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Carbon trading, the environmental campaigner Friends of the Earth claimed recently, is the new subprime. It is a market dominated by derivatives and speculation. It is thus of the devil and will go the same way.
The comparison might seem facile and in some respects it is. But it prompts a thought about derivatives in general.
Over the years, the various calamities suffered in derivatives have taken different forms. In 1973 Rowntree, the UK chocolate company, was crippled by cocoa futures. Equity derivatives then did for Barings, interest rate swaps for Long-Term Capital Management and credit derivatives for much of the Western banking system. Curiously, once disaster has struck in a given market it tends not to recur there. It is as if risk managers and corporate treasurers sit up and take permanent notice. So if we are looking for the next upset, it makes sense to look at newer forms of the game.
In picking on carbon, I take no position on its merits as a way of controlling emissions. Rather, the purpose is illustrative. If I were a risk manager, what danger signs would I look for as the market develops? Let us take three yardsticks of risk — simplicity, liquidity and leverage. The more a market has of the first two and the less of the third, the safer it should be.
Derivatives based on subprime mortgages ticked all the danger boxes. So far at least, carbon does not.
In one sense, it might seem odd to describe the carbon market as simple. Some primary determinants of the price — the absolute size of the carbon cap, especially — are set by governments. Other complicating factors include the relative price of coal and gas and the number of so-called offset permits created by European Union (EU) companies through projects to reduce emissions in the developing world.
But the financial instruments are simple enough. The market has always been based on futures — a form of derivative — if only because after the EU signed the original legislation in 2004, it took till the following year for governments actually to issue permits. And futures are more or less all there is today. They are duly employed by corporations to hedge their carbon exposure, just as airlines hedge their jet fuel costs or travel firms their foreign exchange.
And then, of course, there is speculation. This brings us to liquidity. Speculators are a good and bad thing in any market. They lower the cost of using the system, since their presence reduces the buy/sell spread that would result from a handful of actors using the market only intermittently.
But they also increase the market’s volatility. Electricity generators, for instance, hold a fairly stable number of permits for operating purposes. But they are also big speculative traders, as are the banks and hedge funds.
Price swings
The result could be crowded trades, which lead to big price swings in response to market shocks and might make carbon futures illiquid in a crisis. But that is equally true of orange juice or lumber futures. What made subprime derivatives different is that some proved so complex as to be impossible to value. Hence the fact that a crisis which in simple futures might last days has dragged on for many months.
What about leverage? This is often associated with arbitrage, whereby minute differences between related markets can yield magnified profits.
Some leverage is applied, I am told, to the spread between EU-issued permits and offset ones, and also to futures of different date. But real arbitrage between different markets is not yet feasible, since the EU market is the only one around.
Subject to politics — again — this is supposed to change. Australia is scheduled to open a market around 2012 and the US perhaps a year later. In markets based on permits specific to the country or region, I cannot quite see the scope for arbitrage. But never put it beyond the wit of investment bankers to come up with something.
And this is the big caveat — that as markets develop they become more complex and risky.
When I first studied credit derivatives six years ago I decided they were harmless, precisely because they were still fairly simple. I also took heart from the fact that several banks and insurers had blundered into this new market and retired hurt. But in the event, that simply gave remaining operators the false assurance that they knew what they were doing. And sure enough, several continental banks and insurers have recently retired hurt from carbon trading.
In summary, the carbon market as it stands does not look dangerous. But it could grow enormously, in which case it will develop in unforeseeable ways. Friends of the Earth is wrong today, but you never know.
By Tony Jackson