the CO2 content based on the material's specific carbon content.

For example, last year Saarstahl processed 27,133 tons of manganese metals, which are responsible for 4,555 of the approximately 480,000 tons of CO2 the plant emits. But because the carbon content fluctuates with each delivery, lab technicians constantly take samples and subject each one to a chemical analysis. In this way, they obtain data on 600 material flows in the entire plant, adding to an enormous heap of data and samples, which also have to be archived -- for the experts who come to the plant once a year to verify all results.

There are already more than 200 companies in Germany that specialize in auditing emissions reports. They conduct on-site plant inspections, recalculate results and, if in doubt, even review the paperwork on individual deliveries. Then they send a report to the German Emissions Trading Authority (DEHSt) in Berlin.

The authority, which most people refer to as "Deest," is also the nerve center of the system. Its employees in Berlin review emissions reports and maintain a separate account for each plant to account for the certificates. They determine how many rights are assigned to each company, and they impose fines if a company's numbers don't add up by the annual deadline of March 31. Offenders must pay a €100 penalty for each missing certificate.

The DEHSt offices are in an old Nazi building in the Grunewald neighborhood, the former headquarters of the State Labor Service. Its staff of 120 employees handles all aspects of emissions trading, with each employee assigned to an average of 60 to 100 companies.

All processes are conducted electronically, from managing applications to assignment of emissions rights and certificates -- nothing but flashing characters on computer screens. But a world without paper isn't even possible at the DEHSt, as evidence by a look into the office of Hans-Jürgen Nantke, where stacks of files are piled high behind his desk.

'It'll Be a Hot Summer'

Nantke, who has a degree in chemistry, has been the head of the authority since the beginning of emissions trading. The system was implemented extremely hastily in late 2004, says Nantke, who expects a similar feat next year, when the allocation procedure for the third trading phase is clarified. "It'll be a hot summer," he predicts.

First, the new rules will have to be ratified by the European Parliament and the European Council, comprised of the heads of state or government of EU member countries, in Brussels. Then national lawmakers will address implementation, probably in the spring. Once the legal framework is in place, it will finally be time for Nantke's team to get to work.

They will request and examine new data on production and emissions from all companies. It is highly likely that the economy will apply for more certificates than are available. The European Commission has limited the number of certificates Europe-wide to a little more than 2 billion or, to be exact, 2,039,152,883 for 2013. The number will be reduced by 1.74 percent each year in subsequent years.

If the sum of incoming applications exceeds this volume, each individual company will receive proportionately fewer rights. DEHSt calculates how many certificates it allocates to each industrial plant, but first computer scientists will have to develop and test software for this purpose. "There can't be any errors in the software," says Nantke.

The Berlin authority is required to send a list of all plants and the anticipated allocation volume to Brussels by Sept. 30, 2011. The Commission plans to approve the documents by early 2012, at which point companies will be able to calculate precisely how many additional certificates they will have to buy.

The whole thing will hardly be accomplished without conflict. In the first trading period, German companies filed about 800 appeals against DEHSt decisions. The legal department in Berlin, originally staffed with only three people, now employs 10. The lawyers who work there will likely have plenty to keep them busy in the future.

Design Flaws in the Trading System

Starting in 2013, a lot of money will be at stake, giving companies that feel unfairly treated more of an incentive to take their cases to court. And this is likely to occur often.

The potential challenges start with the question of who is even required to participate in emissions trading. Neither agriculture nor forestry is included. The real estate sector doesn't need certificates, nor do small businesses and operators of motor vehicles. On balance, about half of all emissions being pumped into the skies above Germany will not be subject to trading.

The example of the ceramics industry highlights the seemingly arbitrary nature of the decision as to who is required to be part of the system and who is not. While makers of ceramic tiles need certificates, producers of plates and cups do not.

This is because porcelain factories are consistently small businesses that fall below a production threshold of 75 tons a day. Paradoxically, it takes much more energy to fire porcelain than to produce tiles.

Another design flaw is that the amounts produced by a plant play an important role in the allocation of the free certificates. This is bad news for glass manufacturers whose plants happened to be undergoing maintenance during the reference period. Glass plants receive a general overhaul once every 10 to 15 years, which can take up to three months.

It's also bad news for airlines whose planes were grounded for days in April because of volcanic ash unleashed in Iceland. For airlines, lower sales during the reference period means fewer free certificates.

A Disincentive for Investment?

Another concern for companies is that in the future, businesses hoping to expand will only be entitled to additional certificates if they increase their capacity by at least 10 percent. In other words, those that expand to a lesser degree will have to make do with their existing allocation. In some cases, this could prompt companies to decide against the investment. As a result, emissions trading could put a damper on growth.

German companies should be bracing themselves for substantial changes, but very few are adequately prepared. Many small and mid-sized businesses are only gradually realizing what costs and risks they could face, says Ines Zenke, a Berlin expert on energy law. Many are downright shocked and some are worried that the new regulations could put them out of business, says Zenke.

Help will come in the form of consulting firms that manage the entire emissions trading process for their customers. They search for efficiency reserves in companies, they buy and sell CO2 rights and they procure certificates from climate protection projects in developing countries and emerging economies. Examples of projects for which such certificates are issued include the capture of mine gas in Chinese coal mines and the disposal of old refrigerators in Brazil.

A company can use up to 22 percent of such certificates for its DEHSt account. They cost about €12 apiece, which is more than €2 cheaper than conventional pollution rights. Critics charge that this is nothing but the sale of indulgences. Some of these arrangements were recently discredited when polluting industries were developed solely for the purpose of promptly eliminating them and then collecting certificates for doing so.

Both documents, the certificates for development projects and the classic polluting rights, are traded on special exchanges, mainly in Paris, Amsterdam and London. Leipzig has developed into the most important trading center in Germany.

A 'Lack of Imagination'

The European Energy Exchange (EEX), which offers trading in electricity, gas and CO2 certificates, is located on the 24th floor of Leipzig's Panorama Tower building. The trading room isn't much bigger than a large living room, and the trader for CO2 rights walks into the door with a cup of coffee in her hand. It's a Monday afternoon, and there isn't much going on.

Nothing at all is happening on the spot market. The market closes in an hour and a half, but sales are still zero. There is at least a little movement in the futures market, where contracts for delivery on a specific date in the future are traded. "There's a lack of imagination at the moment," says EEX Managing Director Oliver Maibaum.

Apparently companies are still well provided for with certificates, as a result of the economic crisis, which meant that they were involuntarily producing and emitting less. For this reason, Maibaum already has high hopes for the third trading period, when the market will expand several times over. "Then there'll be music," he says.

When that happens, emissions trading could also turn into a goldmine for speculators betting on the development of certificate prices. The CO2 market is still relatively small and poorly regulated. There are no position limits for traders, meaning limits on how many contracts they can buy or sell. Some fear that powerful financial jugglers could move prices at will, adversely affecting companies that depend on the certificates, because they would have to adjust to price fluctuations.

The wild rollercoaster ride on the commodities markets, for metals like nickel and copper, for example, give a manager like Saarstahl CEO Klaus Harste every reason to be concerned. If the prices of CO2 certificates start fluctuating in a similar way, says Harste, it will become extremely difficult to estimate the cost basis for a steel plant. "It will get harder and harder to put together a business plan."

'We Need the Same Rules for Everyone'

He is even more concerned about the fact that emissions trading is limited to Europe, which Harst believes puts him at a disadvantage against competitors from China and the United States. The two countries are responsible for 40 percent of all CO2 emissions. "Steel is a global market," says Harste, "and we need the same rules for everyone." He disagrees with the argument that someone has to take the first step. Being a pioneer is all very well and good, he says, "but what happens if no one else follows suit?"

In fact, there is little indication that emissions trading will take on global dimensions in the near future. But the system has to be global to function properly, or else every ton of emissions Europe carefully saves will simply be blown into the air someplace else, where emitting CO2 costs nothing.

The lime industry already fears that production will shift to the edges of the EU, namely to Russia and North Africa, to the detriment of European production sites. "We are developing into a green backyard," warns industry association head Fuchs. Lufthansa expects to be at a competitive disadvantage with its intercontinental flights through Frankfurt and Munich, compared to the competition at Emirates, for example, which uses Dubai as its hub.

However, a true global emissions trading system could also produce effects that German industry would not welcome at all. If CO2 certificates were distributed worldwide, every person would have to be granted the same right to pollute the atmosphere. This would create more leeway for the economies of heavily populated countries like China and India, while Germany and the United States would have to limit themselves considerably.

Contradictions in German Policy

Such a system of consistent climate justice once had a prominent champion. German Chancellor Angela Merkel introduced the per-capita principle at the 2007 G-20 summit at Heiligendamm, Germany. But she no longer even mentions the idea today, and emissions trading is only discussed as an aside in the energy plan the German government unveiled in the fall.

The 32-page document also steadfastly ignores the fundamental contradiction of German energy policy: The government spends billions to subsidize renewable forms of energy, like wind and solar power. As a result, the demand for CO2 pollution rights declines, and so do prices.

This automatically makes it worthwhile for energy providers to return to burning dirty coal. "The subsidization of renewable energy is incompatible with emissions trading," says environmental economist Till Requate of the northern port city of Kiel, who is critical of the failed incentive policy.

In the end, the question remains as to what will happen to the epochal project, given all of these problems. When the concept of emissions trading was first raised many years ago, an alternative was also discussed: the so-called input or upstream solution.

Under that concept, emissions trading would not affect products and consumers, but would instead be applied at the source, so to speak: where petroleum, natural gas and coal enter the economy. Then every refinery owner, every gas supplier and every coal producer would have to buy certificates, at differing prices determined by carbon content.

A ton of bituminous coal wouldn't just cost €80, but many times as much. Electricity producers would have no choice but to pass on the costs to their customers -- or invest in alternative energy. The advantage of this approach is that it would cover a large share of emitters, and the system would be more efficient and less costly and complex.

But this alternative was quickly discarded. Europe's politicians apparently feared the consequences of brutally confronting citizens and companies with the true costs of climate protection. Instead, they favored the complex version, despite all of its contradictions.

Translated from the German by Christopher Sultan

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