Climate Conundrum

The phrase climate change often renders an image of melting icecaps, rising sea levels, and other environmental changes. The environmental dimension is just one part of it. Not quite perceived by many are the sweeping changes taking place in the world of business and politics in an effort to respond to climate change.

2007 saw the IPCC (inter governmental panel on climate change), headed by Dr. RK Pachauri give its verdict: the climate is changing and we ourselves are largely to blame. The question now is not whether to act or not, but how to respond to climate change in a sensible way. Climate issues rank high on the political agenda; needless to say comprise much of rhetoric. Quite obviously climate change and related regulatory reactions will have significant implications on the world economy.

According to the IPCC, general warming of the earth is almost certain, rainfall patterns will change, and heat waves will become more frequent. The weather gods will become more capricious and we may see more Katrinas and Ritas. On one hand extreme weather events will cause destruction to plant machinery and crops, while on the other planning of future events would become complicated due to increased uncertainty. These are the twin factors which would have economic significance.

The first repercussion is increased financing costs. Institutions which lend to weather exposed sectors like agriculture, would expect a higher premium for the increased risk they are taking. Industries which have to reckon heavy losses due to the vagaries of the weather would find it difficult to finance themselves. Secondly, governments can no longer afford to sit quiet on potential climate threats and will be forced to take regulatory actions. This will result in growing climate protection efforts, which will result in higher costs. Regulations which aim at improving parameters such as heating efficiency, insulation, and low carbon technology are likely to be put in place. On the brighter side, some industries like construction and renewable energy do benefit, the costs however trickle down to you and me. Finally, climate change has the potential to change consumer behaviour. Increased awareness is already reflected in consumers’ efforts to conserve energy and support reparation efforts.

The key challenges in tackling some of these economic ramifications are

• Funding climate related technological advances

• Reducing the costs of greenhouse gas emissions

• Distributing weather risks effectively

• Create monetary incentives for environment friendly behaviour

Keeping these in mind, a lattice work of instruments and strategies needs to be evolved to respond to climate change in a sensible way. With the help of suitable financial instruments, it is possible to create incentives for climate protection, fund climate protection strategies, and share unavoidable risks effectively.

Emissions’ trading is an effective tool to augment efficiency of climate protection efforts on a global level. The Kyoto Protocol regulates green house gases like carbon dioxide, methane, nitrous oxide, sulphur hexafluoride, and fluorocarbons. All these emissions are converted to carbon dioxide equivalents, and measured. These measured quantities are used to issue emission certificates.

The Kyoto Protocol and the auxiliary agreements describe diverse emission certificates. At the outset, a distinction is made between emission rights and emission credits from project based mechanisms. In the first case, there is a ration of emission rights, which can be traded among the emitters of greenhouse gases. This includes the EU allowances that are traded in the EU emissions trading system and the assigned amount units (AAUs) that are intended for international trading. In the second case, credits can be obtained from additional climate protection projects in third countries and used to meet their own reduction target. A distinction is made according to whether the projects are realised in another industrial country (Joint Implementation) or in a developing country (Clean Development Mechanism, CDM). Another option provided for in the Kyoto Protocol is the realisation of carbon-sink projects at home, for instance in the form of afforestation. This results in so-called removal units (RMUs). Finally, it is possible to generate tradable project-based credits in the form of verified emission reductions (VERs).

The emission of greenhouse gases is a global problem; however, emerging markets and developing countries have been exempted so far from the Kyoto Protocol’s quantitative reduction commitments. All else being equal, the capping of greenhouse gases can often be realised at much lower cost in emerging than in industrial countries. This is where the Kyoto Protocol’s project-based mechanisms kick in. They allow emission credits (CERs and ERUs) from additional climate protection projects in third countries to be credited to the own reduction target. However, to prevent the industrial nations from buying their way out of any reduction commitment at home, there are limits to how much can be credited to their own reduction targets.

The trading of carbon credits is a lucrative opportunity for Indian companies and India in general. Indian companies can develop their own CDMs and sell their carbon credits to developed nations which have specific reduction targets under the protocol. Carbon credits have made climate protection a viable business prospect. Thanks to carbon credits, climate protection need not be at the mercy of benevolence.

The second class of members in our lattice is pretty simple - climate related investments. There is an investment theme evolving, which tries to demarcate sectors which profit from climate change, and sectors that don’t. Firms involved in renewable energy, companies offering solutions to adapting to climate change. Growing investor interest eventually reduces financing costs for these companies. It also gives a fillip to better capital allocation.

The third class is - a market for catastrophe and weather risks. Reinsurance is a typical example. Reinsurance is where insurance companies are insured by other insurers against mass catastrophes like tsunamis and hurricanes. It’s not significant in a country like India, but a big business in developed economies. Natural catastrophes are huge in terms of the volume of disaster, potentially affecting a whole region, this is where reinsurance helps. Another example would be cat bonds – a special purpose vehicle issues bonds which are used to fund contingency claims. This class of instruments enable efficient risk sharing. Many other members of the lattice are in the nascent stage of their genesis.

Of all the complex mechanisms to tackle climate change, carbon credits are the most relevant from the Indian perspective. Indian companies have already started to realise their potential, and are developing clean mechanisms. Carbon credits are increasingly being seen as supplementary products. There are trillions at stake to curb fossil fuel pollution, switch to clean energy.

Whether all these instruments are significant to climate protection is unclear. What is clear though is there is a lot of money involved. The future of all these treaties is uncertain. Bush’s successor may object to Kyoto protocol style of emission curbs. Though waning American hegemony is very much alive. While the countdown is on to save the planet, world leaders will bargain on treaties with monstrous complexities.

The gap between the need for action and political rhetoric is widening. Almost all global summits on climate change have been plagued by finger pointing. Who should foot the bill of climate change is still a nagging question. Uncertainties are a part and parcel of doing business.