Carbon Markets:
Volatility & Trading
Institutions
Craig Pirrong
Bauer College of Business
University of Houston
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
Basic Economic
Considerations

Volatility tends to be greatest when supply constraints tend to be
binding: can’t 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
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 volatility—volatility
lower on average

Borrowing tends to mitigate intensity of price spikes: loosens a
constraint that binds in natural commodities
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
Secondary Market Design

The design of secondary markets in carbon is up in the air—but 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-thecounter 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
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. What’s 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