Slowly but surely, the idea of carbon trading is gaining traction in North America. But it’s dawdling governments — not reluctant companies or disinterested traders — that are stalling its adoption.

As governments grapple with the issue of climate change and the challenge of limiting greenhouse-gas emissions, two basic methods of encouraging businesses to curtail their carbon dioxide emissions are being floated — taxes and trading. The basic goal is the same in both cases: to put a price on CO2 emissions, giving companies that are major polluters a price point that either forces them to reduce their emissions or pay up for the privilege of polluting.

Some jurisdictions, notably British Columbia and Quebec, have embraced the notion of carbon taxes. And some economists prefer this sort of measure because it’s straightforward and relatively easily to implement. However, taxes are regarded by others as too blunt a tool — not to mention potentially politically unpalatable.

In Canada, the federal government has long backed the idea of a “cap and trade” system, which theoretically allows for more efficient emission reductions, compared with a carbon tax. Under such a system, the government caps CO2 emissions, issuing permits that allocate those emissions among major polluters. Then companies that can easily cut their pollution do so, and bank their emission credits; those that face a costlier effort can buy pollution permits from these cleaner companies.

What has been slow in coming is the necessary infrastructure to allow such a trading system to develop in Canada. Without a cap on emissions being imposed by the government, there’s nothing to trade and no incentive to stop pumping pollution into the atmosphere. Yet, the federal government has proved reluctant to impose such caps, largely for fear of disrupting the energy boom that is fuelling the Canadian economy.

The issue can’t be ignored forever, particularly as the big holdout on the worldwide effort to reduce carbon emissions — the U.S. — appears to be heading toward policies to curtail GHG emissions. There are a variety of emission-reduction bills working their way through Congress and, perhaps more important, all three of the remaining U.S. presidential candidates are said to support some sort of cap-and-trade system as a way to cut emissions.

In the meantime, there are also efforts underway to reduce emissions at the state level. The large and economically powerful state of California is imposing reductions. And in mid-March, the states participating in the so-called Regional Greenhouse Gas Initiative (comprising 10 northeastern and Atlantic seaboard states) announced that the RGGI will hold its first carbon permit auction on Sept. 10; compliance with its cap-and-trade program will begin Jan. 1, 2009.

The Canadian government is crawling when it comes to implementing its plan to limit GHG emissions in the years ahead. In the latest federal budget, federal Finance Minister Jim Flaherty pledged $66 million over the next two years to, among other things, develop the necessary framework for a carbon trading system (including the creation of an electronic tracking system for the credits that are issued).

And, in early March, federal Environment Minister John Baird provided further details on the government’s emission-reduction plan, including a bit more clarity on the plan for emissions trading. That plan spells out how emission-reduction targets will apply to various different industries, and how the system of offsets and credits will work.

In response to that announcement, the Montreal Climate Exchange (a joint venture of Mon-treal Exchange Inc.and the Chi-cago Climate Exchange, a vol-untary U.S.-based carbon exchange) announced that it plans to begin trading carbon futures by the end of May, pending regulatory approval.

Last October, the MCeX filed an application with Quebec’s Autorité des marchés financiers to trade two types of futures contracts based on so-called “CO2 equivalent units” (each of which essentially is the right to emit a metric tonne of CO2).

Assuming that the plan receives regulatory approval, the emergence of this futures market will be coming well in advance of any actual cap-and-trade system getting up and running in Canada. But that’s also how things developed in Europe (which has the wold’s most advanced emission trading system): the derivatives market emerged before the underlying cash market really came into being.

As the MCeX explains in its submission to the AMF, futures markets have been launched before an underlying cash market can develop because governments have to create, and allocate, trading units and develop a registry to track these units; but heavy polluters are eager to manage their exposures before they have to start actually cutting their emissions.

@page_break@The MCeX also reports that, based on the European experience, about half of the carbon trading will be carried out on the exchange, and half will be over-the-counter, with about 90% of trading occurring in the futures market.

Indeed, not only is this sequence of events the way things unfolded in Europe, but on Mar. 17, the New York Mercantile Exchange dé-buted its pollution trading facility, known as the Green Exchange, which offers futures and options on EU carbon allowances and sulphur dioxide emissions, along with futures on certified carbon reductions and nitrogen oxide emissions. This also comes in advance of any federal carbon reduction regime in the U.S.

The MCeX stresses that futures trading will act as a price discovery mechanism for a tonne of carbon, and provide a method of managing the risk associated with the cost of emission reductions. Along with polluters, the MCeX suggests, players in this market could include financial services institutions, institutional investors, hedge funds and insurance companies looking to hedge exposure to insurance products that carry some carbon price risk. Moreover, setting a price for carbon will also inform the business plans of companies that aim to develop new technologies to cut their emissions.

Although the promise of carbon trading is great, the weak link has often proved to be the contribution of governments. In Europe, early efforts were troubled by national governments gaming the permit allocation system, overly generous allocations and the fact that permits were given away rather than sold or auctioned; as a result, the prices in carbon trading ultimately crashed. Europe has learned the lessons from that first effort and promises to be tougher with future allocations.

In Canada, the federal government has been slow to do its part to develop a trading market. The MX had hoped to get its market launched by the end of last year, but was only able to do so after the government came forward with the latest details of its plans, providing greater regulatory certainty. That should better enable polluting firms to predict their exposures. In turn, Environment Minister Baird applauded the MX’s announcement of a launch date for futures trading.

But others are not nearly so complimentary of the government’s efforts. In a research report following the announcement, Blackmont Capital Inc. observed: “The government fell well short of what it said it was going to do. It had promised to impose limits on GHG emissions in 17 industries, but only delivered firm targets for two sectors.”

The report notes that the targets for all sectors will now be revealed in regulations, which are due to be published in the autumn. But, in the meantime, the companies that are likely to be most affected by the initiative are left somewhat in the dark: “The more significant implication of this announcement is that it introduces even more uncertainty into what is already a reasonably uncertain market, making it all the more difficult for companies that are reliant on the capital markets to sustain their capital programs.”

Not only are some resources companies probably less than pleased with the government’s efforts at setting policy in this contentious area, but its insistence on a “made in Canada” solution is also drawing some criticism from the MX’s future bedfellow, TSX Group Inc.

In a speech to the Calgary Chamber of Commerce, Rik Parkhill, interim co-CEO of the TSX, criticized the federal government’s latest plan because it focuses on reducing the intensity of emissions rather than a hard cap on overall emissions. That is incompatible with the current European system and may not match up with what the U.S. decides to do, thereby hampering the emergence of a global price for carbon and possibly inhibiting the creation of an efficient market for Canadian firms.

“Our view is that compatibility with the U.S., and Europe for that matter,” said Parkhill, “are desirable if we are to all benefit from having a highly liquid market. A highly liquid market, as with other securities, is essential for efficient trading and lower costs.”

Parkhill also suggested that a system that is fundamentally at odds with the other major carbon trading systems globally may not be big enough to be economically viable from the exchange’s point of view.

All too often, Canadian policy-makers insist on insular approaches to international issues. The folly of this sort of approach is rarely in greater evidence than on a question of such genuine global significance as the effort to mitigate climate change. IE