Q&A: Creating a Futures Market in Clean Air and Water

How much is clean air worth? That's a question Richard Sandor, founder of the Chicago Climate Exchange (CCX), thinks the free market can answer best. The exchange , which started trading on Earth Day in April 2003 , takes aim at global warming by allowing members to trade credits earned for reducing their greenhouse-gas emissions. Sandor, an economist, is no stranger to novel—and controversial—financial products. In the 1970s, he developed the financial futures market on the Chicago Board of Trade to take advantage of newly deregulated interest rates. In the early 1990s, Sandor proposed a "cap and trade" system to reduce the pollutants that caused acid rain. Companies able to exceed reduction targets set by the 1990 Clean Air Act could sell emission credits to those who didn't, creating cost incentives for clean technology and leading to an overall decline in emissions years ahead of schedule.

The Chicago Climate Exchange is based on a similar principle. Members agree to cut their emissions by a certain target. If they exceed the target, they can sell their credits on the exchange. If they fail, they buy credits. Although CCX is a purely voluntary system, since the United States is not a signatory to the 1997 Kyoto protocol, Sandor anticipates that the U.S. will soon enact a cap—or overall limit—on greenhouse-gas emissions, which scientists say are a major cause of global warming. Already, several Fortune 500 companies, including Ford, Dupont and Motorola have joined CCX, along with cities, utility companies and major energy consumers such as universities, all trying to position themselves for a "carbon-constrained" future. Sandor spoke with NEWSWEEK's Karen Breslau about the birth of the climate exchange. Excerpts:

Sandor: 'If you align financial incentives with social objectives, you create value'

NEWSWEEK: How does the market work?

Richard Sandor: The job of the Chicago Climate Exchange is to put a price on a scare resource like air or water, that was previously unpriced. The way you do it is to set a cap; the idea is create scarcity. Clean air is scarce. It can't be like a buffet, the great American barbeque, where you get all you can eat. It has to be priced accordingly.

How can you, or anyone—or any market—put a price on air and water?

When we were developing financial futures, people used to say, "That's a crazy idea; you can't price money. Interest rates are fixed." Well, the principle was that interest rates drive money to its highest and best use. The financial futures market is now worth trillions. Well, I think I've found two more crops bigger than money—they are air and water; there is no planet without them. We are now facing a very similar issue, which is how should we price air and water so that they can be used most efficiently? I think that will awaken financiers and traders; it's already awakened a lot of people. The public goods of air and water are going to be the value proposition of the 21st century. The pricing of air will spur inventive activity.

And how large is this carbon market?

The European Union [carbon] market, which is mandatory [under caps set by the Kyoto protocol] is in its pilot stage. It covers about 40 percent of entities that emit greenhouse gases. Some industries are covered, but other sources, such as cars and aviation are not. Well, that market is now 2.2 billion tons of carbon dioxide. At full market, it would trade $60 [billion to] $80 billion annually at a low price of $15 a ton. [On May 16, the European market price (ECX) was just over $20 per ton.] At the high price, which used to be $35 a ton, that's $150 billion annually. Let's put that in perspective. The United States is the world's largest food grower. At the low end, that's twice the value of all food-commodity markets in the U.S. This promises to be the single largest commodity in the world. I would think that this market could be bigger than crude oil.

Legislation has been introduced in California that would establish a mandatory cap on greenhouse gases, similar to the requirements in Europe. What impact would that have on establishing an overall U.S. market?

We've already seen the northeastern states establish a carbon cap for utilities. If California goes with a multisectoral approach that covers all industries, then it's the driver, the model for the rest of the country, just as California did when it required seatbelts. It would have a significant impact.

Business groups in California are already complaining that if they are forced to measure and limit their greenhouse-gas emissions, it will be cheaper to just move across the border and produce in another state where there are no such limits.

If the California system is designed to reduce greenhouse gasses at minimum cost, it can be done reasonably. If it's done to punish the polluters, then it will be prohibitive. The goal in California should be to do this rationally. Look at the success of the sulfur market. Imposing caps on acid-rain pollutants was supposed to wreck the American economy. The American Medical Association did a study on the reduction of acid rain and found that it led to savings of $27 billion in health-care costs. The point is that when you price a commodity, you unlock value and change behavior.

So the rewards go to whoever figures out how to take carbon dioxide out of the atmosphere?

Exactly. Markets have eyes. As price signals change, we are seeing behavioral change. We are seeing inventors coming out. Our latest member is a Minnesota dairy farmer; we send out a price signal. What's important? The diary farmer has a problem with lagoons of animal waste. He learns he can cover it with a tarp and capture the methane; you burn the methane, you power the milking machines. As a result of the milking machines not emitting methane, a greenhouse gas, he gets a credit on the exchange; he can sell the credit for $10,000. You can say that's not a lot of money, but farmer makes $55,000 in milk, $10,000 in clean air. That's a value proposition. A professor at MIT gets an idea to get algae and spray it on a pond; it does photosynthesis and takes carbon dioxide out of air; he skims the algae, and uses it as biomass fuel and he burns that instead of coal. He raises $10 million from another [CCX] member to commercialize it. The city of Oakland [Calif.] just went through the act of measuring their greenhouse-gas emissions and found that with efficiency measures Oakland can become a seller of credits instead of an emitter of carbon dioxide. I think there will be billions in inventive behavior. Thirty years from now, the fossil-fuel economy may not be there.

This sounds pretty optimistic compared to the doom and gloom normally associated with global warming.

The Chicago Climate Exchange is showing you how to get paid not to pollute. We are showing that if you align financial incentives with social objectives, you create value.

Correction: The original version of this report incorrectly stated that the Chicago Climate Exchange started trading in 2005, not 2003.