Good COP, Bad COP

Designing a trading market
by -- December 16th, 2009

What is the end goal of a carbon market? How should a carbon trading market work?

Duke University, the German Marshall Fund, the International Emissions Trading Associatio have hosted panels and discussion on designing carbon markets in the last couple of days. These panels have brought together a number of viewpoints, ranging from government policy staffers to independent researchers and experts to participants in the EU emissions trading market.

One starting point is to ask whether carbon markets are different than other commodities markets. They are novel, large, being created from scratch, and designed to meet the goal of reducing emissions. On the other hand, it’s just trading and financing, and there’s lots of people doing that work on Wall Street (and in the City). However, this conversation is happening against the backdrop of recent financial and economic collapse, and preventing a repeat is very much on lawmakers minds.

There are two major goals of a carbon market. The first is efficiently allocating carbon permits (ie, permission to pollute) in the near-term. The second is providing information about the value of permits to financial firms and smoothing the flow of capital to abatement projects. This is crucial to developing low-carbon infrastructure for the long term.

The biggest questions are whether permits will be traded on exchanges or over the counter, and what sort of derivatives will be permitted. Banks are hesitant to provide loans for wind power, solar electricity, offsets development, and other capital-intensive projects if the future carbon prices are risky. So, the developer can hedge against carbon price changes with carbon permit futures and other derivatives. Doing this on exchanges ensures transparency and minimizes counterparty risk, but requires substantial liquidity. That’s probably feasible in spot markets, but may not be for long-term hedging – some of these need to be hedged for 10-20 years!

In summary, environmental school students are now working on all sort of things, including high finance. Whodathunkit?

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