It’s easy to dismiss the carbon market as a passing fad or an artifact of a more optimistic, pre-recession world. Yet carbon trading continues to grow, following a trail blazed by another asset class that once seemed obscure and risky but is now a cornerstone of the investing world: emerging market bonds.
In the early 1990s, emerging market debt was exotic, volatile and strictly for sophisticated players. Today it is a widely held, multi-trillion-dollar asset class. It’s probably in your 401k right now.
The carbon market is still at an early stage, but its progress mirrors the evolution of emerging market debt. Here are four similarities.
1. Both markets were tested by crisis and survived.
Emerging market debt trading saw its first major crisis when Mexico defaulted in 1994, just as the new market was gaining a foothold. Trading and new issuance recovered, but just four years later, Russia defaulted and devalued its currency.
Here’s how one analyst described it to the New York Times in 1998:
“’Emerging markets have become more a game for speculators and traders – and a nightmare for dedicated long-term investors,’ said Robert J. Pelosky Jr., global emerging markets strategist at Morgan Stanley Dean Witter. ”In the short run, fundamentals don’t seem to matter.”
Ultimately, fundamentals did matter, and the market recovered. Trading in emerging market debt reached $6.5 trillion by 2007, the highest since the market peak of $9 trillion in 1997, according to the Emerging Markets Trading Association.
Similarly, carbon trading has been battered by policy shifts, notably an over-allotment of permits in
Europe that sent prices reeling. The market also faced the global recession and the collapse of Lehman Brothers and other banks that had been active in the market.
Amid all these challenges, the volume of traded carbon rose steadily, reaching 8 billion metric tons in 2011, with a total value of just under $130 billion, according to PointCarbon. That’s tiny compared to emerging-market debt, but carbon trading has grown fast, nearly doubling in volume annually on average since its start eight years ago.
2. Government policy was vital for each market’s growth.
Emerging market bond trading had its origins in the mid-1980s, when a small group of banks started trading the bad loans from Brazil, Argentina and other “less-developed countries” that languished on their balance sheets. It was a slow and difficult process. It took the Brady Program, which essentially guaranteed the repayment of the face amount on the loans, to set the market in motion. Brady Bonds (named for then-Treasury Secretary Nicholas Brady) became liquid, widely traded instruments that launched the market.
The carbon market is also a creature of public policy. Governments in Europe, Australia, Quebec and elsewhere have established cap-and-trade systems to reduce carbon emissions and support a cost-effective way for companies to comply. Others, like California, are set to follow them.
On their own, banks could not have created a vibrant market in emerging country debt. It took government action to jump-start it. And a carbon market won’t grow without constructive government policy either.
3. These markets reduce the dangers from concentrated risk.
When the less-developed-country debt crisis erupted in the early 1980s, America’s eight largest banks were owed $37 billion by developing countries – an amount equal to nearly 150% of their total capital and reserves at the time. That concentrated risk nearly sank the banks. But the emergence of a liquid market enabled them to shed this risk in an orderly way, and freed up their capital for other productive uses. Banks recovered, and the banking system was strengthened.
The carbon market can play a similar role, reducing the carbon risk for big emitters like electric utilities, refineries and manufacturers. Without a deep market in carbon, these companies will find it difficult to meet to the emission cuts imposed by regulators.
4. Markets need – and benefit from – adjustments.
Every market adapts through experience. The history of emerging market debt is filled with adjustments, as participants sought to strengthen a market that operated across multiple currencies, local-market institutions and supervisory bodies. Processes for documentation, clearing, settlement and reporting went through countless improvements as the market grew.
Although still in its infancy, the market for carbon emissions has been a success by many measures. A solid legal framework is in place. New participants are joining. Government policy is creeping toward constructive measures to spur its growth.
But improvements are needed, too, in areas such as the allocation of allowances, the use of offsets, project auditing and verification and the transferability of credits across jurisdictions. It would be a mistake to let those shortcomings halt efforts to develop the carbon market. It works today, and it could work even better in the future.