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By Lara Crigger

For years, analysts have pointed to carbon dioxide cap-and-trade systems as the ideal solution to the global warming crisis, proclaiming that the best way to "go green" is through the power of green – money. And these days, carbon cap-and-trade is downright in vogue: As the market for carbon futures continues to expand, countries from Japan to Australia to the U.S. have started introducing their own national initiatives.

But some critics worry that this burgeoning market still has a long way to go before it's ready for prime time. One group even warns of a "subprime carbon" market crisis in the works.

So where's the carbon market headed for 2009?

Carbon Trading 101

First, a quick refresher on how carbon cap-and-trade works:

Under a cap-and-trade system, the government sets a limit on the total amount of emissions businesses may produce each year. Each company receives a given amount of emissions allowances (or credits), where each allowance gives the organization permission to emit one metric ton of carbon dioxide into the air.

Some companies will pollute more; others, less. Those with lower emissions won't need all their credits, so they can sell what they don't use for a profit on the open market. Companies that either can't or won't reduce their greenhouse gas output will have to buy these credits in order to legally maintain their emissions levels.

Companies can also obtain credits by investing in offset projects, or special renewable energy efforts in developing nations. These projects, which include everything from planting forests to reclaiming methane at landfills, reduce the global carbon footprint and balance out higher pollution levels caused by the investing companies.

The idea is to make high carbon emissions bad for the balance sheet. Companies that can reduce their emissions cheaply and easily will do so, as they stand to make money by selling unused credits. Those who can't are still allowed to pollute, but eventually credits could become so expensive that high emitters will be forced to convert to cleaner technology – and until that happens, offset projects can mitigate some of their emissions impact. Thus, in theory, cap-and-trade promises to turn global industries green in the easiest, most cost-effective way possible.

Carbon Market Meltdown

The only problem? The global recession has wreaked havoc on the carbon market's underlying fundamentals. Industrial plants worldwide have cut production, lowering their pollution levels and demand for carbon credits. Other companies looking to slash costs have postponed or even scrapped plans to upgrade to green technology, thus reducing the supply of tradable credits. And with the lack of available capital these days, offset projects – which often require substantial up-front investment – are having trouble securing adequate funding.

All this spells bad news, say analysts, who predict that in 2009, the carbon market will contract for the first time since trading began several years ago. In a recent report, industry research group Point Carbon said that although trading volume will likely grow 20% this year, the total value of the carbon market will drop to $79.7 million – down 32% from last year.

"Survival is the focus in 2009," wrote the report's authors. (Source)

Another study by Friends of the Earth draws disturbing parallels between the carbon market and the subprime housing crisis. Uncompleted or misleading offset projects, the report explains, could ultimately fail to reduce atmospheric carbon levels. And since sellers often promise to deliver carbon credits before they've even been issued – and sometimes before crediting agencies can even verify how much greenhouse gases those projects actually reduce – carbon credit contracts based on offset projects potentially carry a high risk of not being fulfilled.

Because many cap-and-trade schemes allow for offset projects to comprise a substantial portion of the total credits on the market, this "opens the door wide for subprime carbon," says the report. If offsets fail to reduce greenhouse gases, carbon credits would crash in value – and it would be the subprime housing market all over again.

Politics of Pollution

The glum news and dire forecasts haven't stopped politicians worldwide from introducing their own carbon cap-and-trade programs.

In Australia, one of the world's biggest polluters – with emissions per capita five times that of China – officials have introduced the Carbon Pollution Reduction Scheme. Set to start in 2010, the system would force the country to cut 5-15% of 2000 emissions by 2015.

The plan has sparked much backlash. Industrialists point to a recent report suggesting that the new regulations might force regional economies to shrink 20% over the next 40 years. And environmentalists say the plan doesn't go far enough, advocating a carbon tax instead.

Japan has also tiptoed into carbon trading. The world's 5th-highest greenhouse gas emitter is now test-driving a voluntary carbon market that consists of more than 200 participants, including utilities, steel companies and car manufacturers.

Japan hopes the volunteer cap-and-trade system can help the country meet its Kyoto commitment levels of reducing carbon emissions to 6% below 1990 levels by March 2013. But so far, reaction has been mixed – only 20% of participants have made plans to trade in the new market.

In the U.S., President Obama has included a controversial mandatory carbon cap-and-trade system in his recent budget proposal. The plan would aim to reduce emissions by 14% below 2005 levels by 2020, and 83% below 2005 levels by 2050.

Under the proposal, the government would auction off carbon credits at an estimated $13-20 per ton, which would help generate an estimated $645.7 billion in revenue over the next 10 years. By 2019, the annual revenue from these auctions could top $83 billion, $15 billion of which would be reinvested in new alternative energy projects. The rest would come back to citizens as a tax cut.

The administration's plan, which is currently under floor debate in Congress, has evoked much opposition. Critics cite the volatility of the European carbon market – where carbon contracts trade anywhere from 2 euros/tonne to 30 euros/tonne – which may deter investors at home. Others say the plan would raise energy costs for consumers already struggling in the recession.

The Evolution Of Pollution

Whether or not the president's national cap-and-trade plan is passed, regional initiatives have shown great success. The Regional Greenhouse Gas Initiative, a carbon credit market of 10 Northeastern and Mid-Atlantic states, started trading last year; the market could see as much as 339 million tons of CO2 trading hands in 2009, which could give RGGI 6% of the total global market share. In addition, new regional initiatives in the Midwest and California could launch as soon as 2012.

RGGI carbon futures contracts are available on the Chicago Climate Futures Exchange and NYMEX's Green Exchange. As of March 30, 2009, prices for these contracts range about $3.73-$4.10/ton.

What's more, the universe of carbon exchange-traded products has also been expanding since we last talked about carbon trading. Current offerings include the AirShares EU Carbon Allowances Fund (NYSE Arca: ASO) and the iPath Global Carbon ETN (NYSE Arca: GRN). Launched in February, ASO is an ETF-like instrument that accesses the European futures market for government-issued carbon credits, while GRN is an exchange-traded note that tracks liquid carbon emissions credits worldwide.

Additionally, in March, Standard & Poor's launched the U.S. Carbon Efficient Index, the first in a series of global low-carbon indexes. The new index, which tracks large-caps with low carbon emissions, has fueled speculation that further exchange-traded products could be on the way.

Will carbon cap-and-trade succeed? Only time will tell, of course, but history may be on the market's side: In the mid-1990s, the U.S. instituted a similar cap-and-trade system for sulfur dioxide, a major component in acid rain. In 2007 – three years ahead of schedule – total SO2 emissions had fallen below the instituted cap, and reached the program's goal of 10 million tons below 1980 levels. Much has changed since the sulfur dioxide program was first put in place, but its success suggests that a similar victory might be achieved for carbon dioxide as well.

Source: Is there a Parallel Between Carbon Trading and Subprime Lending?