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In the previous paper we have discussed about the underlying asset in the carbon market, and how changing the definition can help us achieve emission goals.
In this paper we will discuss further on how the carbon derivative is different from all other derivatives, and it has some inherent qualities of a commodity derivative as well as an equity derivative.
A) It, the underlying asset as defined as 1 ton of CO2 or equivalent of emission reduction is not tangible (unlike other commodities, eg. Crude, cocoa); neither is it observable directly or indirectly ( directly observable is weather; indirectly observable is electricity); even the CDO assets in the sub-prime mortgage days had a directly observable item called home, whose price was incorrectly valued, but that is another story. (It can be advised here that the Carbon derivative can be made observable if the asset is redefined and connected to Global Warming, then it will partially behave like a weather derivative.)
B) With other derivatives, there might be case of incorrect asset valuation, but the asset it self is not incorrect; as in, there might be crude oil which might be incorrectly priced in the market mechanism or in a worst case scenario, there might be a complete market failure, but crude oil will not disappear even in case of market failure, may be less oil rigs will be made or less oil will be drilled, or oil becomes very expensive, but the world will not come to an end; we have had oil crisis before and the world is still functioning, because the underlying asset does not become worse or does not degenerate even if the market for that product fails.
The equity derivatives might also be priced incorrectly, again if there is a market failure, there still will be a company, the products and the human resources will still be available.
The point I am trying to make here is thought the asset price might be incorrect, the asset is correct, it exists, and it can be brought back to a productive point again.
The Carbon Derivative in its present form, however, the asset itself might be incorrect, as there can be wrongly certified projects either due to corruption or incompetence, and since there are no easily visible events with this asset class, the chances for carbon leakage can happen not only due to corruption or incompetence but more dangerously because of unforeseen dangers connected with projects especially where there is a scale requirement. It can be added that immediately observable or tangible assets are also immediately quantifiable, for the carbon derivatives in their present form there is little room for immediate quantification.
C) A corollary to the above, is that the Carbon derivative has an enormously large compliance cost, than any other derivative, and there is very room to maneuver except to add an immediately observable feature to the derivative.
D) Risks associated, well, the weather derivative has a low risk, high probability underlying asset attached to it. The weather insurance which can be thought of as a put option has a high risk low probability event or underlying asset attached to it.
Now the how about the carbon derivative, well there will be two groups, a smaller group will say unknown risk and unknown probability, or larger group of the informed people will say high risk high probability. The risks and probability associated with the Carbon derivative is very different from any other derivative.
E) Carbon markets will not allow for high risk within the market, therefore shorts and backwardation may not be allowed.
F) At present the carbon derivative is purely a function of Global legislation.
G) The consequences of market failure in other markets are different from the carbon market, this aspect will be explored in the series article.
Look out for Carbon Credit Equities, backwardation, documentation risk, Look-back option, Knock in option; Learning from previous crisis.
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