Derivatives and the Carbon Market

Derivatives and the Carbon Market

Derivatives, as most people would say caused the last Financial Crisis; well the last financial crisis can well be a blessing in disguise, as we can learn from the mistakes and very strongly hope that we do not repeat them; and if we do repeat them then it will just not be a financial crisis anymore, it will be much more than that, much more.

It can be said right here that much of the last financial crisis can be reduced to the sub-prime mortgage crisis in the US. In the mortgage market there were two important questions, one which the finance people did ask, and the other they probably asked but did not have the right answer to it. The first question, could the borrowers repay their loans, obviously they were sub-prime borrowers, so it is evident that the borrowers could not repay their loans. The second question and this is the tricky one, if they do not pay back the loans how will the lenders recover the money. The answer to this question was wrongly answered, for some reason there was this belief that land prices will not fall, therefore the house as the collateral was always a good bet. With the benefit of hind sight we know that this was not the case. Similar questions can also be asked in the Carbon Market, and the answer to these have to be right for probably there is no second chance.

Now let us turn our attention to the lessons from the last financial crisis, there is no order of priority over here, the argument points are chosen at random and it is my opinion.

First there is a need to be cautious, small scale experiments need to be done to verify whether complicated mechanisms can be implemented on the large scale or not. The experiments need to be properly guided and well thought out. This will be particularly true for the carbon market.

Second, in the last crisis the financial institutions were far more complicated than any other institutional structures; as a result others in the system were not at the same pace as them. For the sake of an analogy, the institutions work like a three legged race, where some limbs are free but some are tied to limbs of other people; therefore at the cost of being trite, these institutions are as strong or fast as their weakest links. Therefore the objective will be to ensure that all the institutions are as strong as each other. It may well be the case the Investment banks were indeed good and had created very well advanced financial instruments, however since no one else could understand it; or from our analogy, since very few could keep pace with it, the collapse was inevitable.

Third, mathematical modeling is not always the best method for asset transformation, or decisions should not be purely taken because a model says so. Qualitative analysis also has to play a crucial role; and this is particularly true for the carbon markets; as this involves the entire world. An important task will be to link qualitative analysis to mathematical modeling, such that the best decision can be taken with all the wisdom available.

Fourth, understanding the underlying asset in derivatives is a very important aspect in the entire scheme of things. Here we can come back to asking those very questions we had asked in the Mortgage Market albeit the words will be different, the essence remains the same. How do we decide, or more precisely how do we plan the financial incentive mechanism, for reduction of emission globally, this will also involve selection of projects and implementation criteria. The second question, very similar to the one asked earlier, what if they, the projects chosen fail, how do the lenders to the carbon projects recover their value or in this case more appropriately, the planet. The answer lies again in understanding the underlying, and that is ‘not’ just carbon emission reduction, but carbon emission reduction globally. Redefining the underlying asset is crucial or correctly defining the underlying asset is more important than the plain financial jugglery with derivatives. Derivatives are important, I am not saying for once that the futures markets are unimportant in carbon credit trading, however to my mind the definition of carbon credits is not well understood and here lies the problem, plus the true value of carbon credits is not on individual projects working, but whether it is working for the planet overall; therefore the true value of carbon credits will when emission reductions take place globally.

We should go back to the three legged race, that race is not won by a person who can run the fastest but by the team which can motivate everyone in the team to run the fastest. Here this incentive structure is very important, this team incentive would mean that competent groups will share best practices and methods, therefore will increase overall competencies for all groups working on Carbon emission reduction projects.

Then, since groups know that the ultimate valuation of carbon credits depend on the overall reduction of emissions, so groups will have to incentive to be honest and corruption free. So here we have a financial incentive mechanism which can promote competency and mitigate corruption. Well, yes the task of implementing this will be tough; however this to me seems like a viable alternative which might gain acceptance from all across the board.