Public policy issues can be frustrating to investors. When you're analyzing a potential investment, you have to make allowances for the regulatory environment that businesses face. However, the laws and regulations that apply to a given industry can change without notice. Oil companies such as ExxonMobil (NYSE:XOM), BP (NYSE:BP), and Chevron (NYSE:CVX) found that out last week, as the new House of Representatives imposed new royalty taxes on oil and gas drilling in certain previously tax-free areas. The uncertainty of potential changes in businesses' regulatory environments can be one of investors' biggest challenges.

On the other hand, public policy issues aren't always bad for markets. In some cases, laws and regulations use free-market mechanisms to achieve positive results. Many governments and international agreements have established markets to help enforce pollution-control guidelines, creating opportunities for resourceful businesses to profit from government regulation.

How the emissions markets work
Most government and international efforts to control emissions use the cap and trade system. First, the government or international coalition determines appropriate maximum limits on emissions, usually based either on current emission levels or maximum safety levels. Once an overall cap is established, all parties allocate allowable emissions among themselves. For instance, the Kyoto Protocol envisions placing caps on national emissions levels based on a fixed-percentage reduction from 1990 emissions levels. The Clean Air Act of 1990 established a similar program to reduce the sulfur dioxide emissions responsible for acid rain. For international agreements, each national government then proceeds to distribute emissions credits among businesses within its borders.

Once all market participants have an initial allocation of allowable emissions, they can begin to trade credits for those emissions. The cap and trade system recognizes that some participants can't limit themselves to their initial allocations. To fulfill their agreement, these participants may purchase emissions credits from other businesses emitting less than their allocations.

Several markets have sprung up to trade emission credits. The Clean Air Act's sulfur dioxide regulations authorized the Environmental Protection Agency to monitor transfers of emissions credits among businesses, with futures contracts available on the Chicago Climate Futures Exchange. The European Union Emission Trading Scheme has been for trading carbon dioxide emissions credits since the beginning of 2005, with the possibility of adding markets for other pollutants in 2008.

Selling pollution reduction
The market mechanisms for trading emissions credits are already changing the business of reducing pollution. Industrialized countries generally find reducing emissions levels expensive, since they've already implemented many of the easiest, most remedial pollution-cutting measures. But many emerging-market countries have taken few or no steps at all to curb emissions in the past, leaving them with opportunities to reduce emissions at lower cost. If an emerging-market business reduces its level of emissions, it can sell the resulting credits for cash to other businesses worldwide.

As a result, countries throughout the developing world are seeing an explosion in pollution-curbing projects. For instance, many developing countries still use older refrigerants, greenhouse gases that harm the ozone layer. Disposing of these refrigerants isn't generally cost-effective, but the promise of cash from emissions credits can help make such projects economically feasible. Other projects designed to reduce emissions, such as retrieving methane from landfills and harnessing renewable energy via wind farms and hydroelectric dams, can produce strong cash flows into emerging-market businesses. In addition, projects to create so-called carbon sinks, such as forest management and reforestation programs, are especially beneficial in countries like Brazil, which has large areas of land available for forestry projects. Many companies in industrialized countries, including Repsol (NYSE:REP), Norsk Hydro (NYSE:NHY), and Endesa (NYSE:ELE), have already begun investing in these projects, hoping to generate credits that they can use for their primary manufacturing operations.

Critics of these programs argue that the brief history of emissions-credit trading suggests problems in those credits' allocation. Prices for credits on the European markets have fallen dramatically since their initial introduction, with current levels of four euros per ton representing a huge decline from highs of more than 30 euros. A glut of credits may be responsible for the depressed prices.

Nevertheless, the beginning stages of emission controls and credit trading appear to meet expectations. As more of the Kyoto Protocol's provisions take effect, trading in these markets will likely accelerate, and emerging-market projects designed to take advantage of that trading will continue to provide opportunities for global investors.

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