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Two hundred miles north of Bangalore and 4,500 miles southeast of Copenhagen, where world leaders will meet next week in a landmark conference on climate change, sits the southern Indian village of Toranagallu. While the residents of this mostly rural hamlet may not realize it, the same environmental problems they grapple with in their daily lives may well be on the table at the U.N.'s Copenhagen conference, as attendees decide whether to overhaul an international carbon-trading mechanism designed to help developing nations cut greenhouse gases.

That's because Toranagallu is also home to a 3,700-acre forest of puffing smokestacks that make up the Jindal South West steel factory. Opened a over a decade ago, Jindal South West has over the past several years claimed an estimated $150 million in carbon credits thanks to its internationally recognized status as a part of the Clean Development Mechanism (CDM) administered by the U.N. under the Kyoto Protocol. But while the steel plant's efforts to reduce its emissions may in a very small way be helping the earth's atmosphere, villagers complain any benefits are lost on them. "Since the plant has come, the village's water supply is polluted, and the air is polluted from the dust and smoke," says KSL Swamy, the Toranagallu representative in the state legislature. "Salaries at the plant are very good," he says, "but the pollution is very bad. We feel it."

The controversy in Toranagallu raises questions about the effectiveness of CDM projects and the wisdom of relying on the carbon market to combat climate change. While carbon trading has helped lower overall global emissions, some argue the CDM system has significant flaws that need to be addressed in Copenhagen. One problem, critics say, is that the mechanism is subject to manipulation and creates undeserving winners. For example, the U.N. body in charge of managing carbon trading reportedly has suspended approvals that would have awarded credits for the construction of dozens of wind farms in China. Projects only qualify for credits if applicants can prove they could not be built without them. According to the Financial Times, the U.N. determined some 50 wind power projects were in fact viable without the credits because they qualified for Chinese government subsidies — but Beijing had deliberately lowered subsidies to make them eligible for CDM funding.

Toranagallu illustrates another unintended consequence of the CDM system: it tends to prop up the dirtiest industries in developing countries such as India, essentially allowing the industrialized West to outsource the heavy lifting of greenhouse-gas reduction to the world's poorer nations. "The trouble is the design of the CDM has been to guarantee the cheapest option for the Western countries to balance their carbon books," says Sunita Narain of the Center for Science and Environment in New Delhi. "It's not [just]what is happening in India that is flawed, it is flawed in design."

The CDM was meant to create a market-based system to curb global emission of greenhouse gases. To help make this happen, instead of strictly holding countries to their emission reduction commitments under the Kyoto Protocol, it allows companies and countries to continue to pollute if they offset their emissions by purchasing Certified Emissions Reductions (CERs) — each representing 1 ton of carbon — from developing countries —where carbon-reducing modifications to power plants, factories and other facilities would be less costly. This was meant to promote the dispersion of green technology to the developing world, and also give emerging economies like India and China a financial incentive to start cleaning up their dirty industries. In mid-2005 the global carbon market sprang to life and three years later had grown twelve-fold to $126 billion, according to the World Bank. "In terms of total investment it's been a remarkable success," says Henry Derwent, President and CEO of the Geneva-based International Emissions Trading Association(IETA). "It's done exactly what was expected of it."

But concerns persist about whether the market is generating enough highly effective carbon-reducing projects, such as solar power plants and public transit systems — or if it is actually retarding the pace of reducing greenhouse gas emissions by subsidizing the dirtiest industries, which can rather easily and cheaply generate credits because they have the most to clean up and often have the resources to make improvements. Fluorochemical companies in India, for example, have been the biggest generators of CERs for the global market. That's because companies like SRF, a fluorochemical company headquartered outside of New Delhi, emit a gas called HFC-23 during the process of making chemicals for refrigerators and air conditioners. HFC-23 is 11,700 times more harmful to the atmosphere than carbon dioxide. SRF invested $3 million to equip its factory to burn the gas instead of releasing it into the atmosphere, a project that could earn it some 3.8 million CERs annually, worth about $600 million over the next decade.

It's easy to rush to condemn projects like these that seem counterintuitive to the very logic of the CDM. But the planet's atmosphere is perfectly happy with the tradeoff, says Derwent of the IETA, "just as much as it would be happy with the reduction of CO2 over a long period by the adoption of wind power in the place of coal." What matters is the absolute reduction in carbon emissions, regardless of the source, he says. "That's what markets do, they find the cheapest, most cost-efficient way of producing whatever it is that's demanded," says Derwent. "That's a good thing, not a bad thing. That means that the atmosphere gets an emissions reduction at a cheaper cost."

In Toranagallu, the Jindal plant continues to expand as the company pursues carbon credits by generating power through the burning of waste gas created during steel manufacture. In a bid for more carbon dollars, a second power plant was built. "The carbon revenues were a major factor in taking up these projects," says Suresh Iyer, the chief coordinator of carbon trading at Jindal South West. If a project is reducing carbon, he says, "we do take the initiative and put up the plant because of that." The second plant, which Iyer estimates cost the company $50 million to build, was approved by the CDM in January 2007 and now earns an estimated 700,000 CERs a year.

The carbon financial windfall has yet to trickle down to the villagers in Toranagallu, many of whom say life has gotten worse, not better, since the steel mill first arrived. What they don't know is that, like it or not, the global battle against climate change is being fought in their backyard.

• Elliot Hannon/ Toranagallu, INDIA
• Market-based mechanisms for reducing greenhouse-gas emissions are subsidizing some of the world's worst polluters, critics say