Planet Worth

Of all the different industry groups scrambling to shape climate policy in Washington--from electric utilities to Detroit automakers--one stands out as a bit unexpected: Wall Street. Financial giants like Goldman Sachs and JP Morgan have enlisted, all told, more than 100 lobbyists to roam the Capitol and influence the debate over how to curb greenhouse gases. There’s a reason for that: Any cap-and-trade bill that puts a limit on emissions and allows polluters to buy and sell permits will create a vast carbon market. That will mean new opportunities for financial firms to broker deals, package carbon offsets, or offer hedging instruments. And that, in turn, will mean profit. Little wonder that investment banks have been bulking up their carbon-trading desks in recent years.

But, given what happened the last time bankers went wild on a hot commodity, some politicians are leery of their interest in cap-and-trade. “I know the Wall Street crowd can’t wait to sink their teeth into a new trillion-dollar trading market,” wrote North Dakota Senator Byron Dorgan in July. “But given recent history, I have little confidence that markets are free or fair enough to trust them with a new, large cap-and-trade carbon securities market.” A small but vocal group of climate activists agrees. In The New York Times, NASA scientist James Hansen warned that the carbon market “appears likely to be loosely regulated, to be open to speculators, and to include derivatives” and that bankers would extract profits by inflicting high energy costs on the public, while volatile prices would make it harder for companies to make investments. These critics prefer an approach that leaves Wall Street out--say, a simple carbon tax.

As it turns out, there’s a decent case that a well-regulated carbon market would make tackling global warming easier--and that Wall Street’s wizardry could be put to good use by lowering the overall costs of reducing emissions. But whether that actually happens will depend on Congress’s ability to regulate the financial sector--a task it’s planning to take up after health care. And that means the fate of climate policy may end up hinging on how financial reform shakes out.

To see why carbon markets can be a flexible tool for cutting emissions--and why they could also fall prey to the sorts of problems that dragged down the economy last year--it’s worth reviewing how a cap-and-trade system works. Congress sets an overall limit on the amount of carbon dioxide that can be emitted by issuing a fixed number of pollution permits, which businesses can buy and sell; each year, the limit declines. Companies that decide it’s cheaper to reduce their emissions (say, by boosting energy efficiency) than it is to buy permits will make those easy cuts first. As the cap tightens each year and the total number of permits dwindles, the cost of polluting will steadily rise, and more and more businesses will cut emissions rather than buy increasingly pricey permits.

That’s where Wall Street comes in. Because the cost of permits depends on supply and demand--which, in turn, depends on factors like weather, economic activity, or the cost of clean-energy alternatives--the price of carbon can fluctuate quite a bit. A utility trying to decide whether to operate a power plant that will be around for decades may want to hedge against the chance that carbon prices will rise or fall, and so offload that risk onto investors by buying derivatives. (This is similar to how farmers can buy futures contracts to hedge against an unexpected plunge in wheat prices.) Meanwhile, outside investors would be making bets on how carbon prices will move. In theory, this is all supposed to make the market more efficient.

Critics of carbon-trading usually focus on this derivatives market, which could swell to as much as $2 trillion in the program’s early years. “There’s considerable worry that this market would have the problems that have been found in other physical commodity markets for the past few years,” says Michael Greenberger, a University of Maryland law professor who oversaw the U.S. Commodity Futures Trading Commission’s trading division in the late 1990s. Speculators, for instance, could artificially inflate the price of carbon--which is what some economists think happened in the oil markets last year, when the price of crude shot up from $60 per barrel in February 2007 to $147 per barrel in 2008. That, in turn, could cause energy prices to skyrocket and lead to a mass revolt against the whole idea of a carbon cap.