In a recent WSJ article entitled "Cap and Trade: Recipe for Disaster", Louisiana State University economist Joseph Mason outlines his concerns that special interests have already taken control of the European carbon markets and that the US carbon markets are unlikely to fair any better. That given the poor performance of Federal Reserve in preventing blow ups like Enron and AIG, even a Fed-like regulator for the carbon markets will not be enough to keep a cap and trade program viable over the long term. Instead, he recommends in a recent paper that Congress abandon the idea of a cap and trade program in favor of a more “elegant” carbon tax.

Putting aside the challenges of creating a carbon tax, Professor Mason’s concerns that a carbon market would be too difficult to oversee is worthy of further discussion.

Professor Mason is correct in arguing that without strong regulations in place, the carbon markets would be prone to the same kind of wild price fluctuations seen in other markets today. However, he fails to see how creating a new market from scratch gives us the ability to avoid these market excesses. For example, under the Senate’s carbon market oversight proposal, the carbon regulator would create an exchange based market where speculators are required to adhere to strict position limits and reporting requirements. These requirements are expected to effectively ban the "dark" or unreported trading practices that have plagued the other derivatives markets and lower carbon price volatility over the long term. The ACES climate bill would pass similar measures for the energy commodities, driving down price volatility in these markets as well.

Further Professor Mason’s assertion that “special interest  have already succeeded in “capturing” the European carbon markets program” also lacks merit. While the EU carbon markets have been subject to two crashes over the past five years, both of them were one-time experiences that won’t be repeated here. The first price crash was caused by an over-estimation of emissions by market participants. This won’t happen in the US because we will have the emissions data ready at the get-go. The second price crash was caused by the fact that the allowances in their trial period became worthless at the end of the trial. This also won’t happen in the US because all allowances will be bankable for use in future compliance periods.

Although Professor Mason also refers to the recent price volatility in the European carbon markets as "extreme", if anything these markets are demonstrating that they aren't being pushed around by market speculators. Currently, 80-90% of trades are either cleared through or take place on registered exchanges. The remaining trades are non-reported OTC trades which are small in scale, tailored to meet specific emitter needs, and do not have a large influence on day to day market prices. Further, the European carbon markets themselves are behaving as we would expect them to behave, rising when economic growth is running above trend, and falling when economic growth is running below trend (see graph below). This counter-cyclical behavior compares favorably to a carbon tax which would not be nearly as flexible in meeting the challenges of the business cycle.

In sum, while Professor Mason is right to highlight the urgency of assuring the carbon markets, his arguments don't support his conclusion that a carbon regulator would not be effective in supporting the cap and trade program. A Fed-like carbon oversight committee, like the one envisioned in the Senate climate bill, creates regulations that can protect the carbon markets from excessive speculation and allow us to meet our long term environmental goals.