The carbon-subprime connection: A cautionary tale?

A report in the Guardian today quotes a trader at Bache Commodities predicting that carbon market transactions could reach $3,000bn - double the size of the oil futures market – within 10 to 20 years. Andrew Ager also says carbon futures could be used to hedge against falling equities or rising inflation. Sound familiar?

As the story notes, critics of carbon trading are not just from environmental groups such as Friends of the Earth; even EDF chief Vincent de Rivaz has voiced concerns that financial instruments based on carbon trading could cause another subprime crisis.

FT columnist Tony Jackson today considers these very same arguments, and concludes a subprime-style catastrophe in carbon markets isn’t likely – at least, judging from the state of the market today.

Jackson uses three basic tests – all of which, he writes, sub-prime derivatives failed, but carbon markets appear to pass.

Firstly, he says, carbon deratives are relatively simple futures – they may be subject to the vagaries of government policy, fossil fuel prices and offsets, but the instruments themselves are fairly straightforward.

Nor is liquidity, and by extension speculation, a big cause for concern, he writes. Speculators have their pros and cons, but on the whole they shouldn’t be more detrimental than in other commodity markets (whether you find that comforting or not is another matter).  Thirdly, the scope for leverage and arbitrage appears limited, even when new carbon trading markets launch, due to their regional nature.

So overall, then, a derivatives blow-up looks less likely than some cap and trade critics would have us believe?

Well, perhaps.

Jackson concludes with a rather cautious note:

And this is the big caveat – that as markets develop they become more complex and risky. A confession here. When I first studied credit derivatives six years ago I decided they were harmless, precisely because they were still fairly simple. I also took heart from the fact that several banks and insurers had blundered into this new market and retired hurt. But in the event, that simply gave remaining operators the false assurance that they knew what they were doing. And sure enough, several continental banks and insurers have recently retired hurt from carbon trading.

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