Asked five years ago what we did for a living, we got blank stares when we responded "carbon trading" and "carbon investing." Now, with everyone from PepsiCo to Google to Pearl Jam striving to offset their carbon footprints, placing a value on carbon reduction has become commonplace.

The Kyoto Protocol, negotiated in 1997, required participating industrialized countries to take on legally binding limits on greenhouse gas emissions. Central to the treaty's architecture was a global cap-and-trade system that allowed participating countries to buy and sell the right to emit a metric ton of carbon dioxide equivalent.

This trading system was largely based on the United States' experience with emissions-trading for the pollutant sulfur dioxide, regulated under the Clean Air Act Amendments of 1990. The Kyoto Protocol was ratified by 182 countries, creating a global market for carbon that, by 2003, was valued at approximately $200 million.

In 2004, the Kyoto Protocol came into force, and what a force it has become. Today, the global carbon market is valued at $64 billion - and growing.

Sixty-five percent of this market is driven by the European Union's Emissions Trading System, which was a result of Kyoto-negotiated emissions targets at the EU and national levels. The EU market is liquid and made up of the same derivatives - forwards, futures, swaps, and options - that you would find in any other commodity market.

The global carbon market is not a single market but a complex amalgam of regulated programs at the international, national, and state levels, and voluntary programs fueled by the desire to reduce "carbon footprints."

In addition to the EU's Emissions Trading System, Australia and New Zealand recently passed legislation creating their own greenhouse gas emissions trading schemes that will link to a Kyoto Protocol system. Canada and Japan have struggled with internal politics to develop successful systems. While developing countries such as China, India, and Brazil do not have binding emissions limits under Kyoto, they are able to sell emission reductions from projects in their countries to emitters in industrialized countries.

And then there is the United States. Until recently the world's largest emitter of greenhouse gases (now surpassed by China), the United States is currently a bit player on the global carbon-market scene. The 2007 value of the U.S. carbon market was $331 million, or 0.5% of the global market, and was driven only by voluntary participation.

However, federal legislation capping greenhouse gas emissions across the economy is likely in the near future, as President-elect Barack Obama has supported a national cap-and-trade program that would limit U.S.-based emissions.

The most prominent legislation, the Lieberman-Warner Climate Security Act (S. 3036), would cap emissions 4% below the 2005 level by 2012, and then lower it year by year, reaching 19% of 2005 levels in 2020 and 71% of 2005 levels in 2050. If cap-and-trade legislation is enacted, analysts estimate that the United States could see a market twice the size of Europe's in five years and worth $1 trillion by 2020.

STATES STEP INTO THE GAP

In the absence of federal legislation, states and regions have demonstrated their own leadership on climate change mitigation policy. The Regional Greenhouse Gas Initiative - which includes Connecticut, Delaware, Maine, Maryland, Massachusetts, New Hampshire, New Jersey, New York, Rhode Island and Vermont - has developed the United States' first regulatory cap-and-trade emissions market, and held its first auction of carbon dioxide allowances on Sept. 25, 2008.

The Western Climate Initiative - which includes Arizona, British Columbia, California, Manitoba, Montana, New Mexico, Ontario, Oregon, Quebec, Utah and Washington - is following suit and released its final blueprint for structuring a carbon market on Sept. 23, 2008. The Chicago Climate Exchange has also developed a voluntary, but legally binding, trading platform that is used widely by companies interested in prepping themselves for mandated trading down the road.

On the state level, California legislated emissions limits of 1990 levels by 2020 and is developing a cap-and-trade program covering almost all sectors of the economy. It expects to legislate deep emission cuts beyond 2020. Like clean air and car fuel efficiency, many believe that California may serve as a model for how the United States will ultimately play in the carbon market.

The implications of state and regional legislation on municipalities, utilities, and industry remain to be seen, but largely depend on what areas - electricity generation, industrial sources, transportation - are regulated under a particular policy and how low the cap is set. Many industry groups believe that cap-and-trade programs would drive up rates and costs as utilities and industry are forced to pay for emissions associated with power generation and manufacturing.

Prices in the emerging carbon market have been highly volatile, due to influences as divergent as politics and weather. EU emission allowances and Kyoto trading instruments are currently trading around 20 units per metric ton of carbon dioxide. Prices for units traded on the Chicago Climate Exchange were as high as $7.50 per ton of carbon dioxide (approximately 5.57 units) over the summer, but have collapsed to around $2 per ton currently. A recent U.S. study noted that voluntary carbon credits are trading at approximately $6.30 per ton, a price increase of 26% over 2007 prices and 60% over 2006 prices.

On the financing side of the emerging carbon market in the United States, a number of financial institutions and private equity players have begun to invest. Some investment banks have set up carbon-credit trading shops on their commodity desks in anticipation of the rising value of these speculative investments. These institutions have been providing project financing and taking early positions in carbon credits, but with the current credit crunch and investor appetite for risk falling, it is unclear at the moment whether the former giants of Wall Street will continue to be major players in the emerging carbon market.

PRIVATE EQUITY'S ROLE

Private equity firms have also created funds that invest in projects designed to generate emission reductions. These include firms like Climate Change Capital and Natsource, which invest millions of dollars in emission-reduction projects around the world. Other private equity shops focus on a particular sector. New Forests, a Sydney-based firm with offices in Washington, D.C., and San Francisco, has raised $100 million to invest in carbon-emission reduction projects associated with forests, primarily in the U.S.

Cities and states are also becoming increasingly involved in financing emission-reduction projects, usually under the rubric of energy efficiency and clean energy. Boulder, Colo., the District of Columbia, Milwaukee, Seattle, Berkeley, Austin, and New York City are only a few of the municipalities that have efforts underway to finance energy conservation carbon-reduction projects.

Incorporating the value of carbon credits would only improve the economics of the deals, as the ability to sell them generates additional revenue for the project. It is impossible to say that the current turmoil in the financial markets will not affect the viability of the carbon market, but a new administration in January, coupled with continuing global pressure to invest in climate protection, may open the door to the creation of a national policy.

Credit is tight; investors are cautious; emerging investments are being placed on the back burner. Nevertheless, events to date have shown that investors are willing to place bets that the carbon market in the United States has legs, and that potential returns could benefit both the bottom line and the environment.

Ann Grodnik is an assistant vice president at Seattle-Northwest Securities, specializing in energy issues. Radha Kuppalli is director of New Forests' Washington, D.C., office.