Spring 2002
Trading Effluence
Photos by Terry Faust
The aims of Wall Street and the goals of environmentalists are rarely seen as one and the same. Short-term profits are pitted against long-term conservation. But economist Richard L. Sandor believes in the power of capital markets to address environmental blights. Air pollution, global warming, desertification, vanishing species--there's hardly a problem that good old cost-cutting, profit-making thinking can't solve.
Take, for example, acid rain. "When's the last time you read about acid rain as a problem in the U.S.?" Sandor asks, exhuming a subject that regularly made headlines in the 1980s for its suspected role in causing lung disease, killing lakes, and licking paint off cars. But in 1990, Congress passed the Clean Air Act. As part of this aggressive move toward cleaning up sulfur-dioxide emissions, the major cause of acid rain, lawmakers authorized "emission allowances" trading at the Chicago Board of Trade. Sandor, widely known as the father of interest-rate derivative markets and then a member of the board, had dreamt up such trading as a way of yoking environmental and financial values.
Emissions quid pro quo
Emission-allowances trading gave companies that might have difficulty reducing pollution levels the ability to buy "credits" from companies that could do it more easily. The theory went like this: Company A, a manufacturer with old plants and outdated technology, must spend, say, $100 for every "unit" of pollution reduction, whereas Company B, a more agile company using new technology, discovers it can reduce pollution at its facility by the same amount for $10. If both companies must reduce pollution by a unit each, the total cost for a two-unit reduction would be $110. But if the aim is overall reduction of two units, it could be done for as little as $20 total. How? In exchange for cash from Company A, Company B agrees to reduce its emissions by a two units, rather than just one. Assuming Company B is willing to sell a unit reduction for less than $100, Company A has great economic incentive to buy such a "credit."
Trading emission credits has proven an astonishing success, Sandor says. "The Environmental Protection Agency says there are a couple billion dollars of allowances traded each year in their registry, and we reckon that there's a similar amount of derivatives traded, which is not part of their registry. So the size of market is one piece of evidence" of the program's success, he says. "The real significant evidence is that [sulfur-dioxide] emissions are well below where they were in 1990 and even below where they were targeted to be after the institution of the program." EPA estimates put the cost of the program at no more than $2 billion, while the benefits--in saved medical costs and other measures--range from $15 billion to $40 billion. "So the costs of the program have been very small relative to the benefits," Sandor says, adding that his critics initially claimed that reductions would be minimal and costs too high.
In some part, the program owes its existence to the University of Minnesota, where Sandor received his Ph.D. in economics in 1967. "Those were the halcyon days of Walter Heller," Sandor says of his decision to move to the Twin Cities. The much-hallowed professor and adviser to Presidents Kennedy and Johnson had added luster to the department's profile. "It had a good reputation for theory as well as public finance--and they were subjects that interested me," Sandor says.
Photo by Diana Watters
At Minnesota, Sandor also met classmate Jon Goldstein, Ph.D. '67. The two kept in touch after graduation, and in the 1980s, Goldstein, a senior economist with the Department of the Interior, urged his old friend to apply to environmental problems his talents in creating new economic markets. (Sandor had already brought derivatives to the agricultural, insurance, and utilities sectors.) Rising to that challenge, Sandor saw that his "credit" ideas could be applied to a wide range of environmental problems. "As a student of research and development, I think we've only just begun," he says, noting that the same concepts can be applied to water usage, endangered species, and other matters.
Today, Sandor has his eye on greenhouse gases. Last year, he helped found the Chicago Carbon Exchange, and he hopes trading will be up and running later this year or in early 2003. Among the major industry and nonprofit entities backing the concept are Ford Motor Company, International Paper, Mexico City, and the Nature Conservancy. And Sandor, chairman and chief executive of the Chicago-based boutique trading firm Environmental Financial Products LLC, plans not only to watch trades, but to make them as well. As with sulfur-dioxide, he expects his firm will buy and sell hundreds of millions of dollars worth of allowances.
And although the United States recently abandoned plans to sign the Kyoto Protocol, a treaty limiting production of greenhouse gases--carbon among them--Sandor says many multinationals and American companies remain interested in taking steps toward reducing greenhouse-gas pollution. "We seem to have found a latent demand for people to want to be involved," he says. "They're beginning to recognize that their shareholders and consumers want them to have a sound environmental policy."