The Australian government has announced plans to introduce a carbon tax from July 2012. It is not clear whether it will boost carbon trading and encourage companies to reduce their emissions or it will simply add to the state coffers.  

Traditionally the idea of a carbon tax has been viewed as a knee-jerk reaction of the political classes to force companies to reduce emissions, versus the more progressive cap-and-trade approach which generates significant funding for renewables projects in the developing world. However both can work together if the revenue raised from the carbon tax is used to fund emission reduction projects. There is a big question mark of course as to how this can be implemented in practice.

A carbon tax can only achieve emission reductions if it's sufficiently high to make an impact on a company's turnover. In other words the carbon price per metric tonne emitted must be such that the total carbon tax bill for an average emitter amounts to a significant percentage of the turnover, otherwise there would be no real incentive to make a serious effort to curb emissions (which can be costly to implement). The downside of a high carbon tax is that there can be implications for the end consumer of goods and services in higher prices and a decrease in competitiveness.

Effectively emissions reductions can be very costly and take a long period of time to implement because in most manufacturing processes changes require a timescale of years. Without a clear plan of how the carbon tax revenue will be allocated to drive the low-carbon economy and clean energy investment, it remains simply yet another tax.

It is expected that the registries in the UK, Germany and France will reopen either later this week or next week at the latest. The disruption of spot trading will not even dent a market where 90% of the volume is traded in derivatives, but the real damage is to the credibility of the system.

It's unlikely that the registries of countries where security measures are lax will reopen anytime soon or perhaps even ever. After all, reputable trading firms need not use those registries and all carbon credits can be securely kept in the registries of the countries where the main carbon exchanges are located ie. UK and France.

By B Bell

My eye caught an exchange in the Letters section of the FT where two readers write in about the problems in the carbon markets.

One said that the reason why the concept fails is because a carbon credit has no physical reality attached to it. Another replies today saying that financial instruments lack a physical reality but that the carbon markets failed because credits were designed to be used (or retired as they say in the industry), like fishing licences, not traded endlessly for profit.

I think both readers miss the point.

Carbon credits do have a physical reality. They enable compliance buyers to emit a set amount of CO2 that in the manufacturing process does have a very tangible physical form. Just like a financial instrument such an insurance policy does not have any physical reality until it is activated in the form of a claim for a loss, which is when it becomes connected to the real world, in the same way a carbon credit connects directly with GHG emissions and our impact on our climate.

At the point of origination, they provide the funding for a very physical reality, say in the form of a renewable energy project, that would not happen without those funds.

The present problems are not caused by the fundamental concept of the credit, they are due to the poor security of some of the national registries. It is true that carbon credits do not lend themselves to trading as much as equity for example. Equities can go up in value fairly linearly over the long term, whereas carbon credits are more likely to coast around reasonably fixed values so the amount of speculation that can go with it is more limited.

The suspension of spot trading this week in the main European carbon markets undermines the credibility of a system that is still finding its place in the financial world. 

The theft of 1.6m EUA owned by a Swiss cement company from a carbon registry in Romania shows that a lot of work needs to be done to strengthen the system so that it can be taken more seriously. The European carbon market is worth an estimated £80bn a year and growing, and it deserves a more credible process of checks so that the ultimate consumers of carbon credits can have faith that the trading exchanges and all the agents involved from project origination to retirement of credits deliver a credible product with the equivalent assurances of other commodity markets.

Obviously the weakest link in the process are the 30 national carbon registries, and the centralized registry to be introduced in 2013 cannot come soon enough.