[Corp. Watch] Cap-and-trade: More Wall Street smoke and mirrors

[Corporation Watch]

Could Cap-and-Trade Cause Another Market Meltdown?

  By Rachel Morris

(Mother Jones, June 8) -- You've heard of credit default swaps and sub- 
prime mortgages. Are carbon default swaps and sub-prime offsets next?

	If the Waxman-Markey climate bill is signed into law -- setting up a  
system in which corporations buy and sell pollution credits -- it will  
generate, almost as an afterthought, a new market for carbon  
derivatives.

	That market will be vast, complicated, and dauntingly difficult to  
monitor. And if Washington doesn't get the rules right, it will be  
vulnerable to speculation and manipulation by the very same players  
who brought us the financial melt-down.
	Cap-and-trade would create what Commodity Futures Trading  
commissioner Bart Chilton anticipates as a $2 trillion market, "the  
biggest of any [commodities] derivatives product in the next five  
years."

	That derivatives market will be based on two main instruments. First,  
there are the carbon allowance permits that form the nuts and bolts of  
any cap-and-trade scheme. Under cap-and-trade, the government would  
issue permits that allow companies to emit a certain amount of  
greenhouse gases. Companies that emit too much can buy allowances from  
companies that produce less than their limit.

	Then there are carbon offsets, which allow companies to emit  
greenhouse gases in excess of a federally mandated cap if they invest  
in a project that cuts emissions somewhere else -- usually in  
developing countries. Polluters can pay Brazilian villagers to not cut  
down trees, for instance, or Filipino farmers to trap methane in pig  
manure.

	In addition to trading the allowances and offsets themselves,  
participants in carbon markets can also deal in their derivatives --  
such as futures contracts to deliver a certain number of allowances at  
an agreed price and time.

	These instruments will be traded not only by polluters that need to  
buy credits to comply with environmental regulations, but also by  
financial services firms. In fact, a study by Duke University's  
Institute for Environmental Policy Solutions anticipates that the  
derivatives trade will probably exceed the market for the allowances  
themselves.

	"We are on the verge of creating a new trillion-dollar market in  
financial assets that will be securitized, derivatized, and speculated  
by Wall Street like the mortgage-backed securities market," says  
Robert Shapiro, a former undersecretary of commerce in the Clinton  
administration and a co-founder of the U.S. Climate Task Force.

	Banks like JPMorgan Chase, Morgan Stanley, and Goldman Sachs already  
have active carbon-trading desks that deal in instruments connected to  
Europe's cap-and-trade system and voluntary markets here. But business  
will explode if a cap-and-trade system becomes law.

	So it's no surprise that the financial industry has taken an intense  
interest in the fine print of the Waxman-Markey bill.

	According to data compiled by the Center for Public Integrity, the  
financial services industry has 130 lobbyists working on climate  
issues, compared to almost none in 2003. They represent companies like  
Goldman Sachs, JPMorgan Chase, and AIG (before it was shamed into  
temporarily halting its lobbying activities last fall).

	The industry "wants lawmakers to create a brand-new revenue stream  
for its bottom line, and cap-and-trade would do it," says Tyson Slocum  
of Public Citizen, who is a member of a Commodity Futures Trading  
Commission (CFTC) advisory committee considering how carbon trading  
should be regulated.

	Among environmental groups, there is understandably less focus on the  
finer points of financial regulation.

	"The derivatives side is not something that a person who comes to the  
table worried about carbon emissions has on their agenda," says  
Michael Greenberger, a derivatives expert at the University of  
Maryland who has also served in the CFTC and the Justice Department.  
But "[t]hose people -- and they're fighting a good battle -- opened  
the door" to the new carbon derivatives market by seeking to regulate  
greenhouse gases.

	Experts from the Congressional Budget Office have said that the most  
stable and effective form of cap-and-trade would involve a system in  
which the government periodically sets prices in much the same way  
that the Federal reserve determines interest rates.

	That would prevent volatility, which would in turn remove the  
temptation to gamble on big price swings. In other words, it would  
provide far less opportunity for wheeling and dealing -- and profits.

	Rep. Jim McDermott (D-Wash.) offered a proposal for a managed-price  
cap-and-trade scheme, but failed to gain any traction. Meanwhile,  
industry groups like the International Swaps and Derivatives  
Association pushed for a system in which a "broad suite" of financial  
products can be traded, and that's what Waxman-Markey delivers.

	In an especially audacious move, the industry also argued that cap- 
and-trade should allow the very same types of unregulated instruments  
that helped spread risk throughout the financial system like a cancer,  
contributing to the economic meltdown.

	In particular, it lobbied for "over the counter" (OTC) carbon  
derivatives -- deals conducted directly between two parties with no  
one monitoring the risk. (Perhaps the most notorious form of OTC  
derivative is the credit default swap, which crippled AIG when it  
issued too many high-risk swaps while lacking the money to cover them.)

	On this front, however, Wall Street was less successful. The day  
before the bill passed out of committee, Rep. Bart Stupak (D-Mich.)  
inserted language requiring all allowance derivatives to be either  
traded on an exchange or cleared by an organization registered with  
the CFTC.

	This would provide a paper trail for regulators, although the  
reporting requirements for clearinghouses are less stringent than  
those for public exchanges. Stupak also added limits to prevent  
speculators from cornering too much of the market.

	Still, the bill leaves many vital specifics to the White House,  
directing the president to form a task force to determine precisely  
how to avoid "fraud, market manipulation and excess speculation."

	Andy Stevenson, finance adviser at the National Resources Defense  
Council, says, "I would feel comfortable if much more of it were  
explicit." He applauds the bill's "spirit" but cautions that "the  
details are important."

	The lobbying battle is not over. CFTC commissioner Chilton praised  
Stupak's 11th-hour amendment, but expressed concern that it could be  
removed in the legislative process ahead. The bill, after all, has yet  
to pass through several more House committees -- before the Senate  
weighs in.

	That gives the financial sector a few more bites at the apple. At the  
same time, Wall Street is marshaling its forces against Treasury  
Secretary Timothy Geithner's proposal to move most derivatives trading  
onto public exchanges, which would also cover carbon derivatives.

	"There are so many issues, so many jurisdictional obstacles out  
there, I'm just worried it's not going to get done," Chilton says. "I  
don't want people's good intentions to be all we get. I'm worried that  
people will start clustering and positioning, and the reforms these  
markets require aren't going to be enacted."

	Even a well-designed regulatory system may not be able to prevent  
gamblers from contorting prices and discouraging the investments in  
green energy that are the entire purpose of cap-and-trade.

	After all, one lesson to be drawn from the economic crisis is that  
complexity is like catnip to the unscrupulous, and the carbon regime  
that would be created by cap-and-trade is nothing if not complex.

	Perhaps the biggest uncertainty hinges on how offset derivatives --  
such as a contract to buy offset credits at a future date for a  
determined price -- will be monitored. This too would be left to the  
White House task force to figure out.

	It will be a tough task, because the quality of offset projects is  
notoriously difficult to verify. Sen. Jeff Bingaman (D-N.M.) has  
described them as "fraught with opportunity for game playing, which  
will be fully exploited, I'm sure."

	In 2008, the U.S. Government Accountability Office (GAO) examined the  
use of offsets in Europe's Emissions Trading Scheme, which  
theoretically has a rigorous process to certify that offsets are  
"additional" -- that is, that they cause emissions cuts that wouldn't  
have occurred if the project hadn't been implemented.

	But even though projects must be reviewed by both national officials  
and an external independent monitor to qualify, the GAO found that it  
was "nearly impossible" to ensure that offsets really were additional.  
It concluded that offsets present "a significant regulatory  
challenge", and should probably be viewed as a temporary measure at  
best.

	"In practice [offsets] have proved impossibly difficult to  
successfully implement without fraud," writes Michael Wara, a carbon  
trading lawyer and co-author of a Stanford University study that found  
that one- to two-thirds of offsets authorized by the Kyoto Protocol's  
Clean Development Mechanism didn't represent true emissions cuts.

	"Even in the presence of a tough regulatory system…that is working  
hard to get things right…lots of counterfeit carbon currency is making  
it into the system," Wara said.

	Michelle Chan, the investment program manager for Friends of the  
Earth, believes that if offset derivatives aren't properly regulated,  
they could become "sub-prime carbon" -- futures contracts that promise  
emissions reductions but fail to deliver and then collapse in value.

	Already, she points out, some banks are bundling credits from  
multiple offset projects and splitting them into tranches to sell to  
investors. This kind of activity is "hauntingly close" to mortgage- 
backed securities, Chan told the House Ways and Means committee in  
March, arguing that it has the potential to spread risk throughout the  
financial system.

	At a CFTC hearing earlier this year, Skip Hovarth, president of the  
Natural Gas Supply Association, questioned whether the agency had the  
tools and the manpower to keep track of such an incredibly complex  
market.

	"If this market fails, and all the derivatives and all the markets  
that attach to it and grow over time fail, it will make this last  
recession look like nothing," Horvath said.

	Again, Europe's experience offers a glimpse of the difficulties of  
tethering an environmental goal to the whims of the financial system.  
In the early years of Europe's cap-and-trade system, speculators  
flocked to trade carbon.

	Prices seesawed wildly, and analysts warned of a "carbon bubble."  
Regulators made adjustments to stabilize the market -- but then the  
financial crisis hit and carbon prices crashed.

	This January, an executive from the French energy giant EDF warned  
that carbon trading was in danger of becoming "a new type of sub-prime  
tool which will be diverted from its initial purpose: encouraging real  
investment in real low-carbon technology."

	During the negotiations over cap-and-trade, little airtime has been  
given to the idea that perhaps carbon is fundamentally different from  
other purely commercial markets that weren't conjured into existence  
to save the planet.

	After all, the allowances are an artificial commodity -- according to  
the logic of cap-and-trade, the government will issue fewer permits  
each year to encourage polluters to cut their emissions.

	"The supply is dwindling and will tail off. Arguably, it's much less  
clear that you need a derivatives market," says Greenberger, the  
derivatives expert. "You could try to control speculation, which is  
what [Rep.] Stupak wants to do, but even in a regulated market there  
are speculators -- many of them."

	"Or, Greenberger continued, "you could say, 'This is unlike any other  
market, and no regulation is perfect. So why take even the risk of  
speculation or malpractice that could distort the price -- let's just  
not have derivatives.' I think it's a subject worthy of serious debate."

	Thanks to the persistent lobbying of the financial sector, however,  
that doesn't seem to be a debate that will happen anytime soon.