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Published By: Financial Times
June 18, 2008

By Fiona Harvey and Stephanie Kirchgaessner

Published: June 18 2008 03:00 | Last updated: June 18 2008 03:00

Page A7

Devoid of American participation, the international market in carbon dioxide emissions is a partly formed creature whose health remains uncertain. When President George W. Bush took office he refused to ratify the United Nations' Kyoto protocol on climate change and attempts to set up a domestic system of trading emissions have been thwarted.

But with Mr Bush's departure next January, that is likely to change. Both John McCain and Barack Obama have pledged to introduce a federal carbon trading system if they succeed him. Though a proposal for such a system failed to secure enough support for a vote in the Senate this month, many think it will return successfully under a new administration.

If so, that would do more than anything to propel this obscure market into becoming one of the most important elements in world trade - influencing the price of oil, gas, electricity and more. "It would have a very big effect," says Henrik Hasselknippe, director at Point Carbon, a carbon market analysis company. "It would be a huge event."

Carbon trading elsewhere has been growing solidly since 2005, when the European Union started its trading system and the Kyoto protocol came into effect. Last year the market was worth about $64bn (£33bn, €41bn) according to the World Bank, more than doubling from $31bn in 2006.

Yet the value would soar to more than $3,000bn a year by 2020 if the US introduced carbon trading, Point Carbon estimates. The US, the world's biggest annual emitter of greenhouse gases until overtaken by China last year, would account for about two-thirds of the total. "The market is already preparing for a new policy shift," says Paul Newman, managing director of Icap Energy, an energy trader, in London. "US participation really does matter."

The investment in carbon-cutting technologies that would be stimulated by a global carbon price could also benefit the world's economies, according to Mitchell Feierstein of Cheyne Capital, the fund management company. He predicts that carbon trading legislation will lead to the "development of numerous ancillary climate- change-related businesses, which will provide an immeasurable boost to the global economy that may prove to be bigger than the tech boom".

Conversely, it could prove fatal for the carbon market if the US shunned carbon trading for much longer. The European Union's bloc-wide emissions trading scheme would be in danger, as businesses and politicians would clamour for a more competitive basis with US industry, says Mr Hasselknippe, adding: "It's critical for the carbon market to get the US involved in the long run." Worse, without US approval a successor to the Kyoto protocol - the main provisions of which expire in 2012 - is unlikely, threatening to end a flow of carbon trading investment from rich to poor countries.

Carbon trading was established under Kyoto as the mechanism by which countries and businesses could be encouraged to cut their output of greenhouse gases. Under a provision of the treaty called the clean development mechanism, rich countries can meet part of their obligation by investing in projects that cut emissions in poor countries. These projects, which range from wind turbines and solar power to the elimination of industrial gases, receive carbon credits from the UN, which rich countries can buy to make up their target.

In the EU, heavy industries including power generation, steel and cement-making have for three years been subject to restrictions on how much carbon dioxide they can emit. They each receive a certain quota of carbon permits and companies wishing to emit more must buy extra permits from cleaner businesses with spares. The scheme, called EU ETS, was the world's first mandatory cap-and-trade system for carbon dioxide.

The two systems are linked, with the EU soon to allow businesses to buy a limited number of extra permits in the form of carbon credits issued by the UN. If the US were to enter the carbon trading market - which is unlikely before 2012 - it would probably institute some form of similar mechanism, by which UN credits could also be traded within the US.

Carbon credits under the Kyoto protocol vary widely in price but most are cheaper than those in EU ETS, reflecting the lower cost of cutting emissions in poor countries. That can help to depress the carbon price in spite of high oil prices. "The nice thing about a cap-and-trade system is that emissions reductions are led by the invisible hand towards the places where the cost of reductions are at their lowest," says Mr Newman.

Yvo de Boer, the UN's top climate change official, with responsibility for overseeing the next year and a half of negotiations on a successor to Kyoto, says market-based mechanisms such as carbon trading are essential to bringing down emissions, as they stimulate the high levels of private sector investment needed to kick-start a low-carbon economy. The stance of the two White House contenders "augurs well for the continuation of the carbon market".

Paula Dobriansky, undersecretary of state for democracy and global affairs, says the US is in any event on course to forge the underpinnings of a new global agreement under the Bush administration, which is prepared to sign up to "binding international agreements" requiring emissions cuts.

Emissions trading would be nothing new for the US, which pioneered such mechanisms in cutting the emissions of pollutants such as sulphur oxides and nitrogen oxides in the 1990s. In addition, the US would be able to learn from the EU's experience, says Mr Feierstein. America would "be able to create a much larger-scale cap-and-trade model with meaningful, real, permanent and additional emission reductions based on broad-based consensus".

He warns that any legislative proposals should contain long-term targets, saying: "Any climate change legislation needs to create a degree of long-term policy certainty that offers incentives to ensure and engage the investment community in the long-term deployment of capital in the new and innovative technologies supportive of low-carbon economies, which will create expedited solutions to global warming." While the proposed legislation introduced this month did not muster enough support for a vote on the Senate floor, most analysts agree that the bill would serve as a blueprint for a law that would pass with the support of a new president.

Environmentalists and others who support a cap-and-trade system say the debate proved that a majority of lawmakers agreed on the basic principles but that a detailed plan would face significant hurdles, both from Republican lawmakers and Democrats from regions that could be economically hit by a cap-and-trade regime.

Paul Bledsoe, director of communications and strategy at the Washington-based National Commission on Energy Policy, says the Senate debate showed that a "broad but fragile" consensus exists for an economy-wide cap-and-trade system that would limit costs and offer incentives for developing countries. "Beyond that", he adds, "problematic issues will arise". Those include determining how permits to emit are allocated among polluting companies and individual US states and how thousands of billions of dollars in revenue will be spent.

Myron Ebell, director of energy and global warming policy at the Competitive Enterprise Institute in Washington, has long been an opponent of climate change legislation, arguing that global warming will not have the catastrophic effects predicted. He says high oil prices and the worsening economic outlook will play a big part in any debate over a US cap-and-trade system. "I remain hopeful that we will be able to defeat cap-and-trade legislation in the next Congress because I can't see many members of Congress wanting to tell their constituents that they're just going to have to get used to escalating energy prices for the next several decades in order to enrich big business," he says. "The background for making a convincing case for energy rationing is most unpropitious: people are angry about high gasoline prices, EU emissions are rising, Chinese emissions are soaring, global temperatures are flat and it is becoming ever clearer that cutting emissions is going to be enormously expensive for consumers."

Legislators will also have to grapple with issues such as how low to set the ceiling on industrial carbon emissions, which industries to cover and how to ensure that companies that cut their emissions before the cap was imposed are not penalised.

In a hint of the tough debate that is likely to ensue next year over the shape and scope of any system, 10 Democratic lawmakers said in a letter to Senators Harry Reid and Barbara Boxer this month that the structure of a cap-and-trade bill would have to be designed to "balance" the burdens of compliance costs across states and regions that might be most severely affected by the legislation. "While placing a cost on carbon is important, we believe there must be a balance and short-term cushion when new technologies may not be available as hoped for or are more expensive than assumed," they wrote.

Indeed, Eileen Claussen, president of the Pew Center on Global Climate Change, says the biggest fights on Capitol Hill will centre not on carbon targets or timetables but on how future legislation will contain costs, invest the revenue and deal with regions that rely on coal.

"We will have to find a way to draft legislation that can garner support from the middle without losing senators from the left," Ms Claussen says. "On the one hand, it is good that we have a lot of senators who think this is a good idea. But for those who thought this was going to be relatively easy, it is going to be relatively hard." The fate of more than just the US carbon market hangs on the outcome.

Does the cap fit?

Is carbon trading better than a carbon tax? That question has been vexing economists and politicians since the Kyoto protocol on climate change was first mooted in the early 1990s.

Carbon trading has the advantage of setting a firm cap on emissions and allowing companies to use the market to find the lowest-cost way of cutting their greenhouse gases. The firm cap is in line with scientists' warnings that emissions must at least be halved by 2050.

But according to many economists, a carbon tax - levied on energy consumption - would be preferable because the firm cap makes cap-and-trade systems vulnerable to shocks, such as a sudden sharp movement in the gas price. That could cause turmoil for companies covered by the system.

A carbon tax set at an appropriate rate would be more predictable, allowing companies to plan better.

The catch is that new taxes are unpopular with consumers and imposing a carbon tax would require unusual temerity from politicians. The fact that carbon trading affects only companies and is invisible to consumers makes it more palatable and gives it a greater chance of survival at the hands of the electorate - which is why it has been the clear winner among politicians vowing action on climate change.

Copyright The Financial Times Limited 2008