Friends of the Earth, a non-profit think tank on environmental policy, asks a good question in a report and video today. Given what we’ve seen in the mortgage market, where heavy-handed government intervention created distortions that crashed the economy, why would we want to emulate that same model in carbon emissions? Think of cap-and-trade as the ultimate derivative market, based literally on vapor:
Most proposed climate bills rely on cap-and-trade systems to achieve greenhouse gas reductions, and the Obama administration also prefers this approach. But these bills do not seek to regulate carbon trading as a massive new derivatives market, which is, in fact, what it is.
This new report finds that existing financial regulations, as well as those in major cap-and-trade bills, are inadequate to govern carbon trading, creating a potentially huge regulatory gap.
It also outlines how lessons from the current financial crisis apply to carbon markets. In particular, it raises concerns about “subprime carbon,” risky carbon credits based on uncompleted offset projects (projects designed to sequester or reduce greenhouse gases).
Subprime carbon credits may ultimately fail to reduce greenhouse gases and, like subprime mortgages, could collapse in value, yet they are already being securitized and resold in secondary markets. The report recommends that lawmakers include carbon trading in current debates about financial reform, and warns against hastily creating carbon markets without proper oversight.
If that sounds familiar, it should. It’s the exact same mechanism Congress mandated on subprime mortgages in the late 1990s in order to incentivize lenders to make loans to customers who normally wouldn’t have qualified. It resulted in a major bubble in the housing markets, both in lending and in construction, with irrational expansion of home values that wound up getting highly leveraged. When prices leveled off, it set off a domino effect as the leveraging collapsed, and along with it all of the securities and derivatives attached to the subprime loans.
Waxman-Markey and other cap-and-trade bills propose the exact same system, but instead of having real estate at the center of the derivatives — which has some value at all times, no matter how unclear the actual value may be — this system gets built on carbon dioxide. It’s vaporware in the most literal sense. In fact, it’s not even based on CO2, but on the absence of CO2. When it collapses, the derivatives will have absolutely no actual value at all, which would make a resultant economic collapse even worse than what we’re experiencing at the moment.
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