PHOTO: Mandel Ngan/AFP/Getty Images

Carbon futures: On 22 January, Jeffrey Imelt [left], chairman of GE, and Jonathan Lash, president of World Resources Institute, called for strong U.S. action on climate change, including creation of a carbon trading system.

Since its launch in January 2005, the European Union’s carbon trading system has exploded into a market totaling nearly US $20 billion, providing a model for countries seeking to limit carbon dioxide emissions. The Europeans have demonstrated beyond doubt that the right to emit CO2 is destined to be a major internationally traded asset—but their experience to date also exemplifies some of the pitfalls the rest of the world faces in establishing such trading systems. The price for the right to emit a metric ton of carbon has fluctuated wildly in Europe’s carbon markets, from a high of ¤30 (US $39) in early 2006 to a low of ¤3.40 in January 2007, amid much controversy about the system’s basic design and regulation.

“It is an obvious and crucial point,” says James Cameron, vice chairman of the London-based investment bank Climate Change Capital, “that this is a policy-driven market. It can’t be made to work unless governments impose the proper constraints on greenhouse gas emissions.”

In the United States, Congress is considering several bills to establish a cap-and-trade system for carbon, with action expected now that the Democratic Party has taken control of both houses. On 22 January, the day before President George W. Bush’s annual State of the Union speech to Congress, a coalition that included both top U.S. environmental groups and Fortune 500 companies like DuPont, General Electric, and Duke Power, called for carbon regulation, including a trading system [see photo, “Carbon Futures”].

A concern among some energy company executives in the advanced industrial countries that have not yet joined in the international program to reduce carbon emissions—notably the United States and Australia—is that they will suffer a competitive disadvantage as their counterparts in Europe and other regions gain experience with carbon trading systems.

“It is a real concern for American and Australian companies, and you are seeing many of them pressuring for national legislation on greenhouse gases,” says Henrik Hasselknippe, who is head of the department that analyzes the European trading system for Point Carbon, a power and carbon market consultancy based in Oslo. “They want certainty on this issue now. They don’t want to have to play catch-up later with European companies that are increasingly experienced in the carbon market.”

In cap-and-trade systems, a ceiling is set on a country’s total emissions from certain activities. Rights to emit specific amounts of carbon dioxide are then allocated to the organizations engaging in those activities. Over time the ceiling is lowered, which makes emissions allowances scarcer and more valuable. Industry tends to like the cap-and-trade approach because of the flexibility it offers: those finding it easiest to reduce their carbon emissions can sell allowances to those finding it harder, so that the total reduction aimed for is achieved at the lowest possible aggregate cost.

A disadvantage to cap-and-trade systems like Europe’s is that they generally cover only part of a jurisdiction’s total emissions and initially rely on historical emissions patterns, so that in effect those that have emitted the most carbon are rewarded. In some European countries like Germany, the advent of carbon trading has allegedly caused electricity prices to climb sharply, prompting complaints from big industrial energy users.

Of course, any system that raises the cost of emitting carbon in a given country will arouse concerns about impacts on the country’s competitiveness vis-à-vis countries not restricting emissions.

The European Union’s Emission Trading Scheme (ETS) was created in response to the United Nation’s Kyoto Protocol, which calls for advanced industrial countries to meet emissions targets by 2012 relative to a 1990 baseline, in a phased process. In the system, each member state is required to create a national allocation plan setting greenhouse gas emissions limits. Each state plan must be in line with the EU’s overall Kyoto emissions target, which calls for emissions to be 8 percent below 1990 levels.

Each European state in turn assigns emissions caps to installations in its energy-intensive industrial sectors, representing about half the EU’s total greenhouse gas emissions. Entities in the transport, light industry, and commercial sectors are not subject to caps at present.

In the system, each carbon allowance (known as a European Union Allowance, or EUA) represents the right, strictly speaking, to emit the equivalent of one metric ton of carbon dioxide. Other greenhouse gases are normalized in terms of carbon, depending on their warming potentials. Although some allowances are traded directly, company to company, the lion’s share of them—more than 70 percent—are broker traded. The remainder are traded on exchanges, about three-quarters on the European Climate Exchange, a fully electronic trading system managed out of London.