The Coming Carbon Bubble

Remember the nasty real estate meltdown? All those investors snapping up CDOs and CDSs and other acronyms nobody could really keep straight, but no one cared because we were all going to make a killing. And then the bottom dropped out of the market when somebody realized we had no idea what any of these exotic entities were actually worth but we started to worry that it might not be nearly as much as what we'd been told. So then the government had to come along and give the banks a ton of money and we're all OK now as long as you don't look at the national debt or foreclosure rate or a host of other still-dismal numbers.

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Well, it's good to see we've learned our lesson. We'll never get carried away like that again! Except that we might. If you thought the real estate mess was bad, fasten your seat belts and tuck all personal belongings inside the car because the carbon market is set to take off.

On June 26, after a lot of bickering and wrangling, the House passed the American Clean Energy and Security Act. Although the bill's narrow margin of victory (219 to 212) makes Senate passage an open question, it's more likely than not that some form of emissions-control bill will be passed by Congress sometime this year. The Obama administration is pushing hard for a law to be on the books before the U.N.'s climate change conference in December. The powers that be are also strongly in favor of a market-based mechanism called "cap and trade" to regulate and, hopefully, reduce emissions.

Under cap and trade, the government will issue a fixed number of carbon credits that will give the bearer the right to release a ton of carbon into the atmosphere over the course of a year. In future years, the number of credits issued will shrink, reducing our collective emissions to a degree scientists tell us is necessary to keep from turning the planet into a sauna. In other words, the government is going to create, out of thin air, a market for a commodity that could easily grow to eclipse even the current energy markets.

The system is based on a similar plan used successfully back in the '80s to reduce the amount of sulfur dioxide, the main cause of acid rain, in the air. That program operated successfully, but carbon dioxide is a much bigger and more complicated issue, and SO2 trade flourished in an era before banks were creating and trading the type of exotic derivatives that are now both common and problematic. Currently, there's a small amount of carbon and other emissions trading in the United States, mostly due to regional regulations or voluntary initiatives, but this market is set to explode once federal emissions regulation comes into play.

A reliable guesstimate is that around 6 billion carbon credits a year will be in circulation, at least initially. Commodities like corn and soybean have markets that are 10 to 20 times the size of the crop itself, a result of the derivatives market. Some financial instruments sustain markets as large as 30 times that of the underlying instruments. Early speculation called for credits to be sold for anywhere from $13 to $20 a pop. Even taking the low end of these estimates, carbon is on track to be a three-quarters-of-a-trillion-dollar market. In a speech given last month by Bart Chilton, commissioner of the Commodities Futures Trading Commission, he forecasted that carbon trading could grow to become a $2 trillion futures market within five years.

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More From The Big Money:

• The Critical Flaw in Cap & Trade
• Why a Carbon Tax is Better for Cars
• Beware of Beijing's Commodity Splurge

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A big reason the real estate crash was such a colossal mess is that no one was regulating the most exotic—and most in need of regulation, many would argue—derivative instruments like the credit-default swaps that almost sunk AIG . Is it reasonable to assume that a carbon market, especially one that's being built essentially from scratch, would have stopgaps and safety valves built into its infrastructure?

Maybe. The Obama administration is certainly more regulation-minded than Bush 43, and Congress is dutifully following up on populist outrage generated by mortgage-related misdeeds. Still, there are still many, many ways oversight could fall short. For instance, trading carbon on an exchange would give greater price transparency and keep parties from engaging in the kind of speculation that crippled the mortgage-backed securities market; however, it's safe to say that the financial services industry will lobby hard against any sort of exchange-trading requirement for carbon, as it has with other classes of derivatives.

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