In this transition, environmental issues, including greenhouse gas mitigation, are fast moving out of the confines of company environmental, health and safety departments and are becoming a topic of corporate business and financial strategy. We are witnessing important developments in the form of futures markets for property rights. Financial markets are being used to help address environmental concerns, and capital is flowing to these initiatives at an impressive rate. As carbon becomes a new asset class, these are truly exciting times.

Market-Based mechanisms, such as emissions trading, are becoming very important to corporations and investors, especially as societies approach a carbon-constrained future.

Much has been made about the apparent difference between European and U.S. views on climate-change policy. The general perception is that action on this issue is at a standstill in the United States. But the reality is quite different. Over the past few years, Europe has quietly embraced the concept of emissions trading as a policy tool to cost-effectively address climate change. Meanwhile, in the American heartland, the Chicago Climate Exchange (CCX) started continuous electronic trading in December 2003. These separate events point toward a common fact: Market-based mechanisms, such as emissions trading, are becoming very important to corporations and investors, especially as societies approach a carbon-constrained future.

Cap-and-trade emissions trading systems are successful from both environmental and economic viewpoints because they provide industry with the flexibility in method, location and timing of emissions reductions. Under these systems, participating carbon emitters voluntarily enter into a legally binding commitment to reduce emissions by 4 percent from an established baseline. Companies that cut emissions below the targets can sell allowances–the right to emit–to those that cannot make the cuts internally. Because the overall annual targets are below historic levels, a systemic reduction ensues.

In this system, the entrepreneurial skills of industry are harnessed for pollution reduction. Cap-and-trade provides direct financial incentives for least-cost solutions and technological innovation to reduce emissions. Programs such as the Environmental Protection Agency’s Acid Rain Program are based on the premise that trading can achieve significant emission reductions at costs far below those experienced under a command-and-control policy. The success of the Acid Rain Program so far has proven the practical outcome of this theory. All of the characteristics of a successful emissions trading program may be applied to greenhouse gases.

Australia, Canada and Japan are also aware of the need for action. In the absence of federal regulation, some Australian states are taking steps to set up trading schemes. Canada is considering implementing a cap-and-trade system to fulfill its reduction obligations under the Kyoto Protocol. Japan has been an active investor in reduction projects worldwide. It recently created its first carbon fund: the Japan Greenhouse Gas Reduction Fund.

In the U.S., a wide variety of promising policy initiatives is evolving. The Regional Greenhouse Gas Initiative, organized by nine Northeastern states, and climate proposals by Washington, Oregon and California are good examples. Twenty-eight states have promulgated statewide climate-change action plans. Furthermore, renewable portfolio standards, which require retail sellers of electricity to include in their resource portfolios a certain amount of electricity from renewable sources, now exist in 18 states. At the federal level, legislative interest in climate-change action has been on the rise, as indicated by a significant increase in the number of climate-related legislative bills in Congress. America’s private sector is also showing greater sensitivity to climate change. Large corporations have announced intentions to manage their greenhouse gas emissions, and have gone public in recognizing that profits and environmental stewardship go hand-in-hand.

The marketplace is also garnering tremendous interest from private enterprise. In the U.S., CCX administers the only fully integrated, multisectoral, rule-based greenhouse gas emission registry, reduction and trading system that also employs independent verification and includes all six greenhouse gases. CCX is the world’s first–and this country’s only–system for greenhouse gas emissions trading, and is the only legally binding framework in operation in North America. Since trading began two and a half years ago, total volume has exceeded 4.5 million metric tons. Baseline emissions of CCX members (250 million metric tons) currently account for roughly 8 percent of U.S. major stationary source emissions. The program helps build north-south links by allowing participation from Brazil and Mexico. Membership in CCX exceeds 100 diverse organizations, including leading companies such as Ford, Motorola, American Electric Power, International Paper and IBM; universities such as Tufts and the University of Minnesota; cities, including Portland; the state of New Mexico; and even farmers in Iowa and Nebraska.

The World’s Biggest Market?
The launch of the European Emissions Trading Scheme (EU-ETS) has boosted the global market for emissions trading. The EU-ETS, which opened in January 2005, allocates emission allowances to its 25 member states. Each state, in turn, distributes these allowances to large European emitters using a cap-and-trade system. In its first 14 months of existence, the total value of trades in the mandatory EU-ETS crossed e10.6 billion. The components for a global emissions trading market are now in place.

New global warming initiatives are based on the premise that trading can achieve significant emission reductions at a cost far below what would have been realized under a command-and-control policy.

Today the Chicago Climate Exchange is active in the European ETS through ECX, a fully owned subsidiary of CCX. ECX offered the first quoted and cleared product for European carbon, with financially guaranteed contracts by LCH.Clearnet in London. ECX began trading futures on the International Petroleum Exchange (now called ICE Futures) in April 2005, believing its product was a natural for the energy market. On its first day, it traded 108,000 metric tons of carbon dioxide. Ten weeks later, that figure hit 1 million tons per day. Within four months, the ECX established itself as the leading exchange-traded product in the field, with a volume of more than 150 million metric tons. With average daily volumes of 1 million metric tons of CO2, and more than 85 percent of the market share among active exchanges, ECX futures have become the premier products for trading in Europe. Members active in ICE Futures include most of the leading European and U.S. banks and some of the world’s most prestigious industrial concerns.

CARBON EMISSIONS INVESTMENT FUNDS Trading Emissions Assets: $265 million Headquarters: London (incorporated on the Isle of Man)Activity: The core of its portfolios is a long position in carbon assets (credits). The company also does some trading and invests in other emissions assets. Natsource Assets: $550 million Headquarters: New York Activity: Natsource’s Greenhouse Gas Credit Aggregation Pool (GG-CAP) is the world’s first private-sector mechanism that will purchase and manage delivery of a large pool of greenhouse gas emission reduction credits, which buyers can use to comply with emission reduction requirements. Climate Change Capital Assets: $150 million Headquarters: London Activity: Invests in emission reduction projects around the world. Also trades in the EU Emissions Trading Scheme (EU-ETS). CDC/IXIS Assets: $130 million Headquarters: Paris Activity: CDC/IXIS’ European Carbon Fund buys and sells emissions credits. It helps EU industries manage their long-term exposure to emissions reduction constraints.

Despite the apparent disparity between these markets, the contours of a global marketplace are beginning to emerge. Markets naturally form independently, coalescing and harmonizing at a later stage. Historically, the evolution of the cotton market in the 19th century is one example; local trading hubs developed around Liverpool, New Orleans and Mumbai with varied standards and practices, and ultimately became consolidated. Many international arrangements have also followed this pattern: The EU is a recent example, having developed from coal and steel agreements in the 1950s to the monetary union in 2000. While emissions trading prices in Europe are $30 per ton, they trade for approximately $2 per ton on the Chicago-based CCX. This disparity exists because European market is mandatory and based on one gas, while the U.S. exchange is voluntary and trades multiple types of gases. If a global system operated under one set of rules, prices would likely converge.

The growing activity in this arena has provoked a surge of interest from public and private investors, as evidenced by the growth of funds, hedge funds and proprietary trading desks specializing in emissions trading. More than 20 targeted funds have raised more than $2 billion to invest in projects or new technologies that generate carbon credits as an investment strategy. Moreover, firms directly involved in originating environmental credits, such as AgCert, Econergy and EcoSecurities, have seen successful public offerings in recent months.

Emissions trading is still in its infancy, and challenges remain. We have proven some things, but we still have a long way to go. The world faces some massive environmental problems that will take decades for us to learn how to manage. With that in mind, many analysts believe that the current global emissions market is merely the start of what could be the biggest financial market in the world. I am as excited about this development as I was when we were involved with the birth of financial futures in the 1970s.

Richard L. Sandor is chairman and CEO of the Chicago Climate Exchange. He has been lauded as "the father" of the multitrillion-dollar interest-rate futures markets now traded worldwide.