Ian Ayres and Doug Kysar, law profs at Yale, apply The Theory of Moral Sentiments to carbon trading. They include this paragraph:
In addition to his famous arguments in favor of markets and liberalized trade, Smith also had a well-worked-out theory of moral behavior, one that was not so neatly separated from his economic thought as we treat it today. For example, Smith’s arguments in favor of free trade included an assumption that owners of capital would naturally prefer domestic to foreign industry, even if the latter offered higher returns. Smith thought this was a good thing because it reflected the moral sentiments that ultimately help make markets work.
What? Citation, please.
I can find no such suggestion in chapter seven of Doug Irwin’s Against the Tide
Every individual is continually exerting himself to find to the most advantageous employment for whatever capital he can command. It is his own advantage, indeed, and not that of society, which he has in view. But the study of his own advantage naturally, or rather necessarily leads him to prefer that employment which is most advantageous to the society.” [Irwin p.76; Smith IV.ii.4]
Moreover, how does not pursuing the profit-maximising returns in allocating productive resources across industries or countries “help make markets work”? Smith wrote:
The value of its annual produce is certainly more or less diminished when it is thus turned away from producing commodities evidently of more value than the commodity which it is directed to produce. According to the supposition, that commodity could be purchased from foreign countries cheaper than it can be made at home. It could, therefore, have been purchased with a part only of the commodities, or, what is the same thing, with a part only of the price of the commodities, which the industry employed by an equal capital would have produced at home, had it been left to follow its natural course. [Irwin, p.79; Smith IV.ii.12]
If Ayres and Kysar are right about Smith, then I’d like to learn how capital’s home bias provides a public good necessary to the system of natural liberty or otherwise enhances simple-minded profit-seeking in the market. Synthesizing such a bias with Smith’s more familiar work quoted above doesn’t strike me as obvious.
Trade Diversion 
They’re actually referring to the famous “invisible hand” passage in WON (Book 4, Ch. 2):
By preferring the support of domestic to that of foreign industry, he intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention.
However, these authors make a questionable reading of Smith by stating support is being lent to (less profitable) domestic industry for “moral” reasons. Gavin Kennedy of Adam Smith’s Lost Legacy makes a more convincing and consistent argument that support of domestic industry is nothing more than the result of risk aversion to engaging in foreign industry, not moral sentiments, on the part of the merchants.
Whatever the virtues of their carbon trading scheme, invoking Smith only confuses matters.
Thanks very much, Emmanuel.
“He intends only his own security” seems a far cry from “moral sentiments.”