Businesses and envi-ronmentalists agree that carbon markets are one of the most practical ways to curb carbon emissions. Yet, the carbon market in Canada is stalled. To get it off the ground, policy-makers should take heed of lessons learned elsewhere in early attempts at carbon trading.

Growing fears about the detrimental impact of climate change on the global economy and human habitat have focused politicians’ attention on the problem of stemming greenhouse-gas emissions throughout the developed world. In Canada, the political fight is now over the details of how to do it and by how much, not whether the objective is a worthy one.

Ottawa released a reworked environmental plan at the end of April, after its initial effort, published last fall, was widely condemned. The new plan calls for carbon intensity reduction of 20% less than current levels by 2020 — and it reiterates that the government sees emissions trading as central to the objective.

The feds envision a domestic trading system, along with some ability to buy credits from developing countries, and potential links to other carbon markets, particularly in the U.S., as they become more mature. What’s needed, however, is the framework necessary to get such a scheme off the ground.

All major Canadian exchanges have expressed an interest in the possibility of getting involved in emissions trading. Montreal Exchange Inc. has established the Montreal Climate Exchange in conjunction with the first volunteer carbon market in North America, Chicago Climate Exchange Inc. The MX’s chief rival, Toronto-based TSX Group Inc. , has also expressed interest in emissions trading — calling for a regime that allows competition among markets in the arena. WCE Holdings Inc. , parent to the Winnipeg Commodity Exchange, established Canadian Climate Exchange Inc. in 2003 for the purpose of trading carbon credits.

So far, however, the government has been slow to give the idea the kick-start it needs — imposing emission caps that companies then must find some way to meet, as well as introducing a regulatory framework for trading to take place.

According to a recent report by the World Bank on the development of the world’s carbon markets, for emissions trading to work properly and reduce pollution efficiently in a regulated market, policy-makers must set proper emission limits: “Regulated carbon markets can only achieve environmental goals when policy-makers set scientifically credible emission reduction targets while giving companies maximum flexibility to achieve those goals.”

Trading systems are a popular solution, in theory, because they apply the efficiency-maximizing features of markets to achieve very difficult policy objectives. Rather than having a government dictate indiscriminate emission cuts from the top down, a cap-and-trade system works by setting an overall, economy-wide emissions limit and issuing permits for specified levels of emissions, by either handing them out or auctioning them off. Polluters can then trade the permits — the idea being that the burden of cutting emissions will then be allocated efficiently, as firms that can cheaply cut their emissions will do so, whereas those that find it harder will buy permits from those that don’t need them.

While the theory is great, the practice has been less impressive. Setting credible reduction targets has proven a problem so far in the market trading schemes that have been developed.

By far the most extensive experiment with carbon trading has been the European Union emissions trading scheme. The World Bank says it accounted for about US$25 billion of the US$30 billion in emissions trading that took place worldwide in 2006.

INAPPROPRIATE CAPS

The World Bank report found that the EU system “demonstrated that a carbon price signal in Europe succeeded in stimulating emissions abatement, both within Europe and especially in developing countries.” It also observed, however, that following the release of verified 2005 emissions data, “it became clear” that the emissions cap “had not been set at an appropriate level relative to what actual emissions were in that period.”

In other words, the authorities issued too many permits. As a result, market expectations and carbon prices were based on incorrect assumptions of the carbon constraint, “leading to high volatility in the market,” the World Bank report notes.

Analysts atJ.P. Morgan say the mistake was due to either poor up-front calculations or various national governments gaming the system. The more permits each country issues means the fewer genuine emission reductions they’d have to make.

@page_break@The J.P. Morgan report found that the only countries that had fewer permits than actual emissions in 2005 were Austria, Ireland, Italy, Spain and Britain. Overall, the EU issued 5% more permits than actual emissions, but several countries had allocations that exceeded their actual emissions by as much as 25%.

The World Bank says that the EU Commission has characterized its first stab at emissions trading as a “learning phase,” and it insists it will do a better job allocating the permits in subsequent phases. The World Bank also notes that in the second half of 2006, markets began to reflect the expectation that future allocations will be much stingier. J.P. Morgan says allocations to date have come in, on average, 9.5% below their requested levels.

Along with credible targets, the World Bank says, regulated markets also require clarity on the assumptions for economic growth and baseline carbon intensity improvements; standardized, transparent emissions data; and strict penalties for fraud or non-compliance.

As well, the TSX has stressed the need for a framework of basic policies, including trading rules, surveillance and enforcement to create a level playing field among marketplaces; a minimum of regulatory fragmentation; no barriers to entry; and national compliance requirements, so that an emission credit has a common national value.

So far, Ottawa has yet to deliver such basic preconditions. As a result, the Canadian markets that could develop are left in limbo.

Steve Kee, director of media and marketing at the TSX, indicates that the government’s current plan doesn’t provide enough of a framework for the TSX to get moving on the development of a carbon market.

Similarly, Jean Charles Robillard, the MX’s director of communications, says that the exchange is still in the process of consulting with potential participants in a carbon market. The MX remains committed to launching a market, he stresses, but before it goes ahead, it wants to be sure such a market is needed, that the right sort of products are available and that it gets the timing right.

Naturally, the issue is politically sensitive. A new report by CIBC World Markets Inc. highlights the regional disparity that exists within Canada in terms of emissions. It notes that a national emissions-trading scheme would probably create significant interprovincial trade in carbon credits, which may become yet another significant transfer payment among provinces.

Depending on the price of carbon and how permits are allocated, CIBC notes, heavy emitters such as Saskatchewan, Alberta and New Brunswick would probably be big buyers of credits, with Quebec and Manitoba as notable sellers.

By industry, CIBC estimates that about 40% of the TSX market capitalization would be affected by carbon pricing, largely negatively. Utilities are the most vulnerable, it says, accounting for 45% of the carbon emissions associated with the index but just 1% of the market cap. CIBC says coal-fired electricity generators could be hit hardest by carbon caps, followed by the oilsands, smelting and crude oil industries.

Markets can be an efficient mechanism for reducing carbon emissions. But to be effective, they first require a framework that ensures trading will be fair and that emissions data is both transparent and scientifically credible.

Canada isn’t there yet. IE