April 5, 2009

“Subprime Carbon”


Friends of the Earth has released a report written by Michelle Chan entitled  Subprime Carbon: Rethinking the World’s Largest New Derivatives Market (report linked  here ). This refers to the securitization of emissions permits and offsets which are the two most common mechanisms in setting up a cap and trade. Carbon trading in general is futures derivative trading. As Chan says, the seller “promises to deliver carbon allowances or credits in a certain quantity, at a certain price, at a specified date”. The market is small now, but according to CFTC commissioner Bart Chilton it could become “the biggest of any derivatives product”.
Chan defines subprime carbon as “futures contracts to deliver carbon that carry a relatively high risk of not being fulfilled, and could collapse in value”. These are most likely to come from offset projects, “because sellers can make promises to deliver carbon credits before credits are issued for a project or even before greenhouse gas reductions have been verified”.  
As we’ve been learning, large, complex, ill-regulated entities and systems which have a free hand in “innovating” financial instruments are the Typhoid Marys of the globalist economy. All reasonable people agree that our main program here must be to downsize and deconsolidate these entities, unwind their complexity, and severely regulate them so that they never again become so large, so trustified, so complex that they can put this gun to our heads again.
So where we propose an extensive new system to impose a carbon price and cap, it seems like a no-brainer that we should do so in a way which does not run against the general definancialization of the economy. It should not provide a new way for financial entities to run ponzi schemes and blow up bubbles.
While I’m not writing here to attack the concept of cap and trade in principle, I do think that the specific proposals put forward so far have not been sufficiently active in trying to prevent a carbon bubble. This is the subject of the FoE report.
After giving an overview of the financial crisis in general and what must be done to prevent a recurrence, the report delves into how reforms should be applied specifically to a cap and trade. With the entry of finance speculators into the carbon market we’re already seeing all the same things we saw in the last bubble: exaggerated or fraudulent promises, derivation, bundling of “assets” of very different putative values, slice and dice, securitization. This speculation already represents most of the world carbon market – over 70%.  They are asset managers, investment banks, carbon funds. Chan says “two thirds of carbon investment funds were not established to help companies comply with carbon caps, but rather for capital gains purposes”. 
This is the reason why the 1990s SO2 trading market does not provide an adequate model. The financialization of any trading market is far more complex. Carbon speculators, especially those involved in “offset aggregation”, the bundling and tranching of offset projects, are generating the same opaque and excessive risk as with previous financial tricks. Chan also sees conflicts of interest, as the same investment bank may be involved in rating projects for offset credits even as it is managing or owning carbon portfolios.
These speculators, according to the report, will also drive up prices and render them more volatile. They represent a clear danger to effective mitigation policy and general financial stability. While we want a rational carbon price, we don’t want one artificially inflated beyond what’s reasonable or politically sustainable. Most of all we want a stable carbon price, since the whole point here is to rationally cap and rationally mitigate, and that won’t be possible with the market caroming all over the place.
According to Chan, because the carbon market, unlike most other financial markets, is being artificially, politically created*, it is therefore more susceptible to the pitfalls of lobbying and regulatory capture, and therefore needs special insulation from the political system. (So the report also affirms that we need real campaign finance reform.) The primary market will lobby for safety valves and off-ramps, for the creation of more offset assets, and for opacity regarding cap compliance. The secondary market will want all this plus the same old deregulated wasteland where it can generate its “instruments”.      
[* ALL markets beyond basic barter economies are artificially and politically created by governments. But it’s a core element of the right wing project to deny this and claim governments hinder markets; that markets can somehow exist without the strong hand of strong government assisting them every step of the way. This is of course a lie.]
The report is especially skeptical of carbon offsets, which even in principle are close to being junk carbon, let alone in practice. (Joe Romm and others call them “rip-offsets”.) These are prone to the abuses of:
1. Just being out and out scams;
2. Claiming inflated emissions reductions – even given good faith on the part of everyone involved, it’s very hard to accurately determine how much carbon remains sunk by e.g. foregoing deforestation of a particular tract (and of course everyone involved has a financial, political, and/or emotional incentive to err on the side of inflation);
3. Then there’s the seemingly intractable additionality issue. To deserve and under most policies receive offset credit a carbon-reducing project must be such that it would never have been built except to receive the offset credit. But this is fiendishly difficult to ascertain, since almost nothing is going to have only the carbon-reducing benefit; it will have other uses as well, and how do you prorate the multi-levelled motivations that went into something?
This is probably impossible to really figure out, and so those opposed to offsets take this as prime evidence for why we shouldn’t have them at all in government carbon policy, while those who are gung-ho (as a rule those who stand to profit from them) say we should just give up on additionality and give credit to everything.
Such a promiscuous offset policy would be a rich feeding ground for financial predators on the hunt for derivation opportunities. The more irresponsible and unaccountable something is in principle, and offsets are certainly dubious, the more readily it can be securitized, since the whole point of the finance scam is to become as unanchored from reality as possible and then really get to work manipulating people’s perceptions. They set up a hall of mirrors where each new image more monstrously distorts the last, and they seek to arbitrage the distortions.
All of this, as it burgeons, would spread new securitization throughout the financial system, creating new systemic risk. Then when the inevitable carbon crash comes, we’d have the same kind of reverberation as we have today – in this case, first for the compliance buyers (the actual emitters who needed the underlying allowances), and then on through the general economy. (I imagine under those circumstances the first thing to go would be actually having to comply with the cap.) 
All of it – first the risk of it, then the actual crash and economic destruction – would be for the benefit of a handful of FIRE sector cadres. Just as with the current crash.
Therefore, Chan says, we must not create the new carbon trading system without robust regulation. FoE recommends a hard cap, quarterly auctions (hopefully frequent enough to limit arbitrage opportunities), a published set price, the limitation of participants to regulated entities and those actually able to emit (Chan compares this to last summer’s anti-speculator proposal that oil futures trading be limited to those physically able to receive delivery), and bans on offsets, secondary market trading, and allowance hoarding.
The report gives these basic guidelines for regulation:  
1. Carbon must be specifically factored into general Wall St reform. The basic problems are the same. We know “self-regulation” doesn’t work (I can’t resist repeating Willem Buiter’s great line, “Self-regulation is to regulation as self-importance is to importance”), yet carbon traders have already called for it. We also need regulatory coordination, not an easily gamed patchwork. Regulatory gaps need to be closed. Much general reform sentiment is focused on CDSs, yet most carbon trades OTC. So as important as it is to fix the destruction wrought by the CFMA, we also need emphasis on shifting carbon trades from OTC to public exchanges.
2. Carbon trading also needs its own specific regulation, which must be dealt with in the carbon legislation. Chan surveys the many carbon-trading legislative proposals, with their attempts to find the right policies and  ways of distributing authority among FERC, EPA, CFTC, SEC. (A problem is proposals which want to give EPA the lead authority over trading. This could be fine if we only have a primary market among the emitters themselves. But the EPA is not set up to deal with any secondary derivatives market among finance speculators.)
3. The size and complexity of the trading market must be limited and simple, to foster price stability, keep out speculators as much as possible, and prevent the proliferation of subprime carbon. The goal must be to reduce the space available for a carbon bubble to inflate. Since speculation, derivatives markets, and bubbles are based on perceived arbitrage opportunities, measures that seek a stable price like a firm cap and frequent auctions provide a habitat hostile to this bubbling.
(I have to add here, since the entire political and economic elite are looking for nothing but the next bubble opportunity, since that’s the only way they can hope to prop up the debt economy a little longer, for them a report like this must read like an advertisement or how-to manual. They’ll just say they can avoid the “abuses” this time around.)
This report gives a good rundown on the potential pitfalls awaiting a carbon policy which bulls ahead without properly safeguarding against its own hijacking by the FIRE trust. Although the report doesn’t go into the underlying stability of the cap and trade concept per se, we can infer that the concept seems inherently vulnerable to this kind of abuse, and that where it comes to any cap and trade legislation, we must be vigilant in scrutinizing its trading setup and safeguards. If these are inadequate, this is sufficient reason to reject the bill.
That’s not just a general economic concern abstracted from the core focus of mitigating carbon emissions. On the contrary, the more a carbon trading system becomes the playground of the finance sector, the more it will be hijacked toward the goal of maximizing “trade”, and therefore the less firm the cap will be.  


  1. Ha ha, that’s funny! Are you sure you shouldn’t call yourself the Carbon Comedian?

    I invite anyone who wants a good laugh to read the link with its touching faith in how our stern, tough, civic-oriented government is going to “regulate” and make darn sure those Wall Street rascals don’t try any monkey business.

    After all, that’s how things have worked over the last few decades, right?

    (I’m of course talking about the American government and American legislation, though the piece seems to be from Australia. Maybe you doesn’t understand the situation here. You certainly don’t understand our media, or the fact that Matt Taibbi is one of a handful of trustworthy journalists we have.)

    You also cite hack number one Paul Krugman as your main source?

    As I explain here


    Krugman descended to Republican-worthy lies to deny the real Wall Street machinations here and defend this form of disaster capitalism.

    He pretends to not even understand how derivatives work, and lies in claiming opponents think the permits themselves are anything more than the underlying.

    And then there’s the offsets, which are a scam in themselves, let alone once they’re securitized.

    And how pathetic to cite Kruggie’s tawdry pseudo-nobel prize as evidence of his authority. By now that’s counter-evidence.

    Comment by Russ — February 4, 2010 @ 6:48 am

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