Industry Overview

Energy Hedging, Part III

Published by: Laura Walker Chung | Post a Comment

Climate Change

When sunlight hits the earth’s surface, some of it bounces back into the atmosphere, where it is absorbed by atmospheric carbon dioxide (CO2) and water vapor, preventing heat from escaping the atmosphere into space. Were it not for this “greenhouse effect,” the earth would be uninhabitably cold. However, human activity since the industrial revolution has artificially added enormous amounts of carbon dioxide and other “greenhouse gasses” (GHG) into our atmosphere. These anthropogenic emissions appear to be increasing the greenhouse effect enough to significantly affect global climate patterns.

Unfortunately, the energy sector is the primary culprit: electricity generation is responsible for one third of the increased GHG concentrations, and fuel use for transportation is responsible for nearly another third (the remaining third results from a combination of deforestation and manufacturing processes).

During the 20th century, the earth warmed by an average of 0.6° Celsius, with portions of the Arctic and Antarctic warming by 5° C. Melting of polar ice caps resulted in an average sea level rise over the century of 6 inches. At current rates of increase of GHG-generating activity, climate models predict an additional rise in average temperature of up to 14° C by 2100, and a host of changes to weather patterns:

• Increased average temperature. Air and water temperature changes would be distributed unevenly around the globe. Moderate warming in the U.S. would be a boon to agriculture, but would also expand the tropics and promote increased spreading of infectious diseases. Given enough time, animal species can adapt to climate changes, but if climate change occurs quickly (like, within a couple hundred years), many species would likely die off.

• Increased average precipitation. Precipitation changes would vary regionally, and be offset to an uncertain degree by increased evaporation. Dry areas are predicted to get drier, putting drinking water supplies and agricultural viability in question; coastal areas would be expected to receive more rainfall, increasing flood risk.

• More chaotic weather. Higher ocean temperatures would lead to increased frequency and severity of storms.

• Localized cooling effects. For example, as the Arctic ice cap melts, cold freshwater is entering the North Atlantic. An increase in this phenomenon could be expected to stagnate the Gulf Stream and dramatically cool northern Europe.

• Higher sea level. Climate models predict a sea level rise of up to 35 inches by 2100 if current GHG emissions rates remain unchecked and polar ice cap melting accelerates. Coastal flooding in low-lying areas like Bangladesh, the South Pacific islands, and the Netherlands would increase dramatically in such a scenario. Even if temperatures stabilize at 3° C above current levels, ice cap melting would continue slowly for the next thousand years, ultimately increasing sea level by 20 feet.

What elements of such climate change predictions are in question? Principals of chemistry tell us that greenhouse gasses have a warming effect. Historical records detail the enormous amounts of greenhouse gasses that human activities have added to the atmosphere. We can directly observe that the earth has indeed warmed during the last century. What cannot be known for certain is whether the correlation of these phenomena reflects causality. In the 1970s, atmospheric scientists proposed a theory of climate change to describe a causal link. This theory has steadily gained adherents, and today
there is broad consensus in the international scientific community that climate change is resulting from human GHG emissions.

Like all scientific theories, climate change can never be proven. Accumulating evidence can only make a theory more widely accepted. Nonetheless, we structure our lives based on the acceptance of many scientific theories: germ theory provides the rationale for developing medicines, atomic theory allows us to make nuclear bombs, gravitational theory makes us wary of walking off cliffs. Climate theorists advocate adoption of the precautionary principle in response to the threat of human-
induced climate change: act now to prevent climate change because by the time the amount of evidence approaches irrefutability, the devastating effects would have already occurred.

The climate change question is whether, when, and by how much we will choose to reduce our GHG emissions and thereby prevent some amount of the devastation forecasted by today’s climate models. Happily, reducing GHG emissions often goes hand-in-hand with increasing energy efficiency and thus saving money, which is why countries and companies around the world began voluntarily reducing emissions many years ago, despite any lingering uncertainties about climate change theory.

Carbon dioxide is the most prevalent greenhouse gas. However, methane and nitrous oxide in the atmosphere also trap heat. In addition, a number of purely man-made substances have extreme greenhouse properties. The United States is responsible for 25% of global CO2 emissions. As a result, the U.S. has been at the heart of the climate change debate, annually

producing 4.5 tons of carbon emissions per capita, compared to 2.3 tons per capita in Europe and just 1 ton per capita worldwide.

In 1997, representatives from 160 countries collaboratively proposed a solution to the greenhouse gas emissions problem: the Kyoto Protocol to the United Nations Framework Convention on Climate Change. This legally binding treaty sets a year 2012 cap on GHG emissions for each industrialized country that chooses to ratify it. The Kyoto Protocol finally came into force in 2004, when Russia became the 126th country to ratify it, bringing the percent of global GHG emissions represented by the ratifiers up to the 55% requirement.

Notably absent from the list of Kyoto ratifiers has been the United States (in addition to coal-rich Australia, the only other major holdout). In the years right after the Protocol was written, the Republican-controlled Senate announced it would not ratify the treaty if then-President Clinton submitted it for consideration; and in more recent years, President Bush has been quite clear that he would not support it (despite a 2004 Pentagon study emphasizing the national security concerns associated with ignoring climate change). Notwithstanding that administration’s feelings on the topic, bipartisan legislation to provide incentives for voluntary reductions, require disclosure of emissions levels, and impose a cap on companies’emissions continues to circulate through Congress. In addition, several individual U.S. states have enacted policies to specifically cap carbon emissions from power plants.

Despite the criticism leveled at the U.S. for being the largest GHG producer yet refusing to ratify Kyoto, it ultimately may not matter whether our government adopts the protocol or not. U.S. companies decided years ago that voluntarily capping their carbon emissions would be in their own best interest. Today, there is a Chicago Climate Exchange, where carbon credits

are traded as a commodity, just like corn futures are traded at the Chicago Mercantile Exchange. But why would a company voluntarily reduce its carbon emissions? Reasons include:

• Legality. Divisions and subsidiaries of U.S.-based firms operating in Kyoto-participating countries are bound by their host country’s laws to meet Kyoto targets. If a company goes through the effort to identify emissions-reduction strategies in its international offices, it may very well find it prudent to go ahead and make similar changes to its domestic operations.

• Long-term planning. Many people believe that, despite the current administration’s stance on the issue now, one way or another, the U.S. will eventually impose a carbon cap. Some companies find it fiscally prudent to take action now in order to be prepared, and possibly get retroactive credit for early action.

• Influence. Companies may believe that those who establish a strong track record in voluntary carbon reductions will be more credible participants in defining the particulars of whatever carbon legislation is one day adopted in the U.S.

• Profit. The global carbon credit market is becoming a substantial new trading venue for companies. With huge demand for credits abroad, reducing one’s own emissions to create saleable credits has become an investment opportunity for U.S. firms. In addition, many emissions-reduction solutions are money-savers in their own right, and serve to reduce enterprise risk.

• Innovation. Companies committed to reducing their carbon emissions will rely on new technologies and innovative efficiency measures to do so. If U.S. firms simply “sat out” from this process, they could fall behind on certain technological advances, putting their competitiveness in the global marketplace at risk.

• Employee retention. Companies are increasingly sensitive to their employees’ desire to work for the “good guys.” In fact, employee initiatives initially drove some of the major oil companies to embrace the climate change issue years ago.

• International pressure. Generally, operating as a pariah in one’s industry in the face of constant criticism is not a pleasant position in which to be. U.S. firms who choose to embrace environmental stewardship – whether it be in terms of climate change or other types of pollution – tend to have an easier time doing business abroad.

• Ethics. Corporate officers are bound by law to put their shareholders’ interests first. However, they do have leeway in how to define or meet such a goal. Corporate directors are, after all, people who stand to be adversely impacted by a warming climate just like everyone else ... and most of them are thus fundamentally interested in understanding climate change science and doing their part to work towards a solution.

While current carbon reduction activity in the U.S. is entirely voluntary at present, energy companies do believe that a carbon tax of some sort will eventually exist. Utilities and lenders routinely conduct sensitivity analysis on their assets by incorporating a cost assumption for carbon dioxide emissions.

How will action on the climate change issue affect the energy sector? We can expect to see an ever-stronger push to develop renewable energy generation, implement low-emission coal technologies, further develop relatively low- carbon natural gas resources, improve energy efficiency of the industrial sector, increase fuel economy of combustion engines, and potentially even re-invigorate the nuclear power industry. Climate change is a complex problem whose solution will ultimately come from a variety of sources – for bright, technology-savvy people interested in problem-solving, the energy sector thus offers a wealth of opportunity for meaningful work.