Chapter 15

Conceiving a New Kind of Exchange

The man with a new idea is a Crank until the idea succeeds.

—Mark Twain

The process of going electronic, demutualizing, and going public had reinvented the face of futures exchanges. Unlocking exchange value was its own form of financial innovation. Now that I knew how to both invent new products and unlock value, it was time to use these skills to create a new exchange with new products.

At the beginning of 1999, I found myself in an uncomfortable position with only one ball left in the air—CO₂ emissions trading. I had left the CBOT behind, along with insurance derivatives. In addition, my work on unlocking Liffe would come to fruition and demand less of my time. With my newfound focus, I began a full-time adventure that would occupy me for the next decade.

I worked on two major projects at Environmental Financial Products in 1999, and both had begun two years earlier. The first was brokering a CO₂ offsets trade. I normally eschewed brokering but made an exception in this case because it gave me the opportunity to better understand offsets. The second was writing a feasibility study for a business that sought to monetize the carbon sequestered in trees.

The Largest Voluntary CO₂ Offset Trade in History

In 1997, Mike Walsh from EFP met Bernie Zahren, whose firm, ZAPCO, was in the business of operating landfills. While decomposing, the garbage in these landfills emitted methane—a harmful greenhouse gas. Bernie's business captured this gas by running a pipe approximately 20 to 30 feet down into a landfill's decaying solid waste, somewhat like drilling a well for gas. The gas was then sucked up the pipe by negative pressure, and transferred into an engine that generated electricity. Any excess methane was simply flared. This prevented the excess gas from entering the atmosphere and contributing to global warming. Electricity generated from the methane was sold as renewable energy. Since the methane captured by the landfill process could not enter the atmosphere, Mike and Bernie discussed the possibility of generating carbon offsets from these landfill projects. In fact, such projects had already been envisioned under the Kyoto Protocol. Bernie was confident in the potential of the CO₂ market and wanted to tap into it, creating another source of revenue for his company. Yet his landfill projects were in the United States, where there was no obvious market for greenhouse gas reductions. There was, however, a market for renewable energy. Maybe we could create a market for CO₂ offsets.

EFP signed a contract with ZAPCO to act as its broker for one million tons of CO₂ offsets from landfills. “We can make history together and help scale your business,” I told Bernie, suspecting that he loved doing both, given his record as an entrepreneur and a terrific salesman. We decided to make our brokerage fees directly tied to the price of carbon. As the price of carbon increased, Bernie's return on investment would increase. If we succeeded in monetizing the environmental benefits, then landfill projects, which were not particularly profitable to date, could be upgraded into attractive investments. Our deal with ZAPCO was almost like a joint venture, and was a chance for us to learn if renewable energy and CO₂ offsets from landfills were a scalable businesses.

Between 1997 and 1999, ZAPCO produced its own offsets by capturing methane gas from 20 landfills within the United States. The company was able to capture and destroy 120,000 tons of methane using Bernie's model. We translated this number into 2,520,000 tons of CO₂, or an equivalent of 21 tons of CO₂ per ton of methane, using figures published in 1995 by the Intergovernmental Panel on Climate Change (IPCC).¹ The Canadian government complied with international standards in order to be consistent with the Pilot Emissions Reduction Trading Program (PERT), a Canadian system launched in 1996 which had begun reviewing and registering CO₂ emissions reductions as an alternative to traditional command-and-control.

Although standardization in offsets had been achieved, there was a large regulatory challenge to overcome. If destruction of methane was required by law, then emission reduction credits (ERCs) could not meet PERT standards. This provision was called additionality, probably one of the most contentious issues in the CO₂ offsets market. It was first defined in the Kyoto Protocol and was subsequently clarified in 2001 at the seventh Conferences of the Parties (COP) to the UN Framework Convention on Climate Change (UNFCCC). A project qualified as additional if the originator could prove that the reduction of carbon emissions made was above and beyond what would have occurred under normal business conditions. In other words, the project should have reduced greenhouse gases in addition to what would have automatically occurred in the absence of the project. Of course, if there had already been a law in place that mandated methane destruction, then ZAPCO's activities would not be considered additional as they would have had to comply with the law anyway.

We conducted our due diligence on the additionality issue. The 20 landfills ZAPCO had targeted had not been required by law to destroy methane. However, there was one wrinkle. Landfills were required by federal law to destroy ozone, a gas that caused the buildup of non-methane organic compounds. Since the ZAPCO method did both, we needed to be assured that the EPA would accept these as offsets. Fortunately, the EPA ended up granting this assurance.²

There were other legal uncertainties. When it came to signing the contracts, many agreements were silent on whether ZAPCO or the municipalities in which landfills were located would own the offsets. If you don't own it, you cannot legally sell it. We had to get legal proof that ZAPCO owned these rights, and could only proceed once there was legal certainty. This required going through every contract to determine the ownership of the environmental rights. If the contract was silent on the issue, we either sought another landfill or had the municipality send a clarifying amendment regarding the contract.

We still needed to identify a buyer for ZAPCO's offsets. Because EFP didn't have many small clients to buy piecemeal credits, we needed to find a single large buyer. We had built up valuable relationships over the years, so finding a buyer was difficult but not impossible. In 1995, Ontario Power, the predecessor to Ontario Hydro, had committed to cap its emissions of CO₂ at 26 million tons per year, beginning in 2000. Once the company exhausted all internal means of reducing emissions, it planned to buy the reductions achieved at other sources. In December 1997, despite challenges to consummate a transaction, Ontario Power purchased over 1 million tons from the Southern California Edison Company to meet its goals. In light of this activity in the emissions market, we identified Ontario Power as a potential buyer for ZAPCO's offsets.

EFP was active during this time, acting as a consultant to Canadian roundtables and authoring a number of papers. In 1998, I was invited to give a speech at a conference in Canada. It was a wonderful year from a totally different point of view. Our first grandson, Caleb Sandor Taub, was born on March 27, 2008. Penya chose the name Caleb for two reasons. One was sympathy for the character in John Steinbeck's East of Eden, and the other was in memory of Charlie. It was an extremely poignant moment for me. Now that I had become a grandfather, my work took on a whole new dimension. Climate change was an intergenerational issue.

Brian Jantze, the manager of market mechanisms at Ontario Power, also happened to be at the conference. A dedicated environmentalist, Brian thought the offset idea was perfect for his company. It took a long time to hammer out the details. Most of Brian's time was devoted to convincing management that purchasing offsets was consistent with the company's policies. Brian pushed the envelope internally, and we managed to sign the deal.

Before the deal could go through, we had to assure Ontario Power, the buyer, that emissions reductions were verified. We contacted PricewaterhouseCoopers (PwC) for an opinion rather than a formal audit, given the prohibitive cost of the latter. The company verified our methodology, and we planned to have ZAPCO, the seller, warrant that it had followed the PwC methodology. The trade between ZAPCO and Ontario Power was consummated in October 1999 for more than 1 million tons—the largest single transaction in emission reductions ever executed.³ It was the first time that a Big Five accounting firm had provided expertise on an emissions deal of this magnitude across national boundaries.⁴ The trade itself had been conducted at substantially below $10.00 per ton⁵ and our fees were minimal, given the price. The publicity and revenues from the deal were very important for EFP. There were many committed men and women in the environmental community whose contributions to combating global warming were important but remain unheralded. Brian Jantze from Ontario Power was among them.

We learned a lot from the experience. Legal and accounting fees represented a large amount relative to the value of the trade itself. They constituted about two-thirds of the price of carbon. The transaction costs on bilateral contracts were overwhelming and hampered the development of a carbon market. Had there been a regulated exchange that standardized legal agreements and routinized verification and audits, transaction costs could be minimized. Standardization was critical.

Between trying to figure out who owned the offsets and wading through legal issues, at the end of the day we were seeking to create a solid precedent and infrastructure for emissions trading. Our piecemeal efforts were much like Luigi Pirandello's Six Characters in Search of an Author, lost and trying to find a meaningful plot. We were digging in the trenches those few years, building up supply and demand for CO₂ offsets. We encouraged investments in rainforests and renewable energy to fuel supply and create demand for forests as a source of offsets. All the while, we wrote popular and academic articles, spoke with Congress, and educated the press.

The Dow Jones Sustainability Index⁶

Now that we had created a supply of offsets, we had to create a demand for offsets. If investors understood that sustainability and stock prices were correlated, they would embrace companies that participated in market-based solutions to climate change. I wanted to bridge corporate and environmental performance as another way to reduce the impact of climate change.

At the beginning of the 1990s, two apparently unrelated financial developments occurred. The first was the launch of the International Chamber of Commerce (ICC) Sustainable Development Charter in 1990. It marked the first time that a group of industry CEOs recognized the importance of positive social and environmental behavior in creating shareholder value. Financial innovation followed, thereby facilitating the flow of billions of dollars into socially responsible investing (SRI) and sustainable investments (SI).⁷ The other was the passage of the Clean Air Act Amendment of 1990. The financial and environmental success of these new developments subsequently led to an understanding that these markets would provide profit-making opportunities for companies, thereby increasing shareholder value.

In 1992, the students I was teaching in Columbia University's first environmental finance course prepared a study reporting that the risk-adjusted performance of SRI funds was historically poor compared to the S&P 500. Despite this, they projected that environmental screening criteria and indexes would become better developed and more broadly used. However, this would take time. By 1995, there were 55 socially screened mutual funds in the United States with assets totaling $12 billion. And indeed, 38% of these SRI funds were screened based on environmental performance.

That same year, a Swiss entrepreneur named founded the Sustainable Performance Group (SPG) and Sustainable Asset Management (SAM). The former was a closed-ended equity mutual fund launched and managed by the latter. Launched in September 1995 with over 100 million Swiss Francs to invest worldwide, SPG sought to invest in stocks of companies operating across diversified sectors, typically in energy, water, healthy living, and resource-efficient industries. It was the first departure from SRI to SI, and I agreed to serve on the board of directors, alongside a combination of leading academics and businessmen from Switzerland and Germany. Alexander “Sascha” Zehnder, a scientist and specialist in water resource management, became a life-long friend and colleague. The other professionals on the board later helped me promote the concept of emissions trading in Europe.

The SAM fund provided a different type of incentive for corporations to pursue environmental objectives. Under SAM, hopeful and public-spirited companies were supported by stockholders. Even if a company was a big polluter, its stocks would still be bought as long as it was effective in controlling or reducing emissions relative to its peers. This deviated from the SRI model, under which such companies were often shunned.

At SPG's first board meeting, I shared my belief that SPG could quantitatively be measured against a benchmark index. The chairman of SPG thought this was an ingenious idea. Next to speak was Sascha, who went on to become president of both the ETH and the Water Research Institute. He proclaimed with the certainty of a scientist, “I don't think we even have to debate this.” By the end of the board meeting, there was no question that the SPG needed a benchmark.

SAM decided to develop its own sustainability index to show that SPG not only outperformed its benchmark, the Morgan Stanley Capital International World index, but was also superior to new competitors entering the sustainable investments field. Alois Flatz from SAM, along with SAM's research team, explored the idea of developing an international sustainability index that tracked the financial performance of the world's most sustainable companies. Industry leaders were to be selected from a ranking of the world's biggest companies based on a relatively simple corporate sustainability assessment system. For example, sustainability was measured by safety (as defined by worker accidents and deaths), gender equality in the work force and board of directors, number of environmental law suits, and other industry specific criteria.

SAM planned to develop the index internally but have it calculated and branded by a third party. The management at SAM contacted the major index companies, but there was little interest. The Swiss Stock Exchange entertained the possibility of branding the index, but the global nature of the index unfortunately didn't fit the exchange's strategy. It subsequently introduced SAM to STOXX, a joint venture between Dow Jones and the Swiss, French, and German stock exchanges. The new managing director at Dow Jones acquainted the SAM team with the Dow Jones management. While initially skeptical, the Dow Jones management team became convinced that a sustainability index could be differentiated from SRI and would be consistent with the mission of Dow Jones Indexes.

The most significant investor in SAM and chairman of the board strongly believed that a strategic relationship with Dow Jones would help legitimize the concept of sustainability and increase the visibility of SAM. Fortuitously, I had previously worked with the president of Dow Jones Indexes in licensing the DJIA to the CBOT. His leadership was decisive in the financial decisions regarding the new venture. He gave the green light to consummate the deal in October 1998.

Next, SAM created a corporate sustainability questionnaire. Questions were created to reflect general and industry-specific criteria for sustainability, based on a series of scenarios. SAM invited the largest 2,000 companies in the Dow Jones Global Index—drawn from 64 industry groups and 36 countries—to participate in the first annual assessment. Some companies welcomed the index and provided SAM with completed questionnaires with boxes of supporting documentation. Others refused to return the questionnaire due to their skepticism about sustainability. All in all, the questionnaires prompted self-assessments among corporations and provided an educational tool for sustainability efforts.

In the spring of 1999, the head of SPG, the founding investor of SAM, and I met with the Dow Jones team to hammer out the final details of the index. The historical performance of the index was determined by “back casting,” the opposite of forecasting. There was great uncertainty about how it would perform, but the results were unambiguous. Our calculations showed that the sustainability index outperformed the general Dow Jones Group Index in all three regions, and in eight out of nine sectors.

Commercialization followed. The index was launched on September 8, 1999. At the outset, there were five licenses for the index, though that number has since grown to 31 licenses with more than £2.2 billion under management. This has been accompanied by a dramatic increase in SRI, driven by concerns about stainability and the objective to maximize shareholder value. The DJSI had significantly outperformed all other indexes, with virtually no increase in risk.

I worked with SPG and the DJSI to create demand for emissions trading that was based on increasing the stock price of companies that participated in that activity. If we could bridge the market capitalization of corporations with their environmental stewardship, then combating climate change would obviously be easier.

The original opposition from the Dow Jones management team against stock index futures had evolved into support. The index division cobranded a stock index with SAM in the hope that it would be listed on a futures exchange. In an ironic turn of events, the CME would later buy the Dow Jones Index company in 2010 from Dow Jones.

Sustainable Forestry and Climate Change—A Case Study of Failure

The Swiss Futures and Options Association (SFOA) held an annual meeting in Buergenstock, Switzerland, every year since 1979. I strongly supported the founding of this event and deemed it a great vehicle to educate members of the futures industry in Europe and around the world.

Since the environmental markets were still in their infancy, we followed our usual pattern of speaking and educating the futures industry about its role in combating climate change and the mechanics of such markets. I was often invited to make presentations at the annual SFOA meetings. In 1997, I attended one of the SFOA annual meetings to promote the idea of emissions trading. I bumped into a Chicago born-and-bred attorney who was practicing law as a partner at Mayer Brown & Platt in London. We walked out onto a terrace that overlooked a bucolic pasture with cows. Bells hung from their necks and tinkled gently as the animals roamed. I told him about our work establishing a voluntary emissions trading program and creating an exchange for trading CO₂ credits. “Nothing has really happened since 1992 and now we're trying to work something out with the United Nations and the Earth Council,” I said. Apparently, he had been working on environmental issues with a world-renowned scientist and an explorer concerned about rainforest preservation. He suggested that we all collaborate.

I subsequently had dinner with the three principles at the Savoy Hotel in London. We ate in a dark-paneled room with pictures and scores from the original performance of Puccini's Madame Butterfly, which had debuted at the Savoy Theater next door. We all expressed interest in marrying our environmental objectives with commercial opportunities that could arise from the upcoming UN meeting in Kyoto, Japan.

We eventually formed a company called Sustainable Forestry Management (SFM), which invested in reforestation projects across the globe. SFM retained EFP to do a feasibility study on assembling a portfolio of forestry projects to supply carbon offsets to emissions trading markets. SFM believed there was a potential business opportunity for CO₂ credits in selective harvesting,⁸ reforestation, and avoided deforestation. I had already begun to look at creating demand for emissions credits through SAM and the SPG, and thought the SFM study would provide a great opportunity to stimulate supply.

EFP submitted a feasibility study for SFM in February 2000 which investigated whether carbon mitigation from reforestation could be produced at a cost sufficiently below the market price of credits. If feasible, this could achieve attractive returns on investment while reversing deforestation and climate change. We recommended a number of strategies to exploit new markets that could emerge independently or as a result of the Kyoto Protocol coming into force. These strategies included investment in assisted regeneration of natural forests and the establishment of new forest plantations. Such projects could also protect biological diversity, improve water quality and local climate, and contribute to the sustenance of indigenous cultures.

Our study further examined the financial performance of real and hypothetical reforestation projects under varying prices on carbon, and identified countries with significant prospects for reforestation and low sovereign risk. We evaluated the impacts that selective harvesting of high value timber, bioprospecting, and ecotourism facilities could have on the profitability of forest protection and regeneration projects.⁹ In addition, we studied market-based risks facing SFM implementers, and introduced proven techniques such as portfolio optimization that were prevalent in the capital markets.¹⁰ Estimates of future pricing for carbon credits were as high as $200 per ton. EFP's 1994 estimate of $20 per ton was conservative, while $70-per-ton pricing from BP Amoco's pilot internal trading program held a middle ground. The price of EUA's at the end of 2010 was not too far off, at about $19.00 per ton. We further hypothesized that there would be about 1 billion tons of carbon credits supplied from various sources. The market value of the CDM carbon was $19.8 billion as of 2010. As of October 2010, forestry projects accounted for only 0.58 percent of registered CDM projects,¹¹ with another two years before the first compliance period ends.

Working on the study provided us with significant intellectual capital in the field of forestry and helped us with consulting revenues. Most importantly, the knowledge we gleaned from the study would prove to be useful in developing protocols in reforestation and preservation of rainforests.

A Chance Encounter—The Beginning of the Chicago Climate Exchange

I received a call from Paula DiPerna during the first week of July 1999. Though I hadn't seen her in three years, Paula wanted to follow up on our exchange at the Group of 77 meeting in Glen Cove back in 1995. She had just assumed the presidency of the Joyce Foundation and moved to Chicago.

We had lunch on July 14 at the University Club in Chicago. After briefly reminiscing about my speech at Glen Cove, Paula said, “I'm running the foundation and we have $1 billion in assets. The next millennium is upon us, and I want to make some special grants that will have inter-generational significance. What would it take to try global emissions trading for greenhouse gases?”

I eagerly proposed a feasibility study on a pilot program in the Midwest that could be scaled globally. The economy of the Midwest rivaled that of several EU countries combined, and was large enough to warrant a large scale pilot program.

Since no papers were allowed at the club, I had to sketch out an outline of the program on the back of a napkin, a gesture that reminded me surreptitiously of the drafting of the first GNMA contract, which was done on a paper napkin at a Chinese restaurant. I estimated that the pilot program would cost about $1.5 million, and could be operational in a couple of years. We shook hands on our mutual commitment. And that was how the idea for the Chicago Climate Exchange was conceived.

The University Club was a relatively short walk back to our office at 111 W. Jackson. Impatient in nature, I normally took taxicabs, even for short distances. This time, I meandered and dreamed about the possible ramifications of the luncheon meeting. The door had finally opened.

The challenge excited me and stirred feelings in me the way interest rate futures did in the 1970s. Although EFP continued to work on sustainable forestry and the landfill trade, we now had a greater and more sustainable project. Timing was everything, and we needed to have a comprehensive proposal ready to be submitted to the Joyce Foundation within eight weeks. This was the biggest ball in the air.