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. http://www.asx.com.au/documents/products/carbon_trading_clean_energy_and_the_cost_of_inaction.pdf
However, in Europe, the market under the floating price EU ETS remains actively traded and a forward market is observable www.ecx.eu. 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.