Pollution markets are emerging as a key strategy to combat the effects of global warming. The basic idea is to set limits on pollution emissions, issue tradable credits to polluters and then let the market sort it out. Companies can then meet their limits either by cutting their own emissions or by buying credits from other firms that have emission capacity to spare.

The appeal of pollution trading is that it offers a private-market solution to a public problem. It allows governments to impose emission reductions, but gives big polluters flexibility in meeting the requirements. The mechanism is also believed to be more efficient than imposing indiscriminate, across-the-board emission cuts. And government gives financial innovators something else to turn into a tradable commodity.

Pollution trading markets are not new. In 1992, U.S. firms began trading in sulphur dioxide emission credits as a way to combat acid rain. But such market-based solutions are becoming more popular as companies and governments around the world try to devise practical ways to battle the effects of climate change.

In December 2003, the Chicago Climate Exchange was launched as an experimental voluntary emissions-trading exchange. The goal is to prove that industry can voluntarily cut emissions — market participants from a variety of industries agreed to cut their greenhouse gas emissions by 4% by 2006 — and then efficiently meet the goals through a market mechanism.

The concept is now gathering momentum through the more conventional route of government-imposed emission reductions as a result of the widespread adoption of the Kyoto protocol. Following the implementation of Kyoto, which aims to reduce global greenhouse gas emissions to 5% below 1990 levels, the European Union developed its emissions-trading scheme to allow firms within the EU to trade pollution credits. Under Kyoto, the EU must reduce emissions to 8% below 1990 levels, while Canada must cut to 6% below 1990 levels. The system came to life in January, and a variety of exchanges have popped up to facilitate the trading.

Canada is late to the game, but it’s nevertheless starting down the road to carbon trading. In mid-July, the federal government finally came out with its greenhouse gas emission-reduction plan, which includes plans for a cap-and-trade scheme for large polluters.

Under the plan, which is out for comment until Sept. 14, the government will set the basic rules creating domestic offset credits and establish an electronic tracking system to monitor the tradable units that companies own. It is looking to the private sector to establish the actual emissions-trading infrastructure and a carbon/emission exchange.

The logical choice to develop such a system is an existing trading firm, such as TSX Group Inc. or Montreal Exchange Inc. In mid-June, however, TSX CEO Richard Nesbitt suggested a carbon-trading market was not likely to develop in Canada in the immediate future. Then a month later, the government released its plan, and, indeed, it contemplates a carbon trading market.

Steve Kee, TSX director of corporate communications, says the exchange will certainly study the possibility of getting into emissions-trading business. The TSX plans to comment on the government’s plans.

Jean-Charles Robillard, the MX’s director of communications, confirms that the MX is also interested in the emission-trading business, providing that it makes economic sense. He notes that current proposals would cap the price of carbon, which would inhibit the operation of a genuine free market. (The proposed cap at $15 a tonne is well below the recent market price of almost £30 a tonne in mid-July). Nevertheless, as the government’s plan crystallizes, Robillard suggests, the MX will be interested in the possibility of developing a domestic market.

The government’s plan indicates that it believes the imposition of limits on large polluters and the creation of tradable credits will, in turn, create the conditions for the emergence of an emissions-trading market.
Indeed, in countries that are more advanced in their movement toward meeting Kyoto goals, a variety of markets and products have sprung up to fill the void.

For example, a new carbon futures contract developed by one of the biggest pollution-trading exchanges, the Amsterdam-based European Climate Exchange, traded on April 22 for the first time. The contract allows polluters to lock in prices for emissions allowances delivered at set dates in the future, and is an alternative to over-the-counter forward contracts.

@page_break@As the emissions-trading markets develop, so, too, do the familiar pressures afflicting traditional financial markets, such as the battle for liquidity and the pressure on commissions. In a recent research report, Canaccord Capital Inc. analysts observe that competition between emission brokers and exchanges in Europe has turned into a price war. “Europe has several exchanges vying for the top spot that are in the vicious circle of only attracting trades if they already have liquidity,” the report notes. Canaccord expects the battle for liquidity to continue until one exchange emerges dominant.

The same positioning is also going on among brokers. “We are also aware that several brokers are fighting for volume at the expense of commission. While prices have not fallen to institutional equity trading rates, they are heading that way and we are told one major broker has offered zero-commission emission trades, provided clients continue to trade all their electricity through them,” Canaccord reports.

Given that greenhouse gas emissions are a global problem, it ultimately makes sense that trading take place on a global basis, and there appears to be some movement in that direction. The Canadian government’s recently released plan casts an eye toward a global trading system by suggesting that, along with the polluters that actually need the credits, the Canadian market will be open to individuals, brokers and other levels of government. The Canadian market could also link into an international carbon market and other regional markets.

Indeed, in early June, a group of 24 of the world’s biggest companies (including Alcan Inc., Ford Motor Co. and Deutsche Bank AG), through the World Economic Forum, called on the leaders of the G-8 to take steps toward a global emissions-trading system.

“We consider this a significant development, as the companies were effectively asking for a price to be put on [greenhouse gas] liabilities,” notes the Canaccord report. “We do not believe this move reflects an unexpected burst of altruism; rather, it shows a desire to manage environmental risk [in] commercial terms — using market mechanisms — rather than risk onerous regulation.”

The companies did not get their wish at the latest G-8 meeting held in Scotland in early July, but there is still hope that market-driven approaches will proliferate. “The signs for wider participation are quite favourable, despite a lack of progress at the G-8 summit,” notes a recent report from London-based merchant bank Climate Change Capital. “Recent developments in the U.S., in particular, make some form of federal emissions-trading scheme a distinct possibility after 2008.” Large states such as California have also expressed interest in emissions trading.

The CCC report suggests that the fledgling European carbon market is at a critical stage. High energy prices have pushed up carbon prices, in fear that companies will turn to cheap but dirty coal in the face of persistently high gas prices. There’s also talk of expanding the system to cover other pollutants and bringing more players into the market by imposing emission reductions on other industries. Yet, uncertainty about how the markets will work in the long run is inhibiting trading and investment, it notes.

One of the problems in pricing carbon, notes a report by Oslo-based research firm Point Carbon, is the role of political and regulatory concerns. Other factors such as weather, energy prices and economic growth are also critical, but governments set the emission caps that ultimately influence supply and demand in the market. This creates uncertainty, as does the prospect of Kyoto’s expiration in 2012. That said, Point Carbon suggests: “In the longer term, countries such as the U.S. and Australia may decide to re-evaluate their stance in climate politics and enter into an agreement that would form the basis for a truly global
emissions-trading market.”

Positive results are a long way off, but things are moving in the right direction. For once, traders could come out looking like good guys. IE