Cap & Trade - New Derivatives Market for Wall Street

See what happens when an issue is cast as environmental instead of financial. That appears to be the case with cap and trade.

What is Cap & Trade?

The cap: Each large-scale emitter, or company, will have a limit on the amount of greenhouse gas that it can emit. The firm must have an “emissions permit” for every ton of carbon dioxide it releases into the atmosphere. These permits set an enforceable limit, or cap, on the amount of greenhouse gas pollution that the company is allowed to emit. Over time, the limits become stricter, allowing less and less pollution, until the ultimate reduction goal is met. This is similar to the cap and trade program enacted by the Clean Air Act of 1990, which reduced the sulfur emissions that cause acid rain, and it met the goals at a much lower cost than industry or government predicted.

The trade: It will be relatively cheaper or easier for some companies to reduce their emissions below their required limit than others. These more efficient companies, who emit less than their allowance, can sell their extra permits to companies that are not able to make reductions as easily. This creates a system that guarantees a set level of overall reductions, while rewarding the most efficient companies and ensuring that the cap can be met at the lowest possible cost to the economy.

The profits: If the federal government auctions the emissions permits to the companies required to reduce their emissions, it would create a large and dependable revenue stream. These financial resources could be used to achieve critical public policy objectives related to climate change mitigation and economic development. The federal government can also choose to “grandfather” allowances to the polluting firms by handing them out free based on historic or projected emissions. This would give the most benefits to those companies with higher baseline emissions that have historically done the least to reduce their pollution.

What is in the bill that just passed the house?

The bill is even presented as different titles. One is Waxman-Markey cap-and-trade carbon emissions control act. But the official bill, so you can actually find the legislation and read it for yourself is American Clean Energy and Security Act, ACES, H.R. 2454 and is on Open Congress as well as in Congressional record.

Grist poured through the bill, but little focus on the creation of a new derivatives market

Some rules on credit default swaps are:

SEC. 355. LIMITATION ON ELIGIBILITY TO PURCHASE A CREDIT DEFAULT SWAP.

(a) In General- Section 4c of the Commodity Exchange Act (7 U.S.C. 6c) is amended by adding at the end the following:

`(h) Limitation on Eligibility to Purchase a Credit Default Swap- It shall be unlawful for any person to enter into a credit default swap unless the person--

`(1) owns a credit instrument which is insured by the credit default swap;

`(2) would experience financial loss if an event that is the subject of the credit default swap occurs with respect to the credit instrument; and

`(3) meets such minimum capital adequacy standards as may be established by the Commission, in consultation with the Board of Governors of the Federal Reserve System, or such more stringent minimum capital adequacy standards as may be established by or under the law of any State in which the swap is originated or entered into, or in which possession of the contract involved takes place.'.

(b) Elimination of Preemption of State Bucketing Laws Regarding Naked Credit Default Swaps- Section 12(e)(2)(B) of such Act (7 U.S.C. 16(e)(2)(B)) is amended by inserting `(other than a credit default swap in which the purchaser of the swap would not experience financial loss if an event that is the subject of the swap occurred)' before `that is excluded'.

(c) Definition of Credit Default Swap- Section 1a of such Act (7 U.S.C. 1a), as amended by section 351(a) of this Act, is amended by adding at the end the following:

`(37) CREDIT DEFAULT SWAP- The term `credit default swap' means a contract which insures a party to the contract against the risk that an entity may experience a loss of value as a result of an event specified in the contract, such as a default or credit downgrade. A credit default swap that is traded on or cleared by a registered entity shall be excluded from the definition of a security as defined in this Act and in section 2(a)(1) of the Securities Act of 1933 or section 3(a)(10) of the Securities Exchange Act of 1934, except it shall be deemed a security solely for purpose of enforcing prohibitions against insider trading in sections 10 and 16 of the Securities Exchange Act of 1934.'.

(d) Effective Date- The amendments made by this section shall be effective for credit default swaps (as defined in section 1a(37) of the Commodity Exchange Act) entered into after 60 days after the date of the enactment of this section.

So,unless I am mistaken, these are limited from the current CDS practices.

Yet it's quite clear this bill does create a carbon derivatives market:

SEC. 354. SETTLEMENT AND CLEARING THROUGH REGISTERED DERIVATIVES CLEARING ORGANIZATIONS.

(a) In General-

(1) APPLICATION TO EXCLUDED DERIVATIVE TRANSACTIONS-

(A) Section 2(d)(1) of the Commodity Exchange Act (7 U.S.C. 2(d)(1)) is amended--

(i) by striking `and' at the end of subparagraph (A);

(ii) by striking the period at the end of subparagraph (B) and inserting `; and'; and

(iii) by adding at the end the following:

`(C) except as provided in section 4(f), the agreement, contract, or transaction is settled and cleared through a derivatives clearing organization registered with the Commission.'

What's the issue?

Mother Jones asks Could Cap and Trade Cause Another Market Meltdown?:

You've heard of credit default swaps and subprime mortgages. Are carbon default swaps and subprime offsets next?

If the Waxman-Markey climate bill is signed into law, it will generate, almost as an afterthought, a new market for carbon derivatives.

That market will be vast, complicated, and dauntingly difficult to monitor. And if Washington doesn't get the rules right, it will be vulnerable to speculation and manipulation by the very same players who brought us the financial meltdown.

Cap and trade would create what Commodity Futures Trading commissioner Bart Chilton anticipates as a $2 trillion market, "the biggest of any [commodities] derivatives product in the next five years." That derivatives market will be based on two main instruments. First, there are the carbon allowance permits that form the nuts and bolts of any cap-and-trade scheme.

Under cap and trade, the government would issue permits that allow companies to emit a certain amount of greenhouse gases. Companies that emit too much can buy allowances from companies that produce less than their limit. Then there are carbon offsets, which allow companies to emit greenhouse gases in excess of a federally mandated cap if they invest in a project that cuts emissions somewhere else—usually in developing countries. Polluters can pay Brazilian villagers to not cut down trees, for instance, or Filipino farmers to trap methane in pig manure.

A detailed Duke University analysis shows once again one could have a derivatives trading scheme larger in value than the original underlying assets (sound familiar?).

Public Citizen's Press release on current legislation:

June 27, 2009

Climate Change Bill Must Be Strengthened

Public Citizen Statement

Climate change legislation that narrowly passed the House of Representatives late Friday must be strengthened. The legislation will not solve our climate crisis but will enrich already powerful oil, coal and nuclear power companies.

President Obama got it right when he announced in February his plan to impose strict new limits on greenhouse gas emissions and require polluters to pay. But HR 2454 enshrines a new legal right to pollute and gives away 85 percent of the credits to that right to polluters.

The Senate should do the following:

1. Listen to the scientists, not the lobbyists, and cut global warming emissions by 80 percent below 1990 levels by 2050.

2. Require polluters to pay for emissions credits - don't hand them out for free, thereby providing financial windfalls to coal and oil power plant owners. The nuclear utility Exelon bragged this week to investors that the climate bill will provide it $1 billion in extra profit per year. In addition, giving away allowances deprives the government of money needed to invest in clean technologies.

3. Don't rely on Wall Street to get climate change right. Under the bill, the price of pollution would be determined by a trillion-dollar derivatives market that could be similar to the one that helped sink our economy into its current depressed state.

4. Boost the amount of renewable energy utilities must use. The first draft of the bill would have required utilities to produce 25 percent of their power from renewable energy by 2025; that figure has shrunk to 20 percent, and additional loopholes prompted the American Wind Energy Association to conclude that the renewable standard will result in "effectively zero" new renewables.

5. Remove the "carbon tax" that households would have to pay. This pot of money would be controlled by the utilities and used to fund only carbon capture projects by coal utilities. The bill doesn't, but should, provide money to help homeowners pay for such as things as weatherization or to receive rebates for rooftop solar.

6. Protect consumers - not utility profits. The legislation's primary "consumer protection" provision distributes free pollution allowances to electric and natural gas utilities with the assumption that the 50 different state utility commissions will redirect all that money back to consumers. But there's a reason corporate utilities have called this provision "critical": they understand that they will be able to direct a portion of that money to their shareholders instead. Public Citizen supports directing money directly to households as President Obama proposed earlier this year.

In Rolling Stone's major blast of Goldman Sachs as the ultimate global bubble manipulator, Taibbi notes:

As envisioned by Goldman, the fight to stop global warming will become a "carbon market" worth $1 trillion a year.

Now President Obama claims forcing emerging economies to stop polluting is protectionist. Remember, the keyword protectionist is just code for corporate lobbyists don't want it. What happened to putting environmental standards into all trade agreements?

“At a time when the economy worldwide is still deep in recession and we’ve seen a significant drop in global trade,” Mr. Obama said, “I think we have to be very careful about sending any protectionist signals out there.”

Conclusion

To sum, while the general public believed all of this was about global warming and climate change, instead we discover the creation of a multi-trillion dollar exchange, fees, trades, all creating profits out of polluted air. Obviously we need more analysis on what is really going on here but considering we cannot get the current shadow banking system regulated to date, it seems very odd to be creating yet another system for derivatives under the guise of protecting the environment.

Meta: 

Comments

Good points and are people finally starting

to feel a bit uneasy with the economics of the current Administration? $900 billion will need to come from the economy to pay immediate costs. Where will that come from and who is getting it?

I doubt if Waxman knows what is in the Bill. I think it should be a law that these people MUST read a Bill before voting on it. Or aren't they already required to read it?

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Is it better to 'good big' the first time on major changes?

The Obama Administration seems content with baby steps on major issues such climate change, health care reform and financial regulation. These are very tough issues but the Administration has been absolutely reluctant to get dirty.

Washington seems to think that they can craft policy in a way that is "painless". Sorry, not possible. So, what we are seeing is nothing more than kicking the can down the line.

The problem is that these issues require major reforms now and any small changes may make the situations worse. Cap and trade is an example of that. They have created an incredibly complicated scheme that does very little to achieve the goal of reducing carbon emissions. It may, as you point out, cause major inefficiencies in the markets.

For what? So that you can say you have accomplished something. PleaZe! This is another example of policy not meeting the magnitude of the problem but in this case this baby step may make things worse.

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I think it is more prudent to be 100 percent sure

that there is a problem.

I'm damn glad these people aren't my doctor. I can hear it now, "we aren't absolute that you have a gallstone but we'll yank it just because of the preponderance of truth.

From the movie...........
"Why do my eyes hurt." Morpheus, " Because you never use them."

The sheep buy far too much as truth without considering it may only be an illusion. I mean for goodness sakes, there are some people that think we are so close to the brink of destruction that they want to put apparatus in orbits that will change our climate. Scientists trying to tweak my sky scares me more than any IPCC report. Which BTW I have read and talk about bboring reading!

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So do I have this correct

you are in favor of putting the boot to the neck of people for something that "may" or may not happen? It is about people, not the earth. The earth will not die but in the theory, people could die.

So we will harm the poor to feed the appetite of the theory?

Ok...got it. Now you tell those poor folk, you tell the elderly widow that If the bill's current reduction goals were implemented, electricity costs would rise by 5% to 20% around the U.S., with costs going up more in areas heavily dependent on coal-powered generations. That could cost the average household $100 to $150 a year. Gasoline prices could rise by 20 cents a gallon, costing the typical household $150 a year.

Many of the people mentioned don't have the extra annual $300. Ok, so they can go back to living standards of the 1950's. No summer AC, etc. Maybe you should have the job of telling them.

I just have the stinky, funny feeling that there are some corps that are behind this and are ready to rake up the money. GE may come to mind.

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It is a much better than 50-50 probability

that climate change is happening. So, we do nothing and face extinction.

Reducing carbon emissions is going to cost money and it will along with everything else require adjustments in household costs. But in the long run maybe it change behaviors maybe people will realize that its better to buy that fuel efficient vehicle instead of that SUV or drive the speed limit instead of cruising 85 in 55 zone.

I agree that some corps. will make money off this - that is capitalism. I hope they are American companies that create American jobs.

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No, but

"you are in favor of putting the boot to the neck of people for something that "may" or may not happen?"

No, but I'm *strongly* in favor of reducing our usage of fossil fuels. The earth becoming uninhabitable is just a side state, the truth is that *regardless* of what theory you look at, we're currently using fossil fuels faster than nature creates them.

It's the same reason you should never spend capital. Because you can spend it faster than it is created, and that way yields negative territory.

More than that, increasingly our sources of fossil fuels are in areas that are hard to get to for political or sheer environmental reasons. That alone should encourage ambient energy sources instead.
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Maximum jobs, not maximum profits.

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Maximum jobs, not maximum profits.

I was reading a bit by a Wharton School guy on sufur

and his final analysis was cap and trade worked only because technology led the way.

I am a believer that science leads the way not the other way around.

Civilization advanced from the wood burning smoke laden London long before cap and trade. The smoke belching coal fired locomotives advanced long before cap and trade. And it was all lead not by the politicians but through that person wanting to build a better mouse trap.

Personally I find magnets fascinating and I feel within the next 100 years they will find new and exciting uses for magnets. But politicians in 2009 can crow, can cry, can whine that we should utilize magnetic power but it won't happen until that person thinks up the new idea.

So if the technology is not available and to allow the holier than thou politicians, with their cultist groups to screw with
my time on earth, my little enjoyments in life is a crock of u know what.

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oil drum

I cannot think of all of the good environmental bloggers at the moment, except Jerome A Paris and oil drum, but whether there something is technologically feasible as well as cost effective is really important. There has been so much smoke and mirrors behind technology. I'm thinking of everything from hydrogen to Enron's "selling of bandwidth" market (note the creation of a "market" from nothing again theme), to I believe at one time Qwest was trying to claim they could stream any movie at any time to hotels (someone was)...
there is a host of technological fiction basically and it needs to be analyzed.

In your other sites visits if you see someone who really can analyze the truth behind the fiction from this angle, invite them to cross post.

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Protectionism in this context also means

Don't Upset China.

A country like Iran at least has elections which maybe fraudulent and U.S. political establishment is outraged calling for all kinds of sanctions but a country like China which is not even close to being democratic and is pushing hard for more internet censorship get a pat on the back and most favored nation status. Oh no, don't upset China. China is Ruler of the World.

Sorry, I digress.

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Conspiracy Theorist?

I find it very interesting that I read about this on a Survivalist CT blog after getting reamed here about listening to survivalist CT theories- only to see Robert Oak post this here. Does that mean this isn't CT?

Cap and trade did work for sulfur production. It *might* work for carbon production. But I, personally, would like to see some regulatory firewall pricing it in something other than US $. ANYTHING other than US$.

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Maximum jobs, not maximum profits.

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would be useful

This is not CT because if one bothered to read the post, I pulled up the relevant clauses from the legislation that just passed the house.

Once again, CT means it cannot be proved and/or "evidence" is more of conjecture and is actually not "evidence".

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I have a medical condition

That causes me to, as a default, either fully accept or fully reject "evidence"- with not much in between.

From my point of view, almost all the evidence in economics is invented; the very units we measure economics in are nothing more than imaginary shared myth arising out of tradition. It's hard for me to say "I accept the existence of federal reserve notes, but not the importance of tangibles and a local economy in respect to globalization"- because for me, they're both based on the same level of evidence; slim to none.

Cap & Trade not working for carbon, when it did work for sulfur, is similar. Yes, I see that it is derivative- so what? Almost everything we have past the barter system is derivative of something else.
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Prof. Krugman says Obama is wrong again.

This time on the President's criticism of the tariff provision in the Cap and Trade bill.

The truth is that there’s perfectly sound economics behind border adjustments related to cap-and-trade. The way to think about it is in terms of a well-established theory — the theory of non-economic objectives in trade policy — that owes its origins to Jagdish Bhagwati, who certainly can’t be accused of being a protectionist. The essential idea is that if you have a non-economic objective, such as self-sufficiency in food production, you should choose policy instruments to align incentives with that objective; in normal circumstances this leads to consumer or producer intervention, rarely to tariffs.

And he believes that such a provision would be OK with the WTO.

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note the VAT

reference in his commentary. Most interesting he quoted Bhagwati, for he's one of those cats I call creators of economic fiction, but he is a main architect of these bad trade deals (Bhagwati).

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Outstanding column/post

Thanks for another outstanding column - and yes, it sure does appear this administration is really about re-securitizing the securitization (or more properly put: re-securitizing the securitization of the securitization).

With the creation of ICE US Trust, to negate any true oversight of the credit derivatives, I have no doubt ICE (InterContinental Exchange) will also be the exchange of choice for this new derivatives market.

My only disagreement: I predict that it will more likely become a $10 trillion (or greater market), as the layering on of securities over securities over securities (or derivatives over derivatives....) will occur, as usual.

(Everybody aware that President Obama's appointment of Diana Farrell as Deputy Director of the National Economics Council? Diana is the number one promoter of the offshoring of American (and Euro) jobs - be sure to read the book she edited: OFFSHORING (nope, I'm not joking!)

Please recall The Great Depression, which resulted from issuing shares on debt, then layering shares based upon shares based upon shares.....

Not terribly different from our present situation - only this time its bonds, etc.

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I only wish I could be so far off as government estimates

HIPPA Costs
In 1996 it was estimated would cost about $3.8 billion over five years. Five years later the actual cost was $43 billion.

They are so often off on the amount it will save us and the amount it will cost us.

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Wow great analysis....We

Wow great analysis....We cant now expect anything to come out of America its gone...its really high time that, some other nation take a lead in guiding the worlds destiny.

Capitalism and democracy are both failures and America has unfortunately got both tangled in its neck. Only a revolution can save Americas not wall st or capitol hill.

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You're right, America is no longer a leader

You're right.
Cap and trade does prove that America will not be a leader in the future on climate change. And since it won't be a leader on climate change, it is no longer a leader in anything except some types of technology. But even India and china and many other countries are beating us to many of these technologies.

When cap and trade was first proposed it didn't sound so bad, but the more I read, the more obvious is it that America is no longer a world leader, it can't manage to get its most basic s**t together due to partisan politics and its obsession with making profits, profits, profits above all else. What does this obsession and lack of action mean? We need to sit back for a change and follow what other countries do. For not the first time, the U.S. has no idea what's going on with climate change. It's far more serious than our do-nothing politicians can imagine and it will be mondo-expensive to deal with. So we are now followers.

Cap and trade is a sucky way to deal with a serious earth systems problem. What we need is a real green revolution, the type where we demand things of our government, not wave signs around. People have to get more involved.

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