Avoiding "subprime" carbon—applying lessons learnt from the current financial crisis to the carbon derivatives market

     In their report, "Subprime carbon? Re-thinking the world's largest new derivatives market", Friends of the Earth (FOE) suggest that what we have witnessed during the current financial crisis provides "a cautionary tale for any future carbon trading program", and an attachment to the report documents several bills and proposals that have been floated in an attempt to design carbon markets in ways that set stable prices while maintaining firm caps.     For example, the Safe Markets Development Act of 2009 would amend the Internal Revenue Code to require an independent board to publish a stable price path for allowances (authorizations to emit one carbon dioxide equivalent of greenhouse gas) and for the Secretary of the Treasury to conduct quarterly auctions of allowances and manage the supply of allowances to hit, on the average, the published price.     FOE identifies "a potentially flawed model for managing systemic risks" as one of the causes of the current crisis, and it is this aspect, in the context of the developing carbon derivatives market, that the paper seeks to address.     Black (1992) wrote: "I sometimes wonder why people still use the Black-Scholes formula (to price derivatives) since it is based on such simple assumptions." Indeed, one of these assumptions is that price movements of the underlying commodity are normally distributed. However, an examination of such price movements reveals quite dramatically how they are NOT normally distributed.     For example, an analysis of monthly movements (January 1875 - May 2009) in the Index measuring the value of stocks on the Australian Stock Exchange reveals that falls of greater than three times the standard deviation of the price change are more likely to occur than that predicted by a model based upon the assumption that the price movements are normally distributed!

. 

.      The authors make an appeal to model developers that they adopt a behavioural economics approach and utilise real data in developing models to manage financial market risk, rather than developing risk management models that are based upon esoteric theoretical considerations. In conclusion, utilising real data, the paper illustrates the derivation and application of a risk management model that might be applied to the "real world".

. 

.      The lead author of this paper holds a Ph. D. from the University of Melbourne's School of Earth Sciences, and a Graduate Diploma in Applied Finance and Investment from the Securities Institute of Australia. His previous work has included evaluating the cost of protecting against global climate change utilising options pricing theory and weather derivatives, and the identification of flaws in financial market models.