The Flaws of Cap and Trade: Part I: The Market

By Abel Collins

On paper, cap and trade offers a versatile regulatory strategy to reduce carbon emissions. Rather than the blunt tool of a blanket tax, the innovation of the carbon credit allows industries that might find it particularly onerous to cut carbon pollution to promote other sectors of the economy to make reductions in their place. By creating a carbon market, the world theoretically summons the mystical invisible hand of market efficiency theory to produce the most effective reductions.

Of course, market efficiency theory is now seen as a rather naïve economic model that is disproven on a daily basis, and ideas that make a lot of sense on paper are often met with resistance by reality. Such is the case with cap and trade. The translation of the theory into cap and trade reality is fraught with problems.

The most glaring problem is administration, and it is manifold. Before we delve into the many failings of the administration of cap and trade, it is important to note with administrative costs that resources dedicated to organizing and maintaining the system (administration) are resources that are being taken away from actually addressing the issue that the system is designed to resolve (e.g. healthcare). With cap and trade, there are two distinct areas of administration; the carbon markets, and the validation and verification of the carbon credits to be traded within those markets.

Large banks, notably J.P. Morgan and Goldman Sachs, have graciously offered to administer the commodity markets for carbon credits. They have not made this offer out of concern about global warming or because they have any expertise in environmental matters. No, like everything else they do, they run the carbon markets in pursuit of profits, and there are many to be had.

Not only do the banks get paid to oversee the transactions in the marketplace, they are further allowed to use this position of advantage as they trade within it. Of even greater concern is how they can manipulate the market through unregulated financial instruments (i.e. derivatives, CDOs, etc.). With massive government subsidies aimed at reducing carbon emissions and unlimited sums of low-interest money available to the big banks, carbon markets are primed for overleveraging and bubble formation. As the markets get more and more manipulated, they will become less and less transparent and farther removed from their mission. Indeed, the carbon market, itself, is a secondary approach, regulating an intangible commodity to address climate change, and it in no way needs to be made more abstract through financial wizardry.