The Coming Carbon Bubble

Wall Street is already making its presence known. According to the Center for Public Integrity, there are 130 finance and insurance industry lobbyists currently working on climate change. Matt Taibbi's recent takedown of Goldman Sachs in Rolling Stone (excerpt here), while delivering in his usual paroxysm of indignation, nonetheless raises some valid concerns about Goldman's cozy relationship with top economic officials and advisers. Alumni of the investment-banking giant are certain to have a hand in shaping the government's stance on carbon trading, which means the resulting system will benefit them first and taxpayers (not to mention the environment) second.

Since carbon is essentially a commodity, it's safe to assume that the Commodity Futures Trading Commission would inherit the responsibility for overseeing the CO2 market. Unfortunately, not everyone is convinced the CFTC is up to the task. In a CNBC interview, Michelle Chan from environmental group Friends of the Earth laid into the CFTC's Bart Chilton over Chilton's assertion that the commission is willing and able to weed out speculative run-ups in prices or even outright fraud. Although CFTC Chairman Gary Gensler made headlines on Tuesday when he called for curbs on speculative investing in the energy markets, he didn't offer a plan to do so. Skeptics have already started asking if the commission is willing and able to tackle this issue. As recently as last fall—when the memory of $4-a-gallon gas was still fresh in America's mind—acting Chairman Walter Lukken told the House committee on energy and commerce that speculators had nothing to do with the rapid run-up in oil prices.

President Obama has backed away from his campaign-trail pledge to auction off 100 percent of the carbon credits in circulation; in fact, current plans call for auctioning off a mere 15 percent of them and giving away the rest to power companies. Aside from the ire this has created in those who see the giveaway as a capitulation to the energy industry, eliminating a mechanism that would establish the base price for carbon credits could have market implications. If all credits were auctioned, they'd have a stated value right off the bat. If they're given away, that creates much more uncertainty about their actual value, which sets the stage for the kind of fall holders of many mortgage-backed securities took last year.

The market's also going to be expanded—and complicated—by carbon offsets. Offsets are get-out-of-jail-free cards that allow the bearer to pollute beyond what it would ordinarily be permitted. They work like this: Entities that take carbon dioxide out of the atmosphere—like agricultural concerns whose plants convert CO2 back into oxygen—get offsets for that biochemical activity. They are then free to sell those offsets to power plants and other emissions-spewing companies.

How much money will offsets eventually be worth, and how many of them will be out there? No one knows yet, but agribusiness—especially the ethanol-producing corn sector—is lobbying hard for generous offset allowances. This is going to have an impact on the price of carbon credits. If enough offsets are pouring into the market, the value of the credits will be deflated.

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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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Finally, the recession itself threatens to throw another monkey wrench into the stability of carbon pricing due to reduced industrial production. Less production means fewer greenhouse gas emissions, which means lower demand for credits. Take a look at the European Union Emission Trading Scheme, the largest emissions market in the world today, to see what we mean. Europe, in general, is a few years ahead of the United States when it comes to this whole emissions-reduction game; as a result, their carbon market can, in some instances, be a useful crystal ball.

As recently as last summer, the going rate for a carbon credit in the European Union was about €30. Recently, though, holders have been hocking them for as little as €10 since buyers can't drum up the necessary credit to pay the pre-bust prices. Europe also gave away, rather than auctioned, the credits. This decision factors into the current price deflation: Since utilities got the credits for nothing, they're still making money even if they're selling them for peanuts.

The U.S. carbon market is barely out of the womb, and there are already a whole slew of variables that could knock it into disarray. If the administration can keep its eye on the ball when it comes to regulation and not be distracted by the sweet nothings the i-banking community is sure to be whispering in its ear, CO2 will grow into a stable and well-adjusted market. If not, we're looking at our next problem child. Hope for the best—but don't exhale just yet.

Thanks to Erich Pica of Friends of the Earth, Richard Sandor of the Chicago Climate Exchange, and Ken Schneider of hedge fund RNK.

© 2012 Slate.com

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