Could Cap and Trade Cause Another Market
Rachel Morris <> | Mon
June 8, 2009 4:00 AM PST

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

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.

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. These instruments will be traded not only by polluters that need to
buy credits to comply with environmental regulations, but also by financial
services firms. In fact, a
by Duke University's Nicholas Institute for Environmental Policy
Solutions anticipates that if the United States passes a cap-and-trade law,
the derivatives trade will probably exceed the market for the allowances
themselves. "We are on the verge of creating a new trillion-dollar market in
financial assets that will be securitized, derivatized, and speculated by
Wall Street like the mortgage-backed securities market," says Robert
Shapiro, a former undersecretary of commerce in the Clinton administration
and a cofounder of the US Climate Task Force.

Banks like JPMorgan Chase, Morgan Stanley, and Goldman Sachs already have
active carbon trading desks that deal in instruments connected to Europe's
cap-and-trade system and voluntary markets here. But business will explode
if a cap-and-trade system becomes law. So it's no surprise that the
financial industry has taken an intense interest in the fine print of the
Waxman-Markey bill. According to data compiled by the Center for Public
Integrity <>,
the financial services industry has 130 lobbyists working on climate issues,
compared to almost none in 2003. They represent companies like Goldman
Sachs, JPMorgan Chase, and AIG (before it was shamed into temporarily
halting its lobbying activities last fall). The industry "wants lawmakers to
create a brand-new revenue stream for its bottom line, and cap and trade
would do it," says Tyson Slocum of Public Citizen, who is a member of a
Commodity Futures Trading Commission (CFTC) advisory committee considering
how carbon trading should be regulated.

Among environmental groups, there is, understandably, less focus on the
finer points of financial regulation. "The derivatives side is not something
that a person who comes to the table worried about carbon emissions has on
their agenda," says Michael Greenberger, a derivatives expert at the
University of Maryland who has also served in the CFTC and the Justice
Department. "Those people—and they're fighting a good battle—opened the

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.)

On this front, however, Wall Street was less successful. The day before the
bill passed out of committee, Rep. Bart Stupak (D-Mich.) inserted
all allowance derivatives to be either traded on an exchange or
cleared by an organization registered with the CFTC. This would provide a
paper trail for regulators, although the reporting requirements for
clearinghouses are less stringent than those for public exchanges. Stupak
also added limits to prevent speculators from cornering too much of the
market. Still, the bill leaves many vital specifics to the White House,
directing the president to form a task force to determine precisely how to
avoid "fraud, market manipulation and excess speculation." Andy Stevenson,
finance adviser at the National Resources Defense Council, says, "I would
feel comfortable if much more of it were explicit." He applauds the bill's
"spirit" but cautions that "the details are important."

The lobbying battle is not over. Chilton, the CFTC commissioner, praised
Stupak's 11th-hour amendment, but expressed concern that it could be removed
in the legislative process ahead. The bill, after all, has yet to pass
through several more House committees—before the Senate weighs in. That
gives the financial sector a few more bites at the apple. At the same time,
Wall Street is marshaling its
Treasury Secretary Timothy Geithner's proposal to movemost derivatives
public exchanges, which would also cover carbon derivatives. "There
so many issues, so many jurisdictional obstacles out there, I'm just worried
it's not going to get done," Chilton says. "I don't want people's good
intentions to be all we get. I'm worried that people will start clustering
and positioning, and the reforms these markets require aren't going to be

Even a well-designed regulatory system may not be able to prevent gamblers
from contorting prices and discouraging the investments in green energy that
are the entire purpose of cap and trade. After all, one lesson to be drawn
from the economic crisis is that complexity is like catnip to the
unscrupulous, and the carbon regime that would be created by cap and trade
is nothing if not complex.

Perhaps the biggest uncertainty hinges on how offset derivatives—such as a
contract to buy offset credits at a future date for a determined price—will
be monitored. This too would be left to the White House task force to figure
out. It will be a tough task because the quality of offset projects is
notoriously difficult to verify. Sen. Jeff Bingaman (D-N.M.) has described
them as "fraught with opportunity for game playing, which will be fully
exploited, I'm sure."

In 2008, the Government Accountability Office examined the use of offsets in
Europe's Emissions Trading Scheme, which theoretically has a rigorous
process to certify that offsets are "additional"—that is, that they cause
emissions cuts that wouldn't have occurred if the project hadn't been
implemented. But even though projects must be reviewed by both national
officials and an external independent monitor to qualify, the GAO found that
it was "nearly impossible" to ensure that offsets really were additional. It
concluded that offsets present "a significant regulatory challenge" and
should probably be viewed as a temporary measure at best. "In practice
[offsets] have proved impossibly difficult to successfully implement without
fraud," writes <> Michael Wara,
a carbon trading lawyer and coauthor of a Stanford University
found that one- to two-thirds of offsets authorized by the Kyoto
Protocol's Clean Development Mechanism didn't represent true emissions cuts.
"Even in the presence of a tough regulatory system…that is working hard to
get things right…lots of counterfeit carbon currency is making it into the

Michelle Chan, the investment program manager for Friends of the Earth,
believes that if offset derivatives aren't properly regulated, they could
become "subprime carbon"—futures contracts that promise emissions reductions
but fail to deliver and then collapse in value. Already, she points out,
some banks are bundling credits from multiple offset projects and splitting
them into tranches to sell to investors. This kind of activity is
"hauntingly close" to mortgage-backed securities, Chan
House ways and means committee in March, arguing that it has the
potential to spread risk throughout the financial system. At a CFTC hearing
earlier this year, Skip Hovarth, president of the Natural Gas Supply
Association, questioned whether the agency had the tools and the manpower to
keep track of such an incredibly complex market, adding, "If this market
fails, and all the derivatives and all the markets that attach to it that
grow over time fail, it will make this last recession look like nothing.

Again, Europe's experience offers a glimpse of the difficulties of tethering
an environmental goal to the whims of the financial system. In the early
years of Europe's cap-and-trade system, speculators flocked to trade carbon.
Prices seesawed wildly, and analysts warned of a "carbon bubble." Regulators
made adjustments to stabilize the market—but then the financial crisis hit
and carbon prices crashed. This January, an executive from the French energy
giant EDF warned<>that
carbon trading was in danger of becoming "a new type of subprime tool
which will be diverted from what is its initial purpose: to encourage real
investment in real low-carbon technology."

During the negotiations over cap and trade, little airtime has been given to
the idea that perhaps carbon is fundamentally different from other purely
commercial markets that weren't conjured into existence to save the planet.
After all, the allowances are an artificial commodity—according to the logic
of cap and trade, the government will issue fewer permits each year to
encourage polluters to cut their emissions. "The supply is dwindling and
will tail off—arguably it's much less clear that you need a derivatives
market," says Greenberger, the derivatives expert. "You could try to control
speculation, which is what Stupak wants to do—but even in a regulated market
there are speculators, many of them. Or you could say, 'This is unlike any
other market, and no regulation is perfect. So why take even the risk of
speculation or malpractice that could distort the price—let's just not have
derivatives.' I think it's a subject worthy of serious debate." Thanks to
the persistent lobbying of the financial sector, however, that doesn't seem
to be a debate that will happen anytime soon.

Update: read Kevin Drum's dissent