Cap & Trade’ or ‘Trade, & may Cap’.

What triggered the hottest commodity market as Mark Schapiro chooses to describe it that grew from zilch in 2005 to US$ 150 Billion today? It happens to be the only commodity MARKET that is administered by the United Nations and came into existence under the framework of Kyoto protocol. Funnily, while it works like commodity markets, unlike them it has nothing tangible to deliver at the time of contracting. It deals in IOUs of doubtful value. A friend’s blog invited my attention to this opaque world of ‘carbon trading’ or rather ‘carbon offsets’ trading through a talk hosted on NPR. The ‘Cap’ in ‘Cap & Trade’ refers to the  limits imposed on industries, principally in EU (27 countries), Japan, New Zealand, etc, in terms of Carbon Emissions (Green House Gases – GHG, CO2, CH4 etc.) resulting from their operations. If an industrial unit were to exceed its quota of permitted carbon pollution, then it is obligated to pay to someone who is willing to reduce his pollution to an extent by which payer has exceeded his quota. This ‘promised reduction’ (IOU) by payee in his carbon pollution is called ‘carbon offset’. Trading in carbon offsets does not recognize intra or international boundaries. In other words it recognizes the essential unity of Earth’s climate even though there are pronounced and palpable localized variations in pollution levels.
Markets are held by many as the most efficient allocators of resources and best adjudicators of prices. Markets hold in their thrall decision makers so fully that alternate proposal of a “Carbon Tax” didn’t find favour with politicians though economists prefer it for its simplicity and impartiality. Therefore next step after capping was to start trading in carbon offsets. Before one could do that one had to study, verify and validate the proposals for carbon offsets. UN approved a bunch of companies called Designated Operational Entities (DOE) to certify such proposals before these promises are turned in to carbon offsets. These DOE were to play a role quite similar to Credit Rating Agencies (CRA) like Standard & Poor, Moody, and they did exactly that as one will see later. CRA rates credit risk of a company or financial risk of an instrument. DPE vouches for the potential for pollution reduction a submitted proposal is expected to achieve by certifying its carbon offset. A proposal cannot be traded directly since it doesn’t have liquidity and negotiability that markets demand. It can only be converted at most into a contract between two entities, Polluter & Reducer (promise). But how could it be priced efficiently (?), if it can’t be traded. In come the next bunch of market-makers or market intermediaries, who convert these proposals of carbon offsets into certificates that represent the underlying ‘promised pollution reduction’. Now the loop is complete. These ‘carbon offset certificates’ (or rather ‘carbon offset promissory notes’) can now be traded; that is sold, bought, resold & re-bought and so on. Once this circulatory power is imparted, the next obvious step is bundling to achieve critical mass. Bundling allows creation of sufficiently large lots for meeting the needs of large polluters or of big investors who want to speculate on future movements of the price of carbon offsets. In theory these intermediaries play a crucial role by finding the ‘right price’ at which the ‘disincentive for polluting’ or ‘incentive for reducing’ is ‘properly valued’. The market has ballooned so quickly to become what Schapiro calls the ‘hottest property’ is due to the vigour with which ‘Carbon Desks’ of investment banks from everywhere, including from USA which under Bush withdrew from Kyoto protocol, have crowded London that has emerged as the global capital for carbon trading.
But when mega bucks are involved how will scandals be left behind? First, the whole trading system is based not on actual & verifiable reductions, but on promises to reduce, which is the fundamental flaw. But that has to be accepted in the scheme of things as the money required to implement pollution reduction strategies that will generate carbon offsets has to come up front. This is so, since most such entities are based in developing countries who have the potential to do so but no money, while most polluters who can pay are based in developed countries, and this provides a method of putting money in the hands of those who undertake such commitments and hope that they deliver. Next likely weakness stems from the ability of DOE to correctly validate carbon offsets claims. This is where Schapiro points out that 2 DOE who accounted for more than 50% carbon offsets schemes approved by the UN fell woefully short of the standards they were expected to adhere to and thereby brought the credibility of colossal amount of carbon offsets that were traded in the market into question. Third problem arises with bundling of carbon offset schemes, wherein disparate schemes having varying levels of underlying assumptions, of measurement accuracies, of predictability of outcomes, etc, are sliced, diced and mixed together. These derivatives then become opaque similarly to the Collateralized Debt Obligations (CDO) of the Sub Prime mortgage crisis that froze financial markets in 2008. Trading in derivatives became a lively secondary market for speculators who or anybody else will have no idea what exactly is being traded. Lastly, this liveliness itself can skew the market grotesquely.  
Schapiro mentions an example of a Pig Iron factory that undertakes to plant trees for carbon sequestration, a method of reducing carbon pollution by binding carbon. When the trees mature it plans to cut these trees to convert them into charcoal. Then it proposes to use that charcoal as source of energy in the factory in place of fossil fuels it used earlier. This would undoubtedly reduce fossil fuel consumption, but how would it reduce carbon pollution is not clear. Whatever carbon is sequestered over the life cycle of the trees would be released back in atmosphere as ‘CO’ when trees are converted to charcoal and as CO2 when charcoal is further used as fuel. It will be a zero sum game as far as carbon offsets are concerned. How does it qualify as a carbon offset project begs an answer?

Terry Gross interviews Schapiro on NPR. Listen to this engaging talk here or read the transcript of the interview here.

Schapiro travels to Brazil to see how the REDD program works in practice. See the video here.
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2 Responses to “Cap & Trade’ or ‘Trade, & may Cap’.”

  1. Suvrat Kher Says:

    glad you took up the thread..Suvrat

  2. Shravan Modak Says:

    A point here, which I had never imagined earlier.

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