Page last updated at 00:08 GMT, Wednesday, 18 November 2009

Carbon market clouded by uncertainty

By Damian Kahya
BBC News

The offices of London's carbon trading companies are a little quieter than usual.

The firms - many based in the City - buy and sell one of the world's newest commodities: carbon dioxide.

The trade in such permits allows polluters to pay for emissions reductions made elsewhere.

The market could be huge, but its future is now uncertain. It depends on how governments decide to tackle climate change beyond 2012.

The trade was first created by the Kyoto protocol in 1997.

Abyd Karmali was then an energy and climate change officer with the United Nations Environment Programme.

He now heads up the Carbon Markets & Investors Association, and is the global head of carbon markets at Bank of America Merrill Lynch.

"The thinking was that a market mechanism was likely to lead to lower overall cost for entities that had obligations [to reduce their emissions]," he explains.

The scheme was nicknamed "cap and trade".

The idea is that emissions - initially in developed countries - are first capped at a quantity equal to or below their historical levels.

Polluters in capped industries are then given credits for each tonne of carbon dioxide they emit.

For example, a coal power company may receive credits under the European Trading System for around 80% of its emissions.

But how does it deal with the shortfall?

One way would be to reduce its emissions.

'Offset' credits

Alternatively a polluter could simply buy more emissions. They can come from other firms within the scheme or, crucially, from overseas.

You don't see US businesses cutting carbon just yet... they are probably spending more of their time on lobbying
Dirk Forester, Natsource

The Kyoto protocol introduced the principle that carbon credits could be earned by reducing emissions in countries that do not yet have any cap.

That means finding ways to reduce emissions below where they would be if you hadn't intervened.

One example would be building renewable energy to replace coal power in a developing country.

Cap and trade schemes allow for companies to buy a certain amount of these "offsets" every year.

Abyd Karmali argues the system brings efficiency.

"In the case of Europe it gives flexibility over what measures they take and over what time period," he says.

"The reductions have been achieved at much lower cost than otherwise would have happened."

A global market

That system helped to create a global market worth $126bn (£75bn) in 2008 - mostly within the European Union emissions trading scheme.

In 2008 investors put around $6.5bn into developing country projects designed to offset their own emissions.

Solar panels
Under carbon trading, polluters can buy more emissions from clean firms

The World Bank estimates that this investment could grow to £150bn a year if scientific targets for carbon dioxide reductions are to be met.

Yet growth is not guaranteed.

Eco Securities is one of the largest carbon trading firms. It invests in offset credits through projects which reduce emissions in developing countries.

The Kyoto treaty, which governs offsets, expires in 2012. Investment in new projects was down 12% in 2008.

To Eco Securities' general counsel, Alex Sarac, some agreement at next month's United Nations Climate Change Conference in Copenhagen to extend the system is key. Without it investors including banks and local businesses could lose their money.

"These people will not invest more, and others that look at it will say I'm not going to do this because I cannot trust the international community to protect my investment," he says.

But carbon trading carries a damaged reputation with some at the talks.

The market is currently very limited, failing to include transport, the US and developing economies.

International offsets have been criticized for rewarding projects which would have taken place anyway.

A 2007 World Wildlife Fund report warned that up to 20% of projects accepted by the UN may not, in fact, provide any additional emissions reductions.

Volatile prices

Some economists question whether the market is even the best way to reduce emissions.

During the first phase of the European Emissions Trading System so many permits were allocated the price of carbon fell to almost zero.

United States Capital building
US politicians are discussing a carbon trading bill

Professor Dieter Helm is a former government advisor and now a fierce critic of the system.

"What we had was the worst form of capture of economic rents or lobbying you could imagine... everyone uses whatever is available to ensure its in their economic interest," he claims.

In the second phase, which started last year, caps were meant to be more stringent.

But the global downturn meant companies reduced their emissions anyway and sold off their credits for cash.

The result was another price crash.

The system is so complex the World Bank's latest report claims the EU doesn't even know how many credits are in circulation.

Some analysts predict countries may again have allocated more permits than companies actually need.

A third phase, starting in 2013, may increase emissions cuts, stop companies receiving most of their credits for free and include the aviation sector.

But the details depend on a global agreement at Copenhagen or beyond.

Alternatives

The recent turbulence has led to renewed calls for alternatives to the market.

Professor Helm agues for a tax to be used to provide a minimum price for carbon dioxide.

The UK's Committee on Climate Change, chaired by Lord Turner, has called for state intervention to support the price of carbon.

The future for the market's supporters depends heavily on the US.

There a cap and trade bill has just past its first legislative stage.

Carbon trading firms, such as Natsource, are preparing for a dramatic increase in business.

Natsource's Dirk Forrister ran the Clinton administration's climate change task force.

"You don't see US businesses cutting carbon just yet... they are probably spending more of their time on lobbying," he admits.

If it comes into force in its current form, the bill would create a market 10 times larger than that in the EU, according to Mr Forester.

Unlike the EU scheme, the legislation currently includes all transport fuels in a cap and trade market.

The US bill, like a global agreement on carbon trading, still faces multiple hurdles.

Most believe the carbon market will grow even without international agreement as companies seek to lower the cost of national emissions reductions targets.

But even if it functions well, the market is only a mechanism.

The World Bank notes that most current national and regional targets are below those recommended by the Intergovernmental Panel on Climate Change.

The size of the market, and its effectiveness, will ultimately depend on how stringent and global the caps become.



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