CARBON is set to be the next bubble, one that could make the US housing market crash look like a picnic.
One reason the US market collapsed was that no one was minding the store when companies were trading exotic and little understood derivatives, such as the credit default swaps that almost destroyed American International Group.
Carbon credits are designed to reduce greenhouse gas emissions by selling carbon as futures or forward contracts at a certain quantity and price.
They are derivatives - bets on the future.
Commissioner Bart Chilton from the US Commodities Future Trading Commission told The Financial Times last year that carbon could be the world's biggest derivatives market in five years. Experts estimate it to be worth between $2 trillion and $3.5 trillion.
But that market is being created from a standing start. Little thought is being put into developing safety mechanisms in the public interest. But then, politicians only respond with tough laws after a crisis.
A report from environmental group Friends of The Earth says we don't yet know how to regulate this market.
The report, Subprime Carbon, says: "Little attention is being paid to how and whether new financial regulations will be adequate to govern the carbon derivatives markets, which many experts believe will eventually be bigger than the credit derivatives market. Similarly, most federal climate change bills do not provide for adequate carbon market regulations, creating a potentially huge regulatory gap."
For example, we are yet to see measures minimising potential conflicts of interest with carbon trading, conflicts that echo those perpetrated by ratings agencies that left capital markets in smoking ruins.
Impossible with carbon? How about financial engineers creating "junk" carbon contracts with a relatively high risk of not being fulfilled, similar to subprime mortgages?
Or consultants offering advice on developing carbon offset projects and then, like the ratings agencies, earning fees to verify emissions from those projects?
Or investment banks taking equity stakes in carbon offset specialists and then selling their services as carbon brokers and analysts?
How many Chinese walls do you need to stop investment banks making millions managing both ends of cap and trade transactions?
In October 2008, Goldman Sachs announced a strategic alliance and minority equity stake in carbon credits developer Blue Source, which works with big polluters, including coal-burning power plants.
Hedge funds are getting in on it too. At the end of 2008, Swiss fund Da Vinci Invest launched an environmental, Islam-friendly Green Falcon Fund to put money into carbon markets and forestry.
Given the talent that investment banks have for making money out of thin air, it is not too difficult to see them concocting "green" products that they can flog to retail investors.
Already, the carbon market is starting to have echoes of the subprime debacle where investment banks made enormous profits selling dodgy securities.
There have been reports of Credit Suisse bundling together about 20 projects, then splitting the credits into tranches according to their risk profile. Buyers would pay more for a collection of low-risk credits, less for those with more risk.
That sounds like a green market form of the collateralised debt obligations that investment banks used to sell.
There are also reports of companies making a fortune out of credits by creating noxious chemicals and then destroying them.
Just as Sarbanes-Oxley and corporate governance law changes around the world became a bonanza for accountants, emissions trading is likely to become a bonanza for them too.
Accountants will have a critical role to play as they assess the impact of carbon credits and liabilities on balance sheets.
The big four accounting firms in the US — PricewaterhouseCoopers, KPMG, Ernst & Young and Deloitte Touche Tohmatsu — are beefing up their climate desks in the wake of the US House of Representatives passing legislation opening the way for carbon trading.
We can expect similar developments here if the Senate passes the Federal Government's carbon pollution reduction scheme.
There is no doubt that carbon trading will generate green jobs. It's just that many of those jobs won't be the kind people imagined.
In the meantime, the carbon market continues to boom in defiance of — or perhaps because of — the worst economic conditions since the Great Depression.
Figures from market intelligence provider Point Carbon show the global carbon market grew 124 per cent in volume terms and 22 per cent in value as struggling industry sectors, desperate for cash, sold surplus carbon allowances.
The carbon market needs regulations to prevent a green bubble and to rein in eco-capitalists and carbon cowboys.
Already, the International Emissions Trading Association has written to US Senators claiming that "the market itself recognises integrity and exerts discipline on participants".
The subprime debacle suggested the opposite. As the Friends of the Earth report notes, even Alan Greenspan admitted that self-regulation and self-interest did not ensure integrity in financial markets.
"There is no reason to believe that traders and investment banks can gain some green credentials from carbon trading, [or that] Wall Street will behave more honourably when playing with the new class of derivatives," the report says.
In the end, an emissions trading market has one key problem: unlike other commodities markets, it is politically created and managed so it is vulnerable to vested interests and regulatory capture.
As the subprime meltdown showed, politicians of all persuasions are susceptible. There is no reason to think they will be different with carbon.
* For more information, see: Subprime Carbon?
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