After a mid-year status meeting in early June, it is clear that the 192 or so parties to the international climate change convention's 17th Conference of the Parties (COP17) in South Africa this November have their work cut out for them…and the future of the Kyoto Protocol and the Clean Development Mechanism (CDM) is in limbo.

Following the mid-year meeting, most pundits agree that, after the Kyoto Protocol's first compliance period ends in 2012, a "regulatory gap" will result. In other words, there will a period of some unknown duration where there will be no legally binding, concrete greenhouse gas (GHG) mitigation commitments applicable to parties to the Kyoto Protocol. This will be the case even if, by some feat of negotiations, the parties are able to reach agreement regarding post-2012 compliance under the Kyoto Protocol in South Africa. A "regulatory gap" will occur because an agreement by COP17 parties would still require ratification by all parties to the United Nations' climate change convention (UNFCCC) and the one year time period until the first compliance period ends in 2012 is not enough time for ratification (keep in mind that ratification of the Kyoto Protocol itself took 7 years!).

So when the Kyoto Protocol faces a regulatory gap, what will become of the CDM? The CDM is basically a way to get developing nations to reduce GHG emissions. Under the Kyoto Protocol and the European Union's Emission Trading System, CDM offset credits (known as Certified Emissions Reductions or CERs) can be used in lieu of allowances for compliance. But with the Kyoto Protocol facing a regulatory hiatus, will the demand for CDM offsets from the EU's Emission Trading System alone be enough to sustain the CDM? It's hard to say but it certainly does not bode well for any new CDM projects. Beyond 2012, the only unconditional demand for CDM offsets is from EU's Emission Trading System and that demand is estimated at 1.7 billion tons. Experts agree existing CDM projects are sufficient to fulfill that demand, and the market senses this: the value of primary trading in CERs has been trending downward for the last three years, with the market falling 48% in 2010 to $1.5 billion according to the World Bank. Given the fact that the CER market was valued at $7.4B in 2007, this drop is significant.

What does this mean for business? First, the global carbon market is shrinking, not just the CDM market. After 5 years of rapid growth, global carbon market is now stalled. The global carbon market grew from $15 billion in 2005 to $144 billion in 2009. But in 2010, it fell to $142 billion. This contraction is due to sliding CDM markets, for sure, but is also compounded due to a weak regional greenhouse gas credit market and the weak demand for assigned amount unit (AAU) credits (the so-called "hot air credits" under the Kyoto Protocol.) It is significant to note that the global carbon market shrunk even as global economy stabilized -- not a good sign for the market and businesses dependent on it. Second, with the Kyoto Protocol likely to be in regulatory hiatus, there will be little international pressure for comprehensive domestic climate change legislation. This may bring a sigh of relief to domestic industrial operators. However, this does not mean an end to regulation of GHGs by the U.S. Environmental Protection Agency (USEPA). USEPA's regulation is driven by statutory mandate -- not international pressure -- and domestic GHG regulations would not be affected by a regulatory gap under the Kyoto Protocol. Third, look out for a carbon tax, particularly in the European Union. Even with the Kyoto Protocol's regulatory gap, the EU's regulatory scheme to comply with Kyoto Protocol (including the EU-ETS) is mandated to be in effect through 2020, with ever-increasing, more stringent regulation of GHGs. Absent comprehensive repeals of these EU regulatory schemes, expect to see further regulation of GHGs in the EU. Given the current disfavor (and incidences of fraud) associated with the EU's Emission Trading System, expect EU regulators to look at other ways to regulation carbon, specifically taxation.