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Don’t Be a Bubble-Head on Carbon Market Bubbles!

February 2, 2010

In further proof that Australia’s Sydney Morning Herald will print anything providing it contains no systematic thinking or expertise behind it, Paddy Manning managed to get this article published about carbon trading just two days ago.

According to Paddy, carbon markets are a dangerous solution for tackling greenhouse gas emissions because they risk delivering us the kind of speculative bubbles and free market mayhem that brought the global financial crisis:

 “the next bubble may well be carbon credits”.

His argument? That, according to that bastion of economic analysis Rolling Stone Magazine……  

 ”a booming trillion-dollar market that barely even exists yet … a virtual repeat of the commodities-market casino that’s been kind to Goldman, except it has one delicious new wrinkle: if the plan goes forward as expected, the rise in prices will be government-mandated. Goldman won’t even have to rig the game. It will be rigged in advance.”

Paddy, with the greatest respect, your opinion deserves no respect.

Firstly, it appears you don’t understand how the market works. If you did, you’d realise that as Nobel Economist Paul Krugman has argued, emissions rights are a long way from mortgage-backed securities or credit default swaps. They are a very specific right to do a very specific thing: emit a tonne of CO2! If you need one to emit, you buy it, if you don’t you sell it, or keep it for later. It’s very simple.

Moreover, as designer markets, Governments will have very very good data on how the market functions. Along with all of us carbon market researchers, the regulators will be monitoring the market’s performance in a way that no-one ever thought to do with subprime mortgages. This limits the danger of intransparent concentrations of risk building up in the system.

Secondly, Paddy claims that the “market can be rigged in advance”. How? And what does that mean? The only way to “rig” the market that I know of is to corner it. That is, to have a monopoly on emissions permits and cause a price hike before selling. But the reality is that you would have to go out of your way as a Government to make that possible. The European Union market has over 13000 entities buying and selling billions of permits and the permits are either initially allocated freely among them all, or, as will increasingly occur, they are auctioned. So its absurd to suggest that one player – or even a small handfull of players – could get their hands on enough permits at the outset to have a “rigged market”.

Also, market price control mechanisms such as borrowing and banking of permits, price caps, and offsets purchases, also render strategies like cornering the market practically impossible.

As for the EU “carousel fraud”, that was actual brought about by the myriad different  value added tax systems operating in different European countries. A US or Australian market would have no such problem. Plus, might I add, the perpetrators were quickly discovered, have been charged, and the problem addressed! So where’s the carbon market bubble?!   

Finally, The Pad claims he finds evidence of a bubble in the fact that EU ETS permit prices followed market fundamentals, such as oil prices, until the financial crisis, and then the link broke down. That’s true. But this does not imply speculators are driving the market. Nor does it imply that the EU issues “too many” permits.

The EU issued the number of permits that were consistent with its predecided emissions goal for Europe for each year. The break down in the link between oil and carbon prices is most likely due to the fact that the financial crisis itself drastically reduced EU economic activity and therefore emissions. Therefore demand for EU Allowances fell sharply, and many installations who had been issued permits now found they had more than they could use. Thus, many have sold them for cash, while others have been uncertain about whether they shold buy or sell, because they are uncertain about how tight the EU cap will be after the Copenhagen Accord plays out. (Europe, remember, has said it will have a tougher emissions cap if there is a strong global agreement, and this rightly affects the value market participants put on permits.)  

So, I’m sorry to disappoint you, old Pad, but there are more factors affecting carbon prices than the cost of oil, gas and coal. And that, more than evil “speculation” – whatever you mean by that term – , is most probably the reason for what you think you saw.

Look, if you really want to know about the dirty side of carbon trading policy, a more accurate critique is that, because government creates new value in enacting the law that you need a permit to emit, the allocation mechanism for the permits does give lobbyists a chance to earn free money. If you can lobby your politician to give you free permits, then you get a windfall profit. This does occur, which is why permits should be auctioned, except to companies exposed to international competition from non-regulated competitors. But this is an argument for full auctioning, and for writing your political leaders to demand it, Paddy, not for carbon market bubbles.

Let me end with a Krugman quote:

“…the argument that if you create a market, you’re opening the door for Wall Street evildoers, is bizarre. Emissions permits aren’t subprime mortgages, let alone complex derivatives based on subprime; they’re straightforward rights to do a specific thing. It will truly be a tragedy if people generalize from the financial crisis to block crucially needed environmental policy.”

  1. Dope permalink

    I’m looking forward to Paddy’s response!

  2. hot air permalink

    Organized crime has fleeced $7.4 billion ober the last 18 months using the European ETS. This expenditure did not result in GHG savings, and indicates how open the whole scheme is to fraud, mismanagement and waste.

    • The Carbon Economist permalink

      There’s no doubt that the “carousel fraud” in the EU ETS was bad news for the public image of carbon markets.

      But I would caution against jumping to conclusions.

      The EU ETS fraud you refer to was actually a case of tax fraud, not gaming the market for carbon permits. Traders would sell permits with value added tax in countries that had VAT on carbon, not account for the VAT tax at the point of sale, and effectively rebuy the permits, account for VAT tax and demand a tax credit from the Treasury. Each time they kept the VAT refund.

      As this article makes clear,

      “This particular fraud costs billions of Euros to the EU finances every year in various markets. It is often organised on a large scale, sometimes by criminal organisations.”

      Thus, “In order to allow Member States to take rapid action against this kind of fraud, the Commission has adopted a proposal for a Directive allowing the application of a reverse charge mechanism on supply of five categories of particularly fraud sensitive goods and services, namely: computer chips, mobile phones, precious metals, perfumes and greenhouse gas emission allowances.”

      So surely you would agree that this is not really an issue about carbon markets as a means to combat climate change – its about the insufficient harmonisation of EU countries tax treatment of carbon permits.

      Besides, the point is that the perpetrators were stopped, prosecuted, and the EU has taken quick action to fix the problem.

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