Speculating On Carbon

Washington is beginning a pre-emptive strike on speculation in the upcoming carbon-emissions market. Bloomberg reports that the big banks like Goldman and JP Morgan will be restricted from driving the market. Some in Congress are worried about the wild price swings that have been seen in oil and other commodities over the past few decades, for which Wall Street is generally blamed. Preventing bank speculation would remove Wall Street from the equation, but that will also result in some undesirable consequences.

First, here's Washington's view, via Bloomberg:

"The volatility that has existed in the oil market is exactly what we don't want to happen in carbon markets," said Senator Maria Cantwell, a Democrat from Washington state who wants to exclude financial companies from the carbon market. "The banks contributed to that, and the banks continue to contribute to it."

Stopping speculation might dampen volatility, but it will still fail to achieve another goal that Washington should care about: carbon credits' value being accurately reflected by their price.

Without having Wall Street as a market maker, that will significantly reduce liquidity in the carbon market. Less liquidity generally results in prices including a liquidity risk premium, which drives prices higher. Similarly, a less fluid market will create higher transaction costs, further raising the price of carbon credits past their actual value. The greater the restrictions placed on banks' trading, the higher the prices of carbon firms will likely see, as the market becomes less efficient.

Would these increased prices due to the liquidity risk premium and higher transaction costs exceed those resulting from more bank speculation? It's hard to tell. But just like if speculation were involved, the prices won't reflect the true value of the carbon credits.

Higher carbon prices might not bother some in Washington. After all, higher carbon prices could lead firms to want to pollute less. That might be good news for the environment, but higher prices are probably bad news for the economy. If firms are forced to pay more for carbon, then their costs increase, which will lead to less growth and prosperity.

Speculation might be viewed as bad, but liquidity is good. That's the trade-off Washington faces.