Failure of the Carbon Markets: Implications.

Failure of the Carbon Markets: Implications.

è The failure of the Carbon Market would mean that funds will move away from this market.

è The carbon emission reduction or green projects will not be implemented.

è Global warming threats will become plausible.

è It will become a very difficult task to save the planet then.

                                                                                                                                                                                    

The carbon Market should take small incremental and differentiated or varied approaches; there should not be any common Financial or linked strategy, even if one financial strategy is working fairly well, money flow should be controlled into it.

If the financial markets are linked, the Domino effect will kick in, and we have the 1998 and the 2008 crisis to tell us what happens as a result.

It has to be ensured that the Carbon Markets are not linked, and different Geographies should have unconnected capital flows. In other words the international hot money flow or the hedge fund flows should have set of constraints. In the 1998 crisis, India had saved itself from it by not having full capital convertibility, which the IMF and other think tanks did not like too much, however, the same people later hailed it as one of the best policies. The hedge fund flows were stopped, and taking positions which serve no economic value creative purpose were not allowed. India did not face any severe economic crisis in 1998 as a result.

Mathematical Models:

At present the problem with Mathematical models is we do not know, ex ante, what can go wrong, or under what circumstances the model will fail. In both the 1998 and 2008 crisis, there was no model which could predict the impending troubles.

In 1998, there is an interesting side story, that is, with Black, Scholes and Merton. Economists and academics were never good traders, so claimed the Wall Streets of the world; and it was true, however, the Economists who gave the world the formula to price an option, and got a Nobel prize as well, and traders themselves were using it making big profits; thought to themselves that they should become traders, and use what they had found in their own company, and thus Long Term capital management was born, a hedge fund commanding over immense capital. In the initial years it did make a lot of money, but with a sudden shock of the Russian economy collapsing, and the sovereign country defaulting on its debt, LTCM could not recover. The very principle which made money for them and various other traders, the method of taking an opposite hedge position did not work, they only ended up taking more risk, and in fact created more and more losses, till it had to file for bankruptcy. The only thing we know now, ex post, that the formula does not work in an out of normal market condition, it is not meant for a severe crisis or shock situations, a traders instinct is much better in such cases.

Now what about the CDOs in the 2008, Lehman Brother’s case, what external shock was there, well pretty much nothing, except for the fact, the financial system was not looking at the commercial side of banking that is the borrower and lender relationship, and how the lender in effect becomes the compliance officer as well, looking after the fact that the borrower pays back the loan in an efficient and timely manner. The lender or compliance officer can also figure out ways for the loan re-payer in case the person is stuck.  However, this side of banking was not given due attention, and the entire finance world was far more interested in transaction banking and the great mathematical models, which did not ring any alarm bells or even if they were ringing no one heard it.

In my opinion it is not mathematics or Mathematical Models which are important, it is our instincts which are important, so it might be that some mathematical concepts will work well in pure Science and Engineering, it might not work in other fields, as in the world of Finance ultimately human instincts do take over. In Lehman’s case their boss had an unusually high risk appetite, and ‘ so fell Lehman’.

The derivative market does throw up opportunities to have or take unusually high risk positions, and once those strategies fail, the market collapses, and that is precisely what needs to be prevented.

Derivatives and the Carbon Market, Part II.

Environmental-Finance.blogspot.com

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.

Global Warming - A Trilogy

Dramatis personæ –

1. Developed countries – US, Europe and Japan, they have prominently caused the problem, they also have the solution, most important part of that solution, at the moment, being ‘money’;

2. Emerging Economies – rank outsiders for most of the story, did not play any prominent role till off late gaining a lot of importance – they cannot seem to get enough of what the developed countries have – ‘money’; often they have been noted to be outrageously corrupt, and more importantly, atrociously incompetent; these two marvelous facets of corruption and incompetence have made the wicket very sticky, reason enough to stop money relocation from the Developed world to Emerging Economies. This role is prominently played by BRIC’S’.

3. Financial Institutions of the Planet – very difficult to describe this lot, specially post 2008; succinctly, they are like the eunuchs in the harem, probably a misfit but cannot do without them for the want of anything better. This lot is played conspicuously by the late Investment Banks, their ghosts do lurk around. Disclaimer – there are quite a few good guys in this lot too, perhaps little attention is given to the good guys.

Scenery - Kyoto, Copenhagen, Cancun – locations where Governments meet to negotiate treaties on Climate Change.

The Prequel

In the prequel we had heroes like Al Gore running around the planet saying we are in imminent danger, frankly an inconvenient truth, played out like a typical movie, drama, skepticism, disbelief, however slowly an Inter-government panel on climate change was formed, scientists around the world accepted that ‘Global Warming’ was true, and action needs to be taken very soon. A set of action plans were drawn out, famous among them is the Kyoto Protocol, all nations signed it including the US, seemed like a happy ending. However the US did not ratify the protocol, a sad end awaited at Copenhagen. The good thing is no one is debating global warming anymore; instead the debate is how the planet can be saved from Global Warming.

The Present Story

Well the script is still being written, the road from Copenhagen to Cancun is proving to be arduous, and as of today nothing good seem to be happening.

As I sit in Delhi, the water level seems to rise, its September and raining profusely in this part of the planet, I do not have any living memory of such rain in Delhi. ‘Global Warming’ – I think to myself. It seems like a strange thriller unfolding in front of my own eyes, what is making this very weird and eerie is that first, I am also a part of this drama, my character’s very fate depends on some quick decision being taken by those prominent in the Dramatis Personae.

Now The Interesting Sub-Plot

It might not be far away from truth to point out here that the biggest problem facing us is not Global Warming per se, but how do we save ourselves from it, and the fundamental hassle here is co-operation among nations. One factor which keeps the planet away from co-operation is the distrust we have for each other, and a driver for this distrust is ‘corruption and incompetence’.

How do we know that people will be corrupt and incompetent, for one there are enough ‘green’ projects in the emerging economies which are prone and proven to be suffering from these malaises. Then we look at Signals, ever since Akerlof, Stiglitz and Spence got the Nobel prize for Economics, Signals are in high demand. One signal whether a country is capable of managing big projects is whether the country has done it in managing an International Sporting event. China has pulled it off with the Olympics, South Africa (the ‘S’ in BRIC’S’) has come out with flying colours recently with the FIFA games, and now it is India’s turn with the Commonwealth Games. Sadly the most expensive CWG is also the most corrupt and incompetent as well. The only saving grace is that the world does not really care about the CWG, as in the CWG, the US, Europe, Japan, China all do not feature, so we can safely put under the carpet. Also if we can punish the ones who are guilty, then we can save our grace further. In fact recently we have done such a thing, with the Cricket IPL, yes the cleansing process does take time, but thankfully it has started. Also, given that India is democratic and has a strong media helps build strong credentials. I hope that no one magnifies the misdemeanors of the Delhi CWG, and stop funding the ‘Green’ projects; this will truly lead to some Global Warming.

The Sequel

Well, this one will answer whether we have saved the planet or not. I can write a lot over here, but I will leave it here.

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.