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.