Note to Krugman: Carbon Markets Are a Different Beast

Note to Krugman: Carbon Markets Are a Different Beast

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Michelle ChanBy Michelle Chan, Friends of the Earth

In a recent blog post, Paul Krugman blithely dismisses concerns relating to carbon trading. The Nobel Prize-winning Krugman is one of the sharpest economists out there, and he’s often called attention to market failures, so his opinion is worth considering. Unfortunately, on this issue he underestimates the potential problems carbon markets can cause — and fails to note that better alternatives exist. Krugman’s case is based on downplaying the potential for speculation in carbon markets, which he compares to speculation in wheat markets:

“Should fear of speculation lead us to ban trading in wheat? Nobody would say that. Yes, sometimes speculators will get it wrong — but the advantages of having a wheat market vastly overshadow the possible harm that may sometimes come from speculation. Now substitute “emission permits” for wheat. It’s exactly the same story. … But wait — don’t we have examples of energy markets being manipulated by speculators? Yes — but the proposed cap-and-trade system would NOT reproduce the conditions of those markets.”

Krugman says we must “keep a watchful eye on speculators and regulate derivatives — and make market manipulation illegal,” and he claims the Waxman-Markey bill accomplishes these aims. “But,” he cautions, “don’t apply standards to emissions trading that you don’t apply to any other market.”

There are, however, substantial flaws in Krugman’s argument. After the spectacular governance failures which led to the financial crisis, it’s difficult to believe that, in the absence of serious campaign finance reform and an end to the revolving door between government and Wall Street, we will end up with derivatives regulations that are free of loopholes, dynamic enough to keep pace, and immune to regulatory erosion. (John Kenneth Galbraith, in The Great Crash of 1929 noted, “[R]egulatory bodies, like the people who compromise them, have a marked life cycle. In youth they are vigorous, aggressive, evangelistic and even intolerant. Later they mellow, and in old age — after a matter of ten or fifteen years — they become, with some exceptions, either an arm of the industry they are regulating or senile.”) We haven’t yet finished the task of reforming derivatives rules, but the Waxman-Markey climate bill would create the largest derivatives market in the world and foist it upon an untested regulatory regime.


Subprime Carbon?
Re-thinking the World’s Largest New Derivatives Market

This March 2009 report finds that existing financial regulations, as well as those in major cap-and-trade bills, are inadequate to govern carbon trading, creating a potentially huge regulatory gap.

Read the report

It’s totally expected that Wall Street firms would downplay the risks of market manipulation and excessive speculation (after all, one carbon trader reportedly said that several big banks are set to make up to $1 billion per year in trading fees) but it’s irresponsible for the likes of Joe Romm and Krugman to do so.

Aren’t they even a little worried that Wall Street traders are seeing the carbon markets that the Waxman-Markey bill would create as a huge playground and saying they “can see nirvana coming”?

Instead, Krugman seems to be viewing carbon in the most optimistic light possible: he predicts that we won’t see an Enron-type debacle in carbon because markets will be large and demand for emissions permits will be responsive to prices. He sides with those who do not believe speculators played much of a role in the 2008 commodity price spikes (a hotly debated topic, which even Krugman concedes “is not out of the question”), dismissing concerns about excessive speculation as well.

But carbon is not going to be like any other commodity; the supply of allowances and credits is designed to contract, making market surveillance activities (e.g. monitoring whether prices are being artificially manipulated) more difficult. And unlike other consumable commodities, carbon allowances have one single producer with no marginal cost of production, and can be banked indefinitely with no costs. Since carbon will be dominated by financial speculators (it is already being marketed as a “new asset class” to investors), how does one determine whether the price of carbon is tethered to “market fundamentals”?

Far from assuming that carbon markets are going to behave just like any other type of commodity, we instead should figure out those aspects of carbon which are unique and ensure that adequate market regulations and monitoring programs are in place. For example, the Waxman-Markey bill includes a mechanism which would flood the market with more carbon (from offsets and borrowed allowances) if it a particular trigger price is reached. Such price triggers generally do not exist in other commodities markets, creating the need for additional oversight of market manipulation. In addition, the strategic reserve could create other temptations: since carbon traders often own offset companies, they may rally to push carbon prices to the trigger price, to enrich their offset businesses.

Smaller, Simpler and Easier to Regulate

The appropriate response is to design carbon markets to be smaller, simpler, and easier to regulate in the first place. We are creating carbon markets from scratch, so why should we purposely design them to mimic other commodities markets, which tend to be volatile, vulnerable to excessive speculation, and difficult to regulate?

This doesn’t mean, as Krugman suggests, that the only alternative to the markets created by the Waxman-Markey bill is a command-and-control approach to reducing emissions. Instead, for example, we could take a “managed price approach” to carbon trading, like Congressman Lloyd Doggett proposed in March 2009. His bill would set a hard emissions cap in 2020, and create an independent board to publish a smooth price path for allowance auctions from 2012 to 2020. The government would hold quarterly auctions and manage the supply of allowances to hit, on average, the published annual price. As necessary, the board would adjust and re-publish the price path so that we meet the 2020 emissions cap. Secondary trading would be freely permitted, but predictable carbon prices would take away much of the incentive for pure financial speculators to get into the game.

Under this system, regulated entities could confidently plan for significant capital investments, and still have the flexibility to make investments when doing so is cheaper. Market regulators would be faced with a much more manageable job, since predictable carbon prices would largely obviate the need for a massive derivatives market. Such an approach would deliver the environmental certainty of a carbon cap, and the economic efficiency of a carbon tax. But predictably the bill hasn’t received much traction because it wouldn’t create large trading volumes and lucrative fees for Wall Street (which makes it objectionable to the 130 Wall Street lobbyists working full time on climate change), nor does it give away hundreds of billions of dollars worth of allowances to polluters.

Krugman argues that we should go ahead with an extremely complex carbon trading program (with its trigger prices, strategic reserve, offsets, banking, borrowing, allowance giveaways, derivatives markets, etc., Waxman-Market’s carbon trading system is unrecognizable from your textbook emissions trading system), and accept that sometimes “trading will go bad” because the planet is at stake. We would argue just the opposite: it’s precisely because our planet is at stake, that we have to get it right.