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The Market in Carbon: Can we trade our way out of this mess?

Sun, 26th Jun 2005

CARBON trading is suddenly all the rage. As with number 10 buses, you wait for years, and all at once emissions trading markets are springing up all over the place. Three have come on stream in Europe since the beginning of 2005, and another three will start up in the next few months. Around them, a whole ecology of traders, consultancies, start-ups, newsletters and websites has come into being. Carbon trading is now an industry in its own right.

There have been false dawns - and wildly optimistic estimates of trading volumes - about emissions trading in the past. So will it be different this time? Hopefully not, is the answer. When the Kyoto treaty was signed in 1997, among the mechanisms it put forward to help developed economies reduce emissions cost-effectively was an international emissions trading scheme (ETS).

Under a 'cap-and-trade' arrangement, nations and companies are allotted fixed carbon allowances, which they can trade: buying, in the case of heavy emitters that can't cut pollution quickly enough to meet their target selling, in the case of those that have surplus to their needs. In theory, the market mechanism rewards good behaviour, ensuring that improvements in emissions performance will be made at lowest cost and in the long term encouraging polluters to mend their ways.

When the Kyoto protocol came into effect last year, following Russia's ratification, it ended years of uncertainty. 'Ratification largely addressed the issue of political risk, and there has been an upsurge in interest from the investment community as a result,' says Graham Meeks, director of policy research at Climate Change Capital, a merchant bank specialising in clean energy.

One upshot has been the establishment of the world's first mandatory multinational carbon market, the EU ETS, which came into being this year. So far, volumes traded in Europe are small - around 500,000 tonnes a day, according to market analyst Point Carbon, most of which goes through brokers rather than the infant exchanges. The fledgling European Climate Exchange market, for instance, took 33 days to reach a total of 2 million tonnes. Even the larger figure is a drop in the ocean compared with the billions of tonnes of CO 2 the world pumps into the atmosphere every year, half of it through factory chimneys.

Predictions that one day carbon could be the most heavily traded commodity of all may be overdone. But from small beginnings, the totals are increasing fast. Today's daily totals are the equivalent of a month's trades in the pre-market phases last year.

Under Kyoto phase one, which runs to 2007, the EU is issuing permits for 2.2 billion tonnes a year. For the moment, says Point Carbon's Bjarne Schieldrop, only a few companies have dipped a toe in the market. Small buyers and sellers are fewer and farther between.

However, that may be about to change. At around euros 20, double the price at the beginning of the year, the carbon price is certain to tempt more sellers. Banks and other financial institutions are gearing up to start trading, both as aggregators for small companies and as speculators in their own right. In the longer term, other countries, such as Norway, Switzerland, Canada and Japan, are thinking of linking with the European system. Despite President George Bush's well-known hostility to all things Kyoto, even some American states, including Governor Schwarzenegger's California, are considering the merits of the market. In this context, Point Carbon's predictions of a 10 billion tonne, euros 200bn a year market hardly seem extreme.

So carbon trading may well thrive as a business. But will it succeed in its underlying mission - to cut emissions globally? Opinion is generally positive. 'If it is underpinned by strict regulation it has the potential to be a good system,' says Bryony Worthington, senior climate adviser for Friends of the Earth. 'It corrects the situation where it's cheaper to do the bad thing, and it rewards those that do good: a neat combination of stick and carrot.'

Optimists point to some encouraging precedents. Chicago's market in sulphur dioxide has helped to cut US sulphur emissions from 18 million to 9 million tonnes since 1995. Meanwhile, the UK's experimental Emissions Trading Scheme, now in its fourth year, has received an upbeat assessment from the National Audit Office. Globally, the scheme's voluntary participants have overachieved their annual targets.

Also positive is the example of BP. Spurred by Kyoto, and breaking ranks with the rest of the industry, the oil giant introduced its own trading scheme for group companies in 1998, in effect the world's first global ETS. In three years it reduced emissions by a fifth, nine years ahead of schedule. It also saved $650m in the process, in return for just $20m in outlay - an effective riposte to the standard industry whinge that tackling car bon will cost jobs and put companies out of business.

In the longer term, for firms to go beyond tactical manoeuvres - such as switching from carbon-intensive coal to carbon-light gas and buying permits - to substantial measures such as investing in energy-saving technology will require some further conditions.

At the moment, cautions Climate Change Capital's Meeks, the market is simply not liquid or mature enough for lenders or companies to be sure the current market price for carbon is the underlying, long-term one. 'Governments shouldn't put too much reliance on current incentives,' he warns.

That raises another issue. Phase two of the European ETS, guidelines for which will be discussed next year, lasts only until 2012 - far too short a time horizon for billion-dollar investment in power plant and other capital equipment. An A-list group of global businesses (among them Ford, Toyota, BA and BP) urged the G8 last week to put in place a long-term market mechanism similar to the EU scheme that would give them greater certainty about the future, pledging investment in return.

The third consideration is getting the caps right. If polluters are simply given the carbon rights to their existing emissions, to the extent that they can pass price rises on to customers or make easy tactical emissions savings, they are sitting on a potential windfall. In the Guardian recently, George Monbiot complained that in its present form, 'carbon trading ... rewards the polluting companies most responsible for the problem'.

This must not be allowed to happen, agrees FoE's Worthington: 'The market needs to be short.' Many observers believe that because of frantic national lobbying, this time round the allocations have been too loose. As a matter of urgency, FoE wants to see proper regulation and a global 'carbon inspectorate', much like the nuclear variety, to ensure the markets are kept honest.

On the other hand, she is clear that bringing CO 2 on to company books is a crucial symbolic and practical advance. For once, companies agree. It turns climate change from an environmental issue to a business one - and, as BP's Lord Browne remarked of his company's successful trading experiment, a manageable one at that.

The costs of tackling climate change, he concluded, 'are clearly lower than many fear'. The market makes it business's business to prove it.

The Observer, 26 June 2005


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