The Pitfalls of Manufacturing a Market

policy paper | July 14, 2009

    Emily Gallagher

Go sit in the corner and think about what you’ve done, carbon!  You’re driving us all mad and keeping hundreds of financial wizards employed, trying to figure out why you never follow the price models.

Since 2005, Europe has had the European Union Greenhouse Gas Emission Trading System (ETS).  It’s a bizarre market that refuses to behave like that of other commodities – not like oil, natural gas or coal, nor like corn or pork bellies.  Currently, the most obvious quirk is that carbon allowances trade cheaply in Europe – so cheaply that companies buy allowances rather than cut pollution.  Furthermore, carbon prices do not seem to correlate neatly with traditional commodity drivers, such as long-term demand outlook or negative economic forecasts. This is true for a simple reason:  government has a big hand both in the supply of carbon credits and the long-term demand for them.  And nobody knows what the government might do.

No longer just a European enigma, this enfant terrible of a market will soon arrive in the United States.  The “American Clean Energy and Security Act of 2009,” known as the Waxman–Markey bill, has recently passed through the House, and the Senate will soon take up debate on the matter. Understandably, business groups are squirming; some estimate the bill will have a $1 trillion price tag.
Meanwhile, the mostly-European environmental financial products sector is licking its chops.  Last month the Paris-based carbon exchange, BlueNext, announced its plans to offer the emissions products of the U.S-based Regional Greenhouse Gas Initiative (RGGI) by the end of the year.  A New York exchange for carbon allowances would give BlueNext a toehold in the American market in advance of the planned federal cap-and-trade scheme. Nevertheless, BlueNext is but one of the energy exchanges currently angling for a spot in the pending market.
ICIS Heren, an energy market news provider, reports that “brokers active in the EU Emission Trading Scheme (ETS) market are now looking to attract US companies…keen to test the EU’s ETS before their emissions are capped by a federal emissions trading scheme.”
Why would a company need to “test” a commodities market, especially considering most emitters already purchase, and, therefore trade in, an array of commodities (such as coal, natural gas, oil, alumina, lumber, etc…)? Because carbon prices simply do not adhere well to a rational trading model, and they never will.  This should worry the captains of industry, who will need to navigate this thorny market.  Who should polluters blame when carbon prices throw them for a loop? Perhaps they should throw their sludge at the basic economic theory of manufacturing a large-scale commodity market for a complicated negative externality.
While carbon cap-and-trade may succeed in reducing carbon emissions within the countries that practice it, the carbon market will always be riddled with inefficiencies. As a financial product, carbon will never be free of the political influences that reduce scarcity and, therefore, cause market players to trade carbon differently than they would the commodities that release it – making price forecasting an art best left to the gods.
Click here to read the full policy paper (PDF, 8 pp.).


  • Photo of Emily Gallagher

    Emily Gallagher