Carbon: The New Financial Frontier

As world leaders meet in Copenhagen this week to debate climate change policy, one constant remains consistent: the devotion to cap and trade as the cornerstone of policy to price carbon emissions. As maintained in my recent Senate testimony, carbon is a poor candidate for cap and trade implementation (

Cap and trade is the optimal way of reducing clearly identifiable and measurable externalities. Carbon, however, is arguably the least clearly identifiable and measurable externality in the world, being emitted by not only every productive firm but every living being. Moreover, scientists differ considerably on the amount of carbon emissions that will trigger a “tipping point” in climate change and the degree to which current increases are the result of natural versus man-made influences.

As a result, the “cap” on cap and trade is the subject of the most vociferous debate. Russia was hugely over-allocated carbon emissions via the original Kyoto protocol, so that those emission credits are flooding today’s international markets. Similarly, the EU has been trying to adjust its original over-allocation program at the inception of its own cap and trade program, which has resulted in a tunneling of prices to levels that are not thought to be sufficient to drive businesses to lower-emitting technologies. The EU faced another recent setback, with the addition of Polish emissions regardless of their impact on overall EU allocations.

Additionally, as noted in the background paper for my testimony, carbon prices do not conform to other commodity or financial instrument price behavior characteristics. As a result, active market management will be necessary to develop a worldwide cap and trade market that avoids undue price volatility. That management mechanism will most likely hinge on supply intervention, much like today’s Federal Reserve open market operations. But at the end of the day, if such intervention works the results will be the same as a carbon tax – sacrificing carbon emissions volatility to stabilize prices.

So why go through the whole institutional design mechanism of cap and trade to get a result which is the same as a simple tax scheme? The answer – at least in the U.S. – lies in the allocation of rents. Carbon is the new frontier, made up of value that is created by government fiat. As in the U.S. west – when land could be obtained through homesteading – or the railroad boom – when rents could be extracted for the promise of services – or the tech boom – when telecoms providers could lay fiber optic cable along the old rail rights-of-way and mere patents on new technology could be worth billions of dollars – frontiers drive economic growth.

U.S. financial institutions are begging for new value in today’s markets, and Congress is devoted to giving it to them, regardless of the outcome. What outcome should we expect? The same outcome we see in every frontier boom: overexpansion, bankruptcy, and reallocation of rents. Land in the U.S. west was so cheap ($10) that marginal land was farmed until the next price bust (of which the Dust Bowl years preceding the Great Depression was merely the largest example). Similar low marginal costs led inframarginal railroads (and canals, before them) usually through multiple bankruptcies during construction phases, only to be bailed out by state and federal governments. Most tech firms are gone, and the fiber optic that is in place and sold in multiple landmark bankruptcies is only now being lit.

When asked for advice for our own implementation, nearly every market participant in the EU resoundingly replies, “go slow.” There is no reason that U.S. carbon policy could not begin with a small marginal tax on carbon emissions, today, followed by growing tax levels and slowly increasing reliance on cap and trade alternatives after careful study and implementation. Instead, U.S. policymakers seek to allocate the rents of the new frontier to firms as quickly as possible, forfeiting stable meaningful carbon policy for something far more speculative and risky.

It seems that carbon policymakers – Congressional Energy and Natural Resources Committees – still maintain the mindset of the bubble economy, hoping financial market regulators can just pull the appropriate levers during periods of exigency and keep the market and the business cycle on a steady helm. The one lesson everyone should be learning from the present crisis and recession is that economics is an imprecise science and – while harder than many social sciences – it is still a social, rather than a hard, science. As a result, our greed for quick economic recovery will most likely to another inframarginal frontier.


† Hermann Moyse, Jr./Louisiana Bankers Association Professor of Finance, Louisiana State University, Senior Fellow at the Wharton School, and Partner, Empiris LLC. Contact information:; (202) 683-8909 office. Copyright Joseph R. Mason, 2009. All rights reserved. Past commentaries and testimony are blogged on