‘Subprime carbon’: Risk or hype?
The bill’s backbone is a poorly regulated carbon trading scheme that entrusts the Wall Street bankers who brought us the current economic crisis with the responsibility to solve global warming.
Of course, this isn’t true. It’s not even sort of true. It’s just an attempt to torpedo a bill by sowing confusion about an important and sensitive issue. (There are some legitimate critiques of the bill — and Friends of the Earth (FoE) makes some of them — but this one is a red herring.) You can rest assured that if CEJ passes, it will not be administered by Bernie Madoff.
At heart, the argument is not about CEJ, and it’s not really even about cap-and-trade. It’s about a basic mistrust of market economics. And it has very high stakes: it’s rhetoric that could sabotage a real chance of putting a legal limit on greenhouse gas emissions.
This kind of critique isn’t a first for FoE. In fact, in March 2009, it authored a surprisingly influential and widely cited critique of carbon trading: a 13-page policy paper called “Subprime Carbon: Rethinking the World’s Largest New Derivatives Market” (summary here). The paper does make a few sound points along the way, but it substantially over-reaches in its conclusions. What’s worse, however, is that the paper is dressed up to appear to be a critique of cap-and-trade, but in fact the substance of the attack really applies only to offset programs — and then only in a debatable and hypothetical way.
In a nutshell, the argument spins out a doomsday scenario in which bad offsets replay the housing bubble, muck up the financial sector, and destroy the global economy. More specifically, the argument goes like this: FoE worries that financial firms would intermediate in providing carbon offsets by purchasing offsets and offset derivatives (especially futures), some of which could be of questionable value. Firms might then repackage and securitize the offset products, much as happened with mortgage-backed securities, selling them to various kinds of investors and ultimately, perhaps, to the firms regulated under the carbon cap. If it turns out that large numbers of offset projects go bad (meaning that they cannot be certified as legitimate offsets because they do not sufficiently reduce carbon), then the offset-backed securities could be worth less than they were believed to be. And if the carbon derivatives market is sufficiently gigantic (as FoE believes it will be), the reduction in value of carbon derivatives might lead to a worldwide financial collapse mimicking the recent asset bubble collapse in 2008.
As you can see, there are several strands of arguments and it takes a moment to untangle them. Let’s dig in.
Offsets — and problems with offsets — are not unique to cap-and-trade
Before we wade in, let’s get something straight: offsets are not unique to cap-and-trade programs. A carbon tax program — a real one, I mean, that has a legitimate chance of passing Congress — would almost certainly include offsets, allowing polluting firms to purchase offsets rather than pay the tax. Similarly, straight-up regulatory policies can also include offsets, just as voluntary carbon-reduction schemes do now, by allowing polluters to acquire offsets instead of reducing emissions. In other words, risky offsets are not just a problem for cap-and-trade but for any carbon-reduction policy. And because offsets are not unique to cap-and-trade, it follows that the arguments in “Subprime Carbon” — the risk of bad offsets screwing up the financial sector — is a worry for any realistic carbon policy. Simply put: the concern about so-called “subprime carbon” is no grounds for objecting to cap-and-trade per se.
But of course, FoE isn’t objecting to a generic version of cap-and-trade, but to a specific bill, the CEJ, which does allow a large number of offsets. So maybe the first thing we need to figure out is whether the program’s offsets are likely to go bad.
Will offsets go off?
I’m not about to wade into the whole hairy debate about offsets here, except to say that I think FoE is rightly skeptical about the integrity of offset projects, at least as they’ve been conceived so far. Poor quality offsets are, in my judgment, the number one risk to the environmental integrity of U.S. climate policy. And I worry that because the major cap-and-trade bills allow large numbers of offsets, they could create demand-side pressure for offset providers to produce a lot of offsets, which could in turn reduce the quality of the offsets in circulation.
But let’s be clear, this is a worry about the environmental integrity of the program, not about its potential to single-handedly destroy the world economy.
(Quickly, however, there are some practical solutions to the offset problem. CEJ, for example, goes a long way toward restricting them, devoting literally hundreds of pages to offset provisions and oversight. Regardless, any offset-allowing legislation will require ongoing regulatory vigilance by both government agencies and independent auditors. And since there will always be some degree of uncertainty inherent in offsets, it’s smart to “discount” them — stipulating that, say, five offset credits are equal to four carbon credits — which is exactly what CEJ proposes to protect the program’s environmental integrity.)
Bad offsets — even if they do happen, which is debatable — would not, of course, necessarily lead to financial catastrophe. So what’s the risk? This is where FoE’s arguments start getting slippery.
Might bad offsets threaten the economy?
FoE postulates that the sheer size of a market in carbon and derivatives will be so huge as to pose an existential threat to the global economy. Then, the argument goes, large-scale market manipulation by bad actors could have severe consequences.
You could argue about the scale of the markets created by carbon policy. (I think FoE is blowing it way out of proportion, but what do I know?) Nonetheless, offsets — and potential offset derivatives and other carbon market products — are going to need regulation, plain and simple. It’s just like with housing. The correct policy response to the housing bubble is not to simply outlaw mortgages, or even the trading in derivatives based on mortgages, but to provide regulations that improve transparency and protect the public interest. The same pragmatic regulatory approach should go for carbon.
Fortunately, FoE isn’t the only one to notice this. The major cap-and-trade bills advanced in Congress actually do include stringent market oversight provisions. (In a later post for this series, I’ll go into more detail about the provisions in CEJ.) One good regulatory approach is the Carbon Market Oversight Act, which will reportedly get rolled into CEJ. Another solution, which FoE notes, is the Derivatives Market Transparency and Accountability Act, which passed the House agricultural committee and would require carbon to be regulated as an ordinary commodity — a potentially smart idea and one that is supported by the chair of the Commodity Futures Trading Commission.
Just as the financial markets need regulation, so will any carbon or carbon-derivatives market. Everyone agrees about this. It’s simply not a controversial subject. That’s why important regulation is included — and more is soon to be added — to the Clean Energy Jobs Act. Toward that end, FoE may make a positive contribution. They have recently promoted some constructive ideas in a joint letter with industrial polluters and in a follow-up paper on carbon market regulation.
Climate policy in a market economy
I don’t want to minimize concerns about market manipulation. There’s no way to be certain that we won’t see another harmful bubble in western capital markets. (To the contrary, history strongly suggests that bubbles are an engrained feature; see The Devil Take the Hindmost by Edward Chancellor for a good survey.) Yet there are few who would seriously consider banning trading in stocks, bonds, or the numerous derivatives products that populate the financial landscape because we generally believe that the advantages of markets outweigh their risks. It’s the same for commodities: there’s no movement afoot to ban trading in oil or pork bellies — and rightly so. Fundamentally, carbon need not be any different. There is good reason to believe that regulation and careful oversight can substantially reduce, even if never entirely eliminate, the risk of sinister financial activity.
And that’s just the point. These concerns aren’t really about cap-and-trade. They’re not even really about the Clean Energy Jobs Act. They’re about finance and markets and capitalism. It’s worrisome stuff, no doubt, but it’s hard to see why this albatross should be hung around the neck of a serious carbon bill with a serious chance of becoming law. As Paul Krugman has argued, hysteria about carbon speculation is “not a case of the perfect being the enemy of the good, it’s a case of the perfect being an enemy of the planet.”
This post originally appeared at Sightline’s Daily Score blog.