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Kyoto Summit: Developed nations look to a free market in pollution

The final deal reached in Kyoto this week will open the way for a free market in trading in pollution rights between nations. Nicholas Schoon, Environment Correspondent, explains an extraordinary idea.

You are a country which has signed up to a legal treaty strictly limiting the quantity of greenhouse gas emissions you can produce each year. And you have a real problem - you know you are heading to break that limit in the next few years.

Perhaps one of your nuclear power stations has broken down, so you need to burn more greenhouse-gas producing coal to make up for the missing electricity. Or economic growth is expanding your use of fossil fuels faster than you expected.

So what do you do? You buy a load of extra permits to pollute on the open, international market at a few dollars per tonne of greenhouse gas. Then, when you do go over your limit, you are not breaking international law - for you have the permits to cover the excess.

The cost of purchasing them from overseas is cheaper than cost of cutting your rising emissions at home. The United States has insisted this kind of trading regime must feature in the Kyoto climate treaty for developed countries. It now seems certain to get its way, despite other nations and green groups having serious doubts. Economic theory says that free- market trading in permits guarantees to minimise the total costs of stabilising or reducing the global level of pollution.

In real life, the largest trial to date has taken place within the US through the 1990s. It applied to the acid rain gas sulphur dioxide produced mainly by power stations, and it seems to have worked fairly well.

Here is how it could work if, say, the Kyoto treaty set a target for developed countries to cut annual greenhouse gas emissions to 95 per cent of their 1990 level by 2000 - a fairly likely final outcome. Each country would be given permits sufficient to cover 95 per cent of the quantity of pollution it produced in 1990, to be used in the year 2010.

Those nations confident of being able to cut emissions by more than 5 per cent easily and cheaply would reckon to have surplus permits for that year. So they would offer them for sale, either on the open market or in private sale agreements with other governments, in 2010 or beforehand. Nations which found it too expensive or difficult to meet the target would want to buy them. But overall, emissions from the developed world would be cut by 5 per cent.

It gets more complicated. The permits would, in fact, cover several years of emissions rather than just one - and could be banked up for the future. Not only would there be a market in permits, but a futures or options market too - in which the players would be gambling on the future price of permits. In Kyoto this week, the Deputy Prime Minister, John Prescott, suggested the City of London get involved. But the EU and the green lobby worry about potential loopholes.

Russia and the eastern bloc have had enormous reductions in greenhouse gas emissions since 1990, thanks to economic decline. So if permits were allocated on a 1990 basis, that would give them a big surplus. The natural client to sell them to would be the US, the world's biggest climate polluter, allowing American greenhouse gas emissions to keep rising.

Furthermore, the trading regime would collapse if there was not strict monitoring and enforcement. Nations which polluted above their quota without having purchased the necessary permits ought to be severely penalised. But a watertight regime has not been negotiated in Kyoto.

The EU's view is that trading permits should only play a small part in lowering greenhouse gas emissions; what countries do inside their own borders must deliver the bulk.

Dr Daniel Dudak, of the US Environmental Defence Fund, is a leading advocate of pollution trading and guesses the price will settle down at around pounds 2 for each tonne of carbon dioxide traded. "The permits are, in effect, a sovereign promise by a Government to perform - they're only as good as that promise. I have a lot of faith in the entrepreneurship that will come with trading."