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Carbon trading a tug of war Add to ...

Wall Street sees carbon trading and related derivative products as the next big thing in financial innovation. Critics say it's the next big financial mess.

Carbon trading provides a way for companies to stimulate green energy and carbon reduction projects by financing them through the purchase of carbon credits.

Such trading has slowed over the past year or so amid uncertainty about regulations and global emissions targets. Eventually, though, many expect carbon trading to balloon into a multitrillion-dollar business.

But some environmentalists and Democratic legislators don't want banks' financial engineering behind the business of combatting global warming.

Allowing derivative traders access to carbon trading risks

sowing the seeds of the next financial cataclysm and might hinder attempts to curb greenhouse gas emissions, they argue.

"From the financial crisis, we know that Wall Street is innovative. The other lesson we learned is that our regulations, no matter how well we try to write them, just can't keep up," said Michelle Chan of the Green Investments Project at Friends of the Earth.

FOE and other environmental groups have been pressing the Senate to pass legislation that puts strict limits on banks' involvement in the carbon-trading business. Meanwhile, the banking industry - the same bankers that President Barack Obama chided this week for lobbying instead of lending - has hired more than 100 lobbyists to work almost exclusively on ensuring their role as central players in the carbon market.

So far, the banks have been losing. Legislation adopted by House of Representatives in June prohibits derivatives based on emissions credits from trading outside formal exchanges, such as the Chicago Climate Exchange.

Such "over-the-counter" derivatives are harder to track and parties to a transaction do not have to post collateral with a clearinghouse to back up their trades. That makes it difficult to assess the level of risk in the overall market - one of the reasons OTC derivatives such as credit default swaps have been fingered for causing the 2008 financial meltdown..

The banking industry had hoped to avoid a prohibition on OTC carbon derivatives in a Senate version of the climate change bill; had it been successful, the House might have been forced to drop its interdiction when the bills from both chambers are merged into one.

Instead, two senators - a Democrat and a Republican - introduced legislation last Friday that would prohibit the emergence of a secondary market in carbon trading and limit participation in the buying and selling of greenhouse gas credits to a few thousand fossil fuel producers and importers.

According to a summary of the bill by Democrat Maria Cantwell of Washington, and Republican Susan Collins of Maine, "no Wall Street traders or speculators [could]manipulate prices or supply" because only firms directly engaged in fossil fuels could bid on credits. That would kill any prospect for all carbon-related derivatives, even those traded on exchanges.

"Requiring all financial transactions to be undertaken on exchanges would render the U.S. carbon market extremely inefficient - which from a financial perspective is defeating the whole purpose of setting up a carbon market in the first place," said Abyd Karmali, global head of carbon markets at Merrill Lynch.

In a telephone interview from Copenhagen, where he is attending the UN climate change summit, Mr. Karmali said financial institutions have a critical role to play in helping companies meet their emissions reduction targets, for example by selling futures contracts that enable firms to lock in the price of carbon months or years in advance.

"Companies generally prefer to do their long-duration hedging on an over-the-counter basis where they get much better pricing," said Mr. Karmali, who is also president of the Carbon Markets and Investors Association.

The Cantwell-Collins bill proposes to auction carbon permits among emitters, with 75 per cent of the proceeds to be returned to taxpayers in the form of a monthly cheque and most of the rest invested in research in green technology.

A Senate bill in the works by Democrat John Kerry, Republican Lindsey Graham and Independent Joe Lieberman would make cap and trade the central mechanism employed to achieve targeted reductions in planet-warming emissions. So far, the trio has been silent on who could participate in an emissions-trading scheme.

Under a pure cap-and-trade model, permits to emit carbon are auctioned and firms that surpass their emissions limit must either slash their output of carbon dioxide or buy additional permits on the open market. Under the House bill, however, all but 15 per cent of initial permits would be handed out for free to large U.S. emitters of greenhouse gases.

Banks are also eyeing the carbon offset business, under which projects that take CO{-2} out of the atmosphere - for example, tree planting in the developing world - are bundled together to create securities sold to investors. Such instruments would be based on the same principle as mortgage-backed securities - but they would be more transparent, Mr. Karmali insisted.

"Every offset is documented in the public domain on the UN website. I don't think there is any other market as transparent as that."

 

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