Carbon Markets: Volatility

1
Carbon MarketsVolatility Trading Institutions

• Craig Pirrong
• Bauer College of Business
• University of Houston

2
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

3
Basic Economic Considerations

• Volatility tends to be greatest when supply
  constraints tend to be binding cant 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

4
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 volatilityvolatility lower
  on average
• Borrowing tends to mitigate intensity of price
  spikes loosens a constraint that binds in
  natural commodities

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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

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Secondary Market Design

• The design of secondary markets in carbon is up
  in the airbut 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

7
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.
  Whats 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