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<p align="left"><font face="Arial"><strong><small>About The Author:<br>
<br>
</small></strong><span lang="X-NONE" style="color: black"><font size="2">
ROGER FELDMAN, Co-Chair of Andrews Kurth LLP Climate Change and Carbon
Markets Group has practiced law related to the finance of environmental and
energy projects and companies for 40 years. In particular, he has analyzed
and executed a wide variety and substantial value of project financings. He
chairs the American Bar Association’s Committee on Carbon Trading and
Finance, serves on the Board of the American Council for Renewable Energy,
and has been a senior official in the Federal Energy Administration. He is
a graduate of Brown University, Yale Law School and Harvard Business School.</font></span></font></p>
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<img src="../images/feldman.gif" alt="Washington Viewpoint by Roger Feldman" border="0" width="375" height="75"><p align="left"><b><u><br>
July 2008</u></b></p>
<p align="center"><font size="6"><b>The Road to Avatar</b></font></p>
<p><strong>by Roger Feldman --
</strong><b>Andrews Kurth, LLP</b><strong><br>
</strong><font face="Arial" size="2">(<em>originally published by PMA OnLine
Magazine: 2008/09/01</em>)<br>
</font><span style="font-size: 10.0pt; font-family: Palatino; color: black">
</span></p>
<div>
<p class="BodyText05SS"><span lang="X-NONE" style="color:black">The
received wisdom is that, after the new president is installed, the
desire to establish a “cap & trade” system for carbon regulation will
resume. </span></p>
<p class="BodyText05SS"><span lang="X-NONE" style="color:black">If so,
among other things, the nation will have embarked on a great computer
video game, with carbon credits as avatars, electronic images
manipulated on a screen. A new kind of “currency” to be played online
will be official. The Simms game will be old news. The result will be
even more sweeping than the last game we played, called “Deregulation,”
which was intended to use trading in the service of more efficient
industry structuring. Indeed, the social and technological fervor for
cap and trade is great. It is effectively the energy policy cornerstone
of the McCain campaign and a preeminent plank in the Obama platform as
well. We are on the Road to Avatar.</span></p>
<p class="BodyText05SS"><span lang="X-NONE" style="color:black">This is
not to say that establishing some global climate change management
system is not a vital objective. It is to emphasize the need to shine
the spotlight on these key questions of how its governance will work.
In particular it requires examination of the ramifications of the
allowances/offset methodology, explicit in Kyoto and proposed for the
U.S. (for example in the recent. Lieberman-Warner legislation): The key
questions are:</span></p>
<p class="BodyText05SS"><span lang="X-NONE" style="color:black">
(1) What offsets may be generated -- where and by who?</span></p>
<p class="BodyText05SS"><span lang="X-NONE" style="color:black">
(2) How are these “offsets” differentiated from “allowance”?</span></p>
<p class="BodyText05SS"><span lang="X-NONE" style="color:black">
(3) Who’s in charge of overseeing the trading of these new
virtual embodiments of real value?</span></p>
<p class="BodyText05SS"><span lang="X-NONE" style="color:black">If the
answers to these questions are not reasoned and effective ones, a cap
and trade program is subject to the possibilities of practical
non-functionality, fraud, and ultimately loss of public respect. </span>
</p>
<p class="BodyText05SS"><span lang="X-NONE" style="color:black">First,
some context. Offsets reduce the need for “allowances,” or authorized
pollution rights. They are purchased from third party providers to
reduce cap compliance requirements, <i>i.e.,</i> they are payments for
the privilege of continuing to emit greenhouse gases. Under Kyoto,
offset projects are located only in listed developing (presumptively
poorer) nations. Building windmills there instead of coal-fired power
plants is deemed to net--from a global perspective--reduction of GHGs.
One key problem is that, until 2012, at least, those “poorer” nations,
with pollution productive offset capability include some fairly
non-intuitive locations: China, India, South Korea, Brazil.
Nevertheless, or perhaps because of this fact, not insignificant product
finance businesses have arisen to exploit opportunity to meet the
defined “need.”</span></p>
<p class="BodyText05SS"><span lang="X-NONE" style="color:black">With
that development has come criticism of the offset scheme’s imbalances.
We find <u>Wall Street Journal</u> articles with headlines like “French
Firm Cashes in Under UN Warming Program,” highlighting destruction of
GHG nitrous oxide (laughing gas)--which is a byproduct of nylon
manufacture--in South Korea producing more money for the manufacturer
than the product itself, at a capital cost far below the offsetter’s
allowed Kyoto market revenue return. And other such articles about
special-purpose securities firms, set up to generate offset credits,
shaking the foundation of trust in the Avatar by promising more credits
than the UN administered system had, in fact, been able to provide them.</span></p>
<p class="BodyText05SS"><span lang="X-NONE" style="color:black">We’d
like to believe that can’t happen here. The U.S. model seems slated
(based on models to date) to have narrower identification of permissible
offset production sources, to limit utilization of non-U.S. offset
credits significantly, and to establish parameters for use of
pre-legislative voluntary credits.</span></p>
<p class="BodyText05SS"><span lang="X-NONE" style="color:black">All that
said, it will have one new notable flaw; it will make it harder for the
potential producers of emissions to also be producers of offsets. That
is because the capped points of emissions baselines per Lieberman-Warner
will be coal-fired electric plants (downstream), natural gas/NGL
processors or importers (upstream), petroleum or coal-based liquid
producers or importers (upstream). It is these producers who will
receive the allowances which are the primary currency of “cap and
trade,” and purchasers from these primary sources cannot create carbon
offsets by installation of further abatement devices. This is intended
to prevent double counting. It also promises to shrink the possible
sources of offsets considerably, and the range of opportunities for
third party capital offset development. Investments by regulated
producers in pollution abatement will be confined very likely to be
applied against the requirements of their own facilities. </span></p>
<p class="BodyText05SS"><span lang="X-NONE" style="color:black">A number
of questions remain to be answered definitively. Will a secondary
market for allowances that are received (or acquired in auction), but
not applied to emission reductions, be tradable? (And, assuming so,
regulated? By whom?) As a practical matter, will emission caps be set
so that allowances are, in fact, available for that purpose? Could
there develop a “mega-allowance” market specially for firms financing
“excess” GHG reductions (the value of which could be measured in terms
of displacement of the costs of emission reductions that otherwise would
have to be achieved by a third party to comply with the emissions cap?
</span></p>
<p class="BodyText05SS"><span lang="X-NONE" style="color:black">Whatever
the ultimate resolution of these questions, it is clear that two key
distinctions will be important in Avatar-land: (i) the line between
qualifying offsets and allowances, as well as (ii) which entity is
responsible for the trading of each of the commodities. </span></p>
<p class="BodyText05SS"><span lang="X-NONE" style="color:black">
Responsibility for fine tuning the allowances/offsets distinctions could
be, as some proposed legislation has suggested, the bailiwick of a new
“Carbon Board,” the same entity slated to be responsible for decisions
related to the administration of the allocation of allowances. It
doesn’t take imagination to recognize that many other agencies would
like to weigh in, in this regard.</span></p>
<p class="BodyText05SS"><span lang="X-NONE" style="color:black">The
issue of jurisdiction over trading is generally perceived as the largest
one, because the possibility of another “Enron” fraud situation looms
over it. There is no shortage of proposals for regulation in this
regard, or hunger on the part of agency empire-builders. The
definitional questions “merely” raise issues as to whether the
regulatory system will efficiently generate means of dealing with the
planning problems which the definitional questions will present. </span>
</p>
<p class="BodyText05SS"><span lang="X-NONE" style="color:black">One
category of anti-manipulation approach reflected in proposed legislation
would thrust the EPA into the business (although perhaps limit its role
to the regulation of initial emitters). Other proposals would focus on
adapting and imposing the discipline of the SEC’s and FERC’s respective
anti-manipulation rules, and involve those agencies in the regulatory
process. However, GHG credit futures contracts are still, by many
common reckonings, a Commodities Future Trading Commission (“CFTC”)
bailiwick--as distinguished from “securities” regulated by the SEC.
Tortuous lines have been worked out over time between those two
agencies. CFTC currently regulates the commodities exchanges, like
NYMEX, which offer emission allowance futures, options, and swaps
contracts. </span></p>
<p class="BodyText05SS"><span lang="X-NONE" style="color:black">This
clearly represents an issue which is being debated. One Congressional
response is the Lieberman-Warner legislation for a “Carbon Market
Working Group,” wherein wise agency heads confer and allocate
jurisdiction over aspects of the overall problem. This, however, is a
board game solution for the largest and fastest moving potentially
global video game ever invented. </span></p>
<p class="BodyText05SS"><span lang="X-NONE" style="color:black">In
reality, the two substantive problems regarding the creation of the new
carbon trading market--what will be traded and how it will be
regulated--have significant substantive impact on each other. Overall
system regulation needs to be thought through and executed as a whole.
The impacts on the overall U.S. economy of the imposition of GHG cap
and trade are too great for patchwork repair of jurisdictional authority
over time. </span></p>
<p class="BodyText05SS"><span lang="X-NONE" style="color:black">“The
Road to Ishtar” was a colossal comic movie failure, with a host of the
greatest stars, and a plot that left the studio heads doubled over and
willing to absorb horrendous budget overruns. Particularly at this time
in the U.S. financial and industrial history, the country cannot afford
a video game rerun of that movie: “The Road to Avatar” which reviewers
ruefully dismiss as a madcap romp. </span></p>
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<p class="MsoBodyText" align="left" style="margin-bottom:0in;margin-bottom:.0001pt;
text-align:left"><font face="Arial" size="2">
<span lang="X-NONE" style="color: black">ROGER FELDMAN, Co-Chair of Andrews
Kurth LLP Climate Change and Carbon Markets Group has practiced law related
to the finance of environmental and energy projects and companies for 40
years. In particular, he has analyzed and executed a wide variety and
substantial value of project financings. He chairs the American Bar
Association’s Committee on Carbon Trading and Finance, serves on the Board
of the American Council for Renewable Energy, and has been a senior official
in the Federal Energy Administration. He is a graduate of Brown University,
Yale Law School and Harvard Business School.</span></font></p>
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