Carbon trading worldwide is enjoying spectacular growth, and the outline of a future global cap-and-trade system is beginning to emerge

The presidential election process in the United States may be long and arduous but one outcome is certain already: the next American president will be in favour of carbon emissions trading.

All the hopefuls support the Lieberman-Warner bill, otherwise known as America’s Climate Security Act. This bill, scheduled for consideration by the Senate this month, will cap US greenhouse gas emissions at about 30 per cent of their current level by 2050. An emissions trading scheme will be at the centre of the reduction effort.

Republican presidential candidate John McCain is the strongest endorser of Lieberman-Warner. In October 2007, he said he was “bitterly disappointed” by US inaction on climate change so far. “The Europeans implemented a cap-and-trade system; they stumbled and had their problems but it is still the right thing to do,” he said.

Peter Liese, a German centre-right member of the European Parliament, says a US scheme, which could be up and running by 2012, is crucial both for the establishment of cap-and-trade worldwide, and for a global agreement on greenhouse gas reduction targets after 2012, when the Kyoto Protocol expires.

The US coming on board will be “a very important signal for all other countries; nobody will have an excuse any more,” says Liese, who is in charge of steering through the European parliament the EU legislation that includes aviation in emissions trading.

Rolling bandwagon

In fact, a cap-and-trade programme is becoming a must-have for every industrialised country. New Zealand is launching a scheme; Japan has been convinced of cap-and-trade’s virtues; and Swiss and Norwegian programmes are under way.

In Australia, prime minister Kevin Rudd immediately ratified the Kyoto Protocol on taking office in December 2007 and has a plan to start an emissions trading scheme (ETS) in 2010. Rudd describes climate change “the great moral and economic challenge of our age”.

Cap-and-trade is gaining ground not only because it is seen as the least painful and most politically acceptable way of reducing greenhouse gas output, but also because it has been successful – at least in terms of creating value.

The World Bank’s latest “State and trends of the carbon market” report, published in May, shows that the global carbon market more than doubled in value in 2007. Trading in carbon credits amounted to a “whopping” $64 billion, according to the report. The world’s largest cap-and-trade scheme, the EU ETS, accounted for $50 billion.

Andrew Humphrey, an emissions trading analyst at investment bank Morgan Stanley, says the success of the model in creating a viable commodity market means it is supported by the financial sector. “A lot of big banks invest in the sector either by employing people on trading desks or by taking stakes in specialist companies,” he says. “Most of the [banks’] investments are long term and strategic.”

Sara Stahl of the European Climate Exchange, the main EU ETS trading platform, says the market is ready for more. “The market would love it if [EU ETS] grows in scope and regional coverage,” she says. A post-Kyoto emissions-cutting agreement with a global cap-and-trade mechanism at its core is “the only thing the market is waiting for”.

So with momentum building up, what might a future worldwide cap-and-trade system look like? Clues were given at the European parliament in late March when Rajendra Pachauri, head of the United Nations Intergovernmental Panel on Climate Change, said negotiations to find a successor to the Kyoto Protocol could result in either a global carbon pricing scheme or a framework agreement that leaves countries free to decide the details of their own carbon pricing systems.

The world’s policy-makers hope to finalise a deal in Copenhagen at the end of 2009. This “may leave details to be worked out”, Pachauri says, but there should be “a definite agreement on placing a price on carbon,” with “co-ordinated action” to ensure the scope for disputes between countries is reduced.

Pressure for trading

Conceivably, some countries may choose to levy carbon taxes. But the momentum is behind cap-and-trade, with the likely emergence of a series of linkable schemes across developed countries. Avril Doyle, an MEP from Ireland’s Fine Gael party who is overseeing the European parliament’s response to European commission proposals to revise the EU ETS, said at a parliamentary session in May that different countries’ legislation “must dock together”, adding: “The principles [of different schemes] must support one another.”

The result may resemble a beefed-up EU ETS. An overall carbon cap will be fixed, but individual countries will be left to decide how to share out the allowances they are given. National registries, which record allocations made to scheme participants such as industrial plants or power stations, will connect to a central registry, as presently happens in the EU with the community transaction log. The carbon price will be determined by demand for allowances, which will in turn be determined by the cap. As the EU has learned (see box), this must be sufficiently tight. A carbon price that is too low will not incentivise companies to make the emissions-cutting investments the world needs.

Setting up a global system may therefore not be unnecessarily complex. Carbon markets are commodity exchanges, the commodity being permits to emit one tonne of carbon dioxide or carbon dioxide equivalent. A pilot infrastructure is in place, with functioning carbon exchanges in Europe and the US (in the US case, the voluntary Chicago Climate Exchange). Certainly, there have been teething problems. The EU has seen late establishment of national registries and delays in finalising allocations of allowances to individual market participants. But overall a nascent system is functioning.

Crucially, a way of bringing the developing world into global cap-and-trade already exists. This is the UN Clean Development Mechanism, which allows emerging countries to earn tradeable certified emissions reductions from carbon-cutting projects funded by the industrialised world. Projects deal with issues such as energy efficiency, building renewable energy capacity, and reforestation and avoided deforestation. There are currently more than 1,000 projects in 49 countries, the CDM’s David Abbass says.

The infrastructure for trading in certified emissions reductions includes a registry and an international transaction log, which brokers are starting to connect to. Plans are also afoot to link the international transaction log with the EU ETS, though this has been delayed. Countries buy certified emissions reductions to offset their Kyoto obligations. Private companies also buy the permits. EasyJet and SAS Airlines are two examples, Abbass says. The airlines then sell the certified emissions reductions on to customers who wish to make their travel carbon-neutral.

Some way to go

According to a Morgan Stanley report on the emerging cap-and-trade market published in December 2007, developing countries are gaining crucial emissions trading experience because of the CDM. Russia and China are two major emerging economies “developing the infrastructure for emissions trading through participation”, the report says.

But although an infrastructure is emerging, there is some way to go before a “real, proper market” is in place, says Morgan Stanley’s Andrew Humphrey, one of the December 2007 report’s authors. This is even the case for the EU ETS, the world’s largest cap-and-trade scheme. The Morgan Stanley analysis notes: “Most of the current trade in emissions is based on short-term compliance requirements rather than the recognition of a long-term shift to a carbon-constrained environment.”

The market “needs real demand”, Humphrey says. A tight emissions cap will force market participants to make strategic decisions: whether to invest in carbon-cutting technology, or to take positions on the market to offset the pollution they pump out. When this happens, money will start to flow and a real, liquid market will emerge. Global agreement at Copenhagen on tough greenhouse gas reduction targets will be the key.

Agreement will also be needed on standards, in particular to regulate emission reduction credits. In addition to Kyoto mechanisms such as the CDM, a voluntary offset market has emerged in the past few years. But this is “not yet a robust mechanism for actually creating emissions cuts”, says Tejas Ewing, author of the “Guide to Carbon Offsets 2008”.

Instead, offsets are a “mish-mash of systems and standards”, says Ewing. The credits traded on the world’s largest offsets market, the Chicago Climate Exchange (CCX), lack transparency and have high risks associated with their measurability and verification, he says. CCX credits are generated by a variety of projects including methane trapping, restoration of carbon-rich soils, and renewable energy. For the credits “to get to the level where they would be acceptable for a global programme would take at least five years”, Ewing says.

Evolution not revolution

Emergence of a global cap-and-trade system will thus be an evolutionary process rather than a big bang. But regulators are convinced by the arguments in favour of carbon trading, while companies on the whole prefer it to direct pollution taxes or other more heavy-handed ways of forcing emissions down. The Association of European Airlines, for example, supports including aviation in the EU ETS, though it calls for a rather generous cap of 110 per cent of baseline emissions.

For those at the heart of the debate, the prospects of gaining worldwide agreement at Copenhagen are improving, with barriers gradually being cleared out of the way. German MEP Peter Liese says the main obstacle has been US opposition but “the major problem will no longer exist when a new president is in power”.

Sara Stahl of the European Climate Exchange says that, although it is too early to say if it will be possible to have a “truly global carbon price”, politicians will increasingly come under pressure to deliver emission reductions because of worsening climate change. It is, she says, “hard for western governments to argue against that”.

Emissions trading: theory and practice

Emissions trading has been a success if judged on its track record of creating from scratch a $64 billion market. But does it actually reduce greenhouse gas emissions? There are indications that it does, but its long-term effectiveness is not yet proven.

The cap is the key to cap-and-trade. Regulators place binding limits on how much pollution may be emitted but leave it to the market to trade allowances and thus decide exactly who emits what. The tighter the cap, the higher the allowance price, encouraging participants to make investments to cut their greenhouse gas output.

Kevin Smith of Carbon Trade Watch, a non-governmental organisation platform monitoring cap-and-trade, points out that in the world’s largest scheme, the EU ETS, application of the theory has yet to result in cuts in carbon dioxide emissions. European Commission data released in April showed a 1.1 per cent rise in emissions from ETS participants in 2007 from the previous year.

“The problem with market-based schemes is they are vulnerable to being gamed for self-interest,” Smith says, adding that lobbying pressure generally results in caps that are higher than they ideally should be. Traditional regulatory measures to force emissions cuts are preferable, he argues.

But Barbara Buchner of the International Energy Agency says EU ETS emissions increases are not surprising because the scheme’s first phase cap (2005-07) was set too high. This became clear in May 2006 when 2005 emissions data was released, showing that installations covered by the ETS had polluted less than expected. A carbon price collapse swiftly followed. The European Commission has set a tighter cap for the second phase (2008-12). The feeling so far is that they have been tough enough, with carbon presently trading at about €26 per tonne.

According to Buchner, ETS participants acted to cut emissions in the early part of phase one “when there was uncertainty” about the carbon price, but reverted to their bad old ways when it was clear they would not have to pay any penalties. The main emissions-lowering technique used was fuel-switching by power companies – moving from coal to more expensive but less polluting natural gas. This showed that industry was exhibiting “rational behaviour”, Buchner says, implying that a tight cap and a forcefully regulated market could successfully deliver carbon cuts.

Useful links:
World Bank State and trends of the carbon market 2008 report
Morgan Stanley Clean energy: emissions trading: trends and opportunities report
Ends’ Guide to Carbon Offsets 2008 report