The Big Question: What is carbon trading, and can it save the world from global warming?

Why are we asking the question now?

Britain and California, the most populous American state, are to sign a new carbon trading agreement. It is particularly significant because it appears to be a snub to President George Bush's decision to renounce the Kyoto treaty which set targets for reducing emissions of the gases that are blamed for global warming. Ken Livingstone, the Mayor of London, is also set to announce an agreement between the United Kingdom capital and Los Angeles. The agreements would, in effect, bring a significant portion of the United States into the European carbon trading market.

What is carbon trading anyway?

In today's globalised world, anything can be bought and sold. Companies can sell the rights to the future profits; food companies can buy up their orange juice needs a year in advance. The idea is to apply that market-based system of valuation to pollution. If countries can be persuaded to agree to limits on pollution then the right to exceed that has a price. "Good" organisations can reap the benefits of cutting their emissions while "bad" ones pay a financial penalty. Economists believe it is more efficient and more effective because, unlike a tax, it rewards and punishes particular patterns of behaviour.

How does it affect climate change?

As each country signs up to the Kyoto treaty, it submits to a legally-binding agreement to meet a pledged emissions target by 2012. Industrialised countries have committed to cut their combined CO2 emissions to 5 per cent below 1990 levels, but each country that signed the protocol agreed to its own target. When the Kyoto trading scheme gets underway in 2008, companies in the signatory countries will have to buy permits from each other if they breach their limits.

Currently, the European Emissions Trading Scheme (ETS) is the only game in town. Launched on 1 January 2005, it enabled governments to limit the supply of permits needed to emit carbon. The idea was to discourage the burning of oil and coal. In effect, this means the European Union requires about 12,000 factories and power stations to comply.

However this accounts for less than half of the union's total CO2 emissions. In time, the five other greenhouse gases listed in the Kyoto protocol will be included in the union ETS. In effect, it applies to traditional industrial activities but leaves households, motorists and airlines unscathed.

How is the system working so far?

The EU scheme has certainly created a market for permits. Some seven million tons' worth of permits changed hands in the first five weeks of operation, compared with just 1.5 million in the previous period, according to consultants, Point Carbon.

The cost of an allowance to emit one metric ton of C02 was about €7 (£4.80) when the scheme started. It rose steadily to €29 in July 2005, then stabilised in the €20-€25 bracket before falling sharply - for reasons discussed below.

Official figures from the European Union for the first year of the scheme's operation showed that the installations in the scheme's ambit pumped out 97.5 per cent of the collective limit that their governments had agreed to.

The official sanction for such a scheme has spurred other private sector initiatives. Companies have set up to exploit the companies' search for ways to cut their CO2 emissions.

In the UK, AgCert, a company listed on the AIM section of the London Stock Exchange, installs a piece of equipment on pig farms, called a biodigester, which cuts emissions of CO2 by collecting and burning methane from animal waste. These cuts in emissions, known as offsets, can then be sold to European companies such as power stations to help meet their targets.

BSkyB, the broadcaster, aims to become the first media company to become "carbon neutral" through efficiency, reduction and offsetting.

Frequent flyers can offset the damage their journey inflicts on the ozone layer by paying money to organisations such as Climate Care which run programmes in renewable energy and reforestation.

Is this just a fig leaf to shield polluters?

The EU's success (in the figures quoted above) in curbing emissions turned out to be a false dawn. Analysts swiftly spotted that member states had been too generous in allotting permits to "national champion" industries such as carmakers and power generators.

The revelation that the EU was operating well within its self-imposed limits sparked a crash in the price of tradable carbon permits, as analysts realised big business would have less need to buy and sell. This reduced the incentive for companies to cut back on their emissions or spend money finding ways to offset it, and undermined the economics of businesses investing in renewable energy sources.

Should the scheme now be extended?

The EU is already looking at one of the big holes in the current coverage - airlines. The union is hoping to bring aviation within the ETS net by 2010. However key questions have to be answered. These include whether it will apply to flights beginning or ending in the EU, or only to flights between member states. Another unknown is how it will be measured and which pollutants it will cover.

An even ambitious vision was outlined by David Miliband, the Secretary of State for the Environment. Last month, he backed the idea of carbon rationing for all, based on smart credit cards that record an individual's energy use. In theory it would operate as a microcosm on the ETS, and households that run an SUV car would have to buy credits from a household that runs a more efficient car. In a perfect world the polluting household would decide to sell the SUV, save 2.2 tons of carbon a year and bank the profits for selling their permits.

What does the future hold?

With the US resolutely standing outside the Kyoto treaty, along with Australia among the advanced nations and China in the developing world, the future looks bleak.

However the volume of anger and concern among citizens within all countries of the world is starting to change the minds of politicians - as witnessed in Los Angeles yesterday.

Is carbon trading the right way forward?

Yes...

* It provides incentives that reward people directly for changing their behaviour to help limit carbon emissions

* Europe has successfully launched a scheme at a time when there is no working alternative

* It avoids the need for blunt tools, such as taxes or physical quotas, that would increase cumbersome government intervention

No...

* It enables governments and companies to avoid implementing serious and immediate cuts in polluting activity

* It allows countries to cheat by giving their own big companies large quantities of permits

* The US and China, the largest polluters, are not taking part and show few signs of joining