Climategate: How To Follow the Money

Of course, some people would buy CERs out of commitment or guilt -- say Hollywood folks who want to continue to use their private jets -- but the market in guilt is actually pretty limited.

For this scheme to work, there has to be some reason why the power plant would be forced to reduce their carbon emissions. That's where the Kyoto Protocol come in. Part of the protocol is an agreement by each of the Annex I countries that they will reduce their carbon emissions by some amount, but that reduction can either be in actual reductions or by buying CERs.

Put together, these two parts -- an enforced reduction or "cap" on carbon emission and a way to trade CERs -- are the key components of a "cap and trade" scheme, which is the basis of the Kyoto Protocol.

Carbon Markets

There's one more missing component here. There has to be a way for people with CERs to find people who want to buy CERs -- in other words, there has to be a market. This market operates, just like the New York Stock Exchange, the Chicago Board of Trade, or the rug merchant in a bazaar in Istanbul, as a profit-making entity. Every time Wayne in Chicago buys a CER from Wang in Shanghai, the guy facilitating the market -- call him "Al" -- takes a little off the top in the transaction.

Now we've got a picture of the whole transaction:

1. Wayne in Chicago needs to reduce his CO2 emissions by 500 tons, so he contacts Al.

2. Wang in Shanghai has a 500 ton CER.

3. Wayne and Wang agree, through Al, that the 500 ton CER is worth $1000.

4. So Al takes the CER from Wang, paying him $980 (subtracting a $20 commission from the $1,000 trade price) and gives it to Wayne in exchange for $1,020 (because Al is charging Wayne a commission too.)

Now, on paper at least, Wayne is only producing (net) 500 tons of carbon emissions.

Perverse Incentives

"On paper" is the key here. In reality, Wayne alone used to be emitting 1,000 tons of carbon. Now, Wayne and Wang together are emitting 1,500 tons in total. Wayne is out $1,020 for the CER, Wang is $980 richer, and Al has made $40.

On paper, it's a reduction of 500 tons of CO2 emissions, but it's only a real reduction if Wang really would otherwise have built a power plant to emit 1,000 tons. But because Wang knows he can make money on the CERs, that is going to factor into his decision to build a power plant at all -- all the incentives in Wang's case are to build more power plants and emit more CO2, as long as he can convince someone (in this case a UN organization) that he "really would have built the power plants anyway."

Of course, Wayne could have kept his $1,020 if it weren't for the government forcing him to reduce his "carbon footprint." So this is effectively a tax. The effect is that Wayne is paying $1,020 in taxes, of which $40 goes to Al and $980 goes to Wang in China, and there is a net reduction in carbon output only if the CERs really represent carbon that "would have been emitted anyway."

And this all managed by the paragon of incorruptible altruism, the United Nations.

Follow the Money

The frightening thing, at least for Al and Wang, is that this was all set to go away. The Kyoto Protocol expires in 2012, and without an agreement to extend it, new Chinese power plants would have to be built without cash coming from the developed world and carbon trading markets would have nothing to trade.

The amount of money involved isn't trivial. According to Richard North at the Daily Mail, the carbon trading market last year was worth about £129 million (or about $205 million U.S.) and was heading toward trillions of dollars by 2020. So it's probably not a coincidence that, for all the discord in Copenhagen, the one thing to which all the parties did agree was to extend the Kyoto cap and trade system. The market in carbon offsets or CER would continue.

Who benefits from this?