Wednesday, December 28, 2005

Rewarding Economic Inefficiency: Kyoto at Work

The New York Times on wednesday had a great article on Russia's newest export to the West --- carbon credits. There is clear evidence that there are gains to trade between Russia's electric utilities and Western nations.

After reading this article, I'm still puzzling over what are the unintended consequences from these anticipated transfers to Russia? Is this rewarding "bad behavior"? Is this similar to North Korea case where we seem to always be sending $ to its leader in return for his delaying his nuclear program?

Could this Russian case be an example of rewarding "bad behavior" without any dynamic incentives problems? In the case of the North Korean leader, once he recognizes that we pay blackmail he has an incentive to continue developing nuclear weapons to be paid again in the future. Is there an analogous situation here with Russia? I can't see it but I'm an old man!

December 28, 2005
In Russia, Pollution Is Good for Business

MOSCOW, Dec. 24 - By its own admission, Russia's electricity monopoly is the world's largest corporate producer of greenhouse gases, accounting - by itself - for nearly as much carbon dioxide as is emitted by Britain.

From smokestacks across Russia's 11 time zones, the company, Unified Energy Systems, spews out 2 percent of all human-generated carbon dioxide accumulating in the atmosphere.

What will the utility get for being the world's largest greenhouse gas polluter? It is hoping for $1 billion.

It is one of the paradoxes of the Kyoto Protocol on climate change that companies in Russia and other Eastern European countries, which are among the world's largest producers of greenhouse gases, are poised to earn hundreds of millions of dollars through trading their rights to release carbon dioxide into the air.

The Kyoto treaty, negotiated in 1997 and adopted by 36 industrial nations, established a mechanism aimed at finding the cheapest way to curb emissions of gases that contribute to global warming. The idea was that countries that produced more than their treaty-imposed limits could reach their goals by buying rights from producers in other countries where controlling output is easier and less expensive.

It is not clear how successful that approach will turn out to be. But because Russia's companies operate such outdated and inefficient equipment, they can easily and cheaply upgrade. As a result, the Kyoto process has already emerged as a potential source of earnings for the country's big energy and manufacturing companies, according to company executives and analysts. They have hired consultants, inventoried pollution sources to earn credits, and opened carbon-trading divisions.

Unified Energy and Gazprom, Russia's natural gas monopoly, which together release more than 50 percent of greenhouse gas emissions in Russia, both have such trading units.

"We're intensely interested in the carbon-trading market," Andrey V. Gorkov, the head of the carbon-trading division at Unified Energy, said earlier this month in Montreal, where he was attending the United Nations climate conference. Member countries formally approved emissions-trading rules at the meeting.

The protocol requires the 36 industrial nations - with varying targets - to reduce their emissions of greenhouse gases below their 1990 levels, in the five years from 2008 to 2012.

For the European Union, the target is to reduce emissions to 8 percent below 1990 levels. In an indication of how robust the demand for emissions credits may be, this year the European Union is 6 percent above its 1990 levels. The United States, which generates a fifth of greenhouse gases but has not joined the Kyoto Protocol, is 19 percent above its theoretical limits.

Russia, in contrast, suffered an economic collapse in the 1990's, and is 43 percent below its 1990 baseline in the Kyoto agreement. In fact, Russia does not expect to reach 1990's emissions levels until around 2020 - attesting to the severity of the economic setback from which it is still recovering.

At the same time, Russian industry is generally wasteful with energy, so that a few cheap upgrades go a long way to reducing emissions. Thus, with both outdated equipment and a surplus of carbon emissions, Russian companies have become attractive to European, Canadian and Japanese companies that need emissions credits.

The pace is increasing at Mr. Gorkov's cluttered office in Unified Energy headquarters, a drab concrete building on the outskirts of Moscow. Analysts give credit to the company's forward-looking chief executive, Anatoly B. Chubais, for recognizing the potential for profits under Kyoto. Mr. Chubais, a former deputy prime minister, had helped negotiate the pact while in government.

Mr. Gorkov's 16 employees at the division, which is called the Energy Carbon Fund, scan the Internet for companies or countries in need of carbon dioxide emissions credits. They also study their own company to identify areas where they can reduce pollution. The company signed its first deal in June, with the environmental protection agency of Denmark.

Denmark will pay an undisclosed sum for Unified Energy to replace coal-fired boilers at the Amurskaya power plant in Khabarovsk, near China in eastern Siberia, so that units will burn more efficient natural gas. It will also pay to upgrade an existing natural gas plant in the Orenburg region, in southern Russia near Kazakhstan, with a more efficient model.

The conversion to gas at the Amurskaya plant will cut carbon dioxide emissions by a million tons a year, according to Unified Energy. The upgrading of the natural gas generator at the Mednogorskaya power plant in Orenburg will save 210,000 tons.

Under the deal, the Danish government will receive 1.2 million carbon credits (one carbon credit being equal to reducing one ton of carbon dioxide), to be applied toward meeting its emissions goal in 2012.

This fall, six other clients from Europe and Japan also lined up to buy emissions credits from Unified Energy, Mr. Gorkov said. The Toyota Corporation of Japan is co-financing studies at one plant, and may pay for upgrades, according to a Unified Energy Systems statement.

Gazprom, Russia's largest company, is studying ways to attract Kyoto financing to upgrade other pipelines, said Bogdan Budzulyak, director of the company's transportation and underground storage department.

Midsize Russian companies are also eyeing the emissions market.

The Arkhangelsk Pulp and Paper Mill, with revenues of about $250 million a year, has said it will monitor emissions, according to an article in the August 2005 issue of Carbon Finance, a trade publication.

In total, Russia could potentially reduce emissions by two billion to three billion tons of carbon dioxide by 2012, said Alexander A. Golub, a senior economist at Environmental Defense, a nonprofit group based in New York. The potential value for Russia ranges from $20 billion to $60 billion, he said. Or it could be worth nothing, if future climate talks collapse. The United States, the world's largest economy, is already sitting out the process.

President Bush rejected the Kyoto Protocol in 2001, citing the high cost to American industry. Now, without the support of the world's largest economy, there is less chance other countries will agree to extend the treaty beyond 2012. Companies must decide if it is worth investing millions of dollars to comply with an international regulatory regime that may not be enforced after 2012 - and may collapse before then.

"Discussions over the future of the Kyoto Protocol are affecting our market," Mr. Gorkov said.

Even so, emissions trading has been slowed in Russia more by the sluggish pace of government bureaucracy than by uncertainty over the Kyoto Protocol.

The Danish deal was signed in June. It hinged on the Russian government passing a decree to endorse Kyoto trading. That was due in late November, but delayed until February, according to an e-mail message from Hans J. Eriksen, the program coordinator at the Danish environmental ministry.

Annie Petsonk, international counsel for Environmental Defense, said: "This is quite a new commodity for Russia. Maybe they don't understand that Russia has tremendous potential."

Both Gazprom and Unified Energy have issued statements urging the Russian government to enforce Kyoto as quickly as possible. In the United States, in contrast, Exxon Mobil led corporate opposition to Kyoto.

In Russia, the Ministry of Trade and Economic Development has formed a working group to study the decree. It needs to clear various agencies and committees. Russian officials sent a letter of apology to the Danish ministry in November.

Meanwhile, at Unified Energy, where the order book for pollution credit projects is stacking up, Mr. Gorkov is getting impatient. "We needed this document signed yesterday," he said.


Anonymous said...

It's not a reward for bad behavior - it's the low-hanging fruit. It's precisely how Kyoto is supposed to work. Get the easiest cheapest stuff first; put big first world money into the easy stuff first and drive up the cost of emissions in heavy polluting but more technologically advanced countries, to create an incentive to reduce carbon emissions in the first place. make perfect sense. the point is the two to three billion tons of carbon dioxide that will be cleaned up in russia.

David Jeffery said...

I'm inclined to agree with your anonymous commenter - to an extent. I think the point is exactly right - it is low hanging fruit and it's (hopefully) leading to big and cheap emission reductions being made sooner than would otherwise be the case. So it is promoting economic efficiency, not rewarding economic inefficiency.

However - because of the way the targets were established originally - I think it does reward prior bad behaviour (or energy-inefficiency). But I think this is just another example of market-based solutions achieving allocative efficiency but arguably at the expense of distributional equity: countries that were more energy-efficient do not have the same opportunities to reduce emissions and be financially rewarded.

One other comment that may be worth making is that this situation has resulted from a political bargaining process at Kyoto and the solution is likely also to be political - countries and large companies will want to be seen to be buying credits that come from real emission reduction programs - not just Russia's ('unreal') pre-existing surplus credits.