The Basics of Carbon Markets, Cap and Trade, and Derivatives
Aldyen Donnelly has a story for everything. Many involving hijinx with famous people that should not be printed here. She also has the most experience by a few decades in carbon markets which she laid out on this Reversing Climate Change podcast episode.
We started with cap and trade for both greenhouse gases and the acid rain markets, which, as she will tell you, took her decades to sour on. The way that cap and trade generally works is that a government will set a limit for a certain pollutant and issue allocations to polluters. Some polluters have an easier time cutting their emissions of the pollutant than others, so they can sell the allocations they don’t need to others who would love to buy them. Over time the government cuts the supply of allocations to either phase the pollutant out entirely or keep it some determined acceptable level.
We get into two objections Aldyen has with cap and trade. The first objection is that when it started decades ago mitigation of greenhouse gas emissions could carry more of the weight. At this point though there are so many greenhouse gases in the atmosphere that removal is now necessary. Enter: Nori.
The second objection is what you would expect from an economist. Quota-based supply management (general term for what cap and trade is) is recognized by most economists as inefficient. Canada, Aldyen’s home and native land, employs quota-based supply management for various agricultural products like dairy, poultry, et al. The government determines how much milk is allowed to be produced by law in a given year and allocates quotas. This is done with an eye to keeping prices high for producers and is a large barrier to entry for new participants in these markets. This reduces competition and thus potentially leads to less choice and quality, as well as higher prices for consumers.
It isn’t all terrible though. Cap and trade is an effort to put a price on pollutants, as they do not economically behave like poultry or dairy and thus does not come to exist in a more natural way. She prefers a carbon tax to cap and trade, but that’s the way history played out. We’ll get to carbon taxes in another blog post.
We then fumble our way around the development of the discipline of accounting (admittedly not our strong suit) and end up discussing why prices for carbon credits are so low. Aldyen’s theory is that the credits are listed as one tonne of carbon dioxide offset or sequestered, but people don’t often believe that the underlying action has been taken to the face value of the credit. Simply put, the amount of carbon addressed by a single credit may be a fraction of what is claimed, and the market reflects this in low prices. This is one of the key problems Nori’s model aims to solve, and thus how we were able to connect with her so fast and convince her to become a cofounder of Nori alongside us.
Aldyen also was a public governor of the Vancouver Stock Exchange, and saw her fair share of pump and dump schemes while there. She approaches the cryptocurrency markets warily as a result. A pump and dump scheme is when a group of people make it seem like a trading asset is going way up in value. They can do this through buying a lot of it, or through the use of derivatives (more on this below.) Once it booms, other people start to think it is organic demand and buy in at an inflated rate as the original groups sell out to a hefty profit. This often falls afoul of the law, but does occur and is common in cryptocurrencies with low market capitalizations and less regulation which are easy to manipulate with not much money.
And so then, what is a derivative, you may ask? Get ready to sound smart at a cocktail party: commodity and equity markets are about the distribution of ownership, derivative markets are about the allocation of risk. They are derivative in the sense that they refer to an underlying asset and thus derive from it. A farmer growing corn is betting that the price of corn will be good that year. But what if it’s not? She can hedge and buy a derivative product betting that corn will go down in price. If corn goes down in price, her losses will not be as severe as they would otherwise be. If corn goes up in price, her profit is a little bit lower, but the important thing is that the farmer was able to offload some of her risk for a price, and that helped her sleep at night.
We’ve been talking since the inception of Nori about how derivatives market can help both buyers and suppliers to our project manage their risk, and how this might play out and affect our operations. It’s a fascinating topic I hope we’ll get to discuss on the show more, if they let me (open question.)
This might be my nerdiest economics post yet. I tip my hat to you if we’re still friends.
Please share the podcast, rate it in your podcast app, and follow us on Facebook, Twitter, LinkedIn, and/or Instagram.
