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May 1, 2010

CLIMATE CONUNDRUM

Even with rich and poor nations at loggerheads over greenhouse gas emissions, fallout from the debate alone poses risks for business.

Illustration by Colin Johnson

When Thomas Edison announced he could provide better, cheaper light and power to homes through electricity generated by coal-fired dynamos, scientists called his ideas absurd. The British Parliament in the late 1870s declared that Edison’s scheme was “unworthy of the attention of practical and scientific men,” wrote his biographer Matthew Josephson.

Edison and his competitors persisted. Homeowners and businesses responded, and the rest is history. It’s a classic story of consumer demand and entrepreneurial drive overcoming the status quo in the minds of scientists and politicians to create progress.

Today, the tables have turned. Climate scientists and political leaders are driving the world to recognize that new sources of light and power are needed to save Earth from man-made warming by burning fossil fuels. This time, the normal forces of supply and demand are not in charge. Thomas Edison, the shrewd capitalist who liked to be photographed in the white laboratory coat of a scientist, would be as perplexed. So are his modern counterparts.

At the heart of the problem are two—perhaps more—intractable issues. Developing nations such as China won’t consider halting growth to cut emissions from within their borders. Developed nations, they say, caused this problem; developed nations should pay to fix it. But in developed nations such as the United States there is no political consensus for a solution that might reduce living standards or make their own industries globally uncompetitive by taking the lead unilaterally. Obviously, if one major nation or region cuts emissions and another doesn’t, total world emissions cannot be reduced in line with scientific goals. China is the world’s biggest emitter of greenhouse gases.

“I categorically reject the idea that the U.S. steel industry should not be allowed to grow and that all the growth should be in China,” says Kevin Dempsey, general counsel and senior vice president of public policy for the American Iron and Steel Institute and one of the leading advocates for industry in Washington, D.C., on the global warming debate. Last year’s United Nations Climate Change Conference in Copenhagen, Denmark, produced fresh political momentum toward resolving various global warming problems but no concrete action on enacting a single, universal emission reduction agreement. Forecasts for a follow-up meeting set for later this year in Cancun, Mexico, suggest that the outcome will be more talk and little action on a global treaty. Revelations of shoddy, even cynical work by climate scientists add to skepticism.

Still, being at loggerheads has an upside, says L. Stephen Larkin, president of The Aluminum Association in Arlington, Virginia. “I think what this standoff and friction reflect is a good thing,” he says. “People are truly engaged in this issue for the first time. When you are really getting under the hood and trying to figure out how things work, then people do get testy, because you have to deal with trade-offs. People are going to have to put some cards on the table and put some money behind the cards, and that always makes people annoyed.”

Risks for Business

Moreover, no matter what they believe about human-caused global warming and the obligations of developed versus less developed nations, manufacturers must address the risks, if not the opportunities, arising from scientific evidence and political responses to it.

“Even for companies that are skeptical, if there is a small risk, companies are risk averse and they need to be prepared for all possible outcomes,” says James Tansey, president of the environmental consultancy Offsetters Clean Technology, Inc., in Vancouver, British Columbia.

Several conflicting business risks loom amid the global warming uncertainty: costly government mandates and fees related to mitigating greenhouse gases; reputational risk in not being perceived as “green”; disadvantages against international competitors who are unencumbered by greenhouse gas limits; delays in adapting to the eventual winners in the race for environmental friendly fuels and production methods; ill-fated reliance on traditional fossil fuels, as their scarcity and prices increase; premature abandonment of cheap and reliable fuels, such as coal; and the opportunity cost of not taking the lead marketing products to the green consumer movement.

In short, businesses, especially “energy-intensive trade-exposed industries,” in the words of government regulators, face immediate and significant risks caused simply by the global warming debate, apart from the global warming threat itself. Waiting for a conclusive global treaty on global warming to be signed, sealed and delivered before thinking about this issue is waiting too long.

A recent ranking by Ernst & Young and Oxford Analytica of risks facing business listed “radical greening” in fourth place, after the credit crunch, regulation and compliance and the recession. The category jumped from ninth place in the 2008 survey.

Ernst & Young cited the 2008 sharp rise in oil prices, which have remained historically high despite the recession. In addition, “climate and environmental concerns also pose a direct challenge to reputations and brands. Failure to be seen to be responding to climate change could have huge reputational risks for companies in high-carbon sectors and elsewhere. However, impacts on revenue and market share are just as important,” as demands increase for green buildings, cars and power generation systems, E&Y said.

More remarkable, a separate Ernst & Young/Oxford Analytica survey of risks to the insurance industry counts “climate change,” which evolves over centuries, along with “catastrophic events,” such as hurricanes and floods, happening overnight, as near-term risks to insurers: “The manner in which [insurance underwriters] deal with climate change and its impact may influence investment and financing availability in the future.”

The U.S. Securities and Exchange Commission also shed light on the issue this year in adding “climate change” as a topic that publicly traded companies should consider in making SEC-mandated disclosures of material risks. “It is neither surprising nor especially remarkable for us to conclude that of course a company must consider whether potential legislation—whether that legislation concerns climate change or new licensing agreements—is likely to occur,” said SEC Chairman Mary Schapiro in announcing the new guideline.

Message Unclear

The Ernst & Young surveys and the SEC action are just two of many developments suggesting that important climate change handwriting is on the wall. But what is the message to manufacturers trying to make business strategy decisions? It’s not clear, because critical issues are unresolved.

One solution, of course, is to end the debate through a global treaty among nations mandating reductions in greenhouse gas emissions, as the scientific consensus urges. “I think a global agreement that is enforceable, that imposes the same scheme to put a price on carbon, that ensures a level playing field around the world—that would be the most effective way to deal with this,” says Dempsey. “Then, producers who are most efficient, who can produce steel, and the lowest level of emissions per ton of steel are going to have an advantage, and that is the U.S. steel industry.”

But progress toward a genuine global warming treaty is hard to find, as the Copenhagen meeting demonstrates. Meanwhile, climate change doubters are attracting a larger audience, well beyond right-wing talk shows. “Based on my discussions with business and government leaders in the U.S. and China, these efforts are slowing,” says Deerfield, Illinois-based Andrew Rice, senior vice president for international business at The Jordan Company, a private investment firm that has had extensive investments in the Chinese coal mining industry.

“The urgency is just not there, due to the recent climate- related [research] scandals,” Rice says. Last November, e-mails leaked from a major world climate research center—at the University of East Anglia, northeast of London—casting doubt on the ethics and science of researchers who assert that global warming is a major problem caused by human activity. Several investigations were launched by the British government. “There are more people who feel the science is not decided about the role of CO2 in global warming, versus the role of the sun, ocean currents and other factors which many believe have a greater impact,” Rice says.

But the greater impediment to resolving the climate change debate is politics, not science. “I think the issue is dead indefinitely,” says David Hale, chairman of the global economic research firm David Hale Global Economics.

“The real stalemate is in the United States Senate, and I don’t see it breaking,” Hale says. “If the Republicans gain four or five Senate seats in the [November] election, I don’t see the Senate passing [climate change legislation] in President Obama’s second two years.”

Canada in Limbo

In Canada, greenhouse gas abatement appears to be more popular politically, especially in certain provinces such as Ontario and British Columbia, than in America. “The difference between the U.S. and Canada is that the provinces have been able to be far more proactive and aggressive in setting their own targets than states in the U.S.,” says Tansey. For one thing, he says, Canadian provinces have primary jurisdiction over their natural resources.

But progress at the federal level in Canada remains in limbo. “I think it has lost momentum, and that doesn’t surprise me, because it’s lost momentum in the U.S.,” says Nancy Coulas, director of environmental policy for Canadian Manufacturers & Exporters, Canada’s largest industry and trade association based in Ottawa. “We need to be able to stay in line with what the U.S. policy is going to be, because we could face punishments if we are not in line with the U.S.,” she says. On the other hand, “we need to have our own system that is right for Canada.”

Cap and Trade

A few months after President Obama took office, the U.S. House of Representatives, with its heavy Democratic majority, passed a cap-and-trade bill, the American Clean Energy and Security Act of 2009 (H.R. 2454), also known as the Waxman-Markey bill, after Democratic prime sponsors Henry Waxman of California and Edward Markey of Massachusetts. Cap and trade is a system whereby governments establish an emissions target (cap), issue permits to emitters and establish a trading market in which emitters may offer or bid for permits as they lower or fail to lower their emissions. Over time, the emission cap decreases. No action is expected any time soon on cap and trade in the Senate, where Obama faces opposition from fellow Democrats as well as Republicans.

Last fall, Democratic Senators Evan Bayh of Indiana, Sherrod Brown of Ohio, Claire McCaskill of Missouri, Arlen Specter of Pennsylvania and Debbie Stabenow of Michigan asked the administration to assess the competitive impact of the House bill on energy-intensive, trade-exposed industries, which comprise much of Midwest manufacturing.

The senators raised the specter of carbon leakage, a process by which U.S. companies with carbon emission track records shift production to countries, such as China, that do not cap emissions. One result would be a continuation of overall carbon-based dangers combined with significant damage to the economic well being of North American companies.

The White House quickly responded to the five senators, suggesting that the potential of carbon leakage is quite small in relation to overall U.S. emissions, about 1% of the U.S. emission reductions contemplated in the House legislation.

EPA Forces Action

It also makes higher interest plus fee loans more attractive. “Banks in general are looking to a secured environment,” says Parr, “They want every piece of tangible property they can get their hands on.”

The Banks Have Their Own Problems

Of greater immediate concern, not unrelated to the stalled cap-and-trade bill, the Environmental Protection Agency last year proposed to regulate greenhouse gas emissions as pollutants under the Clean Air Act of 1970. A 2007 Supreme Court decision (Massachusetts v. EPA) found that greenhouse gases were harmful pollutants under the Clean Air Act, thereby empowering the EPA to regulate in this area for the first time. Shortly before the Copenhagen summit, the EPA formally declared greenhouse gases to be a danger to Americans’ health and welfare.

In March, the agency delayed any regulatory action against stationary sources of greenhouse gas emissions, such as factories and other industrial sites, until at least 2011. Still, the EPA’s entry into the debate could remove Congress from the carbon regulation playing field. Again, several Democrats in the Senate joined Republicans in crying foul.

In February, eight Democratic Senators—Brown and McCaskill plus Robert Byrd and Jay Rockefeller of West Virginia; Bob Casey, Jr., of Pennsylvania; Mark Begich of Alaska; Carl Levin of Michigan; and Max Baucus of Montana—warned the White House that independent EPA regulation in this area “may squander critical opportunities for our nation, impeding the investment necessary to create jobs and position our nation to develop and produce its own clean energy.”

Interest groups representing U.S. business, including the AISI, have sued to block EPA regulatory action. “The EPA announcement is the attempt by the Obama administration to create discomfort for business so they will support global warming policy,” says Hale. “But this means there will be litigation. It will be very messy.”

“Under the EPA’s interpretation of the Clean Air Act, once the EPA regulates a particular greenhouse gas from one source, say automobiles, they are legally obliged to apply the rest of the Clean Air Act to emission of that greenhouse gas, which triggers regulation of greenhouse gases from stationary sources,” says AISI’s Dempsey.

That means industrial emitters will need to go through a new regulatory process when they seek to build, acquire or modernize plants, even if the results are more environmentally friendly plants. “That’s going to have a big impact on the economy,” Dempsey says.

What the EPA doesn’t have, he added, “is the authority to deal with the international implications of greenhouse gas emissions. That’s the critical issue of energy-intensive trade-exposed industries like steel and aluminum. You create an incentive for the shifting of production to overseas facilities that are unregulated.”

“We think it’s a bad idea,” The Aluminum Association’s Larkin says. “It would be better to legislate than have the EPA go through its process.”

Political realities in China are similarly nuanced, China insists it will not take the lead in capping greenhouse gas emissions or join any cap agreement that doesn’t include the United States.

China pledges to improve the environmental efficiency of its power generation and industrial production, based on carbon use per unit of output. But China’s strong rate of economic growth precludes any move away from coal-fired electricity, says The Jordan Company’s Rice.

“The bottom line is even if China takes the most aggressive plans to build out wind, solar, nuclear, geothermal, all that, coal is going to double or triple in usage, because their economy is growing 8% to 10% a year,” he says. “There is no way China can continue at that pace without coal being the driver for electricity. Any way you look at it, they’ve got a lot of coal resources. It’s cheap. It’s efficient.”

Greenhouse gas emissions probably aren’t at the top of China’s environmental priority list. China’s primary goal is to reduce its dependence on imported energy, such as oil, through energy efficiency and alternative fuel sources, says Tansey. “It’s an energy security play,” he says.

Moreover, jobs and economic growth trump pollution abatement, says Rice. Many coal-fired plants don’t use smokestack scrubbers designed to stop the release of such pollutants as mercury, sulfur and lead that hurt their domestic environment and raise domestic political concerns, he says.

“In China, they need to figure out how to reduce real pollution—pollution going into rivers and the steel plants that are belching out terrible lead and mercury,” he says. “They are at a point where they are realizing this is causing acid rain and hurting the rivers.”

Greenhouse gas is different, noted AISI’s Dempsey. “A ton of greenhouse gas emissions in China has the same greenhouse gas warming effect as a ton of carbon dioxide in the United States. This is why a global agreement is the first best solution.”

Ironically, China is the principal beneficiary of Congressional inaction, says economist Hale.

“What that means is that China is protected, because China doesn’t want to make any commitments on carbon production,” he says. “If we pass cap and trade, there will be demands from the U.S. Congress and the Europeans that China have the same policy or be subject to trade discrimination on the grounds that we have an unlevel playing field. I think China would have no choice but to comply, because they cannot have those trade sanctions. Since the United States has no policy, the danger of that has gone away.”

“Where the rubber is going to meet the road is on trade,” agrees The Aluminum Association’s Larkin. “One idea is that we make whatever changes there are going to be in climate change contingent on what other countries are going to do.”

So far, such an approach hasn’t impressed China, which formally declares climate issues to be a matter of national sovereignty and insists that all national compliance with emission reduction goals be voluntary. China in March joined forces with other major developing nations—India, Brazil and South Africa (known as the BASIC bloc)—in voicing support for the Copenhagen goals, but only as voluntary actions financed by billions of dollars of aid paid by developed nations to less developed nations.

Aluminum, Steel Required

An irony in the diplomatic standoff is that jobs and economic development, which have caused many industrial leaders and politicians to balk at a greenhouse gas treaty, stand to benefit from action on global warming. AISI’s Dempsy notes that steel and aluminum are important ingredients in the infrastructure investment needed to accommodate alternative sources of energy. The AISI estimates, for example, that a single wind tower generating energy requires 204 tons of steel and that the goal of 6% of U.S. energy from wind would require as much as 13 million tons of steel.

Increased uncertainty about global warming policy spawned by the recent recession may impede the flow of capital to the green economy. Before the recession the likelihood of government mandates was one of the forces attracting dollars into the field, according to data on U.S. venture capital investing.

In 2008, venture capital firms invested $3.98 billion in green technology enterprises, up from just $122.5 million 10 years earlier, says the National Venture Capital Association (NVCA). The 2008 amount represented 14% of venture capital investments in all categories that year.

Last year, all venture capital investing dried up along with the near halt in initial public stock offerings and merger-and-acquisitions deals. The share of green technology investing declined to 11% in 2009. Current investor disillusionment with rapid-fire boom and bust cycles in Internet-related start-ups may create interest in green technology investments that require more patience, says James Tansey of Offsetters. “There’s lots of money moving into clean tech, but people’s expectations about how quickly they’ll see that money back are more realistic than in the Internet technology boom. If you came out with a really smart perpetual motion machine, it’s still going to take years to get it [commercially viable] everywhere.”

For example, the province of Ontario earlier this year reached a C$7 billion deal with Samsung C&T Corp. and Korea Electric Power Corp., both of South Korea, for a wind and solar power generation system in Ontario. Ontario officials says the project will generate 16,000 jobs in Ontario in the next six years, including 1,440 manufacturing jobs. Venture capital appetites are just one indicator of green technology promises and risks. Likewise, industrial companies that trimmed costs during the recent recession may have funds to invest in becoming more green, if they see demand spawned by government mandates, higher fuel prices or consumer tastes.

None of these inducements can overcome competitive advantages in countries that do not join the global green bandwagon and cap their emissions. But “you’ve seen a lot of movement without it being passed into a multilateral agreement internationally,” says consultant Tansey of Offsetters.

“Every steel producer has every incentive to make its own facilities as efficient as possible so it can lower costs and be more profitable in competition with every other steel producer, domestic producers and producers offshore,” says AISI’s Dempsey. “To successfully transform the energy sector, we need steel; we need a lot of steel.”

THE PRISONER’S DILEMMA

Industrial company managers and government policy makers, regardless of their political biases, confront the same problem in the international global warming debate. It’s called the prisoner’s dilemma.

One of the building blocks of game theory, the prisoner’s dilemma presents the simple scenario in which players are highly motivated to make a regrettable choice. The typical scenario is this:

Two suspects are nabbed by police for a robbery. The police are certain they have the perpetrators, but they have no evidence other than what they can obtain as statements from the suspects. The suspects are interviewed separately. Each is told that if he squeals on his confederate while the confederate remains silent, the betrayer will go free.

What should the suspects do? Distrust between the men most likely will prompt both to betray the other and receive jail time. Even if only one suspect squeals, jail time will be imposed—on the other suspect. The best outcome for both robbers, in terms of total jail time, would be to remain silent, trust the other to remain silent and then go free.

In a speech earlier this year, Ross Garnaut, a widely recognized climate change expert in Australia, cited game theory in explaining the current impasse in climate change diplomacy.

“In the absence of communication and cooperation, international climate change mitigation has the features of a prisoner’s dilemma, leading to an outcome that is highly unfavorable for all parties,” he said.

The optimum result would be a solid global treaty, he said. But “in the absence of an explicit agreement, the best course is for each country to presume goodwill in others—action consistent with the international and ultimately its national interest—and take initial steps in line with that presumption. The likelihood of a good global outcome is then enhanced if each country taking this approach announces that its cooperative response will be withdrawn if others do not do as they announced they will do.”

Distrust at the outset will generate more global warming, bitter fights among trading partners, costly subsidies by governments to local industries and other actions designed to win the most economic payoffs for the home team despite the universal global warming threat.

Speaking for his home country, Australia, where the fight over capping emissions is intense, Garnaut offered another solution:

“Game theory suggests that Australia should take the leaders of China, the United States and other major developed countries at their word and initially set its [greenhouse gas reduction] targets accordingly,” he said. “This would be announced as a conditional target; it would be adjusted periodically, upwards or downwards, in light of the performance of others.”

One critical factor in addressing the global warming problem as a prisoner’s dilemma game is verification. In the wake of the Kyoto climate-change trade agreement, numerous organizations are gathering carbon emission data from cooperating nations and industries.

“It is hard to see any system of [greenhouse gas] mitigation being effective without each substantial country agreeing to international verification of its emissions,” Garnaut said. Each prisoner needs to know if he’s being betrayed.

—Bill Barnhart