The Kyoto Protocol Enters Into Force Impacts on U.S.-Based Companies

On February 16, the Kyoto Protocol climate change treaty officially enters into force under international law. Under the Protocol, 35 industrialized countries have committed to meet certain limits on their greenhouse gas (GHG) emissions during the period 2008-2012. Developing countries do not have reduction commitments. Most of the industrialized countries that are subject to commitments under the Kyoto Protocol will be forced to make steep reductions in their GHG emissions in order to comply. Their compliance needs are expected to drive a multi-billion dollar international GHG emissions trading market. Emission reduction projects in developing countries will comprise a significant portion of this market. When certified through the new “Clean Development Mechanism,” such projects will be able to generate credits that industrialized country governments and companies can use for Kyoto Protocol compliance purposes.

The United States government is not a party to the Kyoto Protocol and therefore is not bound by its requirements. The Bush Administration has cited several grounds for rejecting the Protocol, including that it fails to establish a long-term goal based on science, that it poses serious and unnecessary risks to the U.S. and world economies, and that it is ineffective in addressing climate change because it excludes major parts of the world.

Many U.S.-based companies, however, will feel the effects of the Kyoto Protocol despite the fact that the U.S. is not a party to the agreement. For U.S.-based multinationals, the Kyoto Protocol will have direct impacts, creating both new liabilities and potential new opportunities for their facilities overseas. For companies operating solely in the United States, the effects of the Kyoto Protocol will be indirect but nevertheless something they should monitor and assess. In particular, the Protocol’s entry into force likely will be used by proponents of U.S. GHG regulation to pressure U.S. companies to take action on climate change. It is an event that will reinforce the pressure coming from a number of domestic initiatives – including state regulatory initiatives, tort-style lawsuits, and shareholder resolutions.

Thus, for many companies, climate change has become a strategic issue. Companies are meeting this strategic challenge in a variety of ways, including inventorying their emissions, assessing their financial risk under different scenarios for future policies, and exploring emissions trading possibilities.

Multinationals

For multinationals, the Kyoto Protocol’s entry into force could mean new restrictions, a new source of income, or both. Companies operating in industrialized countries will be subject to the programs developed by those countries to meet their Kyoto obligations. Companies with facilities in Europe, for example, could be regulated under the new European Union Emissions Trading System (EU ETS). Launched this year, the EU ETS will regulate carbon dioxide emissions from 12,000 “installations” in four sectors. Beginning in 2008, the program will expand to cover more installations and additional categories of GHGs.

For companies with EU “installations,” the EU ETS will be a new regulatory cost – and penalties for noncompliance are unusually high for an EU environmental program. Some companies operating in the EU, however, may be in a position to achieve reductions at relatively low cost and thereby earn income through emissions trades. Some U.S.-based multinationals such as GE are exploring ways in which they can use their edge in low- or zero-emitting energy technologies to profit in the EU ETS.

Similarly, companies with facilities in developing countries might be in a position to take advantage of a new source of “carbon” financing through the Clean Development Mechanism (CDM). Through their Southeast Asian subsidiaries, companies such as ChevronTexaco and Unocal have explored ways to use CDM transactions to finance new clean energy projects. For most companies, CDM transactions are new territory, involving new types of requirements, criteria, and transactional structures.

Companies Operating Only in the United States

For companies with facilities only in the United States, the Protocol’s entry into force will not have direct effects, but will increase attention on the GHG emissions from their operations. The commitment of other countries to GHG emissions limits establishes a new gauge against which to measure the adequacy of efforts by the U.S. government and U.S. companies. In this way, the Protocol’s entry into force adds to a constellation of other pressures within the United States – including state regulatory initiatives, lawsuits, and shareholder resolutions. Many of these domestic initiatives are subject to court challenges. Some U.S. companies are responding to these initiatives by developing broader corporate climate change strategies.

States — Many states are moving forward with their own GHG regulatory programs, raising the risk that U.S. companies will encounter a patchwork of different restrictions. Through the Regional Greenhouse Gas Initiative (RGGI), for example, nine Northeastern states have committed to establishing a “cap-and-trade” program to regulate carbon dioxide emissions by power plants. California and other states outside the Northeast also are exploring power plant restrictions. California is moving forward with a law that would limit GHG emissions by new motor vehicles, beginning with the model year 2009 fleet. A number of large states, including New York and Massachusetts, have pledged to adopt the California standards. All automakers with facilities in the United States are participating in a court challenge against the California program standards.

Suits — Last year saw the first tort-style lawsuit asserting that companies should be held liable for causing global warming. A number of states and environmental organizations have initiated litigation in federal district court accusing five of the nation’s largest power companies of maintaining a “public nuisance” by emitting carbon dioxide that increases significantly the risks of climate change. The plaintiffs are requesting that the court impose emission limits on each of the companies. The companies have mounted a vigorous defense to the lawsuit, arguing among other things that the plaintiffs have failed to state a valid federal common law legal claim and that they lack standing. For more information on the lawsuits, see Climate Cases.

Shareholders — Corporations increasingly are facing shareholder resolutions requesting that their boards assess and disclose financial risks from potential future GHG regulation and from climate change itself. The resolutions have attracted the support not only of activists but also mainstream investors, including some institutional funds. For example, the board of the California Public Employees’ Retirement System, which has assets of over $182 billion, recently approved an initiative aimed at forcing companies to consider and report on climate change-related financial risks. The boards of a number of companies have committed to providing reports in response to such shareholder resolutions.

Strategies

The entry into force of the Kyoto Protocol could compound other climate change-related pressures in the United States. Some U.S. companies are responding to these pressures by developing comprehensive strategies to manage their climate-related risks. These strategies can include the following: