Lawrence Solomon
FP Comment
November 8, 2008

If you think the causes of the financial crisis are complicated, just wait until we start trading carbon.

Think that the causes of the current financial crisis are hard to figure out? Think that the Wall Street wizards went too far in creating sub-prime mortgages and asset-backed papers and hedges and off-setting derivatives and other financial instruments that few understood on their own, whose value no one could easily establish, and whose interactions no one on this planet could ever figure out, except maybe in theory? Think that central bankers have lost control of their currencies and that they are flailing about, as clueless as to what needs to be done as the governments that throw rescue package upon bailout package at the crisis, hoping that something, somewhere, somehow, will stick?

Think we have learned our lesson about creating artificial securities, divorced from the real world and highly leveraged, so volatile and inscrutable as to be capable of sending markets into even worse hells, and entire economies into real depressions?

Think again.

To the layers of confusion that now exist in our financial markets we are about to add another, as opaque and volatile as the others, and as unhinged from the real world — a carbon currency. President-elect Barack Obama wants it, Prime Minister Stephen Harper wants it and their European counterparts, to some extent, already have it.

Europe’s Emissions Trading System (ETS) is the world’s largest trading exchange for carbon dioxide and other greenhouse gases. If ambitious Kyoto-style plans come to fruition, ETS will morph to account for, among other things, the carbon content of all industrial and biological processes, and the carbon carrying capacity of all the real estate on our planet. Because carbon is a building block of life, and because we live in a carbon-based planet, carbon prices will become more ubiquitous than the U.S. dollar. It would become, in effect, a globally traded currency tied to gaseous commodities that until recently were nowhere traded.

What might this commodity-based currency be like? A week ago, the commodity traded on the ETS — EU allowances of greenhouse gas emissions — plummeted in value by 20%, after falling 20% three months earlier. This comes just two years after the ETS exchange had its first major collapse — a 70% decline on rumours that some governments were about to give their industries extra emission rights, followed by even steeper declines that virtually wiped out the value of the allowances. Prior to the declines, the allowances had seen a steep climb in value.

The good news — and the reason no one much cares about these collapses — is that the carbon emissions market is in its infancy, a mere $64-billion last year, compared to the trillions trading hourly in international markets. A collapse in today’s carbon market roils international stock markets far less than, say, a collapse of the Thai bhat might, which is to say not at all.

But what will happen should carbon become a major currency, and a highly volatile one at that? For starters, every carbon-intensive business will need protection against the extreme changes seen in carbon prices. This protection — carbon-hedging mechanisms of various kinds — will themselves assume outsized proportions because the businesses subject to carbon fluctuations will vastly outnumber those that now hedge against fluctuations in fossil fuels — in addition to the energy industry, airlines, utilities and others that now need fossil fuel hedges, will be forestry, agriculture, real estate, deserts, dams and other land-based sectors.

How will the new financial sector that emerges to price these hedges determine values? The “marketplace” for carbon allowances will be one in which both supply and demand are set by governments, in which intense corporate lobbying for changes to both supply and demand is all but certain, and in which moral hazard — in the form of an expectation of a government bailout — is an absolute certainty. Valuing the toxic instruments created by Fanny Mae and Freddy Mac, that corrupted the pool of debt securities, will seem like child’s play in comparison.

To avoid a future market meltdown of the likes we are now experiencing, almost all are agreed, we need to avoid opaque financial instruments that can’t be easily understood or valued. Carbon offsets, credits, allowances sinks and other instruments attempt to create pricing for vast stores of carbon dioxide — something that can’t be seen, that has no intrinsic commercial value, and that may prove to benefit rather than harm the environment. They are obscure and opaque, instruments both green and toxic.
Lawrence Solomon is executive director of Energy Probe and author of The Deniers: The world-renowned scientists who stood up against global warming hysteria, political persecution, and fraud.