From the September 01, 2009 issue of Futures Magazine • Subscribe!

Carbon trading coming home to America

Patrick Birley kicks off most workdays with a brisk, life-affirming run along the Thames near the Tower of London.

“It puts you in a great mood,” he says. “And it keeps you there all day.”

Running a booming business can also put you in a good mood, and Birley has nailed that down as well. He runs the European Climate Exchange (ECX), which leads the world in futures and options on carbon credits: financial instruments that measure the degree to which emitters of greenhouse gasses reduce their emissions. There are plenty of gasses that contribute to the greenhouse effect, but carbon dioxide is the most common, so emissions tend to be measured in “tons of carbon dioxide equivalent,” or “tCO2e,” but we’ll stick with “carbon.”

The volume of global carbon trading doubled in 2008, and nearly all the growth came in the secondary markets, which provide the liquidity that helps make the primary market more efficient. As secondary trading grows, the carbon markets are beginning to behave more like markets for corn, wheat, or currencies — with identifiable trends and deep, if spotty liquidity. As liquidity increases, exchanges like Bluenext (a subsidiary of NYSE.Euronext) are teaming up with information providers like Markit (a joint venture backed by several investment banks) to develop indexes based on different sub-sectors of the carbon market. Many of these will one day form the basis for futures and options themselves.

CAP & TRADE 101

The United States invented cap-and-trade, and it’s proven effective when done right.

It begins with two basic premises: one, that we can only continue to harvest our natural resources as long as our rate of renewing them exceeds our rate of harvest; and two, that our current economic system doesn’t factor the cost of environmental degradation into the cost of production. The logic flowing from these premises ultimately boils down to the conclusion that we have to embed the cost of environmental degradation into the cost of production.

That means first determining what constitutes a safe level of degradation, and then coming up with a way to keep the rest of us within that limit. Cap-and-trade gives government the task of determining that amount by setting one limit for the entire economy, but it lets companies decide among themselves how they can hit those targets most efficiently by issuing or selling pollution allowances that can be bought and sold.

In theory, this means that government’s role in cap-and-trade is to set and enforce the limits, while the private sector’s role is to figure out the most effective way of achieving them. In reality, the government ends up playing the role of market overseer — and, critics would say, also market manipulator.

The market mechanism in cap-and-trade schemes is designed to funnel money into efficient environment-friendly technologies, especially those that aren’t yet market-viable, and to reduce the costs of compliance for companies that can’t reduce emissions by giving them the option of paying others to reduce emissions
more cheaply.

The government can either give allowances away or it can sell them through an auction, and the global trend is towards a hybrid of issuing and auctioning. This means some allowances are given away, and others are auctioned, with the proceeds from auctions going to specific environmental programs (it’s this aspect that some critics have derided as “cap-and-tax”). Waxman-Markey follows the hybrid model, and carbon traders will have to learn the intricacies of the auctioning process the way bond traders have learned the intricacies of how the Federal Reserve Board operates, especially since, unlike bonds, the carbon markets are not yet deep or liquid enough to support purely technical strategies.

Creating the tapestry of global cap-and-trade regimes that will replace the Kyoto Protocol is a daunting task, but cap-and-trade itself is hardly an untested method. In fact, it forms the cornerstone of the Environmental Protection Agency’s Acid Rain Program (ARP), which aims to reduce acid rain by placing a cap on emissions of sulfur dioxide and then auctioning off those allowances every year.

Environmentally and economically, the program has been an unequivocal success: emissions of sulfur dioxide have plunged more than 40% since the program’s launch, and at a cost of less than $3 billion per year. Benefits, measured in terms of lower health costs, reduced damage to crops, and other economic goodies that flow from a healthy environment, now top $100 billion per year.

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