Making money from pollution

Following the 1997 Kyoto agreement, carbon trading - where firms trade and exchange pollution allowances - is on the rise. This will create investment opportunities, says Simon Wilson

Why are carbon emissions bad?Gas emissions containing carbon - such as carbon dioxide, carbon monoxide and methane - are produced by industrial processes, such as burning fossil fuels. As the world becomes more industrialised, the build-up of these gases traps heat in the earth's atmosphere, much the same way as heat is trapped in a greenhouse. That build-up is blamed by some scientists for the present rise in the world's temperature and the accompanying increase in extreme weather conditions, such as storms, floods and droughts. Unless the trend is stopped and reversed, many scientists and governments believe climate change could have catastrophic consequences.

How does Kyoto tackle the problem?The Kyoto agreement, brokered by the UN in 1997, aims in the first instance to cut the amount of greenhouse gases in the atmosphere to 1990 levels by the target date of 2012. The crucial part of the protocol is a market-based system of trading in carbon allowances', which gives individual businesses real incentives to cut the amount of carbon gases they pump into the atmosphere. This month the EU - an enthusiastic backer of Kyoto - launched a trading system involving 2.2 billion credits split between 12,000 installations belonging to 5,000 EU firms in energy-intensive industries such as electricity generation, steel, paper, glass and cement. Power generation alone accounts for 55% of the emissions covered by the plan.

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How does the trading system work?

The EU scheme works on a cap and trade' basis. Each company in the relevant sectors is given an allowance for each of its individual installations' (ie, factories or plants), agreed between the firm and the national government. Businesses that then go over their limit get fined e 40 per tonne. But if you don't use up your allowance, you can sell any remainder to a firm that hasn't cut its emissions enough and wants to avoid a fine by buying extra allowances (the current going rate is around e 6.80 a tonne). The net result is that emissions are cut by the desired amount, and individual businesses are given incentives and flexibility. In effect, this trading mechanism opens up a new global market in the buying and selling of carbon emissions - or, more exactly, of emission credits.

How big is the market?Small, but it's growing fast. At the beginning of last year, about 25,000 tonnes of carbon dioxide were being traded a month. By October 2004, that had risen to a million tonnes a month; now it's around a million a week. That may seem tiny given Germany alone produces at least 800 million tonnes a year, but analysts think it's just the beginning. The first two years of the EU scheme are seen as a pilot phase to be expanded in 2008-12 in the run up to the first Kyoto milestone. As fines become stiffer, emissions by more sectors become included in the system (currently only 46% of emissions are covered), and as the market becomes more established and liquid, it's likely to grow extremely quickly. Stian Reklev of Point Carbon, a Norwegian market-analysis firm, predicts that allowances worth up to e 10bn will be traded by 2007 compared with just e 65m in 2004. Moreover, the EU system may attract new countries; Canada and Japan are seen as the most likely to join up.

Is there a formal exchange for this?At the moment, it's all done by nine European brokerage houses who arrange trades between market participants. But that's about to change. From early March, once all the EU registration processes have been finalised, Europe's first proper carbon exchanges will go live. The biggest is likely to be the European Climate Exchange (ECX), a brand new exchange based in Amsterdam, but trading on the International Petroleum Exchange (IPE) in London. It aims to provide the first pan-European platform for greenhouse gas emissions trading, in both spot and futures markets, with standard contracts and clearing guarantees - all based on the EU's Emission Trading Scheme. The ECX is likely to face competition from three rival exchanges, Nord Pool, EEX and Powernext, although not all will offer spot and futures trading as well as forward contracts. As a result, London is likely to be the centre of the action.

What does this means for investors?

Carbon trading is already a niche commodity market, but given its huge potential to be more than that, it is a market that investors should be watching very carefully. Right now there is no easy way for the ordinary investor to enter the market, but several organisations, including Clean Air Capital, Barclays Capital and Fortis, are developing investment opportunities for institutions. As the market develops, opportunities for retail investors will start to crop up too.