By Matthew Varilek and Neil Cohn

Introduction to the Greenhouse Gas Market

The existing greenhouse gas (GHG) market encompasses many different types of projects - from solar rural electrification to tropical forest conservation. Landfill methane projects are particularly common right now. Trades of landfill gas (LFG) are attractive because the emissions reductions are measurable, verifiable, and available. Many of the 318 operational LFG projects in the United States are looking closely at the potential value of their emissions reductions, and future projects are adding reduction credits into contracts to sweeten the negotiations process. Additionally, landfill gas (LFG) companies are pursuing GHG transactions to comply with voluntary commitments, gaining market advantage as being environmentally responsible, and providing long-term risk management. Firms are investigating a variety of transaction types, including the sale of "banked" credits, direct investments in mitigation projects, and the purchase of options on future credit streams from a project or a company. In this article, Natsource, a broker of GHG reductions and other energy products, provides advice to parties interested in conducting transactions in the emerging GHG market.

- Shelley Cohen, LMOP program manager

ith visions of dollar signs dancing in their heads, many landfill owners and LFG developers have recently been turned on to the prospect of selling GHG emissions-reduction rights resulting from the capture of landfill methane. Landfill owners are right to be inquisitive, as the prospect of this additional source of revenue could significantly alter the economics of the solid waste industry. But taking advantage of this possibility is not as simple as metering methane and cashing in. Nuances in the GHG market create distinctive requirements from the perspective of potential buyers. So, like any good salespeople, landfill owners and LFG developers must pay close attention to their potential customers’ needs if they hope to capture revenue in the GHG market.

Why Buy?

For sellers, the lure of additional revenue offers an obvious reason to participate in GHG trading. But given the uncertain state of climate-change negotiations, buyer motivation might not be so clear. These motivations are what drive demand for emissions reductions and thus are essential for prospective sellers to understand.

Many large sources of GHG emissions that may face some sort of emissions constraint in the future have taken, for the moment, a wait-and-see attitude toward climate change. Other companies, however, are less sanguine. They believe that some form of GHG regulation is inevitable and that the existence of this possibility constitutes a real and present business risk that managers have a fiduciary responsibility to address.

In this context, the need for likely affected sources to mitigate their risk of future compliance costs becomes more apparent. Emissions trading, whereby one source offsets its own emissions by purchasing rights to emissions reductions achieved by others, provides a way for companies to reduce their costs of compliance at no cost to environmental quality. Buyers of GHG reductions, then, are seeking to insure themselves against risk by offsetting a portion of their overall emissions liability.

The Commodity

Because a regulatory framework does not yet exist, buyers are not sure what exactly they should be preparing for. Though some guidelines exist, there are few hard-and-fast rules about what types of activities may generate government-sanctioned reductions, how such reductions should be verified, where they must be registered, to whom they may be transferred, and so forth. Consequently, what is traded in the existing GHG market differs from the currency of existing legislated emissions trading systems such as those in the US for SO₂ and NO_x.

Whereas participants in legislated systems trade legal authorizations to emit, participants in the GHG market exchange "rights and data associated with verified emissions reductions that may constitute a claim against future compliance requirements." In other words, a seller transfers to a buyer ownership of the change in GHG emissions from a specific activity, and this carries only a possibility - but not a guarantee - of government recognition under some future regulatory regime. The implication of this nuanced definition is that a direct relationship exists between the prices that buyers will pay and the likelihood that their "rights and data" will eventually count toward their future compliance requirements. Thus, buyers naturally prefer reductions with a high probability of government recognition.

Buyer Criteria

In the absence of strict GHG trading rules, buyers have taken cues from other emissions trading programs and the latest developments in climate-change policy to identify the characteristics of desirable emissions reduction offers. One of the first criteria that buyers use to screen offers, namely that real reductions occur as a result of a specific and identifiable action, bodes particularly well for landfill owners. Not only is it clear that the capture of landfill methane constitutes a specific and identifiable way of reducing emissions of a potent GHG, it is also likely in most cases to earn government recognition because the resulting reductions are so readily apparent.

Landfill owners and LFG developers interested in selling GHG reduction rights should consider how they can address the following additional buyer criteria:

• Reductions must be measurable by a mutually acceptable, transparent, and replicable calculation methodology.
• Reductions must be surplus, or additional to reductions required by existing laws or regulations.
• Reductions must be verified by an independent third-party auditor such as an engineering or accountancy firm.
• Ownership of the reductions must be clearly defined, such that the seller is authorized to transfer all legal claims on the reductions.

Other factors may affect the desirability of offers to sell GHG reduction and, therefore, how much buyers are willing to pay:

• The reduction’s vintage, or the year in which the reduction occurs, affects the likelihood of their being recognizable for future compliance requirements.
• Some buyers are willing to pay now for emissions that either already occurred or will occur in the future, while others prefer to purchase call options, a type of financial derivative that provides the buyer with the right, but not the obligation, to purchase actual reductions at a fixed price by a fixed date in the future. Call options tend to be the preferred offer structure, as they allow buyers to mitigate their compliance exposure for a minimum initial outlay.
• The seller’s creditworthiness affects buyers’ willingness to accept risks associated with delivery of future reductions. Risks include the possibility of seller bankruptcy or default.

Taking Advantage of the Emerging Market

Landfill methane projects may be very attractive to potential buyers of GHG reductions. Therefore, the emerging GHG trading market is worth exploring as an avenue to improve project economics. Still, potential buyers of GHG reductions, in contrast to those in more liquid, mature emissions permit markets, might need to know more about offers than simply price, quantity, and vintage. While addressing the buyer concerns described above might seem a daunting task, qualified professionals stand ready to guide sellers through the process.

Matthew Varilek is an analyst with Natsource’s Advisory Service Unit, and Neil Cohn is a GHG broker with the Natsource Emissions Brokerage Desk.

MSW
Nov/Dec 2000