Please ensure Javascript is enabled for purposes of website accessibility

Trading on Climate Change

By Dan Caplinger – Updated Nov 15, 2016 at 1:20AM

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

Markets for emissions credits are starting to take root.

Public policy issues can be frustrating to investors. When you're analyzing a potential investment, you have to make allowances for the regulatory environment that businesses face. However, the laws and regulations that apply to a given industry can change without notice. Oil companies such as ExxonMobil (NYSE:XOM), BP (NYSE:BP), and Chevron (NYSE:CVX) found that out last week, as the new House of Representatives imposed new royalty taxes on oil and gas drilling in certain previously tax-free areas. The uncertainty of potential changes in businesses' regulatory environments can be one of investors' biggest challenges.

On the other hand, public policy issues aren't always bad for markets. In some cases, laws and regulations use free-market mechanisms to achieve positive results. Many governments and international agreements have established markets to help enforce pollution-control guidelines, creating opportunities for resourceful businesses to profit from government regulation.

How the emissions markets work
Most government and international efforts to control emissions use the cap and trade system. First, the government or international coalition determines appropriate maximum limits on emissions, usually based either on current emission levels or maximum safety levels. Once an overall cap is established, all parties allocate allowable emissions among themselves. For instance, the Kyoto Protocol envisions placing caps on national emissions levels based on a fixed-percentage reduction from 1990 emissions levels. The Clean Air Act of 1990 established a similar program to reduce the sulfur dioxide emissions responsible for acid rain. For international agreements, each national government then proceeds to distribute emissions credits among businesses within its borders.

Once all market participants have an initial allocation of allowable emissions, they can begin to trade credits for those emissions. The cap and trade system recognizes that some participants can't limit themselves to their initial allocations. To fulfill their agreement, these participants may purchase emissions credits from other businesses emitting less than their allocations.

Several markets have sprung up to trade emission credits. The Clean Air Act's sulfur dioxide regulations authorized the Environmental Protection Agency to monitor transfers of emissions credits among businesses, with futures contracts available on the Chicago Climate Futures Exchange. The European Union Emission Trading Scheme has been for trading carbon dioxide emissions credits since the beginning of 2005, with the possibility of adding markets for other pollutants in 2008.

Selling pollution reduction
The market mechanisms for trading emissions credits are already changing the business of reducing pollution. Industrialized countries generally find reducing emissions levels expensive, since they've already implemented many of the easiest, most remedial pollution-cutting measures. But many emerging-market countries have taken few or no steps at all to curb emissions in the past, leaving them with opportunities to reduce emissions at lower cost. If an emerging-market business reduces its level of emissions, it can sell the resulting credits for cash to other businesses worldwide.

As a result, countries throughout the developing world are seeing an explosion in pollution-curbing projects. For instance, many developing countries still use older refrigerants, greenhouse gases that harm the ozone layer. Disposing of these refrigerants isn't generally cost-effective, but the promise of cash from emissions credits can help make such projects economically feasible. Other projects designed to reduce emissions, such as retrieving methane from landfills and harnessing renewable energy via wind farms and hydroelectric dams, can produce strong cash flows into emerging-market businesses. In addition, projects to create so-called carbon sinks, such as forest management and reforestation programs, are especially beneficial in countries like Brazil, which has large areas of land available for forestry projects. Many companies in industrialized countries, including Repsol (NYSE:REP), Norsk Hydro (NYSE:NHY), and Endesa (NYSE:ELE), have already begun investing in these projects, hoping to generate credits that they can use for their primary manufacturing operations.

Critics of these programs argue that the brief history of emissions-credit trading suggests problems in those credits' allocation. Prices for credits on the European markets have fallen dramatically since their initial introduction, with current levels of four euros per ton representing a huge decline from highs of more than 30 euros. A glut of credits may be responsible for the depressed prices.

Nevertheless, the beginning stages of emission controls and credit trading appear to meet expectations. As more of the Kyoto Protocol's provisions take effect, trading in these markets will likely accelerate, and emerging-market projects designed to take advantage of that trading will continue to provide opportunities for global investors.

Related articles:

Looking for companies that will change the world? Look no further than our Motley Fool Rule Breakers newsletter. Fool co-founder David Gardner and his team hunt for innovative companies with business strategies that are ahead of their time. See what they've found so far with a 30-day free trial.

Even with the warm winter, Fool contributor Dan Caplinger has been suffering from a poorly insulated house. He owns shares of BP. The Fool's disclosure policy adapts with the times.

None

Invest Smarter with The Motley Fool

Join Over 1 Million Premium Members Receiving…

  • New Stock Picks Each Month
  • Detailed Analysis of Companies
  • Model Portfolios
  • Live Streaming During Market Hours
  • And Much More
Get Started Now

Stocks Mentioned

BP p.l.c. Stock Quote
BP p.l.c.
BP
$28.08 (-8.80%) $-2.71
Chevron Corporation Stock Quote
Chevron Corporation
CVX
$144.77 (-6.53%) $-10.12
Exxon Mobil Corporation Stock Quote
Exxon Mobil Corporation
XOM
$85.75 (-5.32%) $-4.82
Repsol, S.A. Stock Quote
Repsol, S.A.
REPYY
$10.99 (-6.63%) $0.78

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

Related Articles

Motley Fool Returns

Motley Fool Stock Advisor

Market-beating stocks from our award-winning analyst team.

Stock Advisor Returns
329%
 
S&P 500 Returns
106%

Calculated by average return of all stock recommendations since inception of the Stock Advisor service in February of 2002. Returns as of 09/24/2022.

Discounted offers are only available to new members. Stock Advisor list price is $199 per year.

Premium Investing Services

Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool's premium services.