Could cap-and-trade create another economic bubble?

The American Clean Energy and Security Act, which squeaked through the House of Representatives by a vote of 219-212 last month and is set to be taken up by the Senate in September, proposes to create a huge new market for trading carbon emission permits and offsets. This system would create whole new classes of financial assets, which financial firms could securitize, derivatize, and speculate on.

Sound familiar? Many critics are pointing out that this new market for carbon derivatives could, without effective oversight, usher in another Wall Street free-for-all just like the one that precipitated the implosion of the global economy.

Writing in Mother Jones magazine, reporter Rachel Morris explains that this new market -- which is expected to become the world's largest derivatives market -- would be based on two instruments: carbon allowances, that is, permits granted by the government to companies, allowing them to emit greenhouses gases; and carbon offsets, which allow companies to emit in excess of their allowance, provided that they invest in a project that reduces emissions somewhere else, such as a reforestation initiative in the Amazon.

Additionally, carbon emitters and financial services firms would be allowed to trade in carbon derivatives -- think "offset futures" or "allowance swaps" -- creating a market that Ms. Morris calls "vast, complicated, and dauntingly difficult to monitor."

And prone to melting down, Ms. Morris warns. Just as the inability of homeowners to make good on their subprime mortgages ended up pulling the rug out from under the credit market, carbon offsets that are based on shaky greenhouse-gas mitigation projects could cause the carbon market to tank, with implications for the broader economy.

As a Friends of the Earth report titled "Subprime Carbon" notes, a lot things can go wrong with a carbon offset project. In addition to the usual risks faced by any project, independent verifiers could determine that a project isn't cutting the amount of carbon it claimed to cut. This is particularly worrisome because the system would allow sellers to promise to deliver carbon credits before the emissions reductions have been verified. The report warns:

A carbon bubble can also set the stage for the kinds of financial innovation (e.g. complex securitized products) that can unwittingly spread sub-prime carbon through the broader marketplace. When the bubble bursts, the collapse in carbon prices can have destabilizing consequences for compliance buyers (companies) and for the larger financial system.

Despite these risks (or perhaps because of them), a carbon derivatives market has the potential to generate huge profits. The US Commodity Futures Trading Commission estimates that the cap-and-trade market could grow to $2 trillion in five years.

A market this size means that Wall Street has a major stake in the cap-and-trade policy that emerges from Congress. The Center for Public Integrity noted in February that banks have been sending climate change lobbyists to Washington in earnest:

Wall Street banks like Goldman Sachs and JP Morgan Chase, insurance companies like AIG and private equity firms had virtually no reps on Capitol Hill working on global warming policy in 2003; by last year, they had about 130 climate lobbyists, the Center for Public Integrity’s analysis of Senate lobbying disclosure forms shows. About 20 additional lobbyists worked for firms and organizations wholly dedicated to carbon marketing last year.

Writing in AlterNet, Teryn Norris, a Project Director at the Breakthrough Institute warns that this climate "super-lobby" could act to derail any meaningful emissions cuts. Mr. Norris writes:

The policy demands of these financial firms may vary, but most will push for weaker regulatory standards on carbon markets, larger volumes of carbon offset authorization, and provisions to increase the volatility of carbon prices, all of which would hinder progress on reducing U.S. emissions.

In particular, Norris warns that financial firms will call for emissions permits to be traded "over the counter," that is, without a third party monitoring the risk. Over-the-counter trades came under attention last year when one type of this trade, the credit default swap, helped sink Lehman Bros. and Bear Stearns.

Despite these potential pitfalls, many environmentalists are optimistic about the ability of a cap-and-trade system to curb greenhouse gas emissions. After all, it's worked once before. As the Environmental Defense Fund points out, such a program was hugely successful in limiting emissions of sulfur dioxide in the 1990s, at a cost far less than originally projected. As EDF argues, "Markets provide greater environmental effectiveness than command-and-control regulation because they turn pollution reductions into marketable assets. In doing so, this system creates tangible financial rewards for environmental performance."

But limiting sulfur dioxide, which is emitted only in large quantities by power plants, is a far more straightforward task than limiting carbon dioxide, which is emitted by just about everything. As we watch the Senate take up the climate bill in September, we would do well to ask ourselves if we are building another market that is too complex for anyone to understand.

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