Saturday, August 15, 2009

Limiting and trading carbon emissions

Limiting carbon emissions is a well-intentioned goal and a "cap and trade" proposal has already been included in the bill passed by the House. This is one of those major decisions, as in the proverbial "you can't put the toothpaste back in the tube", and it's unclear how many people really understand the ramifications of such a comprehensive change. I certainly don't, I don't know what percentage of Congress does, and that's a concern. "Cap and trade" seems on the surface to be a simple, maybe elegant, idea, but in execution may or will have a complexity like the ever expanding ripples on a pond after a big rock has been dropped into it.

In the Senate there are concerns that are now being discussed more seriously than in the House, is seriously the right word, and it's right to take a pause before this bill gets pushed through. ENS sees two big issues, really big issues. First, is this cap and trade approach the right answer, and second, if passed, how is a liquid and manageable market created for what in fact will be financial instruments that can inevitably be traded globally.

As to the first issue, cap and trade will by necessity create a government oversight and management bureaucracy overlapping several cabinet departments. Just what we need, as bureaucracy can quickly become institutionalized. This one, with this system involving such a major swath of the economy, would be particularly vulnerable to political pressures and corporate gamesmanship, and worse.

An alternative could simply be a tax system. God knows, it's unusual to recommend more power for the IRS, but the devil we know is already in place. Putting in place a tax protocol that penalizes high emissions over a range of levels and provides R&D tax credits for those at low levels or those who improve materially from high levels is an idea worth considering as an alternative to the cap and trade proposal. A tax system does not set up another bureacracy with new opportunities for influence and power, it provides incentives and penalties that can be measured(can't be managed if it can't be measured), and it avoids introducing a global tradeable security for a domestic program that could have significant economic consequences on industry and the U.S. consumer. To be completely cynical, another positive is that the quasi-government of lobbyists and tax lawyers is already in place so a completely new layer of this group that contributes no broad economic benefit does not spawn.

Today, however, cap and trade is the bill, a leap into the unknown with good intentions. If passed, the most difficult implementation issue is creating a liquid market for these pollution rights. Members of the Senate are right to be concerned about the issue but some of the solutions that have been proposed are nuts. Bloomberg reported yesterday that some Democratic Senators drafting the legislation have proposed barring Goldman Sachs and JP Morgan from the carbon emissions market. Why would this be, because Goldman and Morgan make more money trading than others or because they had the gall to pay back their TARP money. Nine Democratic Senators have apparently targeted Wall Street banks in general saying that they would cause excessive price swings in the market. Good thought, let's just let some hedge funds be market makers. Wake up. Now that the investment banks have bank charters there is more Fed oversight power. Oh man, they know nothing but political PR opps.

Perhaps the most remarkable comment was by Senator John Kerry who in a July 29 speech at the National Press Club in Washington said in regard to a carbon emissions rights trading market that "there will be no derivatives, there will be no credit default swaps. There will be a tighter regulatory control so that is will be impossible to play these kinds of games." No derivatives? A simple 30 day FX forward or interest rate swap is a derivative. There will be no market makers, none, if hedging short term inventory is not possible. It's cap and trade, not cap and hold. Perhaps someone has now explained this to the Senator and an aide already has a one way ticket back to Fitchburg, but unlikely.

Despite their awkward attempts to discuss the issue and their dangerous suggestions, the Senators' concerns about such a trading market are valid. Once the carbon emission rights become financial instruments they can plausibly spike like tulips in Holland in the 1600's or oil in this century. The potential for that kind of volatility would be...? what if the Chinese Central Bank decided to bid up these financial instruments... or Dubai... or SAC... or the Phibro unit of Citi. Maybe it's just efficient market theory and the cap and trade promoters that we should trust, I absolutely do not know, but somehow it feels like these issues have not been fully examined.

Take a break Congress, sneak a smoke Mr. President, a window of opportunity doesn't mean jumping from a high floor.


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