Climate Misconception #15: Carbon permits will just be a new source of financial speculation

Have you heard?  Proposals to combat climate change by requiring carbon permits are being pushed by Wall Street, since it gives them a new financial toy to play with.  Soon there will be markets in permits, and then markets in derivatives of permits, leading to a frenzy of speculation and the next thing you know we will all be swallowed up in another global financial panic.

This is an argument made up entirely of buzzwords: Wall Street, finance, derivatives, speculation.  For some activists, intoning them and summoning the demons they evoke constitutes taking a stand.  If you suggest there may be gaps in their chain of logic, that just shows you are either duped or on the other side, an apologist for profiteering and exploitation.

Before dissecting this myth, I want to make it clear that there really are deep problems with the financial sector.  It’s way too big, sucks too much wealth out of the productive parts of the economy, and is prone to bouts of high-risk speculation that will surely put the world economy back in the danger zone at some point.

But that’s a separate issue.

A system of carbon permits does not feed financial speculation, and the entire attempt to link carbon capping to Wall Street malfeasance is absurd.

You can tell that there’s a lot less to this argument than meets the eye because proponents don’t tell you which derivatives they think are likely to feast on carbon permits, and why that would be bad.  It’s a bit like the magic syllables Faust finds in the secret book he’s given: who knows what they mean, but say them and, bingo, Mephistopheles himself is at your service.  Saying “derivatives” works the same way.

Think for a moment.  If there’s a carbon cap, and energy companies need permits to extract or ship fossil fuels—and, crucially, if there are permits for significantly less carbon than companies would otherwise want to dig up or pump—then the permits will have value.  It’s like a taxi medallion, for instance.  If I have a carbon permit, but you want it more than I do, I don’t see the harm in selling it to you.

Now take the next step.  Rather than buying a permit to supply a quantity of fossil fuel today, I could buy the right to acquire it from you a year from now.  If you sell me this right, it obligates you to buy the permit at next year’s price and sell it to me at whatever price we’ve just agreed on.  This is a futures market.  It is definitely speculative: I’m betting that the price will go up beyond what I’m currently paying, and you’re betting the price will go down.  (You are shorting the permit.)  But that’s OK!  This serves many useful purposes.  It transmits expected scarcities in the future back to the present in the form of higher futures prices, enabling everyone, including those who have nothing to do with this market, to prepare for the coming shortage.  Depending on how the permit system works, it can smooth out price increases so they don’t gyrate so much.  They enable producers to hedge, reducing their overall risk exposure.  You really should want a futures market.

And the next step is to incorporate more elaborate scenarios into the derivative.  I agree to buy permits from you at a given price, but only if some other price remains below a certain level, or we build inflation into the price, or something else.  These more complex derivatives can offer more finely tuned hedges, or perhaps the missing pieces that minimize the combined risk of a portfolio as much as possible.  That’s good too.

Of course, speculators can do dumb or dangerous things, but they don’t need carbon permits for that opportunity.  Financial instruments can be constructed to bet on World Cup matches, movie ticket receipts or just about anything else that human beings wish to bet on.  Such instruments may indeed lack transparency or put unsuspecting lenders, depositors or taxpayers at risk.  This is not an argument for suppressing organized athletics or entertainment, much less carbon caps.  It is an argument for regulating the financial sector, but as I said, that’s a different topic.

In this post I’ve actually argued more than I need to.  A well-designed system of carbon permits should result in very little trading; we will see this later.  But even if trading permits becomes widespread—so what?

ADDENDUM: Exposés of the horrors of carbon offsets are not germane.  None of this is about offsets.  Indeed, the offset business has proven to be quite a racket, but that’s not about trading.  There is virtually no trade or speculation in offsets.

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