Carbon trading. Revving up

Money is piling into Europe's new markets for pollution permits

IF ONLY melting icebergs looked up with the eyes of hungry children, global warming might have stood a chance at Gleneagles. But Europe's new carbon markets aren't hanging around for substantive new measures from the G8. Prices, participants and volumes are increasing quickly.

The Kyoto treaty, which came into effect in February, saw an international emissions-trading system as one weapon against greenhouse gases. The idea is that a market-based system which gives countries and companies flexibility to meet their targets will produce the greatest emission reductions at the lowest cost.

Already Britain (in 2002) and then the European Union (from January 2005) have set up trial systems for carbon dioxide, the biggest of Kyoto's greenhouse gases. Europe's energy and industrial plants are being issued tradable annual allowances for emissions. Polluters that cannot squeeze under their caps buy the surplus of light polluters. The right wrists are slapped, and emissions overall are reduced at a lower cost than if each installation had had to meet an individual target.

Though the markets stuttered into life, they have grown surprisingly quickly. Volumes traded recently topped 2.2m tonnes a day. New exchanges are appearing: Austria launched an energy exchange on June 28th. Older ones are consolidating: Amsterdam's European Climate Exchange is joining Paris's Powernext to offer spot and futures contracts on the same screen.

What has made headlines, however, is the recent surge in the price of carbon allowances. On July 4th, it touched €29.35 ($34.90), a record. The cost of the allowances to produce one kilowatt-hour of coal-fired power is now greater than the cost of the coal itself, reckons Louis Redshaw of Barclays Capital.

Many reckon that the rise in emissions prices simply mirrors the rise in gas prices. When gas is dear, as it is now, utilities use more coal; because coal is dirtier, they have to buy more pollution permits in penance. And a heatwave in Europe since late June has dried up hydro power in the Iberian Peninsula and in Scandinavia.

Others, however, see a structural imbalance between supply and demand that may be harder to resolve. One reason why demand is outstripping supply is that a lot of firms that might have permits to sell are not yet participating, especially in new EU member states where allocation registries have not yet been set up. Many smaller firms do not have credit ratings and credit lines, so others are reluctant to do trades for future delivery with them, points out John Marlow of Rabobank.

The shortage, if there is one, may be eased by credits from projects outside Europe. Under Kyoto's Clean Development Mechanism (CDM), rich-country companies can earn certified emission reductions (CERs) by cleaning up emissions in developing countries. The EU allows them to be used to comply with caps. There is a rush to do just that, especially since CERs are changing hands for €7 or €8 and European allowances are heading for €30.

Europe's carbon-trading markets have a touch of the Wild West about them. At least two-thirds of the trades are over-the-counter and relatively opaque. Though part of the huge price gap between CERs and allowances is justified by the former's greater riskiness, it nonetheless invites swingeing arbitrage. “It's an emerging market with an awful lot to learn,” says James Cameron, chief executive of Climate Change Capital, a small investment bank, but he is confident that there is plenty of interest in just these sorts of strategies.

That people will make - and lose - money in the carbon markets seems assured. But will the markets help to reverse global warming? At these volumes, no. “It is just one tool but a very important tool,” says Elliot Morley, climate-change minister at Britain's agriculture department. Now, if only his boss could persuade George Bush to follow suit.