Amidst the tumult afflicting the world's financial market, it is perhaps unsurprising that the fact the price of carbon in the EU emissions trading scheme (ETS) has hit an 18 month low has not earnt much of a mention.

But the slump in the price of carbon from a high of around €25 a tonne earlier this summer to just €18.10 today should give serious pause for concern to many operating in either the carbon market or the wider green business movement.

The reasons behind the slump are not hard to identify.

Oil prices have fallen as the global economic slow down begins to bite and as a result gas prices have also dropped. This means it is cheaper for energy companies to burn gas compared to the more carbon intensive coal and as a result their carbon emissions are lower than expected meaning they have to buy fewer EUA carbon permits.

Meanwhile, heavy industries such as steel, cement and aluminium are also expecting production to fall as a result of the recession, meaning they too are demanding fewer EUAs.

With the supply of credits largely in line with expectations (despite some drop off in the flow of credits through the UN Clean Development Mechanism) and demand lower than expected, the price of carbon has inevitably joined the downward trend.

This raises two sizable concerns.

The first is that having been originally hailed as a success the second phase of the ETS could replicate the failure of the first phase with companies being left with far more carbon credits than they actually need.

If we do indeed experience a lengthy and deep recession then emissions from energy firms and heavy industry could even drop below their emissions caps leaving them with a glut of permits. In such a circumstance, the price of carbon would once again gravitate towards zero.

It could be argued that if firms are coming in under their emission caps then who cares how it is achieved.

But the point of a cap-and-trade scheme is that it is meant to incentivise firms to come in below their emission caps by investing in cleaner processes and technologies. They are not supposed to meet their emission targets by succumbing to a recession-imposed fall in production, on the simple grounds that under this scenario emissions will simply rise again as soon as the economy picks up.

In short, the longer the price of carbon wallows below the €20 mark the harder big polluters will find it to make the case for investment in cleaner technologies and processes. Meanwhile, capital intensive green projects such as plans for carbon capture and storage systems will find it ever harder to find funding when the low price of carbon means that conventional fossil fuel technologies remain a cheaper alternative.

Thankfully, these are likely to prove relatively short term concerns.

The economy will recover eventually, although it might not feel like that at the moment, while the EU still looks committed to tightening the cap-and-trade regime further post 2012 - a move that should push the price of carbon ever higher. Moreover, both presidential candidates have vowed to introduce a similar scheme in the US, suggesting that cap-and-trade and carbon pricing is here to stay.

Consequently, the biggest concern arising from the recent fall in the price of carbon is not the short term implications, but the fact that no one saw it coming.

For most of this year analysts have been predicting that the average price of a tonne of carbon in the ETS for the 2009 to 2012 period will be somewhere between €35 to €40. Well, it's currently at around €18 and doesn't look likely to head north any time soon.

Even after global financial markets collapsed this summer, analysts Point Carbon upgraded its price expectations for EUAs predicting that a reduction in the availability of UN-backed CER credits would more than compensate for any recession-related drop in demand.

Meanwhile, New Carbon Finance similarly predicted the global carbon market will continue to expand rapidly, partly on the back of the rising price of credits.

These organisations were not alone in subscribing to a bullish outlook and it is worth pointing remembering that not many people have covered themselves in glory trying to second guess financial markets in recent months. But in many ways it is this fact that is at the heart of the problem.

Carbon markets may have been constructed by regulation, but regardless of the legislative framework that is put in place any market will inevitably contain a degree of volatility - and it is this volatility that will always make it hard for long term investors to attain the reliable long term outlook they crave.

Unless the EU sets a floor price for carbon, something it is loathe to do, how can an investor in a new power plant or industrial facility predict returns on investment from clean technologies with any confidence?

The simple answer is they can't. They are at the mercy of informed guesses, which as recent events have shown can prove badly wide of the mark.

They might have plenty of other concerns on their minds at the moment, but those politicians who have touted carbon markets as the best mechanism for driving the transition to a low carbon economy should be asking themselves how they are going to ensure the lessons from the collapse of the financial markets are learnt and the new breed of carbon markets do indeed end up serving the purpose for which they were designed.

Right, I'm off to try and track down those three MPs who voted against the climate change bill.

Have a good weekend.

Cheers,

James