Common Tragedies

Thoughts on Environmental Economics

Risk in the Emissions Trading Market

Posted by Erica Myers on April 8, 2008

On March 31, the UK’s Financial Services Authority (FSA) published a 43 page report outlining some risks and challenges for a global emissions trading market. While the FSA does not regulate the underlying emissions markets, it does have jurisdiction over the emissions derivatives markets–particularly related to trading derivatives for investment rather than commercial purposes.

The key findings in the report are summarized as follows:

  • The emissions trading market is still relatively small, but it will expand
  • The EUETS now has good liquidity and is functioning well
  • The emissions trading market will be a key inter-linking market for gas, coal, oil, and freight markets. As such it could eventually be the largest commodities market of all
  • Direct involvement of retail investors is currently very limited
  • There is a less developed set of risk management tools in the emissions market compared to others because there is little market trading history and very few pricing data.

The authors identify risk in 5 different categories.

Market Foundation

As the emissions trading market expands, there needs to be a linked global market with inter-registry between governments and common standards for things such as CDM registration. The liquidity of the market could be hurt by lack of fungibility. Another risk to market foundation is the destabilization of the markets due to over or under allocation of allowances. The price of allowances in Phase I of the EU ETS tended toward zero because the market was over supplied. The authors also cited a concern that with a cap on emissions allowances, the outstanding derivative contracts could grow so fast that the financial contracts exceed the pool of underlying assets to be delivered.

Market Integrity

Any activities that bring doubt to the credibility of the climate change benefit delivered could hurt the integrity of the market. This has been cited as a problem with the Voluntary Emissions Reductions (VERs) market. A mass exodus of investors could destabilize the market if certain products were found to be unsuitable for achieving real climate change goals.

Market Infancy

There could potentially be improper risk management at firms because the market is so young that there are few pricing data and the practitioners lack experience with the market. This could lead to disorder in the market.

Information Risk

Transparency is important for market confidence. Accurate data need to be released in an orderly fashion and to be widely and regularly available.

Market Liquidity

It is anticipated that there will be an expansion of new emissions trading venues with different instruments for reducing carbon. As these markets come together, it is important that the different instruments are fungible in order to maintain liquidity.

There is also a 14 page annex to the report on the emissions trading market that is a really good primer for anyone interested in learning more about emissions trading and the EU ETS in particular.

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