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  "Warming of the climate system is unequivocal, as is now evident from the obsservations in global average air and ocean temperatures, widespread melting of snow and ice, and rising average sea level." With these words, the UN's Intergovernmental Panel on Climate Change (IPCC) virtually assured that the abatement of greenhouse gas (GHG) emissions, which are widely believed to have contributed to global climate change, will be a major policy issue for decades. For many, reducing GHG emissions, and in particular carbon dioxide emissions, which are the largest constituent of GHG emissions, will require carbon trading markets. Carbon trading refers to a system to control the emission of carbon dioxide whereby governments or international bodies set an overall limit on the amount of carbon that can be emitted. Allowances are then granted (or auctioned) to major emitters of carbon, such as electric utilities, paper mills, and chemical plants, which are then freely tradable. Companies who will be emitting more carbon than they have permits to emit must therefore buy additional credits on the open market, while those who will emit less can sell their credits. This system is attractive to governments, and carbon emitters, for several reasons. First, it easily enables sliding reductions in carbon emissions over a number of years. Every year, the number of credits granted can just be decreased by the government. Second, it creates a flexible and efficient market for carbon reduction, encouraging reduction of carbon emissions by those companies who can do so at the least cost. After all, if there is another company who can reduce carbon emissions more cheaply, then the high-cost emitter will buy excess credits from the low-cost emitter. Third, it creates valuable assets, in the form of carbon credits, for large emitters of carbon. These assets have value, and are freely traded, and under some carbon trading systems, the credits are given away, creating a windfall for carbon emitters. 
[edit] History of carbon trading Though a far cry from the New York Stock Exchange, carbon trading volume reached nearly $30 billion in 2006, and is set to continue its rapid pace of growth. Carbon trading has its roots in the successful sulfur dioxide and nitrous oxide trading system instituted to stop acid rain after the U.S. Clean Air Act of 1990. In 1997, the signature of the Kyoto Protocol bound 41 industrialized countries to reduce GHG emissions to 5% below the 1990 level by 2010. Major industrialized nations all signed up for reduction targets. The U.S. and Australia notably failed to sign the protocol, and many developing countries, including China and India, were not included in the protocol to begin with. Having said that, 60+% of global GHG gas emissions are included in the Kyoto Protocol, so it represents a major step towards a worldwide commitment to GHG reductions. Kyoto set the stage for the modern carbon trading market. The European Union signed up as a group for the Kyoto Protocol, and has chosen to implement its Kyoto requirements through the EU Emissions Trading Scheme (EU ETS), which dominates global carbon trading. Under this scheme, each nation in the EU has been allocated carbon emissions targets. Each nation then has allocated carbon credits to its major polluters, and these credits are entirely interchangeable and freely tradable through the EU ETS. In its first phase (2005-2007), the scheme has achieved widespread growth, and become fairly liquid (i.e., regularly traded). Some criticisms remain, however, most notably that an over-supply of credits was granted, resulting in a drastic price decline since the market opened. Critics have also noted that credits were granted, free of charge, to major emitters, rather than auctioned, resulting in lost revenues for government. These issues have mostly been remedied for phase II, which is due to start in 2008. One unique and very important aspect of carbon trading markets, as compared to stock markets, is that credits can be "created" and then sold on the exchange, so the supply of credits, though initially determined by national governments, can change as companies invest in carbon-reducing projects. These project-based credits (as compared to allowance-based credits) are typically certified through the United Nations' Clean Development Mechanism (CDM) and then sold as Certified Emissions Reductions (CERs). For investors interested in carbon trading, this means there are several ways to play the trend, as there are many different types of projects that can reduce carbon emissions, including methane capture, carbon sinks (e.g., investing in new forest development to capture carbon emissions), and renewable energy projects such as wind farms. A flip-side of the above is that carbon credits can be permanently taken off the market, reducing supply. Environmental groups and interested individuals have often purchased credits, only to retire them from the market. Set to expire in 2012, there is much discussion about what a post-Kyoto world will look like for carbon trading. However, there is general consensus that a cap-and-trade system will be introduced in the U.S. in the 3-5 year time horizon, and that a global carbon trading system will be a fixture in the world economy for decades. The supply equation above, in addition to the uncertainty around the details of the U.S. carbon trading scheme, has created uncertainty around the long-term price of carbon credits, though experts generally agree that a price above $10/ton is likely to be the norm. [edit] Carbon trading in the U.S.Where is the U.S., responsible for 23% of the world's greenhouse gas emissions, in all these developments? To-date, no federal restrictions have been placed on GHG emissions in the U.S. However, several initiatives have introduced nascent carbon trading markets. The Regional Greenhouse Gas Initiative (RGGI) is a mandatory system for reducing carbon emissions from U.S. power plants that encompasses the states of Connecticut, Delaware, Maine, Maryland, New Hampshire, New Jersey, New York, and Vermont. The caps are due to come in effect starting in 2009, and emissions trading will will be a key part of the system. The California Global Warming Solutions Act of 2006 mandates the creation of a multi-industry system to reduce California's GHG emissions to 1990 levels by 2020. Though unclear in the details, it is likely that emissions trading will be part of the scheme, and that the scheme may possibly even be inter-linked with the EU ETS. In lieu of a binding federal carbon trading system, the Chicago Climate Exchange, owned by Climate Exchange plc (listed on London's AIM), is attempting to create a voluntary carbon exchange for North American and Brazil, employing independent verification to allow institutions and individuals to trade carbon reduction credits. [edit] Implications of carbon tradingWhat does all this mean for investors? The implications of a widespread carbon trading scheme, especially encompassing U.S. carbon emissions, are vast and highly dependent on the details of any pending legislation. However, a few investment themes are likely to play out, regardless of the details. Increased demand for natural gas - The quickest way for an electric utility to directly reduce GHG emissions is to switch from coal power to natural gas power. This will, of course, not be sustainable over the long term, as natural gas prices rise and as investments in other forms of carbon reduction can pay off. Increased demand for nuclear and wind - Over the long term, generating power from low-carbon sources will be critical to meeting carbon cap requirements. This should encourage investments in both nuclear and wind energy, both of which offer significant carbon reductions and are relatively competitive with coal and natural gas for electricity production.  Higher electricity bills - Ultimately, electric utilities will pass on the costs of any carbon trading system to their consumers, resulting in higher energy bills for the end-user. This should lead to a growth in demand-side management (DSM) initiatives targeted at saving the end-user electricity. Investment in offset projects - Investment in projects to "off-set" carbon emissions would take-off following a worldwide, or U.S. based, carbon trading scheme. This would offer a windfall to, for example, small dairy farmers, who could generate income from methane reduction projections (methane is a large contributor to GHG emissions). It would also further drive incentives to invest in renewable energy projects. [edit] Companies who stand to benefitAmerican International Group (AIG), a leading insurance group, has been among the earliest U.S. based financial services firms to explore carbon trading, and has developed an assortment of insurance products which may prove valuable upon the advent of a carbon trading regime in the U.S. Similarly, GFI Group (GFIG) has pioneered emissions trading in the EU market, and should be well-positioned to take a strong position in a U.S. carbon trading environment. Nuclear companies such as Entergy (ETR) and Exelon (EXC) offer an excellent exposure to climate-change legislation generally, as those companies with existing nuclear assets, as well as expertise in operating them, should find themselves in high demand following any carbon legislation. Johnson Controls (JCI) offers another interesting play on carbon trading. The company specializes in building efficiency services (i.e., helping reduce electricity usage in buildings), and already offers one contract that promises to deliver a fixed reduction in GHG emissions. Climate Exchange PLC (LON:CLE), is the biggest CO2 trading plattform in the world. NYMEX Holdings Inc. (NMX), will open an exchange for trading carbon-emission credits. Contracts at The Green Exchange will begin trading in the first quarter of 2008. The Green Exchange will focus on European and international markets for carbon credits, as well as allowances for two U.S. air pollutants, sodium oxide and nitric oxide. [edit] Companies who stand to loseAmerican Electric Power Company (AEP), a leading electric utility, produces more carbon dioxide each year than any other company in the U.S. With its strong base of coal-powered plants, AEP may be hard-pressed to meet the carbon cap placed on it by regulators, and will therefore need to resort to buying credits on the open market or investing in carbon sinks. The impact on coal-powered generators is unknown, though, until the details of the auctioning versus grant system are determined. For this reason, similar outlooks hold for TXU (TXU) and Dynegy (DYN), both of whom have large coal assets. Domestic auto manufacturers are at risk, should the U.S. government decide to include transportation under the cap and trade system (as the chart above illustrates, transportation is a large contributor to GHG emissions). In this case, the domestic manufacturers, such as Ford and General Motors (GM) will be disadvantaged relative to those manufacturers who have made further advances in hybrid, fuel-cell, and other fuel-efficient technologies, such as Honda Motor Company (HMC) and Toyota Motor (TM). For paper companies, such as Weyerhaeuser Company (WY) and International Paper Company (IP), carbon trading also offers a double-edged sword. On the one hand, their GHG-emitting plants will now be subject to increased regulation, while on the other hand, their forestry assets in North America and overseas may become more valuable, depending on how the legislation defines "carbon sinks."
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