The Dollars and Sense in Trading Carbon

The "trade" portion of the cap and trade bill is getting a lot of heat from the left and the right as being just another way for the banks to get rich and leave us with the bill. These concerns are certainly understandable given the fact that the American consumer is still holding the bucket as the government mops up Wall Street's last great idea for a new market. Indeed, the idea of creating a new market for anything would seem completely absurd were it not for the fact that solving global warming is a multi-trillion dollar challenge that cannot simply be met by taxing people into submission.

According to IEA estimates, the world needs to invest an additional $10.5trln in low carbon technologies over the next two decades alone to keep greenhouse gas concentrations limited to 450ppm. In the US, banks are needed to lend over $2trln to cash starved companies from 2010-2030 to help them improve their energy efficiency, develop cutting edge renewable technology, and build the cleaner cars needed to achieve these targets. Investments that will need to be financed by banks and best facilitated through a cap and trade program like the one being put forward in Congress.

The following is a short Q&A about how carbon trading is being set up under the cap and trade bill and why it will be successful in achieving our environmental goals:

Q: Okay, maybe we need the banks to lend, but do banks really need to be involved in the trading side as well? Why can't we just limit trading activity to emitters only?

A: On the face of it calls for an "emitters only" market for carbon trading certainly sounds appealing. Emitters could buy allowances from the government and trade them amongst themselves, allowing us to spend less time on "trading" carbon allowances and more time on "capping" our carbon emissions.

Unfortunately, this system is expected to prove a more expensive option for the consumer and the planet. In an "emitter only" market, trading costs would be high as it would be no ones job to make markets in carbon and all of the participants will have identical needs. Furthermore, if banks are excluded from an "emitter only" market they would be less likely to lend money (as they will be unable to hedge these capital investments), making our reductions targets even harder to achieve.

Q: Fine, but how are we going to stop Wall Street from turning this into a massive profit center?

A: Under the House-passed Waxman-Markey bill, over-the-counter (OTC) trading for carbon emission allowances is banned full stop and all trading is expected to take place on exchanges. This means the banks are not going to be making  money from OTC trading in the carbon markets (a cash cow business for them in oil and the other commodities markets). As a result, the banks will be limited primarily to broking on exchanges and income from lending. Sensible, "day job" businesses that will keep the banks from turning the carbon markets into a casino.

Q: But how are we going to keep speculators from driving prices up and down like a roller coaster?

A: I can answer that question in three words, "regulation, regulation, regulation". Congress is drafting the rules for the carbon markets in a way that will help make them the best regulated markets in the country. This means strong position limits, strict oversight, reporting requirements, and the ability to enforce the rules with fines or jail time or both. Rules that will keep speculators in check and help ensure that carbon trading is conducted in a way that is in keeping with the cap and trade program's long-term objectives. 

In addition, the "market stability reserve" introduced under the Kerry-Boxer bill will help keep volatility down by injecting additional allowances into the market above a certain price threshold. In a given year, the "market stability reserve will be allowed to auction up to 25% of a year's total cap into the market at this minimum reserve price. This represents four times as many allowances needed to meet the largest percentage increase in carbon emissions since 1990 (adjusted to reflect a 3% declining cap). A wall of additional allowances that can be used to keep speculators in line and keep price spikes from hurting consumers pocketbooks. 

In sum, fighting global warming is not just an environmental challenge it is also a massive financial challenge. A $10trln challenge that requires allowances to "trade" on an exchange as a way to best facilitate the loans and investments needed to meet our climate goals. Lastly, Congress is not relying on the bank's word that they will do better next time when it comes to the carbon markets. The rules are being established to keep speculators in check and give the regulator the oversight authority needed to keep this exchange based new market viable over the long term.