HOW TO KEEP U.S. EMISSIONS TRADE FROM BUBBLING

The Coming Carbon Bubble
Martha C. Wilde, July 10, 2009 (The Big Money via Reuters)
and
Geithner: New commodities regulations should not preclude hedges
Nick Snow, July 10, 2009 (Oil & Gas Journal)

SUMMARY
Perhaps the biggest jab opponents take at the energy and climate bill just passed by the House of Representatives and the matching energy and climate legislation now being hammered out in the Senate is that the cap&trade system in them is little more than a financial market boondoogle just waiting for scammers to come along and turn it into another bubble, something like the recent market misery or the Enron scandal on steroids.

Proponents of cap&trade say it is way to turn the power of the market against the growth of greenhouse gas emissions (GhGs) and win the fight against global climate change.

The cap is crucial. Emitters would be issued allowances for each ton of GhGs they produce. Year by year going forward, emitters would be issued fewer allowances. Total GhGs would, necessarily, go down. If a business could not to do business without emissions beyond its cap, it would be required to buy them on the emissions trading market. More efficient businesses that could do business below their capped levels by relying on New Energy and/or Energy Efficiency could sell their allowances on the market for extra profit.

From NationalWildlife via YouTube

The allowances will, by the terms of the House bill and the proposed Senate legislation, be auctioned to emitters. In the early years of the program, only 15% of the allowances will be auctioned and emitters will be given 85% to allow them to transition to the new system in which emissions cost them. Eventually, 100% of the allowances will be auctioned.

Such a program was used to control sulfur dioxide (SO2) emissions in the late 1980s and early 1990s. It helped end the ravages of acid rain. The GhG problem associated with global climate change is bigger and more complicated. Advocates say cap&trade can still work. Opponents say the SO2 solution came before hucksters found out about Enron-style market manipulations and impossibly opaque credit default swaps, mortgage-backed derivatives and other hypothetical tradables.

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The Obama administration contends that regulation is the solution and believes it can effectively regulate and police its emissions trading market. Opponents say there is every reason to expect the financial industry will lobby against effective regulation at least enough to punch holes in it.

There are plenty of reasons to believe the opponents of cap&trade could be right about its vulnerability.

(1) Regulation would come from the Commodities Futures Trading Commission (CFTC), the body so ineffective at preventing speculators from driving oil prices up and down in 2008. Though CFTC Chairman Gary Gensler recently called for regulations on energy market speculation, he didn’t offer anything substantive enough to make anybody believe he meant it. Acting Chairman Walter Lukken, Gensler’s predecessor, claimed at the height of oil price abuses that speculation was not the problem.

(2) President Obama’s campaign promise to institute a cap&trade system with a 100% allowance auction has been compromised in the legislative process. Many concerned with the urgency of cutting GhGs to control climate change believe a 15% auction will make the price of allowances so low it will leave the cap&trade system impotent. They see the compromise as a capitulation to emitters. They also believe so many free allowances would make the market more vulnerable to manipulations and abuses.

(3) Offsets will be included in the cap&trade system and many see offsets as an even greater vulnerability than free allowances. Offsets are sold by emissions-reducing project owners to help pay for their projects. New Energy installations, emissions-capture plant conversions and agricultural soil sequestration practices qualify as offsets. Those who understand these projects see nothing inherently compromising about selling offsets to help finance them but many believe making such options available to emitters is inviting them to spend in their own self-interest, pay for projects owned by allies, pay for projects that would have been done anyway, etc. If offsets are not adequately controlled, allowance prices could be further compromised, leaving cap&trade yet more ineffective.

(4) The European Union (EU) Emissions Trading Scheme (ETS) is the biggest emissions market in the world. In its first months it suffered from the mistake of giving away too many allowances so as to assist its big emitters’ adjustment to priced emissions. (Sound familiar?) Allowance prices plummeted, failing to discourage GhGs.

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Just when ETS allowance prices were stabilizing at effective levels, the worldwide economic downturn set in. Allowance prices once again fell as markets everywhere crashed. Eventually, the markets stabilized and allowance prices started coming back. But as the recession went on, emitters’ productivity fell off. For reduced productivity, emitters generated fewer emissions and needed fewer allowances. They dumped allowances in exchange for urgently needed capital. Prices plunged again.

Many wonder if this is the kind of system that will turn global climate change around. Advocates of cap&trade say the U.S. can learn from the stumblings of the ETS and build protections to prevent such missteps.

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Unfortunately, the House bill repeats the EU's first mistake, giving away the bulk of the allowances in the early stages of the process.

On the other hand, there are provisions in the bill returning revenues to utility ratepayers to protect lower-income families from the rising costs of power. Studies by the Congressional Budget Office (CBO) and the Environmental Protection Agency (EPA) show the average cost will be small, less than 50 cents per day, and incomes in the lowest 40% would actually profit from the system. The House bill also provides for a fairly rapid increase in the percent of auctioned allowances, so it is perhaps possible for the U.S. system to benefit from its predecessor's mistakes.

The exciting thing is that it looks like cap&trade advocates and opponents alike are about to find out whether such a system can be made to work.

This is the ETS and it is pretty much in the shape of the large financial markets. Regulation here won't change those markets but proper regulation where the problem was could have been effective. (click to enlarge)

COMMENTARY
There is already a functioning U.S. emissions trading market composed of several voluntary platforms, the most notable of which is probably the Chicago Climate Exchange.

Estimates put the initial mandatory U.S. emissions trading market at about 6 billion allowances. Other commodities (corn, soybeans) have markets 10-to-30 times the size of the actual crop because of the derivatives market. Clearly, the cap&trade system is going to be a big deal.

The EPA says cap&trade will be affordable. (click to enlarge)

Designers of the cap&trade system hope to begin selling allowances at $13-to-$20 per ton. At the lowest estimates, the market will have a $750 billion value - initially. Bart Chilton, Commissioner of the CFTC, recently predicted emissions trading would be a $2 trillion futures market by the middle of the coming decade. (If the CFTC regulates it effectively enough to build investors' confidence.)

What worries cap&trade opponents most is that Big Money attracts the big money players. Wall Street’s heavyweights are already making their presence felt. 130 finance and insurance industry lobbyists worked the House during its climate and energy fight and have now turned their attention to the Senate.

The CBO says cap&trade will be affordable. (click to enlarge)

Suspicions of the relationship between Goldman Sachs alumni in powerful positions in the Clinton, Bush and Obama administrations will only be accentuated by the creation of this massive new market. Should big financial institutions like Goldman Sachs find ways to bend the rules of the emissions trading system to their own benefit first, and to the benefit of taxpayers and the environment only secondarily, it will not surprise the cynical.

On the other hand, Secretary of the Treasury Timothy Geithner continues to promise a new regulatory regime that is transparent and includes effective policing. If anybody is in a postion to know how to institute effective regulation that allows commodities traders to continue hedging effectively on behalf of the best market prices, it would be Geithner.

Since the start of last year’s economic meltdown, President Obama and the people around him have talked about proactively regulating the flaws and inequities out of existing financial markets and they will surely call for effective rules, transparency and vigilant policing in the emissions trading market. Because the GhG allowances will essentially be a commodity, the CFTC will get the job. Though Commissioner Chilton says his commission is ready, those who remember the failures of federal regulation in the Enron manipulation of energy markets and the derivatives trading in 2007-08 simply do not believe him.

Is it ready to do its job? (click to enlarge)

QUOTES
- From the essay: “Remember the nasty real estate meltdown? All those investors snapping up CDOs and CDSs and other acronyms nobody could really keep straight, but no one cared because we were all going to make a killing. And then the bottom dropped out of the market when somebody realized we had no idea what any of these exotic entities were actually worth but we started to worry that it might not be nearly as much as what we'd been told…”
- From the essay: “…So then the government had to come along and give the banks a ton of money and we're all OK now as long as you don't look at the national debt or foreclosure rate or a host of other still-dismal numbers…Well, it's good to see we've learned our lesson. We'll never get carried away like that again! Except that we might. If you thought the real estate mess was bad, fasten your seat belts and tuck all personal belongings inside the car because the carbon market is set to take off.”
- U.S. Secretary of the Treasury Timothy Geithner: “The lack of transparency in the OTC derivative markets, combined with insufficient regulatory policing powers in those markets, left our financial system more vulnerable to fraud and potentially to market manipulation...These problems were not the sole or the principal cause of the crisis, but they contributed to the crisis in important ways. They need to be addressed as part of comprehensive reform, and they cannot be adequately addressed within the present legislative or regulatory framework...”

The market today. (click to enlarge)

- From the essay: “A big reason the real estate crash was such a colossal mess is that no one was regulating the most exotic—and most in need of regulation, many would argue—derivative instruments like the credit-default swaps that almost sunk AIG (AIG). Is it reasonable to assume that a carbon market, especially one that's being built essentially from scratch, would have stopgaps and safety valves built into its infrastructure?”
- From the essay: “The U.S. carbon market is barely out of the womb, and there are already a whole slew of variables that could knock it into disarray. If the administration can keep its eye on the ball when it comes to regulation and not be distracted by the sweet nothings the i-banking community is sure to be whispering in its ear, CO2 will grow into a stable and well-adjusted market. If not, we're looking at our next problem child. Hope for the best—but don't exhale just yet.”
- U.S. Secretary of the Treasury Timothy Geithner: “We also will require that regulators carefully police any attempts by market participants to use spurious customization to avoid central clearing and exchanges...In addition, we will raise capital and margin requirements for counterparties to all customized and noncentrally cleared OTC derivatives...[T]o address price volatility issues...I believe more steps need to be taken to make markets more transparent...We’re trying to do something that’s never been done, to move together so that trading doesn’t move abroad, so we’re trying to involve all global financial centers...”