Friday, 19 March 2010

Why Cap & Trade Could Cause the Next GFC

Why Cap & Trade Could Cause the Next GFC

Andy Semple writes how a cap and trade emissions trading scheme could cause another financial crisis.

The European experience with Cap & Trade strongly urges caution. The Washington Post on February 16, 2009, described it as "Exhibit A" of what not to do on climate, and for good reason. Our Senate would be wise to take a close look at Europe's track record on the 1997 Kyoto Protocol, and the Emissions Trading Scheme they adopted in 2005.

The EU’s emissions targets were set too high, and too many pollution allowances were given away to industry. The value of a carbon credit on the market plummeted – it collapsed in price from €33 to just €0.20 per tonne. Companies made windfall profits by charging customers more for energy while selling allowances they didn't need. The Europeans have also not had much success at reducing greenhouse gas emissions. In fact, emissions covered by the EU’s ETS rose 3.6% in the UK in the first year, and rose by 0.8% across the EU as a whole. So much for the capping emissions!

Despite the lofty rhetoric from many European nations about setting even more stringent standards in the future, we are also seeing signs of fracturing in their Cap & Trade coalition. From German automakers to Italian steelmakers, to nations that still rely on coal for a substantial percentage of their electric generation, discussions about exclusions and delays and handouts are now very much a part of the debate in every European Union meeting on climate change. The Russian cut-off of the natural gas supply to Europe was also a reminder of the geopolitical risks of discouraging domestic coal under Cap & Trade.

There are also examples of fraud and unfairness in the EU process. Given the similar politics here - where big businesses have successfully lobbied for free allocations far more effectively than the little guys (consumers, small businesses, and farmers etc...) - it is highly likely that such inequities would occur in Australia as well.

Remember, Cap & Trade isn’t a free market mechanism. It is a Government engineered scheme that cloaks itself as being market driven. When Government’s lazy bureaucratic hand becomes involved, it is no longer a free market driven system. A free market driven system would be best illustrated by the trading activities on the Australian Stock Exchange (ASX) or on the Sydney Futures Exchange (SFE).

You see, unlike real markets, where you have real underlying assets (such as Gold, Oil or BHP shares), Cap & Trade’s only underlying asset is simply created out of thin air by a Government decree (you should be starting to see the risks here). So, to kick off Cap & Trade, the Government makes a law that stipulates that the initial price of Carbon is say $20 per tonne, and thus a new asset class is born – Carbon. The market doesn’t set the price, the Government does. The government also sets the contract specifications, not the free market. So, the Government sets the initial price, the contract specifications, and now runs “the market” - as you will not see Carbon trading done via the ASX or the SFE. I would hardly call this a free market mechanism. Cap & Trade is nothing more than a Clayton’s “market driven” scheme.

The Free Market is replaced by the State. It’s Central Planning at its worst.

Whilst the Government’s CPRS isn’t a threat to the world economy, you can clearly see that if a Global Cap & Trade scheme was in place it would be a clear and present danger should the newly created Carbon asset class ever collapse. Again, no one thought the US housing market would collapse, but it did, and the same could well happen with a Carbon Market. It’s estimated that the global Carbon Market could be worth well over $3 trillion a year by 2020, or twice as much as the Oil Market. This isn’t small beer, and its collapse would have devastating consequences to the global economy. The US subprime crisis, which sparked the GFC, cost the global economy $7.7 trillion dollars. It would appear that no lessons have been learnt from the subprime catastrophe.

At least the US housing market is real, it’s a tangible asset, but the Cap & Trade Carbon Market is an intangible asset - and if it crashes it won’t be worth the permit paper it is printed on.

So what could possibly crash the carbon market? Any sensible approach to global warming has to centre on technological innovation as it applies to energy production and use. Breakthroughs such as ways to produce energy economically with little or no carbon dioxide emissions, or improvements in energy efficiency all make good sense, irrespective of global warming.

Innovation is what we really want. We know from history and experience that free economies innovate better than centrally planned ones. You only need to look at Apple Inc’s incredible success over the last five years. Through innovation they have brought the ipod, the iphone, and now the ipad to the marketplace. The shareholders who believed in Apple’s innovative vision have been handsomely rewarded. Apple’s five year return is 398.32%

But Cap & Trade introduces a significant element of central planning, and thus stifles innovation. We also know that strong economies innovate better than weak ones, but Cap & Trade weakens economies. Perhaps most importantly, stable economies innovate better than unstable ones, especially for something like energy where the investments often run into the billions of dollars, and the payoffs play out over decades. Cap & Trade adds a significant element of instability, which we have already witnessed in Europe, with wild swings in the price of carbon, and energy companies becoming less interested in long-term investment and more interested in the short-term trading of the system.

What would happen, for example, if someone invented Nuclear Fusion? Sure, you may say, that’s way off in fairy land, and it could be decades before the technology is invented, let alone perfected. That is true, but if it was invented the whole Carbon Market would collapse due to fossil fuels becoming obsolete virtually overnight. But why wait? Currently nuclear fission (nuclear power) is the only technology available that is capable of providing emission free energy on a scale required to significantly reduce carbon emissions. Just like Apple Inc re-invented the Walkman with the ipod, there have been significant advances in Nuclear Fusion Technology.

In conclusion, the economic realities of Cap & Trade are becoming very clear in Europe. How can the Rudd Government be trusted to manage a complex Cap & Trade scheme here in Australia when they can’t even manage the current home insulation rebate programme!

If we adopt a similar approach in Australia, expect considerable economic pain for minimal (or even no) environmental gain.

Andy is the founder and Managing Director of Stockbroking firm ANDIKA and the co-founder and Managing Director of boutique Funds Manager Xcelerator Capital Limited. He blogs regularly at and you can read his full article here.