Following last week's successful test of the state's auction platform, the reality is starting to settle in: California carbon trading has overcome legal and political challenges to position itself a mere 10 weeks away from its first official CO2 permit sale.

The carbon market's success or failure will sway U.S. environmental policy for years to come, and early-moving Canadian banks like Bank of Nova Scotia (Scotiabank) and the Royal Bank of Canada, as well European banks like Deutsche Bank and Barclays, could play a critical role in that outcome.

Banks facilitate the purchases and sales of carbon credits for their clients, advise company executives on how to keep their costs down, and ultimately help them meet their environmental goals.

But so far, most brand-name investment banks have either kept their distance or already walked away, wary of pumping precious capital into the nascent market, especially in light of their tumultuous experience in the European carbon market.

Just as California hopes to learn from the mistakes made by their counterparts in Europe, where the eight-year-old market has been beset with plunging prices and regulatory uncertainty, banks hope to marshal their European experience to give them an advantage in California.

"We've been trading in Europe for years, so we have a deep understanding of carbon right now," said Anthony D'Agostino, director of emissions markets for the Royal Bank of Canada.

"To replicate this in California is a no-brainer for us," he said.

Although it does not have a long history in emissions markets, Canada-based Scotiabank is the most active bank in the market at this point, with a client roster of oil companies and utilities that represent over half the state's carbon emissions.

Jeff King, managing director of environmental markets, said the experience he has gained in early exchange and over-the-counter California carbon trading will give the bank a leg up once large California companies become more active in the market.

"The market is new, volatile, and trades on news events," he said.

"Some banks are staying away because they keep hearing that cap and trade is dead," he said. "It's taken a long time but it's really just taking root in North America now. This issue isn't going away."

ALREADY OUT THE DOOR

Some big banks have already walked away from the emerging market, soured by their European experience and disappointed that federal carbon market legislation was killed in the U.S. Senate in 2010.

Jason Patrick led Merrill Lynch's U.S. environmental products desk until the Bank of America-owned bank closed it down last March.

But he opted to stay in the young market anyway, helping launch a new company, Real Options International, to assist clients navigating the complexities of the California carbon market, in addition to other environmental and energy markets.

"We believe the California market is here to stay," he said.

He said the lack of participation by big banks creates an opening for independent traders as well as small investment funds willing to take on risk.

"There is less appetite at the banks for emerging markets after the financial crisis," Patrick said. "That creates great opportunities for those that are willing to get involved, particularly those that get involved early."

London-based bank Barclays, an early mover in the California market, did an about-face and closed its desk in January, letting go of trader Kedin Kilgore, who executed the first deal for a California carbon allowance forward contract in November 2010.

But observers believe Barclays and others will come back to the market once trading ramps up in a market expected to grow from $1 billion in 2013 to as much as $40 billion in 2020.

Germany-based Deutsche Bank is also "sniffing around" the California market, talking to potential clients and developing products, a carbon market trader said.

Deutsche has already won a contract from California to act as the market's financial services administrator, collecting bid guarantees on behalf of the state prior to the allowance auction as well as settlement payments.

But that doesn't necessarily mean the bank will look to get heavily involved in trading, carbon market traders said.

Deutsche and Barclays have seen first-hand how frustrating carbon markets can be, having been two of the leading banks in the early days of the European carbon market, where both have since scaled back their presence.

The EU launched its carbon market in 2005, but regulators gave away too many free permits to utilities and industry, and by 2006 prices had collapsed.

Policy changes helped prices to recover for a time, only to fall again back when it became clear that the market was oversupplied with permits.

Even though prices are currently hovering just above all-time lows, emissions in the EU region have come down. While some argue the economic recession is the primary driver of those reductions, many environmentalists claim the program has also played a significant role in the drop.

UNCERTAINTY

Despite California's study of the European experience, there are plenty of reasons to be skeptical about the new market's prospects.

California oil companies, manufacturers and food processors that will be covered by the program in 2013 have complained loudly about only being given enough free credits to cover 90 percent of their emissions at the program's outset.

Last month they unsuccessfully lobbied for legislative changes to the program that would have given them more permits.

Lawsuits could also disrupt the market.

A legal challenge by a little-known environmental group opposed to carbon trading was successful in forcing the state to delay the official start of the program until January 2013.

Even the state-versus-federal regulatory status of California carbon allowances has been contentious.

It took two years for the state to fight off a Commodity Futures Trading Commission attempt to regulate them, with the federal government finally deciding that they were "non-financial commodities" that would be primarily state regulated.

EARLY TRADING

While banks decide their next move, trading of California carbon allowance (CCA) forward contracts continues to pick up steam on exchanges and in over-the-counter markets.

Since the IntercontinentalExchange first launched California carbon contracts in August 2011, nearly 12 million California carbon allowances (CCAs) forwards and options have cleared on the exchange, largely in the $15-$18 range.

Just as many CCAs have changed hands in over-the-counter markets over that same time period, traders said.

Currently, about $10 million to $20 million worth of California credits are changing hands weekly.

Much of the exchange-based action has been driven by Houston-based trading desks, which already trade western power and that have simply added California carbon to their portfolios.

The modest trading is expected to ramp up steadily following the November 14 allowance auction as natural buyers like utilities and oil refineries start looking for permits.

At that point, banks can easily enter the California carbon market by hiring just one person, without even opening a new office.

Their real risk is in the potential for trading losses.

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