ENVIRONMENT AND ENERGY DECEMBER 11, 2009
Of all the different industry groups scrambling to shape climate policy in Washington--from electric utilities to Detroit automakers--one stands out as a bit unexpected: Wall Street. Financial giants like Goldman Sachs and JP Morgan have enlisted, all told, more than 100 lobbyists to roam the Capitol and influence the debate over how to curb greenhouse gases. There’s a reason for that: Any cap-and-trade bill that puts a limit on emissions and allows polluters to buy and sell permits will create a vast carbon market. That will mean new opportunities for financial firms to broker deals, package carbon offsets, or offer hedging instruments. And that, in turn, will mean profit. Little wonder that investment banks have been bulking up their carbon-trading desks in recent years.
But, given what happened the last time bankers went wild on a hot commodity, some politicians are leery of their interest in cap-and-trade. “I know the Wall Street crowd can’t wait to sink their teeth into a new trillion-dollar trading market,” wrote North Dakota Senator Byron Dorgan in July. “But given recent history, I have little confidence that markets are free or fair enough to trust them with a new, large cap-and-trade carbon securities market.” A small but vocal group of climate activists agrees. In The New York Times, NASA scientist James Hansen warned that the carbon market “appears likely to be loosely regulated, to be open to speculators, and to include derivatives” and that bankers would extract profits by inflicting high energy costs on the public, while volatile prices would make it harder for companies to make investments. These critics prefer an approach that leaves Wall Street out--say, a simple carbon tax.
As it turns out, there’s a decent case that a well-regulated carbon market would make tackling global warming easier--and that Wall Street’s wizardry could be put to good use by lowering the overall costs of reducing emissions. But whether that actually happens will depend on Congress’s ability to regulate the financial sector--a task it’s planning to take up after health care. And that means the fate of climate policy may end up hinging on how financial reform shakes out.
To see why carbon markets can be a flexible tool for cutting emissions--and why they could also fall prey to the sorts of problems that dragged down the economy last year--it’s worth reviewing how a cap-and-trade system works. Congress sets an overall limit on the amount of carbon dioxide that can be emitted by issuing a fixed number of pollution permits, which businesses can buy and sell; each year, the limit declines. Companies that decide it’s cheaper to reduce their emissions (say, by boosting energy efficiency) than it is to buy permits will make those easy cuts first. As the cap tightens each year and the total number of permits dwindles, the cost of polluting will steadily rise, and more and more businesses will cut emissions rather than buy increasingly pricey permits.
That’s where Wall Street comes in. Because the cost of permits depends on supply and demand--which, in turn, depends on factors like weather, economic activity, or the cost of clean-energy alternatives--the price of carbon can fluctuate quite a bit. A utility trying to decide whether to operate a power plant that will be around for decades may want to hedge against the chance that carbon prices will rise or fall, and so offload that risk onto investors by buying derivatives. (This is similar to how farmers can buy futures contracts to hedge against an unexpected plunge in wheat prices.) Meanwhile, outside investors would be making bets on how carbon prices will move. In theory, this is all supposed to make the market more efficient.
Critics of carbon-trading usually focus on this derivatives market, which could swell to as much as $2 trillion in the program’s early years. “There’s considerable worry that this market would have the problems that have been found in other physical commodity markets for the past few years,” says Michael Greenberger, a University of Maryland law professor who oversaw the U.S. Commodity Futures Trading Commission’s trading division in the late 1990s. Speculators, for instance, could artificially inflate the price of carbon--which is what some economists think happened in the oil markets last year, when the price of crude shot up from $60 per barrel in February 2007 to $147 per barrel in 2008. That, in turn, could cause energy prices to skyrocket and lead to a mass revolt against the whole idea of a carbon cap.
A different worry involves carbon offsets. Under the House climate bill, companies could pay for outside projects that would reduce greenhouse-gas emissions--a tree-planting project in Brazil, for example--in lieu of making their own cuts. Polluters like having this option because it can often be cheaper to, say, stop deforestation than build a new wind farm. The downside, though, is that these projects require heavy scrutiny--you have to make sure those newly planted trees aren’t chopped down two years later. So the EPA has to tightly limit what offset projects get approved. But, if Wall Street becomes heavily involved in arranging and financing offset deals, it might decide to use its lobbying clout to increase the number of available offsets--which could weaken oversight and let through dubious projects that don’t actually bring emissions down. “They’re interested in maximizing profit, not making the system as rigorous as possible,” says Michelle Chan, an analyst at Friends of the Earth, an environmental group critical of cap-and-trade. “And more offsets equals more fees for Wall Street.”
Not only that, but, in a report earlier this year, Friends of the Earth warned that, because offsets are inherently uncertain endeavors, they could become the newest version of subprime mortgages--call it “subprime carbon.” In 2008, Credit Suisse bundled together 25 different offset projects that were at various stages of U.N. approval, divvied them up into securities, and sold the pieces off to investors--precisely the sort of deal that was rampant during the housing boom and set the stage for a meltdown once homeowners started defaulting.
Then again, plenty of experts argue that these concerns are overstated. After all, when the EU set up its cap-and-trade market in 2005, it decided to let a largely unregulated derivatives market build up, and, so far, fraud and manipulation have been minimal. (The EU did see the price of carbon crash in the early years, but that was because too many permits were erroneously handed out, not because of bankers.) “No one’s complacent, but you just don’t see the same sort of fear about this in Europe,” says Jill Duggan of the World Resources Institute, who helped implement the EU’s trading system. And, on the “subprime carbon” question, Andy Stevenson, a former hedge-fund manager who now works for the Natural Resources Defense Council, argues that investors aren’t flocking to offset-backed securities--the Credit Suisse deal was an exception, and a poorly received one at that--because of the risks involved.
Still, Stevenson and other cap-and-trade backers agree on the need for sturdy market regulations. Examples include position limits (to make sure no single trader can dominate the carbon market) and stricter oversight of over-the-counter derivatives, which aren’t traded on exchanges and have ballooned in recent years. What’s more, the Kerry-Boxer cap-and-trade bill in the Senate would set a ceiling on the price of carbon: If prices rose above a certain point, the government would start releasing a reserve of permits into the market in order to drive down prices and discourage speculators.
Of course, whether all of those safeguards will actually make it into law is still an open question. The House climate bill included a stringent set of regulations for energy and carbon markets, authored by Bart Stupak, but those rules will be superseded by whatever broader financial-reform package Congress ends up passing in the months ahead. And many cap-and-trade skeptics fear that the House and Senate will end up letting Wall Street off easy. “The debate’s still very fluid,” says Chan, “but, in the last few months, we’ve watched some of the leading derivative regulations become riddled with loopholes.” What’s more, says Joseph Mason, an economist at Louisiana State University and a critic of carbon trading, it’s not always possible to legislate fraud and manipulation out of existence. “A million traders can think of many different ways to take advantage of these contracts that you never thought of.”
That’s why some proponents of tackling carbon are starting to look more fondly on the “cap-and-dividend” idea being pushed by Maria Cantwell, a Washington Democrat and one of the leading critics of derivatives in the Senate. In Cantwell’s bill, carbon would be capped at the source--at the coal mine or the oil well--and the price signal would trickle down through the rest of the economy. The money raised from selling permits would be largely rebated back to consumers, and there’d be little trading and not much room for Wall Street. (Not everyone agrees that this is a plus: Stevenson argues that less liquidity in the system could, at times, lead to more price volatility than in a larger, more active market.)
But the politics are the crucial question: So far, cap-and-dividend has attracted interest from some corners--notably, Maine Republican Susan Collins is co-sponsoring Cantwell’s bill--but, as yet, it doesn’t have the wide support that cap-and-trade enjoys. Still, if financial reform goes badly and more Democrats start fretting about Wall Street’s enthusiasm for carbon trading, this could be the next big climate battle.
Bradford Plumer is an assistant editor of The New Republic.