Trading of rights to produce greenhouse gases is being held back by political doubts, writes Vanessa Houlder

At the launch of the 1997 Kyoto Protocol, Al Gore, the US vice-president, extolled "the magic of markets" as an instrument for tackling climate change. Across the world, this vision is being put to the test.

In the last month, Canadian energy companies have struck two large deals in which they paid others to fulfil their commitment to cut greenhouse gas emissions. In one transaction, they paid Iowa farmers to refrain from tilling their farmland, so retaining carbon dioxide in the soil.

In Australia, the Sydney Futures Exchange has joined forces with State Forests of New South Wales to launch the world's first exchange-traded market for "carbon sequestration" credits. Buyers will be able to offset carbon emissions with credits generated by planting forests to absorb carbon dioxide.

Meanwhile, in the UK, industry leaders last week announced plans to introduce a UK- wide emissions trading scheme by April 2001. Businesses will be able to choose whether to meet emission reduction targets through their own efforts, or by buying surplus permits from elsewhere.

"I think what we are seeing is a convergence of capital and environmental markets," says Richard Sandor, a former senior Chicago Board of Trade official who now runs the specialist Environmental Financial Products company. He describes current schemes as "unlike anything before".

But the future is uncertain. Trading in emissions permits may be doomed unless countries can agree on the rules of the game. Although the Kyoto Protocol sketched out previsions for trading, there is little agreement over how an international trading scheme will work.

This week, differences have emerged again at the latest United Nations summit on the Kyoto Protocol in Bonn.Emissions trading puts the US at loggerheads with the EU, and causes tension between developing countries and the industrialised world. Unless these problems can be resolved by the next summit, which takes place in a year, the Kyoto Protocol could fall apart.

One contentious issue is whether there should be limits on trading. This idea is forcefully promoted by the EU, which wants countries to achieve half their Kyoto targets through domestic measures to cut energy consumption and stimulate technological innovation.

The US is implacably opposed to the imposition of constraints on the use of emissions trading. "Limiting this ability would only make reducing greenhouse gases more expensive for everyone, with no gain to the environment," said Mark Hambley, the US special negotiator on climate change last week.

The US cites its successful use of emissions trading to cut sulphur dioxide emissions that cause acid rain.Emissions have been reduced by 30 per cent more than required, and it claims the cost of reductions was under half the level anticipated. The effectiveness of trading is endorsed by a recent study by the OECD. It calculates that without emissions trading the impact of the Kyoto targets on the OECD countries is comparable to doubling or tripling the price of oil from its 1995 level. Trading could cut costs by a third.

There is a snag. Part of the apparent gains from unfettered trading would come from higher overall emissions than would otherwise be the case. This is because much of the trading would probably involve Russia and the Ukraine. The contraction in the industrial base of the countries is expected to reduce their emissions to well below the level required under the Kyoto Protocol by 2010. This will put them in a position to sell spare credits - known as "hot air" - and allow others to raise emissions.

Russia's potential windfall is expected to be worth $2bn a year by 2010, and several developing countries would like to fix emissions targets at similarly undemanding levels. This appals some industrialised countries, particularly in Europe, which argue that it could undermine the effect of Kyoto Protocol.

The disagreement between diplomats at the UN talks contrasts with the enthusiasm of the private sector in wanting to get schemes going. The private sector is "filling the vacuum", according to Frank Joshua, head of greenhouse gas emissions trading at the United Nations Conference on Trade and Development (Unctad).

The market pioneers have varying motives. Exchanges and brokers are promoting deals because they are keen to take a leading role in the development of what could become a huge new market. According to the Electric Power Research Institute, the total value of carbon dioxide permits could be worth $13,000bn by 2050. The opportunities for trading permits and their derivatives could be immense.

For companies, the deals are partly designed to influence governments. By demonstrating the effectiveness of emissions trading, they hope to fend off the prospect of new regulations or taxes. They also want to hedge future liabilities that could emerge when they are forced to cut emissions. "Not only does a global market for greenhouse gas emissions appear likely, but the potential rewards for smart players in the field are enormous," says Natsource, a New York-based over-the-counter broker of energy derivatives.

Examples include the decision by BP Amoco, which has been experimenting with trading between some of its subsidiaries, to expand the scheme across the group next year. In another initiative, the European Association of Electricity Producers and Distributors and the International Energy Authority organised an internet simulation of greenhouse emissions trading.

National and international bodies are also getting involved. In Japan, the Ministry of International Trade and Industry has set up a company to monitor emissions trading. The European Commission has proposed developing an internal trading system for greenhouse gas emissions that could be launched in 2005.

Meanwhile, Unctad has helped launch the International Emissions Trading Association, which held its first meeting last week. This association's members include the Australian Stock Exchange, the International Petroleum Exchange, Lloyd's Register, Shell, BP Amoco, Statoil and Tokyo Electric Power. It is exploring ideas on how to create the global emissions market that the Kyoto Protocol implies should start by 2008.

There are many issues to be resolved before the goal can be achieved. In order to ensure a thriving market, the trading system would have to allow company-level emission permits to be traded internationally. Arguments over what counts as an emissions reduction must also be resolved. This means reaching a scientific consensus on the value of locking up carbon in trees, crops and soils.

Crucial issues of compliance and verification also have to be sorted out. On the face of it, the issues that need to be resolved are overwhelming. Most companies and countries will be reluctant to invest time and effort in emissions trading unless there are clearer signals about the shape that the market will take.

Yet there are signs that the fledgling emissions trading schemes being set up by pioneering countries and companies could take on a life of their own. Unctad is exploring the idea of setting up a network of bilateral agreements between interested countries that have emissions trading programmes. "It is developing in parallel with the Kyoto Protocol," says Mr Joshua of Unctad. "We need a multinational agreement. But this is a step along the way."

Even the most ardent advocates of emissions trading acknowledge it can only be a partial answer to the problems of climate change. But by opening up markets, encouraging innovation and harnessing competition, it may do something to reduce the world's greenhouse gases.