Carbon Markets: Volatility & Trading Institutions Craig Pirrong Bauer College of Business University of Houston

A New Commodity Market Carbon is a new, manmade (in multiple ways) commodity Commodities, and particularly energy commodities, are notoriously volatile: How volatile will carbon prices be? Price dynamics of “natural” commodities depend on demand conditions and inherent constraints in transforming commodities across time, space and form In carbon, these constraints are subject to regulatory design: carryover, borrowing, and frequency of issuance

Basic Economic Considerations Volatility tends to be greatest when supply constraints tend to be binding: can’t respond to demand or supply shocks by adjusting supply, so price bears the burden of adjustment This is more likely to occur during high demand periods than low demand periods Market design factors will crucially affect volatility and patterns in volatility

Effects of Design on Price Behavior No carryover, no borrowing: very little volatility early in the life of a particular vintage, but prices become increasingly volatile as vintage matures, and prices either skyrocket, or fall to zero Carryover with no borrowing and periodic (e.g., annual) issuance: prices tend to rise from the time of issuance until right before the next issuance period; increasing volatility as new issuance approaches More frequent issuance (e.g., monthly or even weekly) leads to less pronounced seasonals in both price levels and volatility—volatility lower on average Borrowing tends to mitigate intensity of price spikes: loosens a constraint that binds in natural commodities

Implications of Volatility for Investment Unlike with a carbon tax, where the price of carbon is fixed, there will be volatility in the price of carbon with cap & trade This will likely affect investment behavior It is well known that investments are like real options, and that higher volatility tends to induce delays in investment Transition to a completely new market regime will likely exacerbate this investment-delaying uncertainty Ironically, this could also impede investment in carbon emissions mitigation technologies, as the value of these technologies is uncertain due to uncertainty about the price of the commodity Policy uncertainty will also contribute to this effect

Secondary Market Design The design of secondary markets in carbon is up in the air—but so is the design of secondary markets for virtually every commodity in the aftermath of the financial crisis Current zeitgeist is extremely hostile to customization, over-the- counter trading, bilateral performance risk (as opposed to central clearing), and (especially!) speculation Both W-M, and financial regulation proposals more generally, aim to force standardization, force trading onto exchanges, require central clearing of all cash and derivatives trades, and constrain speculation through position limits

Oy! Virtually all of these policies are misguided, and will impair the ability of market participants to utilize derivatives markets to manage their risks Different market participants have unique exposures to carbon price risks, and interactions between carbon price risks and other risks: customized derivatives are essential to manage these risks effectively. One size does NOT fit all. Clearing not appropriate for all instruments. What’s more rigid clearing-style collateralization can create cash flow risks and strain cash flow management systems. Restricting speculation will increase hedging costs as less risk bearing capacity is available, and may reduce the effectiveness of the market as a price discovery mechnism