OTC Emissions Derivatives as Facilitators of Market-Based Climatic Regimes in the Wake of the Financial Meltdown

Abstract

The underlying premise of international and domestic climatic regulatory regimes that employ cap-and-trade schemes to curb emission levels of greenhouse gases is that a market-based approach is the most cost-effective strategy to achieve a benign environmental system that enables sustainable development. The scarcity in emission allowances under those schemes is designed to impose increasing compliance costs on participating nations and business entities that would gradually facilitate transformations to economic equilibriums with lower intensities of greenhouse gases. However, the participants in these nascent and rapidly evolving “carbon markets” are increasingly exposed to exceptionally high and enduring price volatility of the newly created regulatory-based commodities. Unless such volatility could be hedged efficiently, it would constitute mounting regulatory-related compliance costs that could endanger the economic stability of viable industries. Ultimately, such volatility could project negatively on the cost-effectiveness of market-based regimes in the battle against climate change. The overall regulatory burden could be alleviated, to a degree, by linking the schemes to domestic and international project-based flexibility mechanisms, under which GHG mitigating projects are issued fungible offsets. However, the origination of mitigating projects is also dependent on custom made and long term risk mitigating solutions against regulatory, origination, and operational risks and against price volatility in the carbon markets. Over The Counter derivatives have been the strategy of choice, thus far, to overcome these price volatility-related setbacks and uncertainties. Their continuing utilization and development are essential for a cost-effective and winnable battle against climate change, especially given the increased cost-sensitivity in the current economic climate. However, OTC derivatives face increased skepticism and an uncertain future in the wake of the recent financial meltdown. They are blamed for generating unprecedented systemic risk by amplifying the ramifications of the subprime crisis to full-scale financial meltdown. In addition, they are blamed for facilitating excessive speculation in the energy markets in the midst of the crisis, which slowed down economic recovery. This article delves into a consequent inherent tension. The reliance on the carbon markets to facilitate unprecedented transformation entails the employment of potent risk management for fulfillment of their potential as the most cost-effective strategy for a winnable battle against climate change. However, the recent financial meltdown yielded general mistrust vis-a-vis innovative financial technology. In particular it motivated regulators to prevent reoccurrence of OTC-related financial meltdown and, ironically, to protect the integrity of the nascent carbon markets. This article sheds light on the associated vibrant debate over the future financial and climatic regulatory regimes and points to a desirable “center of gravity” that efficiently balances conflicting risks and challenges.