Oil firms learn trading lessons

Most large companies appear to feel that they still have plenty of time to prepare for planned emissions trading schemes. Not so, according to trading pioneers BP and Shell. Mark Nicholls reports

Last year saw the completion of two of the most far-reaching corporate experiments in greenhouse gas (GHG) emissions trading. BP and Royal Dutch/Shell – two of the world’s largest oil and gas companies – concluded internal trading schemes designed to help them cut GHG emissions, better understand the mechanics of emissions trading and help shape the design of future, regulated trading schemes.

The good news for their slower-moving peers is that the pilots have generated a wealth of information and experience that the two firms are happy to share.The bad news is that both of them have found that bringing emissions down cost-effectively – with or without trading – is a complex business, requiring long-term regulatory certainty and, in many cases, years of preparation.

David Hone, Shell: emissions trading scheme "has further enhanced our credibility in the external climate change debate"

Emissions trading is a fast-approaching reality for thousands of companies worldwide. It was adopted by the negotiators of the 1997 Kyoto Protocol on climate change as a way to help governments and companies spread the burden of the Kyoto target: namely the commitment to reduce industrialised world GHG emissions to 5.2% below 1990 levels over 2008–12.

Since then, GHG trading schemes have been introduced in Denmark and the UK, with several others planned. And in 2005, under legislation before the European Parliament, the European Union is set to introduce a mandatory scheme covering around 5,000 industrial facilities, accounting for about 40% of EU emissions of carbon dioxide, the most important GHG.

According to David Hone, London-based vice president of climate change at Shell, his company’s experience showed that, for a 2005 start, companies have no time to waste in beginning their preparations.

“If an EU emissions trading scheme is to start in 2005, then ideally we need to know our allocation [the amount of GHGs a firm will be permitted to emit] now,” he says. “There can easily be a three-year timeline for even quite moderate [emissions reduction] projects.”

While the practice of emissions trading may be complex, the principle is simple. Emitters are allocated a number of allowances (their ‘cap’), which usually falls over time. If an emitter produces less pollution than its target, it can sell surplus allowances, which provides a financial incentive to over-comply. Conversely, those companies for which cutting emissions would be prohibitively expensive can buy allowances from those that have over-complied, ensuring the environmental goal (the overall cap) is met at least cost.

The Shell and BP schemes both followed this ‘cap-and-trade’ approach. Shell’s scheme – called the Shell Tradable Emission Permit System (STEPS) – was voluntary, attracting about 30 business units from its January 2000 start. They accounted for around 30% of the group’s GHG emissions, which stood at the equivalent of 97 million tonnes of carbon dioxide CO₂e) in 1998.

BP’s scheme was rolled out across the whole company in 2000, after an initial pilot in 1998 which covered 12 business units. Its total emissions were 90.1 million tonnes of CO₂e in 1990.

Part of the motivation for both firms was to help them meet company-wide emissions reduction targets. BP’s target, announced in 1998, was to reduce GHG emissions to 10% below 1990 levels by 2010 – a goal that was met by the end of 2001.

The trading scheme was then wound down and, in March, chief executive John Browne announced new targets for the group. It now aims to keep emissions at 2001 levels until 2010, despite a ‘business as usual’ scenario which then anticipated emissions rising by 50 million tonnes of CO₂e by that time. (New, and lower, projections are due to be announced in March, says Mark Akhurst, climate change manager at BP, following the firm’s failure to meet energy production targets last year.)

How the schemes compare
	BP	Shell
Emissions reduction target	2% below previous year's emissions, within overall taret of 90% of 1990 levels by 2010	90% of 1990 levels by 2002
Number of business units involved	12 in initial (1998-99) pilot, 112 by 2001	30
Nature of scheme	Mandatory	Voluntary
Gases covered	Carbon dioxide and methane	Carbon dioxide and methane
Average prices	2000: $7.60/tonne CO2e 2001: $36/tonne CO2e	$2-4/ tonne of CO2e
Volumes traded	7.2 million tonnes CO2e	c.4.5 million tonnes CO2e
Allocation	Grandfathered, differentiatied 'burden sharing'	Grandfathered (initially 98% of 1998 emissions), some auctioning

Shell’s target was to reduce emissions to 90% of 1990 levels by 2002. Hone says that, while verified figures aren’t fully in yet, the group is “on track”, and trading under its scheme ended at the end of last year. An announcement on new targets is also due in March, he adds.

But at least as important to the two firms as hitting their targets was the opportunity to learn how emissions trading works, and to encourage thinking about emissions management throughout their organisations. “This proved to be a very good way of raising the profile of the issue, and getting people to take action,” Akhurst says.

Under mandatory, regulated schemes, financial penalties for failing to hit targets mean that a ‘cost of carbon’ can quickly be established. Managers can use this market price to decide whether it is more economically efficient to reduce emissions themselves or to go into the market to buy allowances.

However, the design of the internal schemes meant that clear financial signals did not emerge. At BP, emissions targets were one component of managers’ ‘scorecards’, which help determine their remuneration. But, while its mandatory scheme was underpinned by shadow accounting, money couldn’t change hands between business units, because tax authorities could have viewed the shifting of profits between jurisdictions as a way to optimise the group’s tax position, says Akhurst.

As a limited, voluntary pilot, STEPS carried no penalties, and Hone admits that it was essentially like playing with “Monopoly money… STEPS didn’t provide the capital for emissions reduction projects, but it drove the prioritisation of projects”. It also gave managers a “better handle on abatement curves, and managing and forecasting emissions,” he adds.

For this reason, Hone and Akhurst caution against attributing too much significance to the prices at which GHG allowances traded. Hone says that STEPS saw prices typically within the range of $2–4 a tonne of CO₂e. As a voluntary scheme, STEPS attracted only those business units with opportunities for low-cost reductions, he notes.

BP’s scheme saw higher prices – averaging $7.60/tonne of CO₂e in 2000 and $36 in 2001 – partly because the scheme was mandatory. The sharp price rise in 2001 stemmed from an expectation, which turned out to be false, that there would be a shortage of allowances, says Akhurst.

“The market was never illiquid – there were always bids and offers [to buy and sell],” says Akhurst, “but not very many, and there wasn’t real price discovery. You couldn’t expect that without real money changing hands.”

Shell’s scheme suffered to an even greater degree from limited trading activity. While around 30 business units accepted targets, many of them traded en bloc – reflecting how they tend to operate across the range of their activities.This meant that there were effectively only seven active trading entities, Hone says.

Of more importance were lessons that can be applied to the design of governmental trading schemes. The Kyoto Protocol, once ratified, will establish an international trading regime. But industrialised country governments are also designing their own national – or, in the case of the EU, regional – markets under which GHG targets will be imposed on companies.

One of the thorniest problems governments face is how to allocate targets between the private sector, government and households, and then between industrial sectors and individual companies.

Both BP and Shell allocated emissions on a ‘grandfathered’ basis, that is, determined by facilities’ historical emissions. Shell’s target was initially simply set at 98% of 1998 levels for the three years of the scheme.

In BP’s allocation scheme, the overall annual cap declined by 2% each year, with yearly allocation between business units made on a ‘burden-sharing’ basis, which saw some face deeper cuts than others.They were also given an indication of their longer-term allocation, to help with forward planning.

However, after the straightforward ‘low-hanging fruit’ reductions were made, it became clear that a longer-term structure was required, says Akhurst. “At the end of 2001, it became apparent that we needed a futures market [in allowances] and a longer-term process for allocation ... The business units needed to start investing in longer-term options, with significant investments,” he says. An annual allocation process was simply not adequate.

Hone adds that Shell’s facilities typically shut down once every three years, to carry out large-scale maintenance, process improvements or equipment upgrades. This means that they need to know their allocation several years in advance to be able to make decisions on emissions reduction options.

Shell also learnt the importance of consistency in allocation policy.Halfway through the STEPS experiment, some participants successfully argued for an additional allocation of allowances – their unexpectedly large increases in emissions were too much for the trading system, with its limited liquidity, to deal with, says Hone.

“This destabilised the system – participants saw that you could get extra allowances by going back to the ‘government’,” he adds. “This brings uncertainty into allocation – it’s important to get it right first time.”

Other lessons that BP drew from its trading scheme were:

• the importance of standardised measurement, reporting and verification of emissions and emission reductions;
• establishing accurate baselines (emitters’ starting points against which any reductions are measured);
• engaging stakeholders in the design of trading schemes;
• keeping scheme design simple;
• getting as wide participation as possible, to maximise the options for making reductions;
• strong compliance measures; and
• clear rules on the tax treatment of international emissions trades.

So, how did the two companies benefit from their experiments with emissions trading? Both say that trading achieved what its advocates claim: it helped them cut emissions faster, and more efficiently, than otherwise would have been the case. “Without emissions trading, we wouldn’t have met our target as quickly as we did,” says Akhurst.

Part of the reason for this was that the schemes raised the profile of emissions management within the two organisations. This awareness-raising, says Akhurst, has served to transform emissions management from a concern of the group’s health, safety and environment function to an issue for all business units. “Emissions trading has moved into the business itself – these are now commercial decisions,” he says.

Akhurst adds that the programme also helped create new business opportunities. BP Energy, which manages energy use for BP’s commercial customers, is now offering an emissions management service to its customers, applying the lessons learned internally.

Hone notes that Shell’s work has increased its external clout, in environmental and policy terms.“It has further enhanced our credibility in the external climate change debate and has given us a seat at the table in terms of setting the agenda for emissions trading in the UK and [mainland] Europe,” he says.

Indeed, Shell’s public support for mandatory trading has provided valuable ammunition in recent months for environmentalists, and advocates of a rigorous emissions trading system, in the debate surrounding the design of the EU’s scheme.And Garth Edward, Shell’s environmental products trading manager, is to chair a committee that will advise the UK government on integrating its emissions trading scheme with the European version.

The establishment of external trading schemes – many of which will affect the operations of both Shell and BP – has shifted the focus of emissions trading at the two companies. Both have suspended internal trading as they begin to participate in external schemes.

BP is developing a group-wide emissions trading strategy, has joined the voluntary UK emissions trading system (which began operating last April) and is considering joining the Chicago Climate Exchange in the US, another voluntary initiative.

It is also looking at how to reduce the emissions generated by the use of its products. Half of the emissions reductions required to meet its new stabilisation target are expected to come from ‘credits’ earned through BP’s customers using less carbon-intensive products (with the rest from internal reduction measures).

Hone, meanwhile, notes that a growing number of Shell’s facilities are “taking on externally imposed targets through national legislative measures,” with Shell Expro, its exploration and production arm, joining the UK trading scheme, for example. These facilities would be unable to participate in an internal trading scheme, as allowances they bought from other business units wouldn’t be recognised by the external schemes.

Also, any meaningful extension of STEPS would have had to run for at least five years, given the need for longer planning horizons as emissions reduction projects become more ambitious.The introduction of further mandatory external trading schemes would disrupt such an extended scheme, as business units moved from internal to external targets.

Ultimately, both Hone and Akhurst believe that their firms’ experiments with emissions trading have placed them in a good position as mandatory trading schemes are imposed around the world.

Nonetheless, Hone warns that even Shell, with a head start on many of its peers, cannot afford to take its eye off the ball when it comes to its GHG emissions: “STEPS has made a lot of people really think about the dynamics of the whole system – and it’s made them realise that the challenge is still significant.”