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Last week, we saw hundreds of carbon market professionals gather in Barcelona for the 8th annual Carbon Expo. This is the carbon trading industry’s annual forum to take stock, listen to expert analysis, and assess the state of the market. While the overall message was predictably downbeat, it is clear that governments and the United Nations Framework Convention for Climate Change (UNFCCC) both have central roles in providing investor confidence and putting private finance to work in combating climate change and encouraging carbon trading strategies.

The last three years have been tremendously tough for the market, with low carbon trade volumes and depressed carbon prices. Globally, the market is shrinking. The Kyoto protocol, which legally binds signatory countries to emissions reduction targets and creates carbon credit demands, does not have a follow-up agreement. As a result, both supply and demand of credits is undermined and unstable.

The market is essentially being “unmade.” The incentives on both the supply and demand side point away from engagement in the market. The supply side (those who undertake emissions reductions projects in order to create credits under the Clean Development Mechanism, or CDM, for example) are waiting to make sure the demand for those credits is still going to be there when Kyoto draws to a close. There is still nervousness that in the absence of legally-mandated cuts for countries, the demand for those credits will not be there.

On the demand side, there is also a stand-off from the buyers. Traders want to wait and see how the post-Kyoto session will play out, reducing trade volumes and depressing the price. The financial crisis resulted in lower production which in turn lowered emissions among countries with binding targets. These reductions meant that companies who would have demanded credits on a business now have no need to buy credits to cover their excess emissions.

So from both the demand and supply point of view, the market is stuck in a hiatus while the players wait to see how everything pans out post-2012. What will it take to remake the market?

As we have seen, confidence (especially in the non-EU Allowance market) is the major inhibitor of growth. Without it, people do not see the value either in buying carbon credits or in providing them. It is clear that negotiators at the 16th UNFCCC Conference of the Parties (COP16) climate meeting in Cancun tried to bolster confidence by confirming that flexible mechanisms would continue after 2012. However, it did little to allay fears that credits may be worthless in 18 months' time, given that demand is not guaranteed because emissions reductions are not legally binding under the UNFCCC.

So for the next meeting at COP17 in Durban, South Africa, the pressure to make the negotiating ends meet is really on. 

It is vitally important to the future of the carbon markets that the UNFCCC provides indications strong enough to get the markets moving again. This will of course be tough. While COP16 may have been viewed as a success, it was only a step in the right direction.

The pressure is on Durban to turn that progress into concrete agreement, and it is a pressure that will have to be managed effectively. A positive outcome is by no means certain: China is struggling with inflation, there still appears to be no political appetite for large-scale commitments from the U.S., and the EU will still be trying to steady the Eurozone.

Nevertheless, if the $100 billion per year to fight climate change is to materialize, the “rules of the game” for the private sector must be made clear. Private sector involvement in the fight against climate change begins in the carbon markets. At the very least, a transparent and credible indication that an heir to Kyoto inevitable rather than a pipe dream is required. Without that, the private sector will remain on the sidelines, when it should be running the game.

Photo Credit: Wikimedia Commons