Why Enron Loved Kyoto, And the EU Shouldn’t

What do the proposed European Commission directive for trading CO2 emissions credits and the current malaise affecting American corporate life have in common?<?xml:namespace prefix = o ns = “urn:schemas-microsoft-com:office:office” />

The answer is that both have their roots in the “creative” application of financial instruments and both could do untold harm to the global economy. Indeed, the potential for abuses in the emission trading provisions designed to meet the EU's targets under the Kyoto protocol almost certainly would make the Enron scandal as exciting as yesterday's mashed potatoes.

The opportunity to make a mint by merely buying and selling emissions credits was the major reason that Enron vigorously lobbied the Clinton administration and the U.S. Senate to support the Kyoto protocol that seeks to reduce greenhouse gas emissions to below 1990 levels by 2012. Before it went into Chapter 11, Enron hoped to cash in on Kyoto by masterminding a world-wide trading network in which major industries could buy and sell credits to emit carbon dioxide.

So what of Europe? Why should proposals for a localized European emissions trading scheme suggest a re-run of Enron-style accounting practices on a global scale?

The proposed European Emissions Trading Directive, to be debated by the European Parliament in September, will apply to EU member states beginning in 2005. However, little noticed in the proposed directive is a provision for countries that are not part of the EU to link their schemes with the EU's and thus mutually recognize each other's allowances.

Designed for those eastern European countries that are in line to join the EU in the next couple years, it could just as easily be made applicable to others. And the directive makes it clear that the European proposal is a mere prelude to gain experience and advantage prior to the global scheme due to come into force in 2008 under the terms of the Kyoto treaty.

What the commission directive does not state is how desperate the EU is to participate in a global scheme. At the time that Kyoto was negotiated, EU member states had a built-in advantage over other industrialized states, notably the U.S. That is because just around 1990, the base year, the United Kingdom switched from coal to gas for electricity generation and the East German economy crumbled along with the Berlin Wall. As a result, British and German carbon CO2 emissions subsequently came down well below their 1990 levels and provided a cushion for growth of emissions within the then-European Community.

But economic growth, real and projected for this decade, combined with Germany's decision to phase out nuclear energy and greater than projected coal use among member countries will likely leave the EU about 10% — or some 400 million tons of CO2 — short of its Kyoto target for emission levels the EU would have to achieve by 2012. No wonder the EU is keen for emissions trading to begin outside the EU area. Otherwise the bloc won't be able to meet its targets without purchasing excess credits from elsewhere.

The most promising place is eastern Europe, principally Ukraine and Russia. In fact, with the EU nations (24% of the covered emissions) having adopted Kyoto, Russia has become the key player needed to bring Kyoto into force.

Russia's ratification would mean that countries that account for 55% of 1990 emissions targets had adopted the treaty. No other big industrial country will push Kyoto over the top, since the U.S. rejected the treaty, Australia won't ratify it and Canada's support is up in the air. The Russians are keenly aware of this and are seeking to extract the highest possible price in return for their “yes” vote the treaty itself.

They have the leverage because the collapse of the Soviet Union devastated the Russian economy and left its CO2-emissions about 36% below 1990 levels. That, in turn, allows today's Kremlin leaders to tap that surplus and sell billions of euros of emissions credits to nations that exceed their Kyoto targets.

These non-existent emissions have been aptly named “hot-air.” The creation of emission reduction credits — and the trading of them — requires a rigorous system of measurement, record keeping, transaction accounting, verification and liability.

No such international system exists today. Building one takes time and the benefits of trial, error and experience. It also requires commercial institutions that are grounded in the rule of law.

Those prerequisites hardly describe conditions in today's CO2 emission estimation and accounting methods. It certainly does not reflect conditions in Russia.

The complexity of a new and untried international emission trading system combined with the difficulty of estimating and verifying CO2 emissions baselines and reductions is an open invitation for fraud and abuse.

Reducing carbon dioxide emissions is not easy, nor cheap because it involves reducing energy consumption. Despite the romantic notions that environmentalists entertain about wind and solar power, there currently are no low-cost alternatives to fossil fuels. Constraining their use or turning to higher-cost energy sources penalizes economic growth and diminishes prosperity.

As it begins to implement Kyoto's draconian provisions, European Union countries are about to be forced into confronting that reality. They will need to buy Russian “hot-air” emission credits to balance their Kyoto books. Based on 1990 emission levels and projected levels for 2010, the Russian “non-existent” emissions could more than fully satisfy the EU reduction commitment.

Russia likely will have almost 600 million tons of credits to sell or use for its own economic growth. This gives Russia tremendous negotiating leverage so the price could reach stratospheric heights.

The revelations about trading irregularities and accounting scandals in the U.S. may well serve as a case study for EU and Russian companies and politicians interested in cooking the CO2 emission trading books. Commodity trading and accounting in the U.S. are highly regulated activities governed by standards that have evolved over decades.

And yet, some firms were able to use their creativity to get away with accounting deception for a number of years. How much easier will it be to cook the emissions books for an international system when the measurement standards and means to verify emission reductions are yet to be developed, tested and verified?

Mr. O'Keefe is president of Solutions Consulting in Vienna, Virginia and former chairman of the Global Climate Coalition. He is also a board member of the Competitive Enterprise Institute.