We have talked at length on previous episodes about the flaws in compliance markets. And the team at Nori obviously believes in voluntary carbon markets, as we’re building one ourselves.
But there’s a wide range of quality among voluntary markets, and the space is 1,000 times smaller than the compliance programs in progress around the world.
So, have cap-and-trade markets contributed to a meaningful reduction in emissions in spite of their flaws? And are compliance markets the only way to address carbon emissions at scale?
Michael Azlen is the Founder and CEO of Cabon Cap Management LLP and Co-Portfolio Manager of the World Carbon Fund. On this episode of Reversing Climate Change, Michael joins Ross and guest cohost Aldyen Donnelly to explain how he got interested in carbon as an asset class and share his take on the benefits of compliance markets.
Aldyen offers insight on the two compliance market models, describing the problems associated with programs modeled after the SO2 Allowance Market—and why she prefers the framework of the Montreal Protocol.
Listen in to understand how Michael thinks about regulating voluntary carbon markets and why he is optimistic about the global growth in compliance markets despite their imperfections.
Resources
Become a paid subscriber of Reversing Climate Change
Follow the Reversing Climate Change podcast on LinkedIn
Climate-Crypto, COP26, and Carbon Accounting Rules on Reversing Climate Change S3EP1
Michael’s Paper on Carbon as an Emerging Asset Class
The US Acid Rain SO2 Allowance Market
Cross-State Air Pollution Rule
The Regional Greenhouse Gas Initiative
California’s Cap-and-Trade Program
California Scoping Plan Documents
Full Transcript
Alexsandra Guerra: You’re listening to the Reversing Climate Change podcast by the team at Nori, the carbon removal marketplace. This is a show about the innovators and entrepreneurs developing solutions to climate change.
Ross Kenyon: Hello and welcome to the Reversing Climate Change podcast with Nori. I’m Ross Kenyon. I’m Nori’s creative editor, Aldyen Donnelly, back again, a co-founder of Nori, but now acting as an advisor to us. Aldyen is currently acting as carbon markets advisor to Alice Canada, Terra Merit Inc. And the Livestock Carbon Exchange. Thanks for being back, Aldyen.
Aldyen Donnelly: Thanks for having me.
Ross Kenyon: It’s good to have you. I needed you for this one. A longtime listener, hope you don’t mind me saying, Michael Aslan, CEO and Co-Portfolio Manager of Carbon Cap Management LLP. Mike, we’ve known each other for a very long time. And I think this recent show we did with Aldyen about the state of carbon markets, I don’t want to say rankled, but you wanted a chance to defend the honor of compliance markets. Is that a fair assessment?
Mike Azlen: Yeah, listen, Ross, as you say, I’ve been a longtime fan and follower, both of the Reversing Climate Change podcast, which is, you know, I think an absolutely excellent product, but also Nori and the fantastic stuff that you guys at Nori are doing. I met Paul at a conference a couple of years ago and have been engaged with you guys ever since and just love the interaction of listening to the great topics that are covered on the podcast. So it’s wonderful to be on.
Ross Kenyon: That’s so nice to hear. And I’m happy to give you a chance to go from listener to podcast guest. That’s always fun for me to get to share that with someone. Mike, I think we should start with your story. I think listeners probably know a lot about Aldyen since she’s been on so many times. Why don’t you tell us a bit about how you got into this space, what you’re doing now, and then from there, we’ll dive into the meat of this topic.
Mike Azlen: Sure, sure. So I’m like Aldyen, I’m a Canadian. I have been living though in London for now 25 years. I did my graduate degree at London Business School and actually I’ve been teaching now on the graduate degree program for 18 years. And one of the things I teach is the impact of climate change for asset managers and asset owners, which is a very fast moving area in the academic literature. Professionally, I’ve been in the investment management industry for most of my career, eventually started my own investment management business, was fortunate to grow that business to a nice profitable size and then achieve an exit and sell the company.
And after a two and a half year earn out period, I became interested in researching climate change. Interestingly, a bit of a skeptic at the beginning. I’m very empirically focused and data driven in terms of how I see the world. So I began my research by reading peer reviewed academic papers on the science of climate change. After reading about 50 papers, I was convinced that a Problem was acute and very serious and B, it was certainly anthropogenic. In other words, it’s humans that are causing it. I didn’t know what to do at that point.
So I enrolled at LSE and they have a high level program on the economics and governance of climate change here in London. And in that program, I was exposed to carbon markets as a policy solution. And that’s where really my journey began. I was curious about the statistical properties of carbon. At the time it was trading about half a billion dollars per day. And I was amazed by this across different carbon markets in the world. So I hired a PhD student from the LSE and we have written a full academic paper, Ross, on carbon as an investable asset, as well as a policy instrument to address climate change.
And the CFA Institute has picked up that paper and published it. And how I got to where I am today is I presented that research at a conference and the CEO of a Swiss private bank approached me and ended up backing me. To put together a team and to launch our current climate change impact fund. It’s called the World Carbon Fund, which invests into these different carbon markets with a goal of achieving attractive returns for investors while also having a direct impact on climate change. And today we’re a team of nine people and we’re managing about $100 million in that fund.
It’s been very successful over its first two years, a return of about 70% over that period. So that’s in a nutshell, my journey.
Ross Kenyon: Aldyen, I wonder if I could pass it to you to explain what a compliance market is. And then Mike, I’ll give you a chance to respond if you think Aldyen missed anything.
Aldyen Donnelly: When it comes to environmental and social goals and objectives, Governments often set policies, the goal of which is to typically clean up our global supply chains to reduce pollution. And historically, when governments have done that, they end up often creating regulations that identify certain sectors or facilities or types of product suppliers, as they call them in regulations, obligated parties. So under the rules, They are entities that have a legal mandate to report their emissions and to reduce them over time. Often those compliance rules also give sectors or facilities that are not covered by what we call compliance caps the option to voluntarily opt in to the compliance market.
So every time this has been done in the past, Not all sectors are covered by the mandate, but over time, sectors that are not covered by the mandate have the opportunity to opt in and supply credits or allowances in the compliance market. So I should say upfront that I believe that the path we are going down ends up with the adoption of a compliance market approach, That includes that opt-in, so certain sectors won’t be covered by mandates, but will have the opportunity to opt-in to the compliance markets if they wish to.
I will argue that our history shows us two different compliance market models. One I will call the U. S. acid rain SO2 allowance market model. The other I will refer to as the Montreal Protocol model. And every time since 1960, We have adopted the SO2 allowance model. It has failed. And every time we’ve adopted what I’m calling the Montreal Protocol model, it has succeeded. So I’m arguing in favor of compliance markets with voluntary opt-in provisions, but I am suggesting that the way we’re doing it now can’t be made to work and that there is a way to do it that can be made to work and has worked every time we’ve tried it.
Ross Kenyon: Mike, I think there’s a lot of good bait in there for you.
Mike Azlen: So thanks, Aldyen. And there’s some really good stuff. I just wanted for the listeners to just run through kind of a generic, the generic outline of how a carbon market works, and then maybe provide a little bit of context about what is happening with compliance carbon markets today and their growth around the world and their scale. So Just coming to the really simple way to envisage this, the objective of a compliance carbon market is, it really is two objectives, to cap and lower emissions. That’s objective one. And number two is to achieve that at the lowest possible impact.
How does it work? It’s a regulated system that’s run by the government and it has mandatory inclusion. So any entity, for instance, in Europe or in California that has emissions above a threshold, that entity is then notified by the government to be included in the program. And when you’re included, you don’t have a choice. It means you’re going to be audited. And these are the big emitters. The government audits them and they have a requirement. They have to give the government allowance permits. So not carbon credits and not carbon offsets.
They have to give allowance permits to the government that match their prior year emissions. So that’s the compliance side. How do they get these permits? Well, normally the permits are auctioned. In some cases there’s a free allocation and we should come back to that. But the way for people to think about this is there’s an auction. The government sells the permits at auction and the total supply. That is sold at the auction. Every year we drop the supply of permits. So that means that we’re playing musical chairs and every year we pull out a chair so there are less permits.
So we know with some level of certainty. Thank you very much. Of a cap-and-trade system because the government controls the quantity of emissions, permits, but the government lets the market determine the price. And this is crucial, Ross, because if you have a market that is liquid, where that price signal, so when the carbon price hits it, like in California, $25 a ton, that price is then internalized Internalized by those thousands of companies. And what we want to happen is we want each company to do the calculations with their engineering team to say, hey, at $25 a ton, it now makes sense for us to issue solutions.
And as long as you have liquidity in the market, what you have is you think about in some ways, Some markets you have steel, cement, chemicals, and all these different industrial emitters. Each of them will have a different cost where it makes sense for them to abate, to cease emitting. And what we want to do with a carbon market, of course, is pick The low hanging fruit. We want the company with the lowest possible cost. Indeed, we want them to make the decision to abate. And that is what a carbon market achieves as we lower that, as long as you have liquidity and price discovery.
Two other really, I think, important points. By having a liquid price on a ton of carbon in a market, if I’m a venture capital investor and someone brings to me a piece of low carbon intellectual property or technology, I will back that business. I will back that entrepreneur with the low carbon tech. Why? Because I have a pathway to monetize. There’s a pathway to monetize because if that new scrubber is put onto the factory and reduces emissions, that has a real impact. On revenues and costs, there’s a pathway to monetization.
And my final really interesting point, carbon markets, a carbon permit does not expire. And therefore, you have companies in Europe, this is very common, big electric utilities, they sell their electricity forward. And then they’re able to buy coal and gas in the forward market and carbon and effectively hedge their forward margin. Quite interesting how the commodity market serves this purpose of allowing some of these companies to plan over multi-year cycles on how they decarbonize and hedge. And the last point is the auction revenues. So in most carbon markets, and it does vary a little bit, but in most carbon markets, the government now sells the permits to the polluting entities.
Is segregated from tax revenues and it is earmarked and reinvested in energy efficiency and low carbon initiatives. So when you step back from the mechanism as I have, and I know, you know, listen, I’m more of a theorist. Aldyen has built and managed these systems, so she knows the real workings, and I’m sure, and it certainly hasn’t been all roses for markets, but if you think about all the ways that those elements that I have now explained, how Once you fully understand that, it is indeed a very, very powerful and I think elegant mechanism to address climate change and one of the few that can do it at scale.
And we really do have an issue of addressing emissions at scale in a very short time that we have remaining.
Aldyen Donnelly: So Mike, I’m totally on side with the theory of carbon markets, as you just stated it. The question is, what is the certificate or the instrument that is traded in those markets? And does it truly have any underlying greenhouse gas reduction value? And I would argue that at least for now in the existing carbon markets, and we can continue to use California as an example, the truth is Those allowances that are being traded have at most best case scenarios, some of those allowances that have a face value of one ton have an underlying greenhouse gas reduction value of anywhere between zero and a third of a ton.
And there are other environmental markets where the certificate that’s been traded is a much more secure and real representation of progress towards the emission reduction goal. When we talk about the idea that government creates permits to pollute, so those are emission quota permits, worldwide, in every case, initially, government freely handed out 90% of the permits they created And sold only around 10%. And most governments are, as you suggested, in the process now of increasing the percent of total permits that they issue that will be sold as opposed to freely allocated to companies.
But when you look at all of the plans to sell more and to reduce the permit supply that are in place worldwide in developed economies, so mostly Europe, California, The US Reggie states the total permits being created, so freely allocated and sold, combine to exceed the maximum physical capacity of the regulated emitters to discharge greenhouse gases through 2027 or 2028. So we don’t start, we don’t stop building the backlog of surplus permits until after 2027 and how long it’s going to take to Deplete that backlog of permits that don’t have any true underlying greenhouse gas reduction value is unknown, at least to me.
So how do we deal with this situation that worldwide, we have a backlog of billions, and it’s hard to get an exact number, but it is more than 5 billion existing permits that are being traded with a face value That suggests they represent one ton of reduction that have zero underlying incremental reduction value. So we only have one of two paths forward to pursue here. One is, or maybe three. One is to, for some reason, encourage people to buy and retire those permits to wipe out the backlog, but they’re not getting any greenhouse gas value out of that exercise.
They’re just increasing, bringing forward the date at which the remaining permits will have real value. Or we say, okay, let’s substitute a Montreal Protocol type market for this emission quota market that we’ve built and has gone offside. I can go into more detail about why those statements are true, but there’s a lot there. I also just want to add, it’s kind of weird that the perception, wide perception out there is that government issued permits, are valid and have a real underlying value of one ton when it’s easy to demonstrate that most of them don’t.
While at the same time we’re saying offset markets and carbon sequestration markets are not reliable because it’s too hard to prove that farmers and ranchers and forest managers are preserving carbon in a solid form in ground and plant systems. In all of the regulated markets, including California’s, if I’m an electric utility and I emit less than what California calls the benchmark, a greenhouse gas per megawatt hour of output threshold, then I get free permits equal to the difference between what I emit and that benchmark. And I get those free permits and those permits trade as if they represent a real emission reduction.
Even if I flipped the coal that I did not burn into a secondary market and that coal got burned this year. So in the existing compliance markets, and I want compliance markets just different. In the existing compliance markets, an electric utility gets to claim they created a permanent long-term emission reduction when there was no retention of any carbon in any terrestrial storage. But we’re saying we can’t trust or issue credits to farmers who we know have drawn CO2 out of the atmosphere and built up carbon in soils because we can’t be sure they’ll retain that carbon for 100 years.
So my question is, why are farmers and ranchers being held to a standard we’re not holding oil producers or electric utilities to? And why are we perceiving that the natural systems market can’t be trusted? It’s hard to get them to commit to retain the carbon for 100 years when we don’t ask the electric utility or oil company to retain any carbon for five minutes.
Mike Azlen: So much in there. A couple of little notes that I just wrote down. So one first has to say, you know, again, Aldyen is so knowledgeable on this topic, having actually been in it. I, on the other hand, have simply reviewed in the case of the academic literature around this topic and the empirical studies. And, you know, so I can only put forward my knowledge from that perspective. So I say that is, you know, definitely, you know, somewhat limited. But based on that and based on what I have read, a couple of things.
First, that the sulfur dioxide program, which was the forerunner to today’s cap and trade carbon markets, in my view, a wide span of empirical studies of that market deemed it to be a Both in quickly reducing sulfur dioxide emissions and in doing so at extremely lower costs than was expected. So it was seen as a success. On the back of that success is why Europe, in And certainly Aldyen is absolutely correct. When a carbon market launches, you can imagine industry is so nervous about this additional cost of operating their business.
Most governments say to industry, listen, guys, don’t worry about this. It’s going to be very incremental. And the industry says, well, what do you mean? And the government says, we’re going to look at your last three years emissions in your steel factory. And if your average emissions were a million dollars, Tonnes per year. On year one of the program, we will just give you a million permits. And then at the end of the year, we’ll audit you. And if your emissions are a million, you just give the permits back to us and we tear them up.
So, you know, that’s how most of the programs work. Now, compliance markets, there’s been so much learning. And in my perspective, looking at the whole cycle, The mistakes and errors, and there were big errors and mistakes made during the financial crisis, which was promulgated by a number of factors. I listened to the last podcast with Paul and it gave me a new take on some of the things that caused that. But that certainly when we had a recession, emissions declined and they still handed out the same size of free allocations, albeit lower.
So the linear reduction factor is about 2. 2% a year in Europe, which, by the way, they’re now with the new Fit for 55 legislation, they’re looking at reducing emissions. The annual reduction in permits by 4. 2 percent. Of course, in California, it’s currently 4. 5. In the Reggie states, it’s 3. 5. So every year, the supply of those permits keeps going down. But certainly, Aldyen is correct. The recession in 08, when they were giving it all out as a free allocation, created a huge overhang. Now, this is why we have to have these scoping reviews in these markets.
And so in Europe in 2017, after a long consultative period, they decided to remove that oversupply systematically by calculating the And then they take out 24% a year for five years of that overhang to reduce the overhang. And really, since they have done that, of course, the carbon price has risen tremendously because the market’s become A lot tighter in terms of the comparison of supply and demand. And of course, really what stimulates abatement activity is the price signal. Obviously, the veracity of the overall program, the fact that you have audits, the fact that if you don’t comply, you have very high penalties in the compliance carbon markets.
And therefore, we get 99. 9% compliance. So I think, you know, for me in reviewing cap and trade, is it perfect? Definitely not. But it certainly has been effective in Europe since the program came in. We are down one gigaton. That’s one gigaton. 1 billion tonnes per year emissions have declined. Now, that is not because of only the carbon market. Clearly, regulatory and other overlapping policies have had a big impact and technology. Cars have just gotten cleaner. Machinery has gotten cleaner. I can tell you knowing intimately the data that I know about fuel switching.
So in Europe, if you’re an electric utility burning coal or gas to make electricity, certainly the carbon price played a huge role in dominating. Dominating the switching of utilities from burning coal to burning gas. That was a big impact at the carbon price. We’re talking hundreds of millions of tonnes of emissions. That sort of sulfur dioxide success, the success now in Europe. And the way the markets have addressed, and I think California, of course, is going through their scoping review as we speak. And I think some very big improvements to the California carbon market, which has quite high ambition to achieve California’s overall climate goals, I think we’ll see some really real tightening there.
But what excites me is what’s happening globally today. When we look at the fact that China, Brazil, Mexico, Malaysia, these large emitting countries are going to adopt a carbon market to put a price on emissions and stimulate abatement activity, for me, that excites me because it’s one of the few things that I believe can address climate change at the gigaton scale that we desperately need.
Ross Kenyon: It was also funny for me to hear that, Aldyen, because people oftentimes refer to the acid rain markets as a success. And I actually haven’t heard that many people say that it was a failure. Maybe you could elaborate upon that a little bit.
Aldyen Donnelly: And I have to, you know, full disclosure here, until about 2002, I was certainly one of the voices that was absolutely sure the acid rain SO2 approach was successful. It was hard for me to look at the numbers and realize I had been wrong. And it was also hard because in 2002, I was the largest private sector speculative buyer of carbon credits representing a group of 14 of Canada’s 20 largest emitters in the world. And when I realized what the deficiencies in the market we were building were, I forecast that the market price for EU allowances would crash to under $8 US a ton by 2010, assuming that the market was going to open at $30 a ton in 2005.
And I would argue that crash did happen and that would have happened whether or not there was the global economic recession. The other thing I would say, and I’m going to relate this back to the SO2 market precedent, is that if you look at the gigaton or so of reductions that have occurred within the boundaries of Europe, almost all of that is what I call offshoring emissions. Most of that reduction, I’m going to go back to electricity, most of that reduction reflects the offshoring of the manufacturing of goods and services that Europeans consume to the Asian countries where emissions have gone up.
So it’s a supply chain shift, which is exactly what happened in the SO2 precedent. With respect to electricity sector reductions, I agree they’ve been significant. But if you look in the details, both in California and Europe, you will see that most of the electricity sector reductions were in response to command and control regulations, not allowance caps. So if the whole idea is the allowance trading regime or permit trading regime is an alternative to command and control regulations, there is no evidence yet so far that has been an outcome. So let’s go back to SO2 allowance.
And I’m embarrassed to say this because I’m on the team that agreed that SO2 allowance trading was the right model. In December 1997, we all agreed that the US SO2 allowance cap and trade regime was the model That was superior. That was proved to be the approach we should take to control greenhouse gases. We signed that agreement in December 1997. In order to reach that agreement, most nations had to have come to that conclusion by a year earlier in 1996. And the first time we actually ever saw any data about how the U.
S. acid rain Market was actually working was in March 1999. So I was on the team of people that was publishing reports talking about how successful that regime was three years before we were looking at any data, which is embarrassing for me to say, but I’m not the only one who made that mistake. When we first started seeing trade data in the allowance SO2 market regime, we saw two things. We saw Emissions not necessarily going down, but changing location. And for acid rain, when we were trying to reduce acidic deposition in certain areas, that was an okay outcome because we were reducing acid rain where it was causing damage and those emissions were moving to generation sources where acidic deposition was not as big a problem.
But between 2000 and 2002, the US EPA did find That the result wasn’t net reductions in true terms, but relocation of emissions sources. So in 2002, under the Bush administration, George Bush signed off on an initiative that was not implemented until 2005, still under his administration, that imposed something called the Clean Air Interstate Rule on top of the Acid Rain Rule. In order to stop the relocation of emissions, instead of having to comply with the first cap and trade rule, the acid rain rule, US electric utilities in 28 states, the states towards which the emissions had moved, had to comply with two cap and trade rules.
And the second cap and trade rule was subsequently replaced by the CSAPR rule. So basically what you have, if you look at that SO2 history, It’s a rule that just caused geographic relocation of emissions, which we are also seeing when we’re trying to apply the same method in greenhouse gas markets. And we then see government intervene to put new rules on top of the old rules and new rules on top of those. So it’s not replacing or fixing old rules. It’s putting rules on top of rules. And there is no more classic example of that same thing repeating itself than the California cap and trade market at this time.
And I thank you, Mike, for referring to the California scoping reports because they’re working on their fifth or sixth climate change scoping report right now. Those reports are in the public domain. And what you can see in those reports is the repeated piling on of Very inefficient command and control regulations in addition to on top of cap and trade and cap and trades not driving emission reductions in that market. I believe, and I call it the Montreal Protocol Model, we know how to build cap and trade so that it is efficient.
It leads it to the market to pick solutions and find prices and work really efficiently without the complete pile on of A plethora of command and control regulations. So let’s step back and say, hey, this isn’t working. Is there something that does work that we’ve tried before? Because the answer to that question is yes.
Mike Azlen: Perfection is the enemy of the good. And therefore, you know, these carbon markets are designed by people. And of course, that means they have flaws. And that’s why we have these scoping reviews so that we can address those, hopefully, you know, going We’re going through time to make the markets more robust and more impactful. And I really believe we’ve moved on from a lot of the flaws of carbon markets, let’s say 1. 0 to markets 2. 0. And certainly I know the Chinese really studied in depth the problems. So overall, I think the exciting part I wanted to mention was this global growth in compliance markets where so many countries now have adopted net zero.
And one of the ways to achieve that is The United Kingdom adopted and launched their own carbon market to achieve the objectives, which are quite high ambition for the UK in terms of its climate change objectives. And in the case of the UK and Europe, certainly, And I believe California, that carbon market, that compliance market is the cornerstone of their policy to achieve their climate change ambition under the Paris Agreement and their NDCs. So I’m hopeful that the markets, they are flawed, but I’m hopeful they will continue to improve and be more robust.
Ross Kenyon: Before we started, Mike, you said something that caught my attention so strongly, and that is that you believe the veracity of carbon removals is much less than cap and trade allowances, assuming I’m not mischaracterizing you. Can you tell our listeners about that? Because they’ve heard the opposite for nearly 200 episodes.
Mike Azlen: Yeah. So I think maybe you have mischaracterized. So what I would say is that the diversity that is available within the voluntary carbon market is extremely wide. And I think all three of us would be in agreement here from things that are Absolute junk, you know, at 25 cents a ton, all the way up to extreme high quality where carbon is removed from the atmosphere, direct air capture, and then solidified and stored beneath the ground with, you know, real power. Real, real long permanence. So I think there’s a huge span here in voluntary.
My view is I think the market is going to bifurcate from sort of, let’s call it lower quality project based offsets where There is big question marks around permanence and additionality, and it’s going to move towards carbon removal. And I think solutions that really remove and are net negative, that is the place to be in the voluntary space. Of course, it trades at a premium, but indeed, it should trade at a premium. And that’s the exciting part where I know Nori is involved in carbon removal, you know, and there are a number of really innovative solutions, both on the technology side, you know, the wizards and the, I forget what you call it, the wizards.
There’s both sides there, but I think that’s an exciting development. My just quick bullet points, I always say to people, because often I get asked about the voluntary market, my key words to people there are buyer beware, of course. And I always point out the fact that the market, it’s about 1000 times smaller in size than the compliance market. So last year, we traded about $800 billion in the regulated and liquid markets. In the voluntary market, we did about 800 million. So it’s not, you know, 10 times difference. This is a thousand fold difference in size.
And I think, you know, voluntary has got to be part of the solution. But my own view is it must be regulated. There must be regulation and standards. My fear is that I think there are so many projects now, and I don’t know if you guys are seeing the same things in your inbox that I received. You can imagine running the World Carbon Fund. I receive every scheme you can imagine, right? Crypto linked to this and it’s incredible. And most of this is really poor and people will lose a lot of money.
I think then regulation comes in and I’m hopeful that then the market can really be standardized and scaled up.
Aldyen Donnelly: I totally agree. We need a regulated marketplace. And the component or the portion of the marketplace that is not regulated for whatever reasons should have a voluntary opt-in provision. So I think Mike and I are aligned in that basis. But I want to just maybe drop into one other experience that we saw in the acid rain program that we’re seeing again in carbon markets. And I also want to quickly just summarize what the solution to this is. So first, in addition to seeing an acid rain that trading government issued emission quota just led to geographic emission shift.
We saw it in SO2, we’re seeing it in greenhouse gases. You also see that when the tradable instrument is a government issued entitlement, bankable and tradable entitlement to emit one ton. So set aside my issue that it doesn’t have an underlying greenhouse gas reduction value. It still is a government permit to issue To discharge one ton of CO2, and it is a permit that is bankable and tradable. As we saw in the SO2 market when we finally saw data, and we are seeing in the greenhouse gas market, no corporation that gets their hands on a perpetually bankable permit to discharge one ton of CO2 is inclined to sell it to a competitor or export it to a different country.
So in the SO2 marketplace, what we saw over the first seven or eight years was that 90% of the reported trades in those allowances were between economically related parties. And when the reported market price of an SO2 allowance was as low as $200, Five or six corporations were paying $2,000 a ton non-compliance penalties, not because they were stupid idiots, but because they could not get or buy allowances in that market because nobody freely would sell an allowance. They would swap or lease allowances, but they would not sell allowances to their competitors.
And what we saw in the SO2 market was this new SO2 allowance supply was the backbone of a new era of trade protectionism and consolidation of market power, that was almost unprecedented. And you can anticipate exactly the same thing to happen in greenhouse gas markets if what we continue to trade is government issued entitlements to emit that are perpetually bankable. What does work? When we were serious about shrinking the growth of the hole in the ozone layer, getting the lead out of gasoline, sulfur levels down in diesel, And in a whole bunch of water and wastewater tradable permit precedents, every time we got serious, we did not trade in those compliance markets.
Government issued entitlements to pollute. And every time we’ve been serious and done this successfully and efficiently, we required suppliers to report what they called the pollution precursor content in their supply chain. And reduce it. So when we wanted to reduce the discharges of ozone depleting substances to the atmosphere, we said if you sell refrigerant chemicals, you report your ODS content and you reduce it and any combination of suppliers can comply jointly. So the private sector ran the secondary market that traded over compliance credits and it was a very efficient, fast, well functioning market.
Same story for leaded gasoline, same story for all of the other precedents. So our history tells us that when we get serious about this, we won’t be trying to create a market of government issued pollution quota instruments. We are going to say if you supply energy, you report your global virgin fossil content per gigajoule or megawatt hour of energy delivered to all markets. And you reduce that pollution precursor content where the pollution precursor is the virgin fossil content per unit of energy delivered at a rate of fill in the blank, 3%, 5% per annum.
Any combination of regulated parties can comply jointly. When you look at that, that’s the Montreal Protocol model, all of the incentives to hoard allowances, impair competition, And all of the barriers to international trade don’t exist. That’s why Montreal Protocol worked. And that’s why the acid rain SO2 market program did not work and got piled on with command and control and subsequent cap and trade rules over and over and over again.
Mike Azlen: If I were to sum up, I think my last little bit summed it up that I think that these solutions are all somewhat imperfect. And what we need is, you know, we really need to pull on every possible policy lever as quickly as we can. You know, we’re trying to solve for We know that this year we’re going to emit another 40 gigatons, even notwithstanding all of this talk and all of these commitments. And therefore, the more we have something that covers and today, you know, only about 23, 24 percent We’re all in agreement that we live in a market-based economy and therefore that price signal, putting a price on carbon to put a price on that externality, right?
It is an externality. There’s no question it has direct economic costs, not to mention the moral and ethical cost of that for our children and grandchildren. So we’re trying to solve for this equation. And, you know, again, having studied and sort of thought about this deeply. Now, over 200 academic papers, 33 books on this subject, and a lot of Reversing Climate Change podcasts. I just really feel that this is one of the policy levers that has a shot at moving the needle at the gigaton scale. The people like Aldyen are extremely valuable and being involved, I would much rather have Aldyen on these committees, on the scoping committee with California and getting these policies right so these markets are robust.
And they really do what they’re set out to do. And we ratchet that cap down every year to achieve the ambition that we all want to see. So that’s my summary. And again, lovely to talk to someone like Aldyen and Ross, to you. I think what you’ve created here in the podcast, again, is just fantastic. And thank you very much for having me on.
Ross Kenyon: Well, it’s my pleasure to have you on, Mike. There’s a lot more to be said. It’s a complicated topic. Hope it was easy for listeners to follow. Aldyen, thanks for being here as well.
Aldyen Donnelly: Thanks for having me again. And it’s great to catch up with you, Mike. And I just want to be really clear. I respect what you’re doing and trying to do.
Mike Azlen: Great. No, thanks, Aldyen. And for those listeners that might be, you know, financial, we believe that our fund really combines. Of course, I’ve got to get the plug in there, Ross. I don’t know if you’ll roll it. But we really feel that running the World Carbon Fund, a climate change in Fund allows us to marry those two objectives of hopefully providing an attractive return and having a direct impact on climate change. And as a firm, we hope to roll out multiple other funds, perhaps in different asset classes. And voluntary carbon is definitely on that radar, but everything focused on climate change and decarbonization to help us get there.
Would love to point people to our website. We have lots of material, both on carbon pricing, emissions trading, and of course, a little bit of information on the fund. Thank you again.
Ross Kenyon: Our pleasure. Links to all of those things are in the show notes. Thanks for listening. Give us a great rating and review on Spotify, Apple Podcasts, etc. And thank you so much for listening. Thank you so much for listening. If you could please subscribe and give us a great rating and review on Apple Podcasts or a rating on Spotify, that’d be much appreciated. It helps us get our content out to more people. You can sign up for our newsletter at nori.com. Follow us on social media. We will catch you next time.
