The global carbon market may still be in its infancy, but its development to date holds many lessons for the embryonic Canadian effort to tackle greenhouse-gas emissions in Canada.

As various countries around the world grapple with the challenge of reducing GHG pollution, a nascent global carbon market has emerged as one of the primary policy responses. In early May, the World Bank issued a report documenting the growth of that market and examining its future prospects.

That report found that the total value of the global carbon market more than doubled in 2007, to US$64 billion from US$31 billion in 2006. The report also notes that the market has been successful in sending price signals about the cost of mitigating carbon emissions: “This, in turn, has stimulated innovation and carbon abatement worldwide.”

The vast majority of this trading activity is accounted for by the most well-developed carbon market — the European Union’s Emissions Trading System, which saw the value of its trading double to more than US$50 billion last year from US$24.4 billion in 2006. Its trading action includes both emission credits and derivatives traded both over the counter and on two public exchanges.

Apart from the EU’s ETS (and a couple of other, much smaller trading efforts), most of the remaining carbon market value was accounted for by project-based transactions — primarily deals consummated under the Clean Development Mechanism, which allows firms to meet their emission-reduction obligations by funding abatement projects in developing countries, receiving credits for that against their own emissions totals.

The World Bank report notes that the volume of emissions trading in this area rose by just 8% year-over-year, but the value of these trades jumped by 34%, primarily because of higher prices for forward contracts on these projects.

To date, Canada is nowhere to be found in the global carbon market. The only real action on emission reduction in Canada has taken place at the provincial level. British Columbia and Quebec, for example, have adopted carbon taxes. Other provinces have joined regional emissions-trading schemes or developed their own.

Ottawa does have a plan to cut GHG pollution, which was introduced last year and clarified earlier this year. The federal plan imagines a variety of ways to meet reduction targets, including emissions trading, the purchase of domestic and international offsets, and paying into a carbon fund, among other things.

Ottawa favours a cap-and-trade system over carbon taxes. But the former mechanism has been slow to develop. The regulations necessary to implement a federal cap-and-trade system are expected to be published later this year. It’s hoped that they will be passed in 2009.

In the meantime, the Montreal Climate Exchange was scheduled to begin trading carbon futures on May 30, providing the first real opportunity for big polluters to hedge their expected future exposures — and for market speculators to trade these new contracts for profit.

The new exchange’s planned launch date is after Investment Executive goes to press, but MCeX spokesman Jean-Charles Robillard confirms that the exchange is on course to open for trading at 9:30 ET on May 30. The MCeX is finalizing participants on the new exchange and which firms will be serving as market-makers.

The launch of a carbon futures market is a welcome development, but lingering uncertainty about federal policy in this area makes it hard for firms to plan their approach to emission reductions. And while Ottawa continues to fiddle with its climate-change policy, increasing quantities of carbon are being burned.

The World Bank report notes that among the countries that ratified the Kyoto treaty on climate change, “Canada is patently not on track” to meet its target of cutting emissions to 6% less than 1990 levels.

As of 2005, says the report, Canadian GHG emissions were almost 25% more than 1990 levels, at 747 megatonnes of carbon dioxide equivalent; that is expected to rise to 830 megatonnes of CDE by 2010, putting Canada 260 megatonnes above its target level.

The federal plan aims to cut 330 megatonnes of CDE from Canada’s emissions total by 2020, although that would still leave emissions about 6% above 1990 levels.

Apart from the fact that the current federal government plan is not enough to meet Canada’s Kyoto obligations, the World Bank report also indicates that the plan is fraught with uncertainty — specifically, in terms of how federal efforts will mesh with existing provincial plans, which differ from province to province.

@page_break@The report notes that various provinces have differing reduction goals and are treading disparate paths to meet those targets. The report points out that some provinces prefer carbon taxes, while others want to use cap-and-trade schemes. The provinces also have varying levels of ambition and different approaches to cost control and the use of international offsets.

Moreover, the report suggests, the planned federal carbon fund may undermine emission-cutting efforts. The fund would set a price of $15 per tonne of CO2 emissions for 2010-12, rising to $20 in 2013, and indexed to GDP growth after that (until 2017).

Such a fund “effectively acts as a ceiling on the price of carbon,” the World Bank report explains. And although this price increases over time, it warns, “This may not be high enough to trigger a sufficiently high level of low-carbon investment decisions.”

Also, Ottawa’s plans are not expected to mesh that well with international initiatives. For one thing, Ottawa’s planned trading system contemplates intensity-based reductions rather than absolute reductions (the basis of the EU system, and the expected basis of a U.S. system), which would limit any possible interaction with other markets to create a global price for carbon.

Moreover, Ottawa’s plan limits the extent to which firms can reduce emissions through international offsets. Only 10% of firms’ reductions can be achieved this way under the current plan. As a result, the World Bank report indicates that the bank is not expecting much demand for these sorts of offsets from Canada: “It’s quite unlikely a substantial demand for offsets will materialize in the next 10 years or so in Canada.”

Projected demand for offsets from Canada is just five megatonnes to 10 megatonnes of CDE per year from 2010 to 2020.

If there’s a silver lining to Canada’s lack of federal leadership on climate change, it’s that this provides an opportunity to learn from the pioneering efforts in this area.

For one, it is now known that carbon markets can work. According to a study of the EU’s ETS published earlier this year by the Mission Climat of Caisse des dépôts at the Université Paris-Dauphine, the European carbon-trading system has been successful in setting a price for carbon emissions in the EU: “All the big industrial and financial players now consider carbon to be no longer free in Europe, and that carbon emissions will continue to be costly in the future.”

The study also found no empirical evidence of any loss in market share in the various power sectors because of the emergence of carbon pricing. The researchers admit, however, that they can’t make any conclusions about the long-term competitiveness of these industries.

Additionally, the researchers point out that the development of the European carbon market represents the first experience with linking markets, and it validates the concept of carbon trading: “Europe’s choice of emissions trading has created a ‘fact on the ground’ that will be difficult to ignore in future global climate negotiations. The EU ETS is likely to contribute to the shape of a future global system, and is already instructive for emerging national and regional schemes.”

Of course, the most important lessons often come from mistakes; and the EU’s initial efforts at carbon trading have been criticized for a variety of these — not the least of which is the fact that it set emissions caps too high and issued too many permits when it was first launched.

Notwithstanding this gaffe, research found that emissions abatement did occur as a result of Europe’s cap-and-trade system, and often in ways that were not anticipated. Moreover, the Europeans are also learning from the mistakes made the first time around. Among other things, the EU is now imposing tougher targets and allowing more flexibility for compliance.

“These proposed reforms create confidence in emissions trading as a credible and cost-effective tool of carbon mitigation,” the World Bank report insists.

That said, the carbon market still has a long way to go. “Carbon market momentum is strong for now,” the bank report suggests. However, it warns that the mechanism for financing offset projects in developing countries is facing an uncertain future. Although the EU continues to improve its trading system, the report says, the project-based market, “after its strongest year yet, finds itself at a significant crossroad.”

The report suggests that this mechanism should be reformed to “focus on catalyzing step changes in emission trends and on creating incentives for large-scale, transformative investment programs.”

And, the report adds, there’s still a need for a primary market to source offset credits, which don’t lend themselves to the sort of standardization required for exchange trading, given the variety of projects available and risks involved.

Despite the challenges facing the global carbon market, the World Bank report concludes, these mechanisms have shown that they can work: “Long-term policy signals about intended carbon constraint policies and well-designed regulatory systems and infrastructure will send the appropriate signals to investors.” IE