Banking on carbon

In November 2010, over 250 investors representing US$15trillion funds under management globally called for “policies to unlock the vast potential of low-carbon markets and avoid economic devastation caused by climate change”. Prominent among these are targets for reducing greenhouse emissions and “strong and sustained price signals on carbon emissions”. This, and similar calls, have been misinterpreted in some circles as the bankers just wanting to find another “venue for billions of dollars worth of speculation” in the carbon market. This concept needs to be examined with further scrutiny.

First note that there are three ways of implementing a carbon price, and only one of them involves any speculation. A carbon price can take the form of a carbon tax, a fixed price permit system (as being proposed for Australia in the first 3 or so years) or a floating price permit system, otherwise known as an emissions trading scheme (ETS) or cap-and-trade. Only the third of these avenues for carbon pricing offer any possibility of speculation and trading. If the price is fixed, as it is in the first two avenues, there is no speculation, no movement, no volatility, no risk management products and so on. In short, if the price is fixed, there’s no role for the financial markets and it’s very difficult for the banks to get involved, let alone to make any profits.

It should also be pointed out that a carbon permit is not a financial derivative. A carbon permit is an underlying commodity, and is treated in financial markets very much in the same way as a barrel of oil, an ounce of gold, a megawatt hour of power, or even a currency rate or interest rate. A carbon permit confers on its owner the ability to emit one tonne of carbon dioxide equivalent (CO2e). Yes, it is a construction of government, in that it only has value by act of a government controlling either its price (eg carbon tax or fixed price permit system) or by constraining its supply (cap-and-trade). But this is similar in concept to government auctioning off spectrum for access to radio frequency. It’s not something to be compared with some of the infamous products associated with the GFC such as collateralised debt obligations and credit default swaps.

Participants in a market always innovate to create new instruments where such instruments become popular mechanisms for transferring risk. It is expected that on the back of a floating price system for carbon permits, there will be a raft of products available, starting perhaps first with futures but also including swaps, forwards, options (eg floors and caps). This will be analogous to the development of financial products on the back of other commodities. The demand for such instruments is usually generated by a need for the market participants (typically those that are exposed to the carbon price such as electricity generators and some large industry) to transfer risk; and if there’s no need for these instruments then they suffer low liquidity, large bid-offer spreads, and ultimately do not trade.

For those interested, the ASX has been developing a set of futures contracts for trading anticipated carbon permits in Australia, known as Australian Emission Units, or AEUs. These plans were put on hold with the demise of the CPRS under the previous parliament, and will most likely stay on hold until a floating price regime becomes again in prospect.

However, in Europe, the market under the floating price EU ETS remains actively traded and a forward market is observable In a future blog, your correspondent will look at the much discussed volatility of this market.

A trader’s role is to make money. Prices go up and prices come down, and if you can get on the right side of the movement you’ll earn a profit. But, in doing so, traders assist an economic instrument to find its appropriate level, normally at the intersection of supply and demand. This provides transparency and efficiency. In the case of a carbon permit, the clearing price is the marginal cost of abatement, ie where the supply of abatement meets the demand set by government.  This can alternatively be viewed as a demand for permits met by a limited supply of permits from the government. Once there is a liquid forward curve established, decision-making in the economy can be on the basis of some price guidance. We don’t seem to have a problem when it comes to trading spot physical or derivatives on other instruments (bonds, equities, currencies, interest rates, metals, oil, electricity, gas, soft commodities), but for some reason some appear to be up in arms allowing traders to make money out of trading carbon permits or associated derivatives.

The notion that we are leaving the task of abatement to the same people that gave us the GFC is a furphy. When we talk about a reliance on the “market” to deliver abatement, we are not talking about the financial engineers that brought us CDOs and CDSs. The “market” in this case refers to all actors in the economy, which almost every minute are facing decisions that may have an impact on our emissions profile, and where the decisions may be made differently if there is a carbon price in place. Many companies have already developed internal “abatement curves”, identifying which internal projects can reduce emissions and at what price of carbon they become economic.

So if investors aren’t so fussed about whether they can trade carbon or not, then why are they calling for a carbon price? At least in the Australian context, it is mainly about certainty. Not certainty about what the price will be necessarily, but just certainty about whether there will be a carbon pricing framework or not. In the power generation sector for example, baseload capacity addition is problematic at the moment because while coal-fired power struggles to attract finance given the impact on profitability from the imposition of a carbon price, gas combined cycle (with around third to a half the emissions) is less viable in absence of a carbon price. This freeze in capital commitment leads to inefficient decision-making in the economy.

The value in a transparent and liquid price of carbon (including the forward curve) is so that each decision in the economy can incorporate the carbon price. High emission intensity activities will be made less viable than they would be in a situation where there is no cost to emit greenhouse gases. Low emission-intensive activities and abatement activities will be made more profitable as a result. A carbon price therefore redirects the flow of capital in the economy, and it is this driver that investors are calling for.

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  1. Thank you CEC. I sought of new that but it adds clarification on the different mechs.

    Can you hypothesise scenarios in your next installment (before the foaming spittle flying crazies turn up here)?

    Carbon and property are very emotive amongst the great unwashed. I, personally, with a science degree am a fence sitter and believe better to be safe than sorry and if so hedge.

    I hedge against the banks in case my house price halves. No biggie throwing 2K ayear in Option shorts ‘just in case’ like House insurance.

    Don’t know what the big deal is.

  2. Came across to this blog from having followed the blogs of Delusional Economics,
    Houses and Holes, and Unconventional Economist, all of whom identified themselves. I think that when you write a lead article, a price you pay for the privelige is loss of anonimity.
    This writer is clearly involved deeply in the carbon pricing business, a topic which rightly concerns many of us.

    So who are you.

      • Oh my, Julian is a venture capitalist in green technologies and a lecturer in energy trading systems. You’d be hard-pressed to find a more vested interest. Talk about rent seeking!

        • Now, now Steven, “A trader’s role is to make money”, all carbon coyote wants to do is make some money.

          If he can persuade the government to guarantee him a return then I guess that just makes him smarter than you or me.

  3. The average punter does not want environmental pollution, but there is a big leap of faith from carbon tax to ‘clean technologies’.
    The average punter is not stupid – equating a financial trading system with stopping the ‘climate change’ remains an elusive utopia.

  4. Sam Birmingham

    Disclosure: I regard myself a “climate pragmatist” and have limited understanding of the science, despite having read reasonably broadly.

    I think it is important that we give CEC a chance to develop arguments before trying to shoot him down.

    At the end of the day, we all have a vested interest in what we write/say/do. And let’s not forget that bloggers are not paid to write – they do it because they are passionate about a topic.

    The reason this blog is so good is that it harnesses the passions of a number of interesting people who have very good “domain knowledge”, to provide their dear readers with a sense of perspective that we might not otherwise get from the mainstream media… And it doesn’t cost us a cent!

    Let’s leave it to the property spruiker brigade to play the man and not the ball.

  5. SS,

    Do you propose that we put a carbon ignoramous in charge of specialist carbon blogging?

    This is a specialist subject. We need experts to argue the case. CC is making an argument that you can accept or reject, not unduly influencing policy so that outcomes favour him or his firm.

    His position is transparent.

    That is the difference between debate and vested interests.

    Do you a have vested interest in preventing your power bill from rising?

    • Coyote’s position does not appear to question the very premise of carbon taxing.

      That sets him well apart from several of your bloggers who have no vested interest and are concerned with the question of premise.

      I think you’ve made a mistake by putting people like this side by side in your blog, as it get’s right up the nose of the kind of people who are thoroughly disenfranchised with spin, bias and deception.

      Quite a few of us followed Delusional Economics and Leith here, in this new endeavour.

      What are you doing putting industrialists here? I suppose that fits with “macrobusiness”.

      I guess I can always ignore Coyote and generally I will

  6. Setting up a carbon price framework can’t deliver certainty because the perception is increasing that the scientific justification is shaky. If global temperature starts to rise again, carbon will be a good bet, if it doesn’t then you’ve done your dough.

    Looks just like any other speculation, except that if it turns out a loser, the reputation of science is trashed – a major setback for the basis of our civilisation.

    Place your bets ladies and gentlemen, the wheel is spinning.