By Richard Conniff, from the Fall 2008 issue of Environment: Yale magazine. You may download a PDF of this article as it originally appeared in the magazine.

Early this year, four major investment firms–Citigroup, JPMorgan Chase, Morgan Stanley and Bank of America–announced standards that effectively prevent them from financing new construction of conventional coal-fired power plants, currently the largest source of electric power in the United States. With the credit crisis dominating the headlines, it was a minor story buried deep in the business section. But it turned on an increasingly important factor in investment decisions, with the potential both for enormous profits and for losses that could ultimately make the credit crisis look pale: The bankers were worried about global warming.

They made it clear that their concern was primarily financial, not environmental. In the event that the United States adopts a cap-and-trade system on greenhouse gas emissions, primarily carbon dioxide, major polluters would be required to pay for every ton of emissions in excess of their cap, and that cap would get lower each year. Even a banker could hardly fail to notice that coal-fired power plants produce many tons of CO2 and that the power industry has no realistic prospect of a remedy. Global warming worries also caused Wall Street to downgrade coal companies this year, and Xcel Energy, one of the nation’s largest builders of coal-fired power plants, agreed in a settlement with the state of New York to provide a detailed disclosure of its climate change risk.

Companies with less-obvious exposure to global warming also found themselves under pressure to come clean about their risks–and the pressure was being applied not just by lawsuits and shareholder resolutions but by the Earth itself. “If you’re Coca-Cola and you can’t get water in some of your main markets because of drought, you’re in trouble,” says Daniel Esty, Hillhouse Professor of Environmental Law and Policy at F&ES. If you’re a real estate company with ski lodges at lower elevations, he adds, you may find financing available based only on their income as hiking lodges. Insurance companies are also factoring climate risk into their policies. Writing in the Financial Times, Kevin Parker of Deutsche Asset Management warned, “If you can’t finance it and you can’t insure it, it probably isn’t going to get built.”

“We’re talking about nothing less than the reindustrialization of the whole planet.”
John Doerr

The idea that there could also be an upside in this scenario might sound wishful. But in fact, a thriving new business sector, climate change finance, is already taking shape, with a focus on likely winners as well as losers. Moreover, business and environmental leaders alike are treating it as a promising development–sometimes in language last heard during the dot-com boom. Venture capitalist John Doerr, for instance, describes the move to a low-carbon economy as a market worth “ENORMOUS trillions” (and the use of the uppercase is his), adding, “We’re talking about nothing less than the reindustrialization of the whole planet.” Likewise, the Carbon Trust, a British nonprofit, has issued “a trillion-dollar wakeup call,” predicting a “revolution in business” as the implications of climate change become apparent: “Companies and investors that prepare now and develop new strategies will reap the commercial rewards of the move to a low-carbon economy” and “badly positioned or slow companies” will lose out.

The rapid growth in climate change finance may well justify the hype. At the start of 2005, for instance, the trade in carbon emissions permits was literally hot air, with a value of zero. But it has boomed since the Kyoto Protocol imposed emissions limits in 38 countries, and permits now sell for about $37 a ton on the European Climate Exchange. The global carbon market logged $64 billion in trades in 2007 and is on track to top $100 billion this year. One recent forecast predicted that the trade would reach $1 trillion a year in 2020, assuming the United States joins the market with the passage of a cap-and-trade system now being discussed in Congress. (President-elect Barack Obama and Senator John McCain are both prominent among the backers.)

Even without that mandate, U.S. companies and individuals moved to reduce their global-warming impact (and get experience in the market) through the voluntary use of carbon offsets and credits. The U.S. voluntary market tripled last year to $331 million, according to nonprofit Ecosystem Marketplace.

Beyond carbon trading, climate change finance now reaches into almost every segment of the economy. Global investments in clean technology (meaning alternative energy, conservation and efficiency measures) totaled $148.4 billion in 2007, according to market-watcher New Energy Finance. But the sector also includes green investments in water supply, agriculture, forestry, seawalls and other infrastructure for adapting to climate change and a growing assortment of relatively exotic financial instruments like weather derivatives (to account for the risk of more intense hurricanes, droughts and floods). The number of players has also rapidly increased. Back in 2005, the first hedge funds specializing in climate change had just set up shop, says Peter Fusaro, an energy consultant and author of the 2006 book Energy and Environmental Hedge Funds–The New Investment Paradigm. Today the climate change sector includes 90 hedge funds and 80 private equity funds, in addition to a large number of venture capitalists.

Yale alumni have taken a leading role in promoting climate change finance, and this summer Fast Company magazine featured “a cadre of young idealistic Yale forestry grads” at the core of the market. One of them, Kate Hamilton ’06, director of Ecosystem Marketplace, says, “When I go into a meeting, I inevitably see another F&ES grad. We’re all over the place in this market, from the finance side to the project development side.” Yale’s dual-degree program offered by the School of Management and the School of Forestry & Environmental Studies is now 27 years old, and it has recently moved to increase the number of graduates, according to Bryan Garcia ’00, program director of the Center for Business and the Environment at Yale. The center has also hosted a continuing series of talks by leaders in climate change finance. A collection of last year’s talks, Carbon Finance: Environmental Market Solutions to Climate Change, edited by Garcia and Eric Roberts ’10, has just been published and can also be found online at www.yale.edu/cbey/carbonfinance2008. This year, the series is focusing on how climate change is affecting the purchase and management of forestland.

“There is no way a couple of thousand people at the Environmental Protection Agency can think about a problem as well as hundreds of thousands of companies when the burden is put on them.”
Daniel Esty

The surge of interest in climate change finance is clearly bringing money to bear on the problem. According to a 2007 United Nations report, 85 percent of the investment to address climate change now comes from the private sector, not government. Esty, co-author of the 2006 book Green to Gold, about business use of environmental strategies, argues that the shift away from government is also engaging the attention of people with the most experience at innovation and problem solving in a way that the old command-and-control style of environmental regulation never did. “There is no way a couple of thousand people at the Environmental Protection Agency (EPA) can think about a problem as well as hundreds of thousands of companies when the burden is put on them,” says Esty, himself a former EPA administrator. Business, he adds, also has the clout to produce dramatic results quickly, like Wal-Mart making a commitment to green in 2007–and then imposing it on 60,000 suppliers.

But the optimism about climate change finance needs to be cautious, too. “It’s the most complex financial market ever created,” says Fusaro. Just in the area of emissions trading, he counts 38 environmental markets in the United States dealing in everything from acid rain emissions permits to California’s mobile emissions reductions credits–that is, credits for reducing tailpipe exhaust. Each of these markets, and each of the different clean technologies, requires specialized knowledge, down to the nitty gritty of how bus engines work or how forests sequester carbon. “If you don’t understand it, don’t invest in it,” says Fusaro. Mutual funds and ETFs (exchange-traded funds) specializing in climate change issues have sprung up in Europe and the United States. But the market is still too young for retail investors, he says. “You’ll get your head handed to you.”

Because this is new territory, volatility is common. Investors in biofuels,
for instance, have recently found themselves whipsawed by drought in the Southeast and flooding in the Midwest, as well as by a rapid turn in public sentiment against the use of corn as a feedstock. The nascent carbon emissions trading industry has also experienced credibility problems over the use of questionable offsets. In the most notorious case, the British band Coldplay claimed to have rendered a concert tour carbon neutral by planting 10,000 trees in India. Then the trees died, causing a public relations debacle not just for Coldplay but also for the idea of offsets. The experience served as a painful lesson in the need for rigorous standards, with independent monitoring and verification.

The complexity of climate change finance also derives from its close connection to public policy. Other investments typically fluctuate on the basis of conventional business considerations like the supply of raw materials or the cost of manufacturing. But many carbon markets exist only because of government intervention. The sector’s single-largest commodity, carbon emissions permits, depends on the Kyoto Protocol, which is due to expire in 2012. A new, more stringent treaty will almost certainly replace Kyoto, probably with the United States joining in. But it is at least conceivable–one of those risks disclosed in small print at the back of an annual report–that the carbon emissions market, forecast to reach $1 trillion by 2020, could also be worth nothing.

Peter Sweatman, of the British investment firm Climate Change Capital, discounted such fears when he spoke at Yale last year. “For people who ask if the renewable-energy bubble is about to deflate, I make the point that we currently have about 60,000 megawatts in the world of operational wind farms and what we need is 2 million megawatts. We’re about 3 percent of the way there.” Referring to the analysis by Princeton professors Robert Socolow and Stephan Pacala that broke down the challenge of stabilizing the climate into a series of manageable steps, now known as Socolow’s wedges, Sweatman says, “We have to reach 700 times today’s coverage of solar panels to create one of Socolow’s wedges. The list goes on.”

But both wind and solar energy remain highly vulnerable to public policy uncertainty, at least in the United States. For instance, companies contemplating renewable-energy projects had to wait until October to find out if the tax credits that make these investments economically practical would be extended beyond the end of the year and, even then, the good news came only as an add-on to the financial crisis bailout package. According to a report from Navigant Consulting, companies would have invested just $7 billion in wind and solar power next year without the tax credits, versus $26.6 billion with the credits.

“We have a short window of opportunity to act, but, at present, business and investor actions are way out of step with the need to tackle climate change.”
Tom DeLay

A final cause for caution about the potential of climate change finance is that making money doesn’t necessarily mean fixing the problem. Overall carbon emissions continue rising dramatically, up 38 percent since 1992. To the surprise of many observers, the numbers actually got worse from 2006 to 2007, increasing by 3 percent, according to a new report from the Global Carbon Project. It is, of course, too soon to expect climate change finance to have made much of a dent in the problem after just a few years in existence. As businesses get more experience with the idea of paying for the harm they cause, these “incentive-based systems” may perhaps have the scale and the speed to stop global warming.

But the emissions problem is also shifting to the East, where carbon markets are less-developed. China is now the leading greenhouse gas emitter and India is about to move into third place, with the United States in between–none of them with a limit on emissions. “We have a short window of opportunity to act,” Carbon Trust chief executive Tom Delay recently warned, “but, at present, business and investor actions are way out of step with the need to tackle climate change.” Al Gore put it more bluntly. With the credit industry imploding in late September, he worried out loud about “a much-worse catastrophe” from “several trillion dollars in subprime carbon assets” doing damage to the atmosphere. “This is a rout,” he warned. “We are losing badly.”

A steady succession of events has helped move climate change finance out of environmental cul-de-sacs and onto Wall Street. It probably wouldn’t have happened solely on the basis of the powerful scientific consensus that global warming is a real and rapidly worsening threat. Market participants often protest, perhaps as a way to boost their credibility on Wall Street, that they are not interested in socially responsible investing. They say it’s about the money. But Hurricane Katrina drove home the likelihood of increasing devastation from more-intense weather events, and Al Gore’s An Inconvenient Truth laid out the logic of the scientific case in the starkest possible terms.

With the beginning of the Kyoto Protocol climate regime in 2005, industrial nations with emissions caps began the tentative move away from fossil fuels. At the same time, the war in Iraq was making many Americans uneasy about how oil can distort foreign policy and about being dependent on an endlessly turbulent region of the world for the lifeblood of the economy. Finally, the spike in oil prices, from about $25 a barrel in 2001 to as high as $147 this summer, gave people an alarmingly immediate incentive to change not just their minds but their behavior, with the sickening prospect of going broke every time they pulled up to the gas pump.

Beyond the news cycle, climate change finance is also the product of a profound shift in thinking about environmental issues. It owes its rapid growth, surprisingly, to a simple but elegant innovation by the EPA. In the early decades of the environmental movement, the EPA was a notorious practitioner of the old command-and-control mode of governance. It did the research and made the rules. Businesses “picked up the Federal Register and learned what they had to do,” said Esty. And generally they didn’t like it, with the result that time and money often went into fighting the rules rather than fixing the problem. In the new mode, the government simply puts a price on doing harm and leaves business to figure out how to fix the problem.

Cap-and-trade systems are, of course, a bit more complicated than that. By definition, there’s a cap on overall pollution. The government then allocates or auctions permits to companies for doing harm within the cap, and the price of permits tends to go up as the cap ratchets lower each year. It’s up to individual companies to figure out the smartest way to use those permits. A utility might upgrade the efficiency of a power plant to reduce emissions and help pay for it by selling the permits it no longer needs, preferably at a premium. A cement company may decide that buying more permits is cheaper, at least for now, than actually reducing emissions.

This new incentive-based approach first got talked about in government circles in the 1970s, when EPA staffers were puzzling over how to put a price on doing harm. But the idea had a rich academic history before then, dating back to the early 20th century British economist Arthur Cecil Pigou. Pigou focused on how transactions cause–but often don’t account for–a variety of external impacts. A manufacturer can cause air pollution and not have to pay for illness among its neighbors. A landowner can plant a forest and not get compensated for improving local water quality. Neither cost nor benefit shows up in the bottom line. Pigou proposed “internalizing the externalities” with the help of taxes and subsidies, so that both costs and benefits would show up in the bottom line. In 1960, the Chicago School economist Ronald Coase added the key idea of using tradable permits for the same purpose. Then, in the 1980s, Bruce Ackerman, Sterling Professor of Law and Political Science at Yale, and Richard Stewart, of New York University School of Law, wrote a series of influential papers arguing that, in the environmental arena, “A reform relying on market incentives is just plain better, in terms of all relevant public values, than the status quo.”

Over the objections of skeptics, the EPA put the idea to the test in the 1990s, establishing a cap-and-trade system for utilities to fix the acid rain problem caused by power plant smokestack pollution. Utility companies initially claimed that removing the major pollutants would cost $1,500 a ton, says Esty, who was then deputy chief of staff at the EPA, and government scientists figured $750. But because cap-and-trade let companies find the most economical way to meet targets, the cost has actually averaged $250 a ton for sulfur dioxide and $125 a ton for nitrous oxide. The program to cut acid rain pollution in half by 2010 now costs power companies $3 billion annually (versus early estimates of up to $25 billion). It also generates $122 billion a year in benefits, according to the EPA, from avoided death and illness, healthier forests and a 30 percent improvement in visibility on the Eastern seaboard.

The experience taught everyone involved a powerful lesson in human behavior: “People respond much more readily to upside opportunity than to downside burdens,” says Esty. “There’s not a person in a business anywhere who gets up in the morning and says ‘Gee, I want to race into the office to follow some regulation.’ On the other hand, if you say ‘there’s an upside potential here, you’re going to make money,’ people do get up early and do drive hard around the possibility of finding themselves winners on this.”

Esty adds: “That doesn’t mean government is unimportant. In fact, quite to the contrary, government has to be even more clever in the structure of rules and regulations to ensure that the incentives are there to engage the private sector, to draw these inventors and creative spirits into putting their time and effort into this set of issues.” Because businesses are entering new territory, with a high potential for market failures, “the only solution is to have rules that really frame and shape” the flow of capital, beginning with the critical first step of putting a price on causing harm.

The peculiar psychology of cap-and-trade may give it a significant advantage in dealing with climate change compared with the alternative approach of a direct carbon tax. People respond tactically to an increased cost, says Jon Anda, then-president of Environmental Markets Network when he spoke at Yale recently. “They can always pay to pollute, and so they don’t have to turn the ship around.” But a cap-and-trade system aimed at achieving 60 to 80 percent reductions in emissions by 2050, in line with scientific recommendations, demands strategic change: “You don’t leave it to your chief financial officer to manage your short position on allowances. You back up the truck on research and development, you say carbon’s getting out of the system and you respond.”

The advantages of cap-and-trade, combined with the success of the acid rain program, provided a model for Kyoto Protocol countries. Thus cap-and-trade has become the industrial world’s standard tool for addressing the global-warming challenge–except, ironically, in the United States, which has lagged behind since failing to ratify the Kyoto Protocol.

For the climate change finance sector, the key question now is how the United States will play catch-up. One speaker in last year’s series seemed to worry that the private sector is moving both too fast and too slowly. “My concern,” says entrepreneur Howard Berke, chief executive of Konarka Technologies, “is too much money chasing” premature technologies, with inexperienced founders “trying to push science faster than science wants to be pushed. I think we’re turning up the heat under the beaker a little bit hot.” At the same time, 85 percent of the market is business-to-business, meaning buyers who are “very, very risk-averse.” The energy and utility sector in particular is “one of the most conservative industries on the planet,” with little incentive to innovate on its own. Utilities have had the advantage of never experiencing a world war on American soil, says Berke, meaning they’ve never had to replace energy infrastructure wholesale. But that’s the disadvantage too: “It’s been with us through two world wars.

“Further combine that with the need for policy that is supportive–and we know how speedily policies move through the nation’s capitals–and then combine that with coordination on a global basis amongst nations. I believe what we’re facing is perhaps a need for a solution that cannot possibly be fulfilled in the time in which we expect or want it.” He predicted passage of federal climate change legislation in 2009, followed by two to four years of debate over the details of regulation, and added, “You can see the glaciers are melting faster than the politicians can figure out what to do.”
Still, limited cap-and-trade systems are already on the way, with the 10-state Northeast Regional Greenhouse Gas Initiative (RGGI) going into effect on January 1, 2009, and the Western Climate Initiative to follow. For opponents of a federal system, cap-and-trade is a euphemism for cap-and-tax, and they will maneuver to delay passage or approve a weak system like RGGI, which applies only to electric utilities and mandates an emissions reduction of just 10 percent by 2018. Many businesses and investors, on the other hand, are pushing to get serious now. The United States Climate Action Partnership is lobbying for a 25 percent reduction by 2020 and 80 percent by 2050, and it includes such unlikely players as Alcoa, Caterpillar and Duke Energy, a heavily coal-dependent utility. Some skeptics have argued that partnership members like General Electric and Dupont–and the climate-change finance market generally–want stricter limits on emissions because it will benefit their investments in the renewable-energy sector. But like patients anticipating a potential cancer diagnosis, some industries may simply find waiting in suspense more stressful than actually having the inevitable bad news in hand. Fusaro says, “What we want is regulatory certainty. We don’t want to make changes. We want policy certainty long-term.”

The United States has the advantage, as it moves toward climate change law, of learning from the European experience. “We need to be cognizant that because the United States has 6 billion tons of emissions annually, we’ll need to go faster than Europe and Kyoto,” says Fusaro. “We’ll need to look at buildings and the transport sector (meaning air, sea, cars, trucks and buses), both of which got left out in Europe.”

A U.S. cap-and-trade system may also need to include remedies not covered by the Kyoto Protocol, says Fusaro, including afforestation (planting new forests to absorb atmospheric carbon dioxide) and geological sequestration (burying emissions deep underground). He argues that U.S. law should include serious penalties for noncompliance, meaning at least $500 a ton (the penalty under the U.S. acid rain program is $2,300 per ton), unlike the nominal penalty of just 100 euros (about $140) a ton in the European system. He also warns against one mistake the Europeans managed to avoid: New Mexico Democratic Sen. Jeff Bingaman has proposed to limit the price of carbon emissions permits to $12 a ton in 2012 (up to $23 a ton in 2025). That would undermine the functioning of the marketplace, says Fusaro. European companies are more likely to make emissions reductions, in part, because they know they can sell their permits for triple that price right now.

Both the United States and Europe will also need to build on the Kyoto Protocol’s Clean Development Mechanism (CDM), says Bradford Gentry, senior lecturer in sustainable investments and director of the Center for Business and the Environment at Yale, who serves as a consultant to the United Nations on how to pay for climate change remedies. The CDM program steers money from the developed world into renewable-energy projects and other emissions reductions in developing nations. It also functions as a kind of safety valve, keeping the price per ton low by allowing companies to achieve a share of their emissions reductions abroad at lower cost than would be possible in their home countries. But it doesn’t deliver nearly enough money to induce India and China to take the essential step of accepting a cap on their emissions. Some kind of large financial commitment will inevitably be “part of the conversation on accepting a cap,” he says. And that will inevitably provoke furious resistance from those who believe, as former Delaware Republican Gov. Pete Du Pont recently put it in The Wall Street Journal, that developing nations (read China and India) basically “want to slow down the economic growth of developed nations so they can gain economically.”

Indeed, the reluctance of the U.S. Congress to save our own economy in the thick of the recent credit crisis suggests that it could be a long, hard fight before it takes serious action to save the rest of the world. Still, the climate change finance world is betting that the lessons of Katrina, Iraq and the latest energy crisis will resonate with voters and that U.S. workers will not want to get left behind in the rush for jobs in the new cleantech economy. The European success in the climate change finance marketplace thus far, says Esty, should teach us one really pressing lesson: “We need to get on with it.”