Could cap-and-trade create another economic bubble?

The American Clean Energy and Security Act, which squeaked through the House of Representatives by a vote of 219-212 last month and is set to be taken up by the Senate in September, proposes to create a huge new market for trading carbon emission permits and offsets. This system would create whole new classes of financial assets, which financial firms could securitize, derivatize, and speculate on.

Sound familiar? Many critics are pointing out that this new market for carbon derivatives could, without effective oversight, usher in another Wall Street free-for-all just like the one that precipitated the implosion of the global economy.

Writing in Mother Jones magazine, reporter Rachel Morris explains that this new market -- which is expected to become the world's largest derivatives market -- would be based on two instruments: carbon allowances, that is, permits granted by the government to companies, allowing them to emit greenhouses gases; and carbon offsets, which allow companies to emit in excess of their allowance, provided that they invest in a project that reduces emissions somewhere else, such as a reforestation initiative in the Amazon.

Additionally, carbon emitters and financial services firms would be allowed to trade in carbon derivatives -- think "offset futures" or "allowance swaps" -- creating a market that Ms. Morris calls "vast, complicated, and dauntingly difficult to monitor."

And prone to melting down, Ms. Morris warns. Just as the inability of homeowners to make good on their subprime mortgages ended up pulling the rug out from under the credit market, carbon offsets that are based on shaky greenhouse-gas mitigation projects could cause the carbon market to tank, with implications for the broader economy.

As a Friends of the Earth report titled "Subprime Carbon" notes, a lot things can go wrong with a carbon offset project. In addition to the usual risks faced by any project, independent verifiers could determine that a project isn't cutting the amount of carbon it claimed to cut. This is particularly worrisome because the system would allow sellers to promise to deliver carbon credits before the emissions reductions have been verified. The report warns:

A carbon bubble can also set the stage for the kinds of financial innovation (e.g. complex securitized products) that can unwittingly spread sub-prime carbon through the broader marketplace. When the bubble bursts, the collapse in carbon prices can have destabilizing consequences for compliance buyers (companies) and for the larger financial system.

Despite these risks (or perhaps because of them), a carbon derivatives market has the potential to generate huge profits. The US Commodity Futures Trading Commission estimates that the cap-and-trade market could grow to $2 trillion in five years.

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