Tuesday, June 9, 2009

Could Cap and Trade Cause Another Market Meltdown?

A twofer from Mother Jones:

The same Wall Street players that upended the economy are clamoring to open up a massive market to swap, chop, and bundle carbon derivatives. Sound familiar?

You've heard of credit default swaps and subprime mortgages. Are carbon default swaps and subprime offsets next? If the Waxman-Markey climate bill is signed into law, it will generate, almost as an afterthought, a new market for carbon derivatives. That market will be vast, complicated, and dauntingly difficult to monitor. And if Washington doesn't get the rules right, it will be vulnerable to speculation and manipulation by the very same players who brought us the financial meltdown.

Cap and trade would create what Commodity Futures Trading commissioner Bart Chilton anticipates as a $2 trillion market, "the biggest of any [commodities] derivatives product in the next five years." That derivatives market will be based on two main instruments. First, there are the carbon allowance permits that form the nuts and bolts of any cap-and-trade scheme. Under cap and trade, the government would issue permits that allow companies to emit a certain amount of greenhouse gases. Companies that emit too much can buy allowances from companies that produce less than their limit. Then there are carbon offsets, which allow companies to emit greenhouse gases in excess of a federally mandated cap if they invest in a project that cuts emissions somewhere else—usually in developing countries. Polluters can pay Brazilian villagers to not cut down trees, for instance, or Filipino farmers to trap methane in pig manure....

...Already, the industry has achieved its main objective: The Waxman-Markey bill would create a big, convoluted market for carbon derivatives. Experts from the Congressional Budget Office have said that the most stable and effective form of cap and trade would involve a system in which the government periodically sets prices in much the same way that the Fed determines interest rates. That would prevent volatility, which would in turn remove the temptation to gamble on big price swings. In other words, it would provide far less opportunity for wheeling and dealing—and profits. Rep. Jim McDermott (D-Wash.) offered a proposal for a managed-price cap-and-trade scheme, but failed to gain any traction. Meanwhile, industry groups like the International Swaps and Derivatives Association pushed for a system in which a "broad suite" of financial products can be traded, and that's what Waxman-Markey delivers.

In an especially audacious move, the industry also argued that cap and trade should allow the very same types of unregulated instruments that helped spread risk throughout the financial system like a cancer, contributing to the economic meltdown. In particular, it lobbied for "over the counter" carbon derivatives—deals conducted directly between two parties with no one monitoring the risk. (Perhaps the most notorious form of OTC derivative is the credit default swap, which crippled AIG when it issued too many high-risk swaps while lacking the money to cover them.)...MORE


Will Derivatives Ruin Cap-and-Trade?

Rachel Morris has on online piece today suggesting that the same Wall Street rocket scientists who destroyed the global economy via derivatives trading may be getting ready to do the same thing with carbon permits from a cap-and-trade system. After all, if they can slice and dice subprime mortgages, why can't they do the same for packages of carbon permits?

I've got a few problems with this, though. First, there's this:

Cap and trade would create what Commodity Futures Trading commissioner Bart Chilton anticipates as a $2 trillion market, "the biggest of any [commodities] derivatives product in the next five years."

I'm not entirely sure what this means, but my best guess is that Chilton is forecasting a market with a notional value of $400 billion per year. This is not as large as it sounds. The notional value of the CDS market in 2007, for example, was over $50 trillion. Chilton's estimate for the carbon market is less than 1% that size. Likewise, the underlying value of the actual carbon permits is likely to be on the order of $50-100 billion a year, which is less than 1% of the underlying value of, say, the U.S. stock market. Even if Wall Street went nuts with this stuff, it couldn't do too much damage.

Then there's this:

In addition to trading the allowances and offsets themselves, participants in carbon markets can also deal in their derivatives — such as futures contracts to deliver a certain number of allowances at an agreed price and time.

This is true, but carbon permits are essentially commodities, and the kinds of derivatives traded on commodity exchanges are generally forwards, futures, and options. But while these may be derivatives, they're mostly not the rocket science kind. They've been around forever, they're well understood, and they weren't responsible for any of the problems that caused our current meltdown....MORE

Merrill came out with carbon based structured products over two years ago.

Collateralized carbon obligations i.e. tranches of income streams from projects claiming the absence of an invisible gas to satisfy policy goals informed by computer models of the most chaotic system on the planet have got to be the coolest financial development of the young century. Let's go!

(and gearing. we need lot's of gearing.)