The past couple of months have witnessed unprecedented weather conditions in different parts of the world -- floods in Mumbai, devastation of New Orleans, and hurricane Rita.
There is a growing consensus that these are manifestations of global warming, the phenomenon of global temperatures going up, because of the rapid increase in emission of carbon dioxide and other similar substances through more intensive use of fossil fuels like petroleum.
Scientists worry that world climate is changing and there is a real danger, among other things, of icebergs melting, leading to a rise in sea levels and inundation of coastal areas. Mumbaikars, beware!
US President George Bush, of course, "knows" that there is no evidence of global warming or its changing climatic conditions. Therefore, after coming to power, he did not submit the Kyoto Protocol on reducing carbon emissions, negotiated by the previous administration, for ratification. (Bush "knew" equally well that Iraq was in possession of weapons of mass destruction; that Iraq was involved in the 9/11 terrorist attacks; and that the coalition troops will be welcomed with garlands by the Iraqi people. What a knowledgeable president the Americans have elected.)
Therefore, the world's largest user of energy and producer of carbon emissions (as much as 36 per cent of the total) is not bound by the limits imposed in the Kyoto treaty.
Most other countries in the world have ratified the treaty that became operative effective February this year. Under the treaty, each country has a quota for carbon emissions -- the objective is to bring down the emissions in industrial countries to 8 per cent below the level of 1990, by 2012.
For monitoring this, by March 2006, energy intensive industries and public utilities have to report their emissions in the previous year for incorporation in the national registries. Based on this, individual units would be given "pollution quotas" for the following year, to help the country meet its own target.
Individual units could either bring down their carbon emissions within the allotted ceiling, or buy "carbon emission credits" from other units, who have more than met their targets.
This has given birth to a new market. Several exchanges are already functioning in Europe, the biggest being the European Climate Exchange.
Although the US has not joined the Kyoto protocol, there is already a functioning Climate Exchange in Chicago; the CCX contract is also traded on Multi-commodity Exchange in India. Major investment and commercial banks are at the forefront of trading carbon emission credits.
The fine for exceeding the quota of carbon emissions, by a unit, is EUR 40 a tonne. Therefore, the price per tonne would not exceed EUR 40, as, in that case, it will be cheaper to pay the fine. Trading started at about $10 a tonne early this year; it has since gone up to $35.
Developing countries are subject to more relaxed emission standards under the Kyoto Protocol. They also have a comparative advantage in earning carbon credits, because their current pollution standards are not as strict as in the industrial countries: by the law of diminishing returns, earning carbon credits when starting with highly pollution inefficient plants, is cheaper than doing so in manufacturing units or utilities which have already, so to say, "plucked all the low hanging fruit".
Another comparative advantage is that, quite often, the costs of installing emission reducing facilities in developing countries would be less -- even if the capital goods cost the same, lower wage, construction, and designing costs translate into overall efficiencies.
Clearly, therefore, countries such as India could become large exporters in course of time by developing a lucrative trade in selling carbon credits. More than a hundred Indian companies have already qualified to sell "certified carbon reductions", under the applicable convention.
It is expected that carbon credit trading on the European exchanges alone is expected to aggregate $60 billion next year. This would give an idea of the size of the potential market.
In passing, two other developments are worth noting:
As the cost to reinsurers of the property claims in southeast US and other places mounts, they are being tempted to issue so-called "catastrophe bonds". The payout from the bonds depends on whether or not a catastrophe occurs. In effect, reinsurers are transferring their risks to the investors in such bonds.
Another instrument that has gained popularity after the recent natural disasters is derivatives on meteorological occurrences, which can be used to hedge or bet on specific events. Trading volume in such derivatives has shot up in recent months on the Chicago Mercantile Exchange. It seems hedge funds are combining bets on commodity prices with positions in weather derivatives.
Clearly, somebody's disaster is somebody else's trading opportunity!