By: John Nikoloff, President of ERG
The proposed cap and trade policy designed to reduce carbon emissions in the U.S. is raising concerns among some members of the U.S. Senate over how the resulting carbon markets would be operated. Experience with other commodities, such as the extreme volatility created in oil, corn and soybean prices in recent years, has led to these concerns.
Could large financial institutions bid prices away from reality and create economic harm by speculation, or could development of new derivatives generate the potential for a new financial crisis, as suggested by some Senators?
Anytime a new commodity market is established, it only makes sense to install basic safety standards to prevent abuse. The carbon markets in Europe have not shown a clear path for success, and the incipient markets in the U.S. have demonstrated limited success and little cohesiveness to date.
Congress, as it works its way through the maze that has become the climate change legislation, will be looking to balance the politics of environmental policies with innate fears of speculative markets. While it seems that most Senators support the large "Wall Street" institutions trading carbon credits, some, such as Sen. Byron Dorgan (D, North Dakota) have publicly talked about either preventing the Goldman Sachs and JPMorgan Chases of the world from carbon trading or placing serious restrictions on their ability to trade.
We are well aware that the prices these markets eventually find for commodities are not always based in economic reality, but rather fueled by speculation. Still, without the inclusion of traders outside the industries affected, there might be too little liquidity for the market to function properly. When trades cannot be consummated, prices will be volatile and price spreads will be extremely large.
In July, Massachusetts Sen. John Kerry said flatly, "There will be no derivatives, there will be no credit swaps. There will be a tighter regulatory control on this so that it will be impossible to play any of those kinds of games." Sen. Dorgan said he will oppose creating any carbon-trading market. "It won't be very long before we have derivatives, we'll have swaps, we'll have synthetic swaps, you name it, we'll have all of them and it'll be a field day for speculation," Dorgan said before the summer recess.
But one reality is that derivatives, like options and futures contracts, do have the value of letting companies hedge their bets, reducing risks for their capital projects and actually getting them built. Companies that need oil can hedge against large price shifts, and farmers who want to significantly expand production of a commodity can protect themselves against price drops. The same should hold true in a carbon market.
The immediate issue being addressed by these Senators is the carbon market that would accompany a cap-and-trade bill, but in a more and more technical world, our public officials are often challenged with making key decisions that affect industries, technologies and of course the economy, in which none can claim real expertise. It's important that these decisions be made using sound science and sound logic, rather reacting to fears. In the end, development of the carbon allowance market, and their structure and regulation, may be as big a challenge as the battle that's already being waged over whether a cap-and-trade system or carbon taxes are a realistic a driver to generate GHG reductions.