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An eCommerce Perspective on Carbon Trading

Version of 6 November 2008

Prepared for an address in the ECom-IComp Experts Address Series at the University of Hong Kong, 6 November 2008

Roger Clarke **

© Xamax Consultancy Pty Ltd, 2008

This document is at http://www.rogerclarke.com/EC/CTHK-0811.html

The accompanying slide-set is at http://www.rogerclarke.com/EC/CTHK-0811.ppt

Abstract

In January 2008, it was reported (e.g. Forbes magazine of 16 January 2008) that the Hong Kong Exchange was seriously considering the introduction of carbon emissions trading. Carbon trading schemes are inevitably electronically supported. They have attracted investors, and much speculative discussion in the trade press, but almost no serious consideration in the eCommerce literature. This presentation provides a preliminary examination of the nature of carbon trading, from the perspective of electronic commerce theory and practice.

Notes to Accompany the Slide-Set

Slide 1 - We're all supposed to believe that so-called 'carbon trading' is going to 'save the world'. In this presentation, I want to bring some of the accumulated knowledge about electronic trading to bear on 'carbon trading'. But to do that, it's first necessary to work out what it is.

Slide 2 - Talking of bringing knowledge to bear, this image is much-used as a rallying call by the climate change movement. (People think that) polar bears are cuddly, and that their ice-world shouldn't be allowed to crack apart, isolate them on ice-floes, and consequently drown them.

Slide 3 - If the not-so-frozen Arctic isn't immediate enough for you, last Sunday's announcement about temperatures in Hong Kong might do the trick.

Slide 4 - More generally, the last 150 years have seen a measurable increase in temperatures. But how you interpret that depends on your perspective.

Slide 5 - From a longer-term viewpoint, the earth appears to be approaching the peak of an ice-age cycle that recurs about every 100-150,000 years.

Slide 6 - But there are claims that the amplitude of that curve will be affected by human interventions since the industrial revolution. We'd better watch the porpoises closely. [According to soothsayer Douglas Adams, human beings think that they're the superior species because they invented things like war, New York City and the industrial revolution; whereas porpoises think that they're the superior species, precisely because they didn't. If they're right, and they abandon the planet, we'll know we're in deep trouble).]

Slide 7 - Another group of soothsayers called scientists argue that the evidence is now very strongly in favour of the proposition that human beings are greatly exacerbating the climb in temperatures. The upper of these two graphs shows that the amount of carbon dioxide in the atmosphere is far greater than it was prior to the industrial revolution. The lower graph shows how much of the increase can be attributed to human activities.

Slide 8 - And scientists also claim that they have worked out the way in which the side-products of industry are doing the damage.

Slides 9-10 - Carbon dioxide isn't the only 'greenhouse gas' that's leading to heat capture and temperature increases. And some of the others have much more serious impacts at far lower concerntrations. But carbon dioxide, because of its sheer volume, is seen as the biggest contributor, and hence the frontline problem to be addressed.

For that reason, many commentators use the lazy shorthand 'carbon dioxide emissions' and even 'carbon dioxide' in many circumstances when they should use a more general term, particularly 'greenhouse gas emissions' (GHG). And many commentators use the even lazier term 'carbon' instead of 'carbon emissions'. Hence 'carbon trading' is shorthand for 'carbon dioxide emissions trading', or sometimes 'greenhouse gas emissions trading'. (And, as the later parts of this presentation will show, most so-called 'carbon trading' is actually in a proxy for emissions, not emissions themselves).

Slide 11 - Emissions arise from a variety of sources. This analysis is by industry. The electricity generation industry has been a primary target, especially coal-fired power stations. But there are many other parts of the problem that have to be tackled beyond the power industry.

Slide 12 - And this analysis is by region. There are two particularly noteworthy features. Firstly, the developed or industrial nations, and especially the USA, are responsible for a very large proportion of the current problem. Secondly, the developing world will become an even larger problem during the next 10-50 years.

Slide 13 - The alarm bells were rung 15-20 years ago. An international framework was agreed for addressing the problem, and is popularly referred to as the Kyoto Protocol. Successive 'mid-life kickers' have been provided, in particular by the sometime U.S. Vice-President and Presidential candidate Al Gore and the British economist Richard Stern.

Slide 14 - Can't we just pass some laws, and force polluters to stop it? Unfortunately, genuine regulation has been out of fashion for some years now, with the mantra of 'self-regulation' substituted for it. But in this particular area, genuine regulatory measures would be doomed to failure. Polluting organisations are big, rich and powerful. And they can play off governments by threatening to take their business somewhere else.

Slide 15 - Instead, the 'power of markets' has been proposed as the means of solving the problem. Capitalists see it one way. The more respectable explanation is provided by economists, whose theory tells us that pollution can be reduced in a more efficient way if the least expensive forms of pollution reduction are tackled first; and that creating tradable instruments will enable the vast intelligence of markets to work that out, far better than the limited intelligence of regulators could ever do.

Economics is based on a host of quite unreal assumptions, so it's far from clear that the theory's right. But whether the theory is solid or deeply flawed, governments of the world have chosen to accept the proposition.

Slide 16 - The Kyoto Protocol imposes responsibilities on developed countries now, and foreshadows responsibilities that will need to be accepted by developing countries in the near future. Europe has galloped ahead in implementing the carbon trading framework it contains, and some other nations are active as well. In the US, the Bush Administration refused to join the rest of the world in adopting the Protocol. The Obama Administration may or may not change that.

Slide 17 - The mechanics of the Kyoto Protocol are complex and confusing. Roughly speaking, each polluter in each country is required to meet a target for the volume of emissions. They may be given some allowances, and they may address some of their excess by reducing their pollution, and they may buy in some kinds of certificates. Those certificates may be permits that are sold by the government and traded on open markets, or credits arising from approved pollution-reduction projects in the same country, or elsewhere.

Slide 18 - The purpose of this recitation of carbon politics was to lay the foundation for a consideration of what the scene looks like from the vantage-point of eCommerce theory and practice. First some theory.

Slide 19 - In eCommerce people trade things in 'marketspaces'. Participants discover tradable items they may be interested in buying and/or selling, and other participants who may be prepared to be the other side of the deal. The participants may be polluters and sponsors of carbon-friendly projects; or they may be traders and speculators. Buyers and sellers may meet directly, but they commonly meet and do their deals by means of an intermediary usefully referred to in the abstract as a 'marketspace operator'.

Slide 20 - For a market to come into being and survive as an observable entity, a range of conditions have to be fulfilled. Whatever the items are that people are supposed to trade needs to be credible, and if it is derived or synthetic, then confidence is needed that there is substance underlying it, and that the ownership of it reliably confers rights on the buyer. There's also the need for sufficient scale, in terms of the quantity of tradable items, the amount of trading that takes place, and the numbers of potential market participants (which are together referred to as 'market depth'). Marketspaces have much wider reach than physical marketplaces used to have, which makes it easier to achieve adequate depth. A trading mechanism has to be contrived that is suitable given the nature of the tradable items and the market participants.

Slide 21 - The basic commodities that are traded in carbon markets are permits and credits. Permits are certificates permitting a quantity of pollution. Credits are certificates recognising a quantity of pollution that has been avoided through some carbon-friendly project of technological innovation.

Slide 22 - One set of important measures to achieve market depth ensure that the tradable items are interchangeable, easily transferable, and guaranteed against such risks as default by or insolvency of the organisation that gave rise to them. Another feature is the provision of some measure of flexibility in relation to the time at which the certificate is surrendered. If they can be held for a period of time, they are described as being 'bankable'.

Slide 23 - In practice, the volume of the base commodities (permits and credits) will always been somewhat limited. The expectation is that the financial markets, ever on the look-out for something more to trade in, will create additional tradable items that are 'derivative from' the 'underling commodities'. Futures and options are once-removed derivatives. A range of further possibilities exist, of increasing opacity, risk and even downright dubiousness (as amply demonstrated by the leveraged 'securities' that magnified the 'sub-prime mortgage' fiasco).

Slide 24 - A wide range of mechanisms exist whereby trading can occur. For tradable items that have been contrived to be commodities (i.e. undifferentiated, one from another), there are no further attributes that need to be negotiated beyond quantity and price, and hence the trading mechanism is essentially a price-setting mechanism. Some schemes are inherently to the advantage of the seller, and some inherently to the advantage of the buyer. Some, on the other hand, encourage buyers and sellers, and especially traders (who are successively buyers and sellers, often repetitively so), by avoiding inherent bias in favour of either party.

Slide 25 - A small sub-set of all the possible trading mechanisms is particularly common. For seller-biased markets, variants of English (ascending) auctions are much-used, but Dutch (descending) auctions also work well in particular contexts. The primary form of balanced marketspace is a 'clearinghouse auction', commonly referred to as an 'exchange'.

Slide 26 - With that background in theory, it's easier to gain an appreciation of what's currently going on in the emergent carbon trading markets. Firstly, marketspaces are being devised for the initial sale of Kyoto-compliant permits by governments. Secondly, markets are needed in which both those permits and Kyoto-compliant credits can be traded. Thirdly, alternative forms of credits, usefully differentiated by calling them 'carbon offsets', need to be supported. Finally, the derivatives that players in the financial markets create also need marketspaces in which they can be traded.

Slide 27 - The Kyoto-compliant permits and credits are something of an alphabet soup. Credits require certification (because of the large scope for corruption), and separate schemes exist for industrialised and developing countries.

Slide 28 - Several markets exist in other kinds of commodities that have similarities to carbon permits and credits, and these have provided a basis for marketspace design. Easily the largest carbon market at present is the Emissions Trading Scheme (ETS) within the European Union. Smaller ETS are emergent in several other countries. Meanwhile, a number of markets are trading 'carbon offsets', which are non-Kyoto-compliant credits arising from voluntary schemes, particularly (but not solely) in the USA.

Slide 29 - Clearing-house auctions are a natural form of marketspace for most of these forms of tradable item. The initial sale of permits, however, can be done in a variety of ways. Drawing on eCommerce theory, there is a primary distinction between single-round and multi-round bidding, and multi-round auctions take a considerable variety of forms.

Slide 30 - Permit sales are only now becoming a signficant market, as Europe moves beyond its initial allowances-based approach, and markets start coming into operation in such places as New Zealand and Australia. Australia provides a useful case study, because the Treasury economists who wrote the present Government's Green Paper (draft policy) propose to apply much the same mechanism as they have long used to sell Treasury Bonds. This is a variant of multi-round, timed-round bidding called an 'ascending clock auction'.

Slide 31 - There are a number of positive features of this kind of auction.

Slide 32 - But, when applied to the sale of carbon permits, there are some negative features that need careful consideration. The participants in bond issues are large financial institutions, whereas it's as-yet unclear what the profiles of participants in the sale of carbon permits will be. Moreover, the size of the demand for permits is unclear. And the aim during the initial phases of the scheme is not to maximise revenue to the government, but to establish a new market. It would be most unfortunate if an inappropriate choice of trading mechanism got an important initiative off to a bad start.

Slide 33 - Carbon trading is a form of market engineering, and it's being performed by governments, motivated by public policy considerations, and in the absence of hard information. In short, it's very challenging to get it right. Some 'reality checks' are already available. The first phase of the EU ETS had very mixed outcomes. The US voluntary schemes have not yet delivered on their promise. Markets in permits and credits remain low-volume, and a very large proportion of the turnover has been in derivatives. Whether equivalances and arbitrage between Kyoto carbon-credits and Voluntary carbon-offsets can be achieved remains an open question.

Slide 34 - Hong Kong sits far from the mainstream of the EU ETS and far from the developments in US voluntary markets. And China is many years away from implementing a permit scheme. On the other hand, China is the largest source of Kyoto-compliant credits (CERs), Hong Kong is a large and sophisticated financial market well-used to trading in derivatives, and Hong Kong should be an attractive regional partner to and time-zone extension for US and European exchanges active in carbon trading.

Slide 35 - Developing an understanding of carbon trading isn't easy. It's first necessary to appreciate current knowledge about the causes of global warming, and the reasons why direct regulation of polluters is unattractive and the creation of markets for carbon-related commodities has been preferred. eCommerce theory and practice, drawing in part on economics and game theory, and in part on the designs of existing markets, provides a useful perspective from which to observe developments.

Author Affiliations

Roger Clarke is Principal of Xamax Consultancy Pty Ltd, Canberra. He is also a Visiting Professor in the Cyberspace Law & Policy Centre at the University of N.S.W., a Visiting Professor in the E-Commerce Programme at the University of Hong Kong, and a Visiting Professor in the Department of Computer Science at the Australian National University.

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