Subprime Carbon Testimony

Friends of the Earth’s Michelle Chan testified before the Ways and Means Committee on March 26, 2009 about the financial aspects of reducing carbon emissions. She emphasized that existing financial regulations, as well as those in major cap-and-trade bills, are inadequate to govern carbon trading, creating a potentially huge regulatory gap.  Read her testimony below.

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Testimony

Thank you Chairman Rangell and Members of the Committee for inviting me today.  My name is Michelle Chan of Friends of the Earth, and my testimony is going to focus on four lessons we have learned from the current financial crisis and how we might apply them to carbon markets.

Lesson One:

Avoid speculative bubbles.  By 2020 carbon markets in the US may reach $2 trillion in value – and will probably be the biggest derivatives market in the world.   And that’s because most carbon trading is done not by those looking to comply with carbon caps, but by speculators looking to make money.  If you take a look at this chart showing carbon markets EU, you’ll notice the carbon prices have been very volatile.

But what’s interesting is that even though carbon prices have plummeted recently due to the economic downturn, trading volumes have continued to skyrocket.  A lot of the churn comes from speculators, and in the long term, a market dominated by speculators creates a bubble.

And that brings us to Lesson Two:

Bubble mentalities encourage excessive risk-taking and unscrupulous behavior.  So for example, in the mortgage meltdown, home loans that would never have been made under normal circumstances were pushed through because prices just kept going up, and banks could pass risky assets onto others.

Again, same thing could happen with carbon, particularly with carbon offset credits.  Most traditional cap and trade systems allow two kinds of carbon commodities to be traded: allowances, which are created by the government, and offset credits, which are generated by companies that are not subject to carbon regulations.  So for example, a giant pulverized coal plant in India can make its operations marginally more efficient, and generate carbon credits to be sold in the US or Europe.

And this is where the subprime carbon come in: in the buying frenzy of a carbon bubble, offset companies could overpromise, selling carbon credits based on projects that do not yet exist or which simply do not deliver the emission reductions.  If that happened, those derivatives would collapse in value, leaving investors holding the bag.

Which brings us to a Third Lesson:

Financial innovation can obscure risks, while securitization can spread it.

We now know that in today’s modern markets, “financial innovation” can get out of hand. With the mortgage market, financial engineers were able to sell increasingly complex and exotic financial products to sop up what seemed to be an unlimited demand for mortgage-backed securities. 

Again, the same thing could happen with a traditional cap-and-trade system.  So many investors will want a piece of the action that Wall Street won’t just be brokering in plain carbon derivatives – they’ll get creative.

For example, last year Credit Suisse put together a $200 million deal in which they bundled together offset projects in various stages of completion, sliced them into tranches and sold them as securities in the secondary markets.  This is the exact same structure as mortgage backed securities. 

If some of these offset projects fail to deliver emissions reductions, they could collapse in value and subprime carbon risks could spread through the system.

And that leads us to a Fourth, painful lesson we’ve learned from the financial crisis:

Wall Street is not well-regulated, especially derivatives markets. 

For example, we now see that there was a really long value chain from mortgage brokers to investment banks, to credit default swap counterparties like AIG.  We had a patchwork of different rules and regulators along that value chain, but no one had the responsibility of monitoring the whole system and responding to the dangerous trends.

Carbon markets are also going to have a long and complicated value chain.  This will not be a simple Econ 101 emissions trading system, where companies who have extra allowances simply sell to those who don’t have enough.

Instead, most traditional cap-and-trade systems will create a whole carbon offset market, possibly covering everything from power plants in India to forest projects in Cameroon.  And then there is the primary market which trades in both credits and allowances, and a huge secondary market in carbon derivatives and financial products built off the back of those derivatives

In Washington, we’re definitely thinking about derivatives regulation and financial reform, but Congress still hasn’t yet agreed on what to do.  It seems imprudent to so hastily create the largest derivatives market in the world and foist it on a new and untested regulatory regime.

So what are our options?

We can go ahead and create these giant markets and try to tame the most excessive behaviors through regulations such as margin limits and anti-fraud rules.  And that’s totally necessary.

But it may just be better to design the system to be more simple.  So for example, here’s the McDermott bill.

It doesn’t allow for carbon offsets. So subprime carbon wouldn’t build up in the system.  There isn’t space for the proliferation of exotic financial products.  And of course it is more manageable from a regulatory standpoint.

It sets both a cap on emissions and a stable price for carbon, which Friends of the Earth appreciates. 

The cap of course gives us the emissions reductions we need, and the stable and predictable prices neutralize the risk of a boom-bust cycle: 

In the boom, skyrocketing carbon prices encourage excessive risk taking, and makes life more expensive for companies and consumers.  In the bust, plummeting carbon prices pull the rug out from underneath renewables investors and those who own carbon securities.

So in closing, we commend Congressman McDermott for his efforts to propose a system which attempts to capture the environmental benefits of a cap and the price stability of a tax.  We think this proposal makes a vital contribution to the debate about how to best solve what may the most pressing environmental problem of our time.