Isramart : Let’s Not Bar Goldman Sachs from Carbon Trading Just Yet

Isramart news:
One of the more potent criticisms of a proposed cap-and-trade policy aimed at reducing America’s carbon emissions is that the market for carbon allowances could come to be dominated and manipulated by financial institutions. These firms, the argument goes, might either bid prices all out of whack, doing significant economic damage, or craft new and dangerous derivatives generating the potential for a new financial crisis.

These claims are not entirely without merit—anytime one sets up a new market, one should try and make sure that basic safety mechanisms are in place to prevent abusive practices, but for the most part, the “fear of markets” line against cap-and-trade is a pretty silly one. Paul Krugman, whose progressive credentials are not in doubt, has written that this anti-market sentiment is a misguided and damaging barrier to sound environmental policy.

But Congress appears to be paying attention to activist complaints. While most senators appear to be in favor of letting financial firms trade allowances, some members of the upper house are considering a measure to prevent Goldman Sachs (GS) and JPMorgan Chase (JPM) from trading or placing tight restrictions on the trading activity.

The concern appears to be that if disinterested groups—that is, those who weren’t originally allocated permits and those who don’t need permits to conduct their business—are allowed to trade, that prices will come unstuck from “fundamental” levels. While in commodity trading there is a limit to which prices can depart from underlying values—ultimately the allowances will need to be sold to an end user at a price that user is willing to pay—we have learned that the prices markets cohere around isn’t always the “right” one. But there are potentially very large costs to excluding disinterested traders from these markets, namely, that there will be too little liquidity for a carbon market to function.

If there aren’t enough traders participating in the carbon market, then orders will go unfilled, prices will be volatile, and bid-ask spreads will be large. Ultimately, the market will fail at delivering allowances to the places they’re most needed, defeating the purpose of the policy. This is why we put up with financial markets in the first place, despite the risks that come along with them; most of the time they do a pretty good job of directing resources to places where they are most efficiently used.

Other senators seem to have different concerns:

“There will be no derivatives, there will be no credit swaps,” said Senator John Kerry, a Massachusetts Democrat, in a July 29 speech at the National Press Club in Washington. “There will be a tighter regulatory control on this so that it will be impossible to play any of those kinds of games.”

Of course, there are many different kinds of derivatives, and some of them are quite mundane—and extraordinarily useful. Remember that firms are making decisions about what kind of investments to make based on the price of an allowance. A power generator, for instance, might conclude that given carbon allowances at a certain price, it makes sense to invest in new green capacity, like a wind farm. But there is a risk that while the firm is in the process of financing and building the wind farm, the price of allowances drops. A recession might hit, or an unusually cool summer or warm winter might diminish power demand.

In a world with derivatives, like options and futures contracts, firms looking to make these kinds of investments can hedge their bets, reducing the risk of taking on major capital projects like that and getting more of them built. This is generally how basic derivatives markets for other commodities work; firms that are going to need oil at some point in the future can hedge against price shifts, a farmer looking to significantly ramp up production of corn can ensure that he won’t be bankrupted by a drop in price, and so on.

So things like this are very disconcerting:

Senator Byron Dorgan, a North Dakota Democrat, said he will oppose creating any carbon-trading market.

“It won’t be very long before we have derivatives, we’ll have swaps, we’ll have synthetic swaps, you name it, we’ll have all of them and it’ll be a field day for speculation,” Dorgan said July 17 on the Senate floor.

This is absurd. Would Mr Dorgan advocate in favour of elimination of current equity and commodities markets based on a fear of synthetic CDOs?

The immediate issue being addressed by these legislators is the carbon market that would accompany a cap-and-trade bill, but similar problems are likely to plague legislative attempts at regulatory reform, as well. It is very worrying that these leaders seem to be unable to distinguish between financial products that have been around for a century or more and complex structured financial products that emerged within the last decade. As necessary as regulatory reform is, I shudder to think what Mr Dorgan might do if turned loose upon a reform bill.