CHAPTER 10

Carbon Finance: Present Status and Future Prospects

We have to stabilize emissions of carbon dioxide within a decade, or temperature will warm by more than one degree. That will be warmer than in has been for half a million years, and many things could become unstoppable. If we are to stop that, we cannot wait for new technologies like capturing emissions from burning coal. We have to act with what we have. This decade, that means focusing on energy efficiency and renewable sources of energy.

Jim Hansen, Director of the NASA Goddard Institute for Space Studies, in an interview in February 2006

INTRODUCTION

Carbon is now a competitive issue among energy intensive industries and power producers, while climate change is already physically affecting many sectors of the economy, and financially affecting even more. As a result, climate change is becoming a mainstream issue with institutional investors as is clearly demonstrated by the rapid growth of the Carbon Disclosure Project which is now backed by investors responsible for approximately half the global investment in publicly listed companies. (See Table 5.3 in Chapter 5.) Boards can no longer afford to dismiss shareholder resolutions calling for engagement on the issue. Even during the writing of this book there has been a marked shift in opinion in the business sector from seeing climate change as a reputational or a regulatory risk to a business, bottom line risk. The new twist is that the risk for businesses outside the European Union (EU) is that their governments will react too late for them to make the most of the opportunities opened up by the challenge of climate change. As the governor of Arizona stated: “In the absence of real action at the federal level, states are stepping forward to address the serious issues presented by climate change” (Environmental Finance 2006). Similarly, major players in the private sector in the United States are investing in opportunities that have been created in the EU in response to climate change. (See, for example, the recent investments of Cargill, the Minneapolis-based agricultural commodities giant in Box 10.1.)

BOX 10.1 CARGILL INVESTS IN BIODIESEL PRODUCTION IN EUROPE

Cargill, a U.S.-based global food and agriculture company recently announced its acquisition of a 25 percent stake in Greenergy Biofuels Ltd. in the United Kingdom. Tesco owns 25 percent of Greenergy Fuels, which owns the other 75 percent of Greenergy Biofuels. Tesco is the leading biofuel retailer in the United Kingdom, offering biofuel blends at more than 40 percent of the petrol stations attached to its supermarkets.

Greenergy Biofuels is building a 100,000-ton (114 million–liter) capacity biodiesel production plant at Immingham on Humberside. There are plans to develop additional production facilities near Liverpool, where Cargill already operates a seed crushing plant. This partnership thus fully integrates the biodiesel business from provision of the raw materials, through manufacturing and retailing.

Cargill also has plans to produce biodiesel in Belgium and Germany.

Source: Cargill 2006. Available at http://www.cargill.com/news/news_releases/060228_greenergy.htm.

The transformation of the energy chain is clearly the heart of the matter. This can be done via incentives to continually improve energy efficiency, by reducing the need for energy, and by switching from fossil fuels to hydrogen and renewables, while relying on gas as the transition fuel of choice.

Despite its erratic progress, the Kyoto Protocol finally came into force in February 2005, a few weeks after the opening of the EU emissions trading scheme (EU ETS), which is linked to Kyoto by its national reduction targets and the flexible mechanisms—international emissions trading, CDM, and JI. Now we have a real, daily price for carbon. The first CDM projects have been certified. There is a growing volume of trade in EU Emission Allowances. In the United States and Australia, there is a continuing push toward cap-and-trade systems at every level other than the federal leadership, where—given the U.S. electoral timetable—we can anticipate a change in the U.S. federal position quite soon.

Recently, we have seen inclusion of the accession countries into the EU (despite some delays), and the neutralization of their hot air problem. Furthermore, two of those new members (Malta and Cyprus) produced national energy plans even though they were not obliged to accept greenhouse gas (GHG) caps. Meanwhile, EU-in-waiting countries (Bulgaria and Romania) have also produced NAPs preparatory to developing JI projects. Russia and the Ukraine have approved JI protocols also. As these and other trading schemes develop, we will see how they affect the transformation of the energy chain—the key to a global climate strategy.

The stakes are very high, potentially affecting the well-being of everyone on earth. We have already seen evidence of impacts at the individual level through the decline of Arctic culture, the spread of disease vectors as the earth warms, and increased deaths from heat stress, forest fires, floods, mudslides, and windstorms.

The world of carbon finance should be seen as broader than the trading of carbon credits because new financial instruments (such as weather derivatives and catastrophe bonds) are being developed to facilitate the transfer of weather-related risks—both for adverse weather and for extreme events. The use of these products will encourage companies to respond to climate change in a proactive way, searching for opportunities in this complex challenge. Furthermore, there is an increase in venture capital and hedge fund activity, which focuses on clean-tech and carbon-reducing activities.

TRADING VOLUMES IN CARBON AND WEATHER MARKETS

Carbon Markets

Table 10.1 illustrates the rapid growth of the EU ETS and the CDM. Current indicators also suggest that the ETS is resilient. It is noteworthy that, despite the price plunge in late April (2006), “During the extreme volatility, the market infrastructure has held up, liquidity has remained high, and participants have been able to trade in and out of their positions” (Nicholls 2006c, 2).

TABLE 10.1 The Beginning of the Carbon Market in Europe

Source: Environmental Finance 2006a, based on a Web survey and interviews by Point Carbon

2004 2005
EU ETS value in € €377 million €9.4 billion
EU ETS CO2 million tons 17 362
CDM CO2e million tons 188 397

Volumes of CO2 traded at the CCX—under a voluntary regime—did not exhibit comparable growth in 2005, although volumes picked up in 2006 (see Table 10.2).

TABLE 10.2 Trading in Carbon Financial Instruments (CFI) at the Chicago Climate Exchange

Source: The Chicago Climate Exchange. Available at http://www.chicagoclimatex.com/trading/stats/monthly/st_0602.html

CFI Vintage 2005 CFI Vintage 2006
Volume of CO2 traded in 2005 in metric tons 483,800 341,800
Volume of CO2 traded in 2004 in metric tons 798,700 629,900

Meanwhile, the CCX model has expanded to Canada, Europe, and will later go to Japan, Russia, and New York. One of the most significant contributions of the CCX project is to demonstrate the key importance of transparent price discovery for the development of a viable market. If decision makers know the price of carbon, they can make rational decisions about markets and investments.

Weather Derivatives

In the weather derivatives market we can see further proof of the importance of transparency with the huge increase in the volume of trading once the CME derivatives market came on-stream. (See Chapter 8 and Table 8.1.) The CME was responsible for nearly all of the virtual doubling of trade in 2004–2005 over 2003–2004. The weather derivatives market is driven by powerful forces that are likely to be with us for some time. First, climate change itself is creating great uncertainty in the weather; it is also producing more extreme events, from droughts to downpours. Even companies that put weather risk low on their list of priorities have had to rethink their business strategy, while those that are heavily dependent on weather—such as power producers and farmers—need to use alternative risk management instruments such as weather derivatives. The growth of the weather market depends both on awareness of the risk to drive demand and on the market infrastructure (including databases on weather) to attract supply.

The second driving force is the growing importance of renewable sources in the energy mix. With the exception of geothermal power (and tidal power to a large extent), renewables depend directly on weather conditions. Skeptics complain that the weather dependency of renewables makes them intermittent and—by implication—unreliable. It is true that the sources are intermittent, but that does not mean that they are unreliable. As we have noted, tidal power is intermittent, but it is highly predictable. Wind is less predictable at any particular site, but when aggregated for regions and seasons it is predictable, so the solution is to produce power from a variety of sites which are either linked to the grid or can avail themselves of a storage device. To the degree to which renewable power producers are hostage to uncertainty, they should assess the relevance of weather derivatives to their risk management strategy, especially as new products are developed for a greater variety of weather conditions and locations.

A growing reliance on renewable energy puts us back into dependence on the physical world. This is counter to the trend in the richer countries since the beginning of the twentieth century, when increasing numbers of people began to live in cities and became protected from the elements for most of the time. As power prices continue to rise and a greater variety of sources of energy becomes available, people will have to take a closer interest in the physical world in which they live.

WHAT CAN BE TRADED WHERE? (AND WHAT CANNOT?)

Carbon finance is still in its infancy, lacking many characteristics of a mature market. For example, what can be traded on this market remains quite limited in scope. Through the Linking Directive, the EU ETS availed itself of the flexible mechanisms designed for the Kyoto Protocol, such that CDM credits would be eligible for use in the EU ETS Phase One (2005–2007), while both CDM and JI credits would be eligible for Phase Two (2008–2012), running concurrently with the First Commitment Period of the Kyoto Protocol. The framers of the EU ETS did however make two exceptions—they excluded hot air credits generated by the collapse of the post-communist economies of Eastern Europe, and they excluded forestry-based carbon credits (for reforestation and afforestation). The principle reason for excluding them was to prevent a flood of such credits driving down the price of carbon in the ETS market and hence reducing the incentive to actually cut emissions of greenhouse gases at the source—the 11,000 installations identified by the various National Allocation Plans. This decision has, however, had important consequences beyond the EU (Bettelheim 2006).

First, forestry projects are ideal for the CDM criteria—carbon sequestration and sustainable benefits for local people (Bettelheim 2006). Such projects and their Kyoto credits are being bought by many carbon funds, but they cannot trade them, at present, into the EU ETS; they will have to hold them until they can be counted toward Kyoto’s First Compliance Period when it begins in 2008. Demand from the EU would have been a helpful boost for the CDM market. This exclusion has been particularly unfortunate for Africa, which lags behind Asia and Latin America in the development of the CDM. The exclusion will also limit interaction between the EU carbon market and Canada and New Zealand, which both intend to use carbon offsets to meet part of their Kyoto commitment.

Another barrier to trade with the EU and emerging carbon markets is the nonsignatory status of Australia and the United States. We have seen a vigorous growth of carbon trading regimes in both countries at the state level. However, the fact that their federal governments have withdrawn from the Kyoto Protocol means that carbon credits generated by the state markets may not be traded into the EU ETS. Meanwhile, Norway and Switzerland, although not part of the EU, are both signatories to Kyoto, and they are designing national platforms that will be compatible with the EU ETS and therefore open to trade with it.

PRICE DISCOVERY

There have been many warnings to the effect that the development of a cap-and-trade system for carbon would be detrimental to business interests, specifically that it would drive energy-intensive businesses out of the EU and would have a very negative impact on the economy. This could still happen in some cases, aluminum being a widely touted example. However, the fact that the EU has embraced the challenge of living in a carbon-constrained world—before its industrial rivals—has already produced some gains. For example, the biofuel business is drawing in major American investors such as Cargill (see Box 10.1). Others will follow as the drive toward renewable energy and clean technology gathers momentum.

The symbol of this change is the visible price of carbon, quoted throughout the business day like many other commodities.1 This fact alone has moved the climate change challenge from the purview of green reporting and corporate sustainable development reports to the boardroom. Since the EU power producers passed along some of the cost of their free emissions allowances, their major customers—the other large final emitters—have raised a protest (Sijm et al. 2005; World Bank and IETA 2006). Governments (such as the United Kingdom and Denmark) considered a retrospective tax on these windfall profits. Already the energy chain is reacting to increased power costs following the placing of most of the burden of emission reduction on the power producers. It is ironic that the burden was placed on them because they are less subject to international competition than the major power users (oil and gas, iron and steel, pulp and paper, etc.), and this same factor has made it possible for them to pass the cost on to their customers.

One reason why it might take a while to work out the secondary impacts on the energy chain is that some parts of the various pricing mechanisms for power are opaque, far from the transparency required for the maximum effectiveness of the carbon market. There is some discernible competition in the smaller-scale retail market at the household level, and there is some visibility in the spot market, but most of the power in Europe is sold under long-term bilateral contracts between producer and consumer.

The most startling proof of the need for greater transparency came with the plunge of the ETS allowance price in the last week of April 2006, when the price fell from nearly €30 to €8 in 48 hours on revelations and rumors about the overallocation of allowances to industry in the Phase One of the scheme. It is to be hoped that the growing availability of verified and publicly available emission data at the installation level will protect the market from similar shocks in the future.

THE EVOLUTION OF PRODUCTS FOR CARBON FINANCE

There is a lingering hope in some quarters that we will find a technological solution to the climate change quandary such that life in the West can continue pretty much as it is now. That solution might be clean coal, the hydrogen economy, carbon capture and storage, or maybe cheap, safe, low-waste, proliferation-proof nuclear power. It is this belief that lies behind the Asia–Pacific Partnership on Clean Development and Climate, which was discussed in Chapter 6. This belief tends to downplay the alternatives identified by Jim Hansen, as noted at the start of this chapter—existing technology for energy efficiency and renewable sources of energy. Belief in technological salvation is usually accompanied by modest amounts of pubic funding for research or a start-up subsidy for the new technology.

For some problems, this approach might be successful. The wonderful story of Harrison’s chronometer (told by David Sobel in Longitude) is a good example where the offer of a modest prize eventually produced the solution. However, it was a highly targeted application, and it took the lifetime of one very dedicated person to solve the problem. Climate change is too big, coming upon us too quickly, and promises consequences that are too grave for us to risk this type of strategy. As Jim Hansen stated, we need to stabilize emissions within a decade. Then we begin the long haul of reducing emissions by 80 or 90 percent below 1990 levels.

Fortunately, in the past 15 years, we have seen plenty of evidence that there is an approach that is likely to produce results much faster than small sums of government money and hoping that a genius will discover a solution. There are many examples of goods and services being provided efficiently and equitably by the public sector. There is also plenty of evidence to suggest that competition in the private sector is more likely to produce innovation, especially when that innovation is radical and is needed very soon. What we have seen in the successful parts of the water privatization story and in the SO2 and NOx emission reduction markets is that we need a two-track approach—the government needs to regulate the requirement (such as the cap) and to identify the general means for achieving the goal (such as trading). We need full transparency as to how the caps are determined (which is not very clear in the EU ETS case), and how the trading takes place—exchanges are better for this than OTC transactions. These are some of the elements needed for designing markets.

There has to be regulation (such as Kyoto and the EU ETS), which creates the need for new products (both technological and financial). We must hope these products will be developed in time and that they will ensure that we reach our environmental objective. They will not appear spontaneously simply because the world has woken up to the climate change challenge. They will not be found quickly enough through the encouragement of government research grants and small subsidies. They are most likely to appear when mandated by regulation, within a market-based framework.

Nowhere is the evidence of the potential contribution of market forces clearer than in the world of venture capital, where “over the past six years, more than 1,100 investors have pumped over US $7.7 billion into ‘cleantech’ companies in North America, making it the sixth largest venture investment category” (Parker and O’Rourke 2006, p. 20). Whereas this is a private-sector initiative, supportive regulation is essential, such as mandated renewable energy requirements, tax breaks for switching to cleaner forms of energy, and extraction taxes on fossil fuels. Some U.S. states (such as Pennsylvania and Massachusetts) have established their own clean technology investment funds (Sterlicchi 2006).

LITIGATION OVER RESPONSIBILITY FOR CLIMATE CHANGE

Who is responsible for the current climate change dilemma, and who will be found responsible for its resolution? How will governments that have undertaken a commitment to reduce greenhouse gases carry out their obligation? Essentially, the answer to this question requires an examination of the energy chain and a decision to exact GHG reductions from one segment of this chain, augmented by complementary actions at other points. For the EU, the targets were the power producers, major industrial energy users, and all entities that produced energy from facilities with more than 20 megawatts of capacity. In the United Kingdom, the NAP placed most of this burden on the power producers. In Canada, it appears that the principal target is still the large final emitters, similar to the EU plan.

A very different approach—that touches much more closely on the responsibility issue—is the allocation of personal carbon allowances to each individual (Boardman et al. 2005). This approach would have the great virtue of placing responsibility where it ultimately lies—on relatively wealthy consumers; and it would let the individual’s choices filter back up the energy chain. It is an elegant idea, but it comes with two major operational problems—it would be hugely complicated to monitor, and it would be politically difficult for any government that tried to implement it.

In the American context, other possibilities arise—namely, litigation by class action. In the American courts, class actions are more favorably received than in other jurisdictions. Here, the issue is not so much a value judgment about “Who is responsible for climate change?” but rather, “Who can be held to be responsible?” As was seen in the Superfund legislation, the American courts are prepared to proceed on this basis. Action on climate change has been anticipated for more than 10 years in the United States. As in the asbestos and tobacco cases, the issues revolve around the question: “What did the directors and officers of companies know about the risks, and when did they know?” Again, the large, stationary emitters are the obvious targets for litigation. The question remained somewhat hypothetical until 2005 when carbon was given a price under the EU ETS. Emitting GHGs was no longer an incidental activity; it was regulated by law and would affect the bottom line of any company that traded in the EU.

On March 3, 2006, “Twelve U.S. states, three cities and a host of environmental organizations appealed to the supreme court to require that the Environmental Protection Agency (EPA) regulate greenhouse gas emissions from road vehicles” (Point Carbon 2006f). This is one of several current initiatives in the United States to use the courts to force the federal government to take action to respond to climate change. What is ironic is that it was the EPA (under another administration) that pioneered the trading of credits for emissions reduction trading in SO2 and NOx.

On an international scale, now that climate change is recognized as already affecting lives and livelihoods, it is assuming momentum as a human rights issue. The Association of Small Island States and the Association of Circumpolar People have already launched suits based on the denial of their human rights.

IS CARBON FINANCE LIKELY TO HELP US AVERT DANGEROUS LEVELS OF CLIMATE CHANGE?

Attempts to identify dangerous levels of climate change have been made since the early stages of the IPCC process. How could anyone define what was a dangerous level? Most people closely involved in the IPCC process probably felt that continuing the present trajectory into an age of unquantifiable uncertainty was already dangerous.

One of the first effective communicators of the climate change risk was John Firor, a widely respected meteorologist. He reported that the question he was most frequently asked on the public lecture circuit was not about the technical implications of climate change, but the more mundane inquiry: “Do we have a problem?” (Firor 1990). The public and the politicians hope that there are actual numbers that the scientists can identify as “Thus far and no further,” and that at that point society can head in a different direction.

Unfortunately, this is not the case. First, the science is not that simple. It is not linear. It involves multiple feedbacks that are not predictable in a linear, stop-go sense. Second, there is a huge amount of inertia in the biospheric system. It has taken modern, fossil-fuel–based society nearly 200 years to produce a definable man-made disturbance at the global (mean surface temperature) level. Saying “It’s time we tried a different path” at this point is not going to cancel the momentum we have created. Although politicians keep asking the scientists to identify what would be a dangerous level of disturbance, this is simply an act of procrastination. The politicians (and their public/voters/taxpayers/consumers), are simply putting off a decision we should have taken 20 years ago.

In answer to the persistent question: “What is a dangerous level of disturbance?” the IPCC scientists selected 400 ppm of CO2e in the atmosphere. At a climate conference in Exeter (United Kingdom) in January 2005 a paper was presented which argued that we had already surpassed this critical level. So, it is probably too late for carbon finance to help us avoid the suspected dangerous threshold. There are many degrees of danger and some climate change scenarios are less attractive than others. However, there is every reason to hope that carbon finance will play an important role in minimizing the ultimate costs of climate change.

CARBON FINANCE WITHIN THE BROADER FIELD OF ENVIRONMENTAL FINANCE

The modern age of environmental finance began with the U.S. Acid Rain Program. There have been many attempts to encourage responsible use of resources through pricing, most notably for water in the past 15 years. Water permits are being traded in the United States and Australia, for example. But it was the Acid Rain Program that first demonstrated that tradable permits for air pollution allowances could be used to reduce the pollution problem. Despite the important differences between the acid rain problem and climate change problem, a similar approach has been adopted and, as a result, the field of carbon finance is evolving rapidly.

Not all the necessary ingredients for success are in place. For a market to operate effectively there should be no free riders’ who will benefit at no cost to themselves. Ultimately, all carbon-emitting human activities—including transportation and households—need to be included in the incentive structure, rather than just those parts of the system that are easiest to target. The leaders of corporations, who have to determine how they are going to meet their targets, need rules that operate over a reasonable timeline—in this case, not less than 30 years. Looking at a big question mark after 2012 is not helpful. We also need operational transparency so that price discovery is available to all the participants in the market, including producers and consumers. If these conditions can be met, then they will provide our best opportunity to meet Jim Hansen’s first target—the stabilization of carbon dioxide emissions within a decade.

Much of the scope of this book has been focused on national, international, and corporate initiatives to develop carbon markets as an important part of a strategy to respond to climate change. However, a great deal of work has been done through local initiatives channeled through local government. Just how much can be achieved is illustrated by Box 10.2, which is drawn from a case study on the Borough of Woking (40,000 households), immediately southwest of London. The work began with a drive toward energy efficiency and broadened out to achieve carbon dioxide emission reductions and adaptation to climate change. Woking is now “recognized as the most energy efficient local authority in the UK” (Takingstock.org 2003).

What is remarkable from the perspective of the issues examined in this book is that these goals were achieved without the benefit of carbon finance or even a facilitative senior level of government. On the contrary, the size of any off-grid operation is specifically limited by U.K. regulation. If this restriction were removed, the proponents in Woking argue that “locally embedded generation could supply all of the country’s energy needs . . . with local sustainable and renewable energy” (Takingstock.org 2003). If these achievements were ever monetized with carbon credits for the reductions that they have achieved, then the bottom line would be strengthened even further. Clearly, much more could be done to bring together potential participants in carbon markets.

BOX 10.2 ADAPTATION IS WORKING IN WOKING

Woking Borough Council established 1990–1991 as a base year for its energy and environmental policies and set a target of reducing energy consumption for the Council’s buildings and transportation by 40 percent over 10 years. This target was achieved, and in 2002 the Council broadened the scope of its activities from Council operations to the borough as a whole and shifting the metric from saving kilowatt hours to reducing CO2 emissions and adapting to climate change. Their efforts were driven by a conviction that climate change was already happening, as they had observed “weather patterns have become more extreme with high winds, floods and high temperatures affecting Woking and many other parts of the UK, and there has been a blurring of seasonal changes in recent years.”

The following is a summary of what they achieved over the 10 years from 1991–1992 to 2001–2002.

Energy consumption savings 170,170,665 kWh 43.8% saving
Carbon dioxide emission savings 96,588 metric tons 71.5% saving
Nitrogen oxides emission savings 319.1 metric tons 68% saving
Sulfur dioxide emission savings 976.6 metric tons 73.4% saving
Water consumption savings 340,011,000 liters 43.8% saving
Savings in energy and water budgets €4,889,501 34.3% saving

Source:Takingstock.org 2003.

The Council and people of Woking realized these goals by implementing “a series of sustainable energy projects, including the UK’s first small-scale combined heat and power (CHP) and heat-fired absorption cooling system, the first local authority private wire (direct supply to householders) residential CHP and renewable energy systems, the largest domestic integrated photovoltaic/CHP installations, the first local sustainable community energy system, the first fuel cell CHP system, and the first public/private joint venture Energy Services Company.”

CONCLUSION

The key concept underpinning the development of carbon finance is the notion that markets can be designed to reduce greenhouse gas emissions at the lowest possible cost for the system as a whole, whether the system be defined as the 11,000 largest power producers and power users in the EU or the global economy. As Richard Sandor noted, when this proposal was first launched at the Rio Earth Summit in 1992 it was greeted with skepticism on all sides (Sandor 2004). There are still skeptics—fortunately, they comprise a diminishing portion of public opinion as carbon markets struggle to emerge and prove that the theory can be put into practice, although perhaps not so elegantly as their supporters might have wished.

The emergence of markets for carbon has been supported by a growing understanding that climate change is a huge challenge that will affect everyone on earth, from the poorest to the richest. The strength of the emerging consensus on this viewpoint is well illustrated by recent indications from elements in the insurance industry, which previously appeared to be less worried about climate change than the European reinsurers (especially Munich Re and Swiss Re) and insurance organizations such as the Association of British Insurers who have been expressing their growing concern for well over a decade. The catalysts responsible for the change in attitude were the hurricane seasons in the Gulf of Mexico for 2004 and 2005, culminating in hurricane Katrina—the largest insured loss from a natural disaster in the history of insurance industry.

In conclusion, we identify three conservative indicators of a fundamental shift in the corporate attitude to climate change. They are conservative in the sense that they come from players who have not been in the vanguard of the movement to identify climate change as a major global risk. First, in the United Kingdom, Lloyd’s has issued a report on catastrophe trends titled “Climate Change—Adapt of Bust” in which it acknowledges the growing risk posed by climate change and the fact that “the industry has not taken changing catastrophe trends seriously enough” (Lloyd’s 2006). Second, in the United States, A. M. Best—a rating company specializing in the insurance industry—produced a special report on “Thinking the Unthinkable: How ‘Mega-Cats’ May Bruise Insurers,” describing a loss scenario in which a Category 4 hurricane makes landfall in Atlantic City, New Jersey, causing more than US$100 billion in insured losses and threatening the solvency of as many as 50 insurers (A. M. Best 2006). Finally, the Catastrophe Insurance Working Group of the National Association of Insurance Commissioners (NAIC) has called “on the US Congress to take action on a national catastrophe plan” (Aon 2006, p. 7). NAIC had scheduled its 2005 annual meeting to take place in New Orleans at the very time that Katrina struck. At a rescheduled meeting in San Francisco, it became apparent that business-as-usual had become a dangerous strategy, and that the Association’s dual mandate to protect the insured and the insurers was increasingly difficult to fulfill in a world experiencing global warming.

These actions can be taken as conservative indicators that mainstream world opinion is coming to accept that climate change is a challenge than can no longer be ignored or downplayed. The focus of this book has been an attempt to determine the contribution that markets can make toward achieving environmental goals—for carbon finance the specific goal is climate change. Can the discipline and drive of the private sector, adequately chaperoned by government regulation, be entrusted with this task? There is a lingering, perhaps pervasive, hope that this happy result might be achieved almost painlessly.

However, as recent experience in the EU ETS has shown, even in the most carefully crafted market, certain primordial elements of competition must remain—otherwise, it would not be a market. Furthermore, among all the invisible hands in the market, not all remain selflessly disinterested in their own fate as they compete to make a profit, return dividends to their shareholders, serve their customers, and reward their managers, consultants, brokers, and accountants.

As environmental markets develop they become larger and more complex. More capital and more corporations become committed to establishing their place in the system. It would be surprising if all the new players remained quite as dedicated to the green goals as the pioneers who invented these markets—many of whom worked for years for slim, or no, returns, hoping that these environmental markets would succeed in saving the planet, where regulation alone had failed. The EU ETS has provided us with the clearest indication, so far, of how the system might evolve.

The EU ETS has survived its first full annual cycle of operations, and thus should be judged a qualified success. Bloodied, but unbowed, it goes into its second cycle in 2006; it will enter Phase Two in 2008; and it will push the Kyoto process into the post-2012 world. We should not be surprised that member states of the EU have squabbled over their NAPs, or that many member states had to contend with industrial sectors squabbling between themselves. Nor should we be surprised that enthusiastic pioneers of the newly created carbon economy now find their idealistic creation treated somewhat roughly by some of the new players. In environmental markets—as in all markets—companies have to meet payroll, rent, taxes, and all the other costs of doing business.

In the theoretical world of perfect competition, corporate idiosyncrasies are irrelevant because all the players have access to the same information, the same access to markets, access to capital, and so on. Outside this theoretical world the situation is quite different. Richard Sandor stressed (as noted before) the importance of striving to meet the ideal of perfect competition in the design of new markets, as best we can, in order to reap the benefits of a free market system. Specifically, he emphasized the value of transparency in price discovery and the need to ensure that the market remains liquid.

As the field of carbon finance evolves we can appreciate the salience of such an agenda. At this point, the key lessons we can draw include the following:

Ultimately, carbon finance will help us find a way to meet the climate change challenge only when all elements of the economy—consumers, producers, and regulators—have to factor GHGs into their bottom line.

1. See the daily price on the Point Carbon Web site at www.pointcarbon.com/Home/News/All%20news/article12242-703.html.