President George Bush in 2001 refused to sign the Kyoto Protocol, which would have required the United States and other developed nations around the world to reduce carbon dioxide pollution. Bush says the agreement would have unfairly strapped the U.S. economy, the world’s largest, by mandating that it reduce carbon dioxide emissions to 1990 levels.  

Karl Ulrich, a Wharton professor of operations and information management, decided to sign on anyway. He and 41 of his students have created a company called TerraPass that applies Kyoto-like methods to cutting pollution from cars. The firm, which began doing business in the fall of 2004, tries to use the market to solve pollution problems, thereby putting it at the forefront of a recent movement toward market-based environmentalism.

Oddly, Ulrich agrees with Bush that the United States should not –indeed, could not — have agreed to be bound by the Kyoto Protocol, which took effect this year. “Our gross domestic product in 1990 was about 40% lower than it is today, so it is virtually impossible for the U.S. to comply,” he explains. Pollution accompanies economic growth, so cutting U.S. emissions to 1990 levels would entail a major economic contraction, at least in the short term. Contrast that to Russia’s GDP, which is 30% lower today than it was in 1990. Russia, he says, would have no problem complying with the Kyoto agreement.

But the Kyoto controversy and his own long-held commitment to environmentalism got Ulrich thinking about other ways that people in the United States might use the market to reduce carbon dioxide emissions. “I’m a capitalist-environmentalist,” Ulrich says. “I ride my bike every day to work, rain or shine. I also believe in the enormous power of private enterprise to do things. Businesses are the most powerful institutions in our society, and there is no alternative to working with them.” 

The Kyoto Protocol tries to harness the power of businesses by giving them freedom to meet carbon dioxide-reduction targets in whatever way works best for them, rather than mandating particular methods. Specifically, Kyoto creates a so-called “cap-and-trade” system that works as follows. A nation — or in the case of Kyoto, the international treaty — sets a limit on the amount of a pollutant that it will accept. Under traditional rules, a regulator would have limits for each polluter, who would have to comply or face penalties. Under Kyoto, companies that can reduce their emissions by more than the required amounts are encouraged to do so with “pollution credits.”

A company that beats its limit receives credits that it can sell to companies that can’t meet theirs; the lower its emissions go, the more credits it gets. This system lets money migrate to where it can do the most good — that is, companies that can reduce pollution most easily. It then gives these firms an incentive — the ability to sell more credits — to keep cutting pollution. At the same time, a country’s overall pollution limit is gradually ratcheted downward as the bigger polluters find a way to either cut their emissions or keep buying credits. Either way, they help pay to clean the air. A system of this sort for sulfur dioxide (as opposed to carbon dioxide) emitted by electric-power plants is already in effect in the United States.

Living Guilt-Free for $65 a Month

Cap-and-trade is the sort of market-based regulation that “capitalist-environmentalists” such as Ulrich like. For the same kinds of reasons, Ulrich has long advocated a higher gas tax. “There are not a lot of environmental problems that a $2-a-gallon gas tax in this country wouldn’t fix,” he says. Such a tax wouldn’t prevent anyone from driving — and polluting — but would encourage people who could cut back their driving to do so. “I got to thinking, ‘What’s stopping me from paying that hypothetical tax?'”

It wasn’t that he wanted to send money to the government based on the number of miles he drove. (While he rides his bike to work, he drives a gas-guzzling pickup to land he owns in Vermont.) Instead, he realized that he could buy wind power to counter the effects of his emissions. He estimated how much pollution he creates in a year based on the amount of time he drives, flies, uses air-conditioning and the like. “I figured out that, for $65 a month, I could live guilt-free. I bought $65 a month of wind power to offset my environmental impact.” He made the purchase through a Pennsylvania company called Community Energy.

Ulrich’s wind power displaces coal power. That’s because the country’s nationwide electric grid operates like a giant reservoir. Utilities — using coal, nuclear, hydro, wind and even geothermal sources such as Hawaii’s volcanoes — produce electricity based on estimates of their customers’ needs and feed it onto the grid. When customers switch on their lights, for example, they are not necessarily using the power that their utility produced. Instead, they are “dipping a cup” into the giant, shared pool. By purchasing wind power, Ulrich crowds out coal power that otherwise would be needed. His actions come at a time when utilities regulators around the country are pushing for more renewable power; a few have even put in place requirements that a portion of power come from “green” sources.

Ulrich suspected other people might be willing to pay to offset their auto emissions but realized that most of them wouldn’t take the trouble that he did. The key, he knew, was making it easy. Enter TerraPass. Ulrich figured that the company could sell memberships — the price would be based on the amount people drove — and then invest its revenues in clean power and pollution reduction.

Ulrich didn’t have time to work out the details himself, in part because he and two partners own a Scranton, Pa., company that makes adult scooters called the Xootr (which Ulrich invented). Therefore, he decided to turn the challenge over to the 41 students in his “Problem Solving, Design and System Improvement” class this past fall. In October, when the half-semester class began, he presented the idea and announced that the students’ assignment for the semester was turning it into a business.

Tom Arnold, a second-year MBA student in the class, remembers surprise sweeping through the room. “It was the initial shock of, ‘We are not actually going to launch a business in six weeks,'” he says. A few students were even skeptical of the need. “I wouldn’t characterize any of us as hardcore environmentalists,” Arnold notes. Still, they embraced the idea. After all, it was an assignment. They split into teams to handle the obvious tasks — product development, pricing, marketing and sales. Ulrich provided $5,000 of his own money as startup funds in the form of a no-interest loan, repayable whenever TerraPass can swing it. The students and the University of Pennsylvania own the company, which is seeking additional investors.

On November 23, 2004, TerraPass, incorporated as BenVen LLC, began selling annual memberships. Customers pay $30 to $80 a year, based on how much carbon dioxide their cars emit during 12 months. Owners of gas-electric hybrids pay the least; owners of SUVs and trucks, the most. “We really forced the launch, and it wasn’t pretty, but we came out, had a test and got some nibbles,” Arnold recalls. By the time the students made their final class presentation on December 9, they had sold 149 memberships, mostly to friends and family members.         

Many class projects would have been declared a success at this point and the project would then have been dropped. Some of Ulrich’s students, however, decided to continue developing TerraPass. This spring, a group of nine, with Arnold as coordinator, is pushing ahead on the company. By early February, the students had sold about 300 memberships and were aiming to raise money from investors. They saw a flurry of purchases in January, when the Los Angeles Times ran an article on the company. Arnold hopes to raise enough venture capital that he and at least one other student can continue to work for TerraPass after graduation.

In February, the company entered into its first pollution-cutting deals. It bought 350 megawatt-hours of power from a wind farm in Minnesota. That will prevent about 300 tons of carbon dioxide from being emitted by coal-fired power plants. “When you add renewable energy to the grid, coal power is reduced and coal-fired plants back off their production,” Arnold explains. “Regulators want renewable power, so coal power companies don’t want to be seen as fighting against wind.” Even so, wind power still accounts for a tiny portion of the electricity generated in this country. 

Customers Wanted

“Wind is a nice, easy story,” Ulrich notes. “People get it. But it’s not the most efficient way to reduce carbon emissions. The most efficient way is through industrial processes like those at an aluminum smelter. If you could take 1% of the energy out of there, you would have a huge impact.” So industrial processes were where TerraPass went to find its second deal.

The typical power-intensive company has a long list of energy-saving projects such as insulating pipes or installing more efficient machinery, Ulrich points out. It does the projects that save lots of money. It also, however, has a list of projects that are close to being economically feasible but don’t quite meet its cost-savings threshold. Maybe these projects would make sense if they generated, say, an additional penny in savings per kilowatt-hour. Thanks to the Chicago Climate Exchange — a fledgling, voluntary pollution market that is modeled on Kyoto — companies like this now have a place to turn. The Exchange matches firms that need money for pollution-reduction projects with investors such as TerraPass.

“With the Climate Exchange, companies can sell the benefits of that project to us,” Ulrich explains. “We trade them on behalf of our members. If companies do that, they might get two cents a kilowatt-hour, and then the project pays off.” Some states require that a portion of their power be environmentally friendly. Rather than forcing utilities to make costly conversions of their equipment, they let them invest in green projects elsewhere. Just like a stock market, the Exchange facilitates these deals. TerraPass did its second deal on the Exchange, buying 500 metric tons worth of “carbon financial instruments (CFI),” a security that represents the right to emit a certain amount of carbon dioxide.

TerraPass’s third transaction linked it with Mainstay Energy. Mainstay is developing a cow-manure digester that burns cow patties to generate power. As TerraPass continues to sell memberships, more deals like these will come, Ulrich predicts.

Selling memberships may be the company’s biggest challenge. Pollution markets sound complicated, but they are identifiable and operating. Potential TerraPass customers are harder to find. They are not, as one might suspect, hardcore environmentalists. “Greens are cheap, and they are anti-business,” Ulrich argues. “Plus, the typical environmentalist doesn’t like TerraPass because he/she thinks we let the government off the hook.”

To Ulrich’s way of thinking, hardcore environmentalists want the government to strictly limit pollution. They also want to discourage people from driving. A few environmentalists have argued in online chatrooms that TerraPass does the opposite, allowing people to salve their consciences but continue to pollute. “The libertarian economist is our target customer,” Ulrich quips. Unfortunately, there aren’t many of them around.

Ulrich says the sorts of people who buy gas-electric hybrid cars could be one promising group. Hybrids, he points out, give their buyers no real financial payback. The price premium for a hybrid over a standard car is about $10,000. Yet the savings in gas money during a typical hybrid’s life don’t come close to that amount. Ulrich suspects that hybrid buyers aren’t motivated by saving money but rather by a desire to clean up their own messes, just as some people voluntarily choose to participate in recycling programs. People who would consider buying a hybrid should also like TerraPass, he argues.

“We are a much better use of that $10,000. Hybrids come way down the list if you are trying to globally reduce carbon dioxide. It’s an inefficient way to [accomplish this] … I don’t believe that any one of us can take an action that is going to result in a measurable change in the environment,” Ulrich says. “TerraPass isn’t going to do that. It’s just too small. But if it starts to build momentum around a big idea, it could have a huge impact.”