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This is FRESH AIR. I'm Terry Gross.

Although many experts have written the obituary for cap-and-trade in the U.S., the European Union and several other developed countries, including Japan, countries which signed a Kyoto Protocol, already have a cap-and-trade system. My guest, journalist Mark Shapiro, has been investigating how the system is functioning and the new complicated regulatory system that's developed around it. He has also reported on how cap-and-trade has turned carbon trading into the fastest growing commodities market on earth.

Major financial institutions, including Goldman Sachs, Berkeley's and Citi Bank, already have carbon trading desks in London. Mark Shapiro's article on cap-and-trade is in the February edition of Harper's. He has also written about cap-and-trade for Mother Jones and is reporting for "Carbon Watch," a joint production of the PBS series "Frontline" and the Center for Investigative Reporting, where he is a senior correspondent. Mark Shapiro, welcome back to FRESH AIR. Let's start with a little recap: What is the basic premise of cap-and-trade?

Mr. MARK SHAPIRO (Journalist): So the basic idea behind cap-and-trade is that the government issues emission limits, limits on the amount of greenhouse gases that major industries can omit into the atmosphere. And then it permits companies to exceed those limits, to go and purchase an offset somewhere else. Now, what is an offset? An offset is something that basically is a project to reduce emissions in some other part of the world. Let me give you an example.

You have got a major German utility for example. Every year they are issued an emission limit, literally a number as to how many greenhouse gases they can omit into the atmosphere. They have a huge complex, it's actually called RWE, the biggest utility in Germany. And they have a complex in their headquarters which literally gives them a reading every day as to how many emissions their utility is omitting. And every month they have an exact reading of how far over their limit they're going.

And so that company has to go out and buy these things called offsets, which are essentially investments in what are emission reduction projects, somewhere else. So you have got a system called cap, which establishes the caps, the limits on emissions, and trade, meaning you can go obtain emission reductions somewhere else to allow you to continue polluting at home.

GROSS: So what are some of the typical offsets in the system?

Mr. SHAPIRO: Well, you've got offset that are kind of wind firms and solar panels. The way the system works now, which is the system that was established by the Kyoto Protocol, is a significant portion of these offsets can be obtained in developing countries. So you, if you're that utility, you can go to Brazil or China or India. And you can invest, say, in a hydropower dam or you can invest in a wind farm or you can invest in an operation like, for example, in Brazil, where there are huge amounts of biofuel - they are taking, you know, agricultural wastes and they are turning that into a fuel which is then replacing oil based fuels in a particular factory in Brazil.

So these things are actually happening all over the world - wind, solar, biofuels, transformations of energy sources that are being utilized as these kinds of offsets.

GROSS: Okay, now, say you have a factory and you're omitting too many greenhouse gases, you're exceeding your permit. I have a factory, I'm under the amount that my permit allows. Can we trade so that you can use what I have left over?

Mr. SHAPIRO: Yeah, yeah. We could do a deal. So, I'm utility X and you are utility Y. You are in Philadelphia, I'm in California and I'm omitting too much, you are omitting under. And therefore I would buy the gap between your emission limits and how far under you are. So let's say you're allowed 100 million tons of carbon dioxide a year, you come in at 90 million tons. I on the other hand am omitting 130 million tons, I need 30 million tons from somewhere, because I have a 100 million ton limit. And I buy 10 from you and then I go buy another 20 somewhere else, either in this country or somewhere else.

GROSS: So the idea is globally it all balances out since people are trading in different parts of the world, like carbon emitters or buying offsets in other parts of the country or other parts of the world?

Mr. SHAPIRO: Well, that's the theory. Suddenly, actually, what's interesting is that the notion of greenhouse gases has suddenly given the world a startling realization that we actually are one planet ecologically speaking. And we have all known this kind of abstractly and certainly it's not a new idea. But the idea of what greenhouse gases are doing to the atmosphere has jolted people into this awareness that if you are polluting into the atmosphere in the United States and you have the ability to reduce pollution in Brazil or India or China, then the overall balance into the atmosphere is reduced. We all share the same atmosphere, the pollution in Brazil is the same of the pollution in Philadelphia or Chicago.

GROSS: Well, (unintelligible) but not if you are living in Philadelphia and that's where it's polluted.

(Soundbite of laughter)

Mr. SHAPIRO: Right.

GROSS: You are still living in a place that's polluted no matter how many offsets are in Brazil.

(Soundbite of laughter)

Mr. SHAPIRO: Well, yes, exactly. I think, yes, I mean we all you kind of think abstractly, Terry, you got to think abstractly.

GROSS: All right.

(Soundbite of laughter)

GROSS: So who is already using this cap-and-trade system?

Mr. SHAPIRO: So this cap-and-trade system that I've described is being utilized at this very moment by the European Union, all 27 countries of the European Union, by Japan, and by several other developed countries, including New Zealand. And those, of course, are the countries which signed the Kyoto Protocol remember, this goes back to 1997, the Kyoto Protocol was signed. In 2001, the United States pulled out of the Kyoto Protocol. But what's left is that the countries that are in the Kyoto Protocol are now operating according to what's called a cap-and-trade system. They are now deeply engaged in this idea of having emission limits on the one hand and the ability to purchase emission reductions somewhere else.

GROSS: And the U.N. administers this?

Mr. SHAPIRO: The U.N. administers it. This is - the United Nations, of course, oversaw the Kyoto Protocol. It's the United Nations agreement, and now the United Nations for the first time in history is in the business of regulating a commodity market. Because this thing called a carbon offset has been turned into a commodity.

GROSS: Now, you write that the commodity market of these carbon offsets, is the fastest growing commodity market in the world with companies buying and selling carbon credits like pork bellies or silver. Would you explain what the market is and what people are actually buying and selling?

Mr. SHAPIRO: Yes. Well, this is what's fascinating, to think, number one, that carbon, this idea of a commodity that is based on an emission reduction promise, is now the fastest growing commodity on Earth. I mean basically this was a market that essentially was essentially around zero in 2005 2005 that kind of market mechanisms kicked into gear. And now it's a market approaching more than $150 billion huge market. What is it that's been traded? Well, this is the commodity that's based on the idea that somewhere else in the world there is an emission reduction happening.

The commodity of carbon is essentially a commodity that is totally dependent on the measurements. So, you have a promise in, for example, a country like Brazil where you are omitting methane from a pig farm. Methane is a very potent greenhouse gas. And you say, you are going to be able to reduce the methane emissions from that pig firm. And you want to obtain money for that technology. So you establish a proposal and you send that proposal to the United Nations, you say over the next five years I'm going to reduce the emissions that otherwise would have happened by five, 10, 15 million tons.

And the United Nations then give its stamp of approval to enable you to then go sell that offset to an industry somewhere in the world that needs to reduce it's own emissions.

GROSS: Wait, wait, hang on. That sounds so speculative to me. So you're saying that company A says that it has a plan to limit methane gas produced on a pig firm in Brazil. And they go to the U.N. for approval for this plan and then they sell that as carbon offsets to another company?

Mr. SHAPIRO: Yes, yes.

(Soundbite of laughter)

GROSS: But nothing has happened yet, it's all speculative like

Mr. SHAPIRO: Exactly, exactly. This whole market is based on speculative promises. You have a commodity that's based on a promise. It's a promise to reduce emissions in the future. It's about how you measure this commodity. You have other commodities in the world, for example, pork bellies. If you're speculating on pork bellies right now, somewhere down the line, in a month or a year, whenever your contract comes due, you're going to get deliver 20 times of pork bellies. The same thing with silver; if you're going to go speculate in silver market, at some point you're going to get delivery of silver which you purchased on the market.

When it comes to carbon, what you get is not something you can hold in your hand, not something you can really even put in your pocket. What you get is a certificate that promises X amount of emission reductions over the next several years. And it's these certificates that are now becoming the hottest commodity in the world right now.

GROSS: Why are they the hottest commodity in the world?

Mr. SCHAPIRO: Well, they are the hottest commodity for two reasons one, you have most of the developed world now operating under this cap-and-trade system, which means you've got hundreds of billions dollars in search of offsets because you've got major industries in all these different countries searching for offsets somewhere in the world to offset their emissions. And at the same time what you've got is a very lively secondary market.

These packages of carbon promises are now being speculated upon also in a secondary market, which is essentially a derivatives market where are people are betting essentially on the price of carbon, very much like they bet on the mortgage derivatives and things like that, on the price that this commodity would reach; that is now becoming a very lively area for speculation. The reason why perhaps many Americans may not be so aware of this enormous economy is that it's been largely headquartered in London. London is now the center of this international carbon trade, largely because the United States pulled out of Kyoto.

In fact, I've talked to many people who are in the financial markets here in the United States and in addition to disappointing many environmentalists, the Bush administration's decision to withdraw from Kyoto also disappointed many financial people, I can assure you, who had anticipated that this carbon market would be centered here in the United States.

GROSS: Well, a lot of financial institutions with very familiar names have carbon trading desks in London now, right, including Goldman Sachs and Citi Group?

Mr. SCHAPIRO: Exactly, what's happen now this economy has become such a huge enterprise that some of the major American financial houses, like Goldman Sachs, Citi Bank, Merrill Lynch, JP Morgan, which is also an owner of one of the biggest carbon brokerage firms, Bank of America, they all have carbon trading desks in London. You go to downtown London, you'll see basically a concentrated area of carbon brokers and carbon traders. So the big American financial houses are certainly seeing this market and very much looking forward to this market essentially coming to the United States.

GROSS: My guest is journalist Mark Schapiro. His article on cap-and-trade is published in the February edition of Harper's. We'll talk more after a break.

This is FRESH AIR.

(Soundbite of music)

GROSS: My guest is journalist Mark Schapiro, who has been reporting on how cap-and-trade is already functioning in the European Union and other developed countries. When we left off, he was talking about how London has become the center of the lucrative carbon trading market and why big American financial houses want cap-and-trade to come to the U.S.

So explain to me a little bit more how investors make money on carbon trading.

Mr. SCHAPIRO: Well, if you are a business and you need carbon offsets to meet your emission limits, where you're going to go to company B and try to buy those offsets or you're going to go to an investment house that controls a whole group of offsets, they're sold in huge bundles essentially, like a million tons each. And you will go to a house. Sometimes it actually could even be JP Morgan or one of these houses, and you'll go by a million tons. Now, if you're also a speculator, you're going to speculate on that price. So for example, the price of carbon now in London is somewhere around $20.

But you can also buy these bundles of carbon offsets at let's say $20 right now, and you can put them in your pocket and hope that that price is at some point going to go up to let's say $22. And then you're going to sell it on the market either to another speculator or to a business that needs those emission offsets. So a lot of people are actually making quite a bit of money now, speculating on carbon. It's a pretty liquid market and it's growing rapidly.

GROSS: I can see how that would be very helpful. I can see how that would be kind of scary in a way that real estate became really scary when the derivatives started to plummet in price and the whole market crashed.

Mr. SCHAPIRO: Well, there are people who see the parallels between the carbon markets and the derivatives markets, and this is the reason why. If you unpack these derivative bundles, let's say a million tons each, but each of these bundles are based on multiple different projects - it could be a methane reduction project in Brazil, it could be a dam in India, it could be a windmill farm in China all bundled together into the same package to make up a million tons, and then that is now bought and sold and traded very much like a pork belly.

But, if you begin to unpack what is actually contained in those bundles, they all have various levels of reliability, various means of measurement, various means of predictability when you say that something is going to deliver X amount of emission credits. There are very different calculations when it comes to a methane reduction plant, than a wind firm, than a solar panel complex. And so there is a great deal of concern about the sort of reliability of the valuation of these carbon bundles.

And what I write about is a whole new array of companies that have been certified by the United Nations to do those measurements.

GROSS: Well, you write that the validation is the Achilles' heel of the whole cap-and-trade system. Is that because of what you're saying that you're measuring a promise?

Mr. SCHAPIRO: Yes. You're actually think of it this way; you're measuring a promise. You're measuring like a sequence of proposed facts that are going to happen. So, you have a company that runs a pig iron factory in Brazil. And that company used to use oil to fire up its pig iron factory. So, what it proposes to the U.N. is that, all right, instead of using oil, we're going to plant a bunch of trees. And we're going to then let those trees grow, seven, eight, nine years. In the process, while they are growing, they are actually soaking up carbon from the soil. Then we're going to burn those trees and we're going to turn them into charcoal.

And then they are taking that charcoal and bring it to the pig iron factory and instead of using oil, they use charcoal to fire up the pig iron factory. So, at several stages along the way, the company claims that they are reducing emissions, because basically, all right, so your trees are standing now and you claim that they're capturing X amount of carbon from the atmosphere, what's that is going to look like in five years? Somebody comes out and measures that. The same thing happens with the pig iron factory. Well, you used to use oil and now you're using charcoal. Let's see how much emissions you're going to reduce over the next five, 10, 15 years.

Once you get approval for these promises, so the developer - and the developer says, okay, we're going to reduce emissions by five million tons. Then a company comes in and the United Nations has certified a group of companies to basically do the audits of these promises. They're called Designated Operational Entities. I don't want to blur you with the million U.N. acronyms, but let's call them validators. They're brought into validate the claims of people who are offsetting emissions who claim to be offsetting emissions.

These guys do the measurements. They are the Standard & Poor's - the way that Standard & Poor's and Moody's operate on Wall Street to establish the valuation of a company - these companies do the same thing for carbon.

GROSS: Now a couple of these companies that are validators, they were found to have done very inaccurate validations, sending the system kind of into a tizzy. Yes?

Mr. SCHAPIRO: Yes. That totally threw a wrench into the system, because, you know, you're talking here about the two major validators, who, together, are responsible for more than half of the offset emissions in the world. Well, imagine that half of the offsets that are claiming emission reductions, the United Nations suddenly found that basically two of the biggest companies had inadequate abilities to oversee their own work; their people did not have the technical skills to even be conducting these analyses; and they found a great deal of discrepancy, even within their own paperwork and even within their own analyses, as to the legitimacy of these emission claims. So, when this happened, it was like an earthquake going through the system, because suddenly, all these - hundreds of millions of tons that were being bought and sold were called into question.

GROSS: So, this calls into question two fundamental things. One is, are the carbon offsets that are being claimed accurate, are we really limiting the amount of carbon through this cap-and-trade system; and it also calls into question, what about the whole carbon trading market? What happens to other derivatives based on these invalid claims?

Mr. SCHAPIRO: Right. And at number one, both of these companies have since been reinstated by the United Nations. After cleaning up their act and actually imposing much more stringent quality controls, they were reaccepted into the into United Nations' system.

But what's still critical is that all the offsets that they had validated under these conditions, that the United Nations itself found were flawed, are still being bought and sold on the international carbon markets. And I think this calls into question, really, essentially the central claim of cap-and-trade, which is that all this money flowing into the system - you know, we're talking about hundreds of billions of dollars - will actually result in the emission reductions that people think.

This is why I wanted to look into this system. Because if you have a market that has two rationales, one is to function as a market - and as a market it's basically functioning, you know, fairly well; it's certainly making people profits and doing what a market is supposed to do. But the second question, is that market resulting in emission reductions - and I think there are some questions about that claim, which is, of course, it's all raison de etre.

GROSS: My guest is journalist Mark Schapiro. His article on cap-and-trade is published in the February edition of Harper's. We will talk more after a break. This is FRESH AIR.

(Soundbite of music)

GROSS: My guest is investigative journalist Mark Schapiro. His article on cap-and-trade is published in the February edition of Harper's.

Now, the alternative to cap-and-trade that's been proposed is a carbon tax, and this is the alternative that's seen as a political impossibility. And that would be taxing companies that emit greenhouse gases for the - taxing them based on the amount of greenhouse gasses they emit. And that's unlikely to pass anytime in the near future in the U.S. So, that's basically been written off, right?

Mr. SCHAPIRO: Well, that's what's - I think that, politically speaking, I think you're probably right and probably I think carbon tax has been written off. But what I think is interesting to think about is if you're to have a cap-and-trade system, for example, that actually had the serious oversight, the monitoring of these transactions, a system which provided a much higher level of guarantees that the emission production promises were actually delivered.

Number one, you could actually have a functioning cap-and-trade system in that case. And in that case, ironically, you would end up, essentially, with a carbon tax - because to do that is expensive. It is expensive to have a monitoring system, a regulatory system with teeth is a commitment of resources.

And so, in order to have those resources and to have that kind of inspection that's going to guarantee the emission reductions promised or the emission reductions delivered, you essentially could end up with a carbon tax. So, this whole elaborate system which I've tried to evoke was created to detour carbon tax. And the irony, I think, is that if you were to actually have this whole system working with the effectiveness that is claimed, you would in some ways end up with a carbon tax.

GROSS: If you're emitting too much carbon and you need some offsets, do you hire somebody to find you a project that you could use as offsets?

Mr. SCHAPIRO: Yeah, yeah. Yeah, that's what the carbon brokers are. Carbon brokers essentially are the intermediaries between the project in the developing world that's promising to reduce emissions and the company that needs emission reduction. So, you have these carbon brokers.

And carbon brokers are the are essentially the middlemen. And these are now becoming huge businesses. Goldman Sachs has a carbon brokerage firm, J.P. Morgan has a carbon brokerage firm, as well as, many other kind of more boutique operations. But yes, you would go to a carbon broker.

GROSS: So, when you say that a carbon tax is not that different from cap-and-trade, the way it's practiced in the European Union, is this a kind of thing that you mean, that you have to like pay a broker to match you up with a project that has offsets and you're paying money right there, and who knows what other expenses come down the line.

Mr. SCHAPIRO: Yes, well there is enormous amount of kind of middle men in between this whole system from the project on the ground till you ultimately getting your offset. And the ability to assure that the emission reductions you think you're buying are actually being delivered requires a level of oversight that is significantly greater than what seems to exist right now.

Economists say that your carbon tax would actually be more efficient because it cuts out all these middle men and it just establishes a simple penalty, which would have to be paid over an emission at a certain level. It would clarify the measurements that are far easier to conduct, the means by which you would access that penalty is far easier to conduct, and so, many economists say, it would be far more efficient. Politically, it's, of course, another question.

GROSS: But the thing with a carbon tax, is it doesn't limit the emissions, it just means you pay to have extra.

Mr. SCHAPIRO: Yes, you pay to have extra, but it creates a powerful disincentive. If you create enough of a cost for the tax, you're going to have a powerful incentive to institute renewable energy technology that would lower your tax.

GROSS: Got it.

Now earlier on our show, Journalist Jeff Goodell said, you know, the carbon taxes are a real political no-go in the U.S. And the European Union has shown that the system they're using for cap-and-trade works. That is a workable system. Would you describe that system as an efficient working system?

Mr. SCHAPIRO: I would say the European system works to some extent. Certainly, as a market, it's being working very well. And there have been small levels of emission reductions that have been accomplished in Europe, partly through this system, as well as partly through a whole series of subsidies to renewable energy technologies and such like that.

And so, on the one hand, you have a functioning market. On the other hand, you do have some levels of emission reductions that have happened. The question, though, that's raised about the European system is are you getting the emission reductions you think when you're buying them?

So, there is an enormous amount of study has gone into this question of promising an emission reduction. And what they have concluded really, over and over again, is anywhere from a 15 to 35 percent overestimation as to how many emission reductions you're actually getting. Which means you're getting far less of the emission reductions than you think in that market.

GROSS: So, you're getting emissions reductions, but not as much as you think.

Mr. SCHAPIRO: Exactly. You're getting emission reductions, but not nearly as much as you think you are.

GROSS: Well, Mark Schapiro, thank you for describing a very complicated system that we should probably all know nothing about. Thank you very much.

Mr. SCHAPIRO: Thank you. Hope it becomes clear now.

GROSS: Mark Schapiro's article on cap-and-trade is in the February edition of Harper's. He's a senior correspondent for the Center for Investigative Reporting, which is jointly producing the Carbon Watch Project with the PBS series, "Frontline."

I'm Terry Gross.

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