Good COP, Bad COP

The Need for Clearing in a Carbon Market
by -- December 17th, 2009

The exponential proliferation of over-the-counter (OTC) derivative instruments is often cited as a major cause of the recent financial crisis. Many have called for ‘clearing’ in markets, especially in the carbon market, to ensure that transactions do not overexpose counterparties to excessive risk. Although clearing makes sense in most situations, requiring it in pre-certified offset projects may stifle that market, and the availability of a major cost-containment mechanism, slowing emission reductions.

Today, for all intents and purposes, NGOs were eliminated from the discussions at the Bella Center. While this was disappointing and seems inconsistent with the spirit of open discussions, Duke University had one last opportunity to represent civil society. In an official side event, co-sponsored by the German Marshall Fund, Tim Profeta of the Nicholas Institute sat on a panel entitled “Designing a Transparent and Credible Global Carbon Market”.

The piece of pending legislation that explicitly addresses carbon market structure and transparency in the United States in the Feinstein-Snowe Bill. Feinstein-Snowe calls for a gold-standard of transparency (both to the regulator and the public), and if passed as is, would effectively remove the possibility of over-the counter (OTC) transactions in the carbon market. Given the economic trauma of the last year, and resulting backlash against Wall Street, calls for limiting any sort of transaction that results in what is perceived as excessive profiteering or public deception (particularly in a carbon market that is meant to provide a public good) is understandable. In this case, outright banning of OTC seems, at least initially to be a step in the right direction. However, overregulation can be just as damaging as underregulation.

At the Nicholas Institute sponsored side event this morning, this concept was highlighted in a conversation between two of the panelists, a representative of Senator Snowe’s office (who helped to write the Feinstein-Snowe Bill) and a representative of Noble Carbon (a carbon offset developer/trader). Carbon offsets are one of the primary cost containment measures in sweeping climate change legislation. While there can be up to 2B offset credits used for compliance purposes in versions of the bills in both houses of Congress (Waxman-Markey and Kerry-Boxer), every report thus far has projected that far fewer offset credits will actually be available in the market in a given year. This constrained supply is the result of many factors. The representative of Nobel Carbon pointed out that banning all OTC transactions involving any carbon contracts (as Feinstein-Snowe is currently interpreted) could be a major choke point in the supply of offset credits. The representative of Nobel Carbon pointed out that the development of offset markets will require financing from the private sector, but that by requiring all contracts to clear it will eliminate some project types (that the clearinghouse does not agree to clear because they cannot quantify their risk) and for those that a clearinghouse would clear, the numbers of projects actually financed will be constricted by the need for clearing. The biggest risk with offset projects is that they will not be certified, prior to which they must be completed, and before that financed. If contracts to complete projects will have to be cleared (which ties up funds) prior to the project being implemented, they simply will be too expensive to complete, let alone initiate. Therefore, he suggested that projects must be cleared once they are certified and become fungible with other offset credits, but that to make a blanket statement that no contracts involving carbon can be handled OTC (which does not require the retention of additional capital for clearing) will stifle the market.

And if offsets are meant to lower the costs of compliance, significantly lowering their potential availability could raise the cost of a cap-and-trade program, increasing the political risk for policymakers (who fear being blamed for a new, expensive tax), and lowering the likelihood of passing a national climate bill. We need to regulate intelligently. We don’t need to regulate everything.

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