The art of setting caps at an appropriate level has been an ongoing challenge for policy-makers. In the earlier days of trading, when the price of allowances soared, it was because of what turned out to be an artificial scarcity. “The market was skewed as power companies with the greatest need to reduce their emissions became active [buyers] in the market, while those who had the allowances to sell were absent from it,” explains Point Carbon’s Hasselknippe. “Many of [the latter] were not used to trading in this way, and they didn’t have [in-house trading] desks set up.”

According to Hasselknippe, when the actual 2005 emissions data were released in the spring of 2006, it became obvious that the nonpower sector had been allotted overly generous caps for the first phase of Europe’s Kyoto reductions (2005 to 2007). Expectations developed that the market would soon be flooded with these excess carbon credits. The price of allowances subsequently collapsed to less than ¤10 in May 2006. As this article went to press in mid-March, an allowance for delivery in December 2007 was trading at ¤3.85.

Recognizing that a sufficient scarcity of the commodity traded is a precondition of a functioning market, the European Commission responded in November by slashing Phase 2 emissions caps for energy-intensive industrial installations to an average of 7 percent below proposed levels for the first 10 nations that submitted plans. It brought formal proceedings against countries that failed to submit plans by the 30 June 2006 deadline, and it announced that the same stricter standards would be applied to them. The commission also ruled that any allocated allowances that were not used under Phase 1 could not be carried over to raise Phase 2 caps.

The commission has also moved to put brakes on participation by European states in the fast-growing but controversial Clean Development Mechanism, an institutional element of the Kyoto program. Under the CDM, entities in industrialized countries can purchase carbon emissions credits by investing in approved emissions reductions projects in developing countries that are not subject to Kyoto emissions targets. The CDM has fast become big business. According to Point Carbon, which tracks CDM deals, the equivalent of more than 370 million allowances were traded in 2006 under the CDM, versus a total of 817 million allowances traded as part of the European system.

The CDM has come under sharp criticism at both ends. For allowance-purchasing Europeans, it has evolved into a relatively cheap source of carbon credit and, some argue, has discouraged big emitters from undertaking more expensive internal CO2 reduction projects. The main selling countries—Brazil, China, and India—stand accused of using the mechanism as a means of extracting money from industrial countries and, ironically, as an excuse to pollute even more.

To be sure, CDM projects must meet certain rigorous tests. “You can’t set up a CDM project that is already technologically common practice or economically feasible in the [developing] country,” explains Miles Austin, a commercialization manager with the emissions trading broker Ecosecurities, in Oxford, England. “You have to prove that the carbon reduction associated with the project would not have happened in the ‘business as usual’ case.”

Yet complaints persist that unscrupulous factory operators in developing countries are stepping up production specifically to sell emissions credits. For example, CDM projects in China that abate HFC-23 gas, a noxious by-product of the production of an ozone-depleting refrigerant, HCFC-22, have come under fire. This is because the sale of their associated emissions credits may allow the owners of the refrigerant plants to sell emissions credits for much more than the emissions abatement actually costs to implement, thus allowing them to reap excess profits. As a result, these CDM projects have reportedly encouraged the production of more HCFC-22.

Responding to such concerns, the European Commission has created a new rule for the CDM and a similar program called the Joint Implementation: carbon credits from projects in those programs cannot exceed 10 percent of a given installation’s emissions allotments in Phase 2. The Joint Implementation, which at present is far less popular than the CDM, allows parties in industrialized countries to purchase emissions credits by investing in emissions reduction projects of counterparties in other industrial countries.

The United Nations also has taken measures to address this concern. “New rules demand that historical production patterns be taken into account,” says Austin. “So you can’t, for example, just turn on the tap and run your HCFC-22 factory 24/7 to churn out more HFC-23 gas for abatement.”

Should emissions caps be set more tightly, and should more sectors of the European Union’s economy be forced to comply with them? Would auctioning emissions allowances rather than allocating them for free create a more efficient market? The answers to these questions may be “yes” in the best of all possible worlds [see box, “Lessons Learned ”], but Cameron of Climate Change Capital argues that the European Trading System, while imperfect, is better than the alternative of inaction.

“One of the great, real problems with addressing climate change apart from its complexity,” says Cameron, “is that the good guys tend to make perfection the enemy of the good, and the bad guys have used complexity as a reason to do nothing.” Cameron is optimistic that the EU trading system is providing the template and a training ground for an efficient global carbon market “where vast sections of the world’s economies will be connected to a common carbon price, and millions of decisions made every day will have a carbon price built into them.”