Stratfor: Public Policy Intelligence Report - November 15, 2006

By Bart Mongoven

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

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

scrap heap 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 phaseout 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.

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posted to ClimateConcern