19 April 2011

Carbon Regulation Default Swaps

The FT provides a small window into financial innovation related to carbon trading with an article describing a new financial product that is intended to allow carbon traders to hedge or even speculate against regulatory changes in the carbon market:
Kiln, a unit of Japan’s Tokio Marine that is one of the leading Lloyd’s of London underwriters, and specialist underwriter Parhelion, have jointly created a policy for an unnamed bank to insure its options on future Certified Emissions Reductions. The credits are issued under the Kyoto protocol to projects that cut greenhouse gases.

Underwriters hope the new policy will act as a safety net and encourage traders to remain active and provide liquidity.

The policy was designed for the bank in response to the move by the European Union’s Climate Change Committee to ban trading in credits earned from plants that destroyed two sources of greenhouse gases – HFC-23, a byproduct of refrigerant manufacturing, and adipic acid.

Julian Richardson, chief executive of Parhelion, said that while policy development under the Kyoto Clean Development Mechanism had settled down, EU policy on the Emissions Trading Scheme was a moveable feast and that this policy uncertainty was discouraging investors.

“Because this market exists purely through regulation, banks are faced with a lot of regulatory risk,” he said. “The EU decided only late last year that these two types of project no longer qualified.”
Hmmm ... a new financial product that allows speculators to win and lose according to future governmental decisions in a market that exists only because of regulation.  Does any one else see some problems here?  A "moveable feast" indeed.

5 comments:

Mark B. said...

Anyone interested in the market shenanigans behind climate/energy regulation should go straight to the Master Resource blog:

http://www.masterresource.org/

It is still not understood by most people that Ken Lay's Enron was built on manipulating government regulation of energy markets. No wonder - if the public was informed that Ken Lay was the master of cap and trade rent-capitalism, even committed greens would have to think twice.

Abdul Abulbul Amir said...

The basic problem is that smart and talented people will be engaged in an activity that produces no real wealth.

Jessica Weinkle said...

Most markets exist because of or in association with regulation. Personally, I think that regulation in and of itself stimulates innovation. Humans are very crafty and the constant changes are needed. So the claim by the Parhelion CEO that “Because this market exists purely through regulation, banks are faced with a lot of regulatory risk,” seems silly. The whole thing exists because of predicted probable futures, which therein is the risk. The regulation claim is a slap in the face of governments and those that believe they have a right to participate in decision making regarding their own welfare. The trading scheme was set up, in theory, to meet general welfare ideals.

The involvement of the insurance industry will encourage growth of whatever this industry is- commodities, it seems. I think though, that who ever is issuing the credits (UN?, EU????) is going to end up on the hook in the event that such a business becomes, oh I don't know, 'too big to fail.'

The problem with the use of the market to address the perceived risks associated with, essentially, atmospheric pollution of sorts, is that it encourages a very limited definition of risk such that, only financial risk is considered. Further, such a market/trading scheme is dependent upon the production of particular gases. Without the gases there is no market. Again, there is no money in a cure.

As an aside, this fun...
The Society of Actuaries uses the following to describe actuary science: "Actuarial science is concerned with the development of models which approximate the behaviour of reality and have a degree of predictive power, not the truth."

With this, it seems like everyone is an actuary nowadays.

eric144 said...

If I remember, Taibbi also sees carbon trading as the successor to the sub prime derivative market.



The great American bubble machine

By Matt Taibbi for Rolling Stone Magazine

The new carbon-credit market is a virtual repeat of the commodities-market casino that's been kind to Goldman, except it has one delicious new wrinkle: If the plan goes forward as expected, the rise in prices will be government-mandated. Goldman won't even have to rig the game. It will be rigged in advance.

Here's how it works: If the bill passes; there will be limits for coal plants, utilities, natural-gas distributors and numerous other industries on the amount of carbon emissions (a.k.a. greenhouse gases) they can produce per year. If the companies go over their allotment, they will be able to buy "allocations" or credits from other companies that have managed to produce fewer emissions. President Obama conservatively estimates that about $646 billions worth of carbon credits will be auctioned in the first seven years; one of his top economic aides speculates that the real number might be twice or even three times that amount.


http://www.rollingstone.com/politics/news/the-great-american-bubble-machine-20100405?page=7

Charlie said...

If I were in an industry potentially affected by government regulations related to carbon emissions, I would consider using these options as insurance against a governmental "unnatural disaster" in much the same way I buy insurance for natural disasters such as floods.

The increased uncertainty of the future government regulations is just one more cost of doing business.

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