Sustainable Investing and Environmental Markets: Opportunities in a New Asset Class

Sustainable Investing and Environmental Markets:  Opportunities in a New Asset Class
by Richard Sandor, Murali Kanakasabai, Rafael Marques, Nathan Clark. 
World Scientific Publishing Co. Pte. Ltd. 2015
$68.00
380 pages.

Many commodity traders have found success in being trend followers. Not many have done so by being trend-setters, but you can count Richard Sandor among the few. Sandor’s glittering resume includes developing the first financial futures contract in the 1970s, the concept of environmental markets in the 1980s and the introduction of the first sulfur dioxide (SO2) auction in the 1990s, which led to the cap-and-trade markets in carbon, nitrogen and other emissions markets. In his spare time Sandor founded the Chicago Climate Exchange to trade weather-related and environmental markets, and his current project, Environmental Financial Products. He also maintains academic affiliations (currently teaching at the University of Chicago) and has written other books.  

In sum, Sandor is an intellectual force to be reckoned with. This latest volume examines environmental issues with more than just an eye toward conservation and increasing the societal benefit. In true Chicago style, he and his co-authors explain how to develop tradable markets around these issues and, more importantly, how to make money doing so.  Incentivize them, and they will come.

The emphasis here is on how to price the asset and allow the free market to determine the types and magnitudes of the reductions. While not directly taking governmental interference to task, the authors show a clear preference for traveling with just a carry-on, rather than the bulky baggage that government programs seem to require. There is a place in the system for regulation of these programs, but it should be more for the authorization of the market and enforcement of the rules, not the implementation.

One example is the original sulfur dioxide auctions. Enabled by the Clean Air Act Amendments of 1990, the first auction was held through the Chicago Board of Trade in 1993. Since then, SO2 (and nitrogen oxide) emissions are more than 75% lower than 1980 levels. 

Just as important, health costs for lung disease were lowered, as were smog levels, forest damage and acidification of lakes and rivers. This was accomplished because regulation helped create the functions that enabled a market to emerge: It legalized the asset class as a commodity; it produced the property rights needed; and it established the infrastructure to allow for transfer of the asset. Then the market took it from there.  

In the past 20 years, cap-and-trade has been burdened with a great deal of political baggage, primarily from those whose oxen will be gored by change, as is often the case. Yet there are now enough programs operating to ensure that their benefits will continue to grow.

But this is not a book about cap-and-trade programs or policies. Nor does it purport that cap-and-trade is the only way to go. This is a roadmap on how to develop markets to allow for other environmental assets to be priced and traded. Early on, the authors outline a seven-stage market development process that is needed. It is no surprise that the first three are similar to the three requirements outlined by Francis Fukuyama in his recent book, “The Origins of Political Order,” in which he says that a political state needs infrastructure, laws, and accountability in order to survive. So it is with a market as described here, albeit writ small. But the ideas presented here are not small.

The first step is the recognition that the structure currently in place needs to be changed due to demand factors. Later explanations bring into play such examples as the “tragedy of the commons,” a concept articulated by many, but notably by Mancur Olson (see “The Logic of Collective Action: Public Goods and the Theory of Groups”). It is here that we find the root of a market. Public goods vs. private goods and collective decisions vs. individual decisions are what make a market. Large groups operate differently than small groups and still more so than individuals. Their resulting decisions are based on the economic pressures affecting each of them, and by the incentives each is given. This is what makes a market. 

Secondly, there must be rules, preferably developed by the needs of the market. Chief among these is that the commodity must be transferable. This requires that someone can own it and then be able to sell it to someone else.  This notion of property rights has come up before. Almost 30 years ago Hernando de Soto Polar’s book, “The Other Path, championed property rights as a means out of third-world poverty.”Ownership allows for buying and selling and, more importantly, establishing a value and price for doing so. If you don’t own it, its value doesn’t matter, and you don’t take care of it. As Larry Summers famously said, “No one ever washes a rented car.”

The third component is accountability. We are careful here to distinguish between the rules that the market needs in order to work, and the regulations the market overseers need to ensure a level playing field. In Washington, this means regulation and enforcement. In Chicago, this means clearing: a neutral third party to ensure that buyers pay and sellers collect.  

Covering such diverse asset classes as emissions, renewable energy, weather-related events and water, and even global fisheries, this book details the necessary steps to develop each into a tradable market. Once a market is created, it can establish a price for the underlying commodity. This price will then become the driver for individual and collective behavior, because the price will factor in all the tangible and intangible (read societal) inputs from the disparate market participants. 

Sandor’s three co-authors all have a long history of commitment to environmental issues. They have each been Managing Directors of Environmental Financial Products (EFP) and were involved in the Chicago Climate Exchange (CCX). Murali Kanakasabai is a Ph.D whose work stretches from the first emissions auctions to designing some of these new products. Rafael Marques has been in all phases of research and development of environmental products for over 15 years, and his portfolio has included the broadening of international growth and relationships for the Climate Exchange and now EFP.  Nathan Clark also spent many years with the CCX and EFP before moving on to become a vice-president of Wabashco, LLC, a clean fuels, carbon offset and renewable energy development company. These are four men who have proven their dedication to helping the planet. 

Sustainable Investing and Environmental Markets: Opportunities in a New Asset Class is an important book in an important emerging field. We are currently at a place in the history of commodity markets similar to that of the 1970s when the first financial products were introduced. Back then the corn and pork belly traders couldn’t understand how you could trade money and debt. That success may ease the way a bit for this new asset class, but market participants are a sticky group.  

They will not embrace a new market until it has proven itself to be viable.  

Are we facing, as Shakespeare wrote, “a tide in the affairs of men/Which, taken at the flood, lead on to fortune?” The market will tell us, because that is what a market does.

About the Author

Jay Sorkin is a 40-year veteran of the futures and options markets. He traded at the Chicago Board of Trade and the Chicago Board Options Exchange, and later was on the management team of two start-up electronic exchanges. He has taught futures and options for more than 30 years.