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16/11/2006 | Industry's New Stake in Kyoto

Stratfor Staff

Negotiators in Nairobi, Kenya, are preparing to wrap up two weeks of discussions about the future of international cooperation on climate change. The conference -- officially the second meeting of parties to the Kyoto Protocol -- gathered to discuss what comes after Kyoto, which will not be in force after 2012.

 

Central to the discussions have been questions about gaining U.S. participation in the treaty, winning emissions-reductions commitments from major developing countries (such as China and India), and determining the strength of the international community's commitment to drastic reductions in greenhouse gas emissions.

The talks in Nairobi also have revealed the new role that a diverse group of companies will play in the future of the climate change debate. These companies come from many industries, but they share a common interest in finding ways to profit from global concerns about climate change -- particularly the provisions in the Kyoto treaty intended to better control greenhouse gas emissions. This industry bloc includes the major innovators in the cleantech sector, but it also includes older industries that are finding ways to make small adjustments in their business processes in ways that, due to Kyoto's market mechanisms, now yield significant revenues.

Because of the way the Kyoto enforcement mechanisms are established, the developing countries of Asia -- particularly China and India -- are the key areas of concern for cleantech companies and commercial opportunists. Both India and China have vast energy needs and are dedicated to transforming their power systems. Kyoto rewards companies that help developing countries to build energy infrastructure in more efficient, less polluting ways. As a result, the vast majority of the investment and profit-making in what could be called the "climate change industry" has come from these two countries.

The emergence of the climate change industry has significant implications -- not only for environmental and economic reasons, but for the future of the climate change debate itself. Many companies -- including a wide range of power generators, chemical companies, high-tech manufacturers and venture capitalists -- spent years battling against constraints on carbon emissions or viewing the climate change issue as a source of business risk. Now, having found ways to make money from the Kyoto system, some industry sectors have a vested interest in the uninterrupted perpetuation of the controls the treaty established. These business opportunists and energy innovators likely will emerge as powerful and increasingly vocal partners for environmental activists, as the clock winds down on Kyoto.

CDM and Emissions Trading

To understand exactly how these businesses profit, and the arguments they are likely to make as the termination for Kyoto protocols approaches, it is necessary to review the terms of the treaty itself.

Though it was signed in 1997, the Kyoto Protocol was not ratified by many countries until its signatories had put mechanisms into place that added flexibility to the treaty's demands. Key mechanisms in this regard include a fund that lends money to new, greenhouse-gas-reducing industrial projects in developing states, a system to reward states for preserving forests and other "carbon sinks," and an emissions trading system that rewards countries that reduce emissions more quickly than the protocol demands. The new "climate change industry" is finding ways to profit from each of these -- the funding mechanism and the emissions trading system in particular.

The emissions trading regime follows the model that the U.S. Clean Air Act established in 1990. In this system, the United States has an established ceiling of annual emissions of nitrogen oxides (NOx) and sulfur dioxide (SOx). Every major emitter is allotted a certain level of permissible emissions of NOx and SOx, using a complex formula for determining the facility's base level of emissions. Those who emit less than their allotment can sell their extra "credits" on the open market to companies that exceed their allotment. Thus, better environmental performers can build a new revenue stream, while poorer performers have to spend money.

In Kyoto's emissions trading regime, countries can win credits either by making cuts in emissions domestically or by building facilities overseas that reduce the foreign country's total greenhouse gas emissions. It follows, then, that Western countries have an incentive to help developing countries build relatively cleaner, more efficient industrial bases. The idea is to encourage richer countries to help poorer ones bypass the stages of "dirty" development that they themselves experienced.

It would be tempting for industrialized countries to sponsor development projects in poorer countries, where there is significant demand for new technologies anyway, even without Kyoto incentives. But the creation of a Kyoto funding mechanism has added further to the appeal: Under this system, industrialized countries donate money to a fund, held by the World Bank, that loans to projects that reduce greenhouse gas emissions. This fund, called the Clean Development Mechanism (CDM), will lend more than $3 billion to projects this year, up from $2.5 billion in 2005.

Greening Development

While this may appear to be an ideal way of helping poorer countries develop in cleaner, more efficient ways than industrialized nations managed to, the image can be deceptive.

Because China and India are viewed as "developing" countries under Kyoto's definition, clean development loans have piggybacked on the predominant trend in foreign direct investment. China has received 73 percent and 60 percent of the CDM loans in 2005 and 2006, mostly for projects that would have been built anyway. India, another major recipient of corporate direct investments, received 15 percent.

This is a crucial point for the climate change industry. Three-quarters of the money being lent for climate change purposes is going to two of the world's hottest markets for foreign direct investment. Much of the FDI headed to those countries likely would have gone there even without subsidized loans, and to projects that would have incorporated energy efficiency regardless.

The gaming of the system is perhaps most clearly evident in a series of deals involving two Chinese chemical companies, Meilan Jiangsu Chemical and Changshu 3F Zhonghao New Chemicals Material Co. Both companies manufacture the refrigerant HCFC-22, and produce the chemical HFC-23 as a byproduct. HFC-23 is the most potent greenhouse gas regulated under the Kyoto Protocol, and -- all other things being equal -- the plants likely would be headed for the scrapheap as the phase-out deadlines agreed under the Montreal Protocol of 1987 approach. However, under Kyoto's CDM and emissions trading mechanism, a ton of HFC-23 eliminated in a developing country is worth 11,000 times more than a ton of CO2 (approximately $920,000 per ton). Thus, the chemical companies applied for -- and received -- a loan of nearly $1 billion from the CDM to retrofit their facilities, using technologies that capture and destroy the HFCs. The revenues they make from producing a pollutant that is strictly regulated by the Kyoto treaty itself is, ironically, what keeps these plants open and profitable.

According to the World Bank, 64 percent of the emissions traded under the Kyoto system this year are related to the refrigerant industry, and the majority of these come from facilities that are manufacturing products that will soon be phased out. Only 36 percent of the world's emissions credits are being granted because of innovations in power generation or manufacturing efficiency. In other words, the reductions being credited to the developing world frequently do not conform to the "cleaner, more efficient technologies" ideal. Importantly, however, the 64 percent figure actually does represent a reduction from 75 percent measured in developing countries two years ago -- and with the phase-out of HCFCs approaching, the period of hefty profits from trading emissions in refrigerants is coming to a close.

Case Studies: China and India

With most of the low-hanging profits having been claimed already, there is a new surge of investment going to industries that seek profits from emissions reductions and emissions trading. The most obvious candidate for investors is the cleantech industry. The industry is particularly active in India and China, as well as other emerging Asian economies. In both cases, cleantech products are being tailored to the specific political, economic and environmental needs of the country.

China's energy needs are multiplying too rapidly for the electricity-generating industry to keep pace. Beijing has set a goal of reducing the energy-intensiveness of China's economy, pledging in its most recent five-year plan to halve the amount of energy needed per unit of gross domestic product. In keeping with this goal, China's long-term plan relies heavily on nuclear power. Beijing is planning for the construction of 30 new pebble-bed power plants around the country by 2020, using new technologies that allow for safer, less expensive reactors.

For now, however, China's electricity needs are growing far faster than nuclear facilities can be built. Thus, coal-fired power plants will supplement, with more than 300 new ones to be built during the next five years. Many of these facilities are likely to represent the most advanced technologies (especially if -- as Canada, the European Union and others hope -- carbon capture and sequestration are included in the clean development mechanism), but the bulk of them will pollute more, rather than less.

Given all of these factors -- and particularly the goal of reducing energy intensiveness without hurting production -- the opportunities for cleantech companies in China leap into view.

In India, the dynamic is altogether different.

In many ways, India's energy infrastructure is even less suited for rapid industrial growth than China's. The system cannot be called a "grid" so much as a series of isolated power stations, scattered in seemingly haphazard fashion around the country. Due to limited central planning and poor investment and infrastructure, extremely long power lines are needed to distribute electricity through the subcontinent. These lines are often tapped by individuals or communities -- much like cable lines in the United States or gasoline pipelines in Nigeria -- rendering power distribution on the whole both highly inefficient and irregular.

When a technologically advanced manufacturer moves into India, it cannot rely on the local power system; consequently, many build their own systems to meet their needs. Major chemical and high-tech companies -- including Intel Corp. and DuPont -- have built stations to serve primarily as reliable sources of routine, reliable power to their facilities. These plants supply some power to the national "grid" but -- because of the underlying transmission difficulties -- the benefits to the country as a whole are quite limited.

Reflecting this pattern of development, India increasingly is turning to a decentralized power system -- often referred to as "distributed power" -- that relies on low-output generators to serve a small area and put any extra power into the larger "grid." These power systems run on natural gas, gasoline or diesel fuel, or they can be waste-to-energy facilities or solar-powered. Western companies that specialize in smaller power facilities, such as Cummins Inc. and Ingersoll Rand Co., are beginning to notice this trend and are appealing to the CDM to lend money for the creation of distributed power networks.

The Future of Kyoto

Given the market opportunities that emission-trading and the CDM open, it is no wonder that major companies like General Electric Co., DuPont and Alcoa Inc. are champions of climate change policy and that investors like Kleiner Perkins Caufield & Byers are funding cleantech startups.
The debate in Nairobi will conclude Nov. 17, but it likely will not produce an agreement on commitments that will follow after 2012. This is a significant problem for the climate change industry. If Kyoto dissolves before another system is in place, the emissions market would fall apart -- endangering investments that were made with emissions credits as the critical determinant of profitability. Recent moves in California and the northeastern United States to establish greenhouse gas emissions trading systems likely will evolve to provide a small market for the foreign emissions credits, but these efforts probably will not be effective (either as a money-maker or as a greenhouse gas emissions-reduction scheme) unless projects in China and India are tied into the regime.

Ultimately, the role of activists and some business communities will merge in the next two years. Industries that are looking at China and India as engines of revenue growth will lobby strenuously to keep commitments to the emissions-reduction scheme from lapsing.

Stratfor (Estados Unidos)

 



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