No, it’s not the American Petroleum Institute, the American Coal Council or some right-wing think tank. Or even Francis Cianfrocca.

It’s the Friends of the Earth. The Friends of the Freakin’ Earth. You won’t find me quoting them often.

But in a March report titled Subprime Carbon: Re-thinking the World’s Largest New Derivatives Market, Michelle Chan with the FOE does a fine job of laying out the potential hazards in creating a huge new market in an intangible commodity such as carbon credits. (In a previous diary, Congress Invents New Funny Money, I described carbon credits as a new off-balance sheet currency, but Ms. Chan sees a potential financial market train-wreck if carbon credits become a trading vehicle.)

[Document Summary] [Full pdf] [Video link]

Don’t worry. The planets are still in alignment. The FOE, in a press release, has opposed the Waxman-Markey Bill (a/k/a “The Let’s-Hogtie-The-Economy-And-Throw-It-In-The-Ditch Act of 2009), but because it fails to go far enough to protect the Environment from Big Business, not because of the risks posed by speculative trading.

Carbon trading is fundamentally derivatives trading. Currently, most carbon is sold as simple futures contracts (a type of derivative). These contracts contain promises to deliver carbon allowances or credits in a certain quantity, at a certain price, at a specified date. Today’s carbon markets are small, but if the United States adopts carbon trading on the scale envisioned by most federal cap-and-trade bills, carbon futures will become what Commodities Future Trading Commissioner Bart Chilton called “the biggest of any derivatives product.”

“Subprime carbon” — called “junk carbon” by traders — are contracts to deliver carbon that carry a higher risk of not being fulfilled, and thus may collapse in value. They are comparable to subprime loans or junk bonds, debts that carry a higher probability of not being paid. Carbon offset credits (credits derived from projects designed to reduce greenhouse gases) can carry particularly high risks because many things can go wrong with offset projects. Not only do such projects face normal commercial and operational risks, but independent verifiers may find that a project has not reduced the projected amount of emissions, for example; or an agency issuing credits (e.g. United Nations) may determine that a project failed to comply with relevant standards. Subprime carbon particularly can become a problem because sellers can make promises ahead of time to deliver carbon credits before the credits are issued, or sometimes even before greenhouse gas emissions have been verified. [emphasis added]

And lest you think Ms. Chan is some Luddite fretting about what might happen in the distant future, traded credits have already created problems in European markets.

Carbon markets, like other markets, are at risk of experiencing boom-bust cycles. Today, as a result of the economic downturn, carbon prices in Europe have collapsed after posting record years. Until the current bust, the carbon market was growing rapidly; between 2006 and 2007 market volumes doubled, and the secondary CDM markets changed almost beyond recognition as traded volumes increased by almost nine-fold.

The boom was largely driven by a flood of new traders seeking financial returns, as well as green bragging rights. Asset managers began marketing carbon as a new asset class, encouraging investors such as pension funds to increasingly allocate a portion of their portfolio to carbon derivatives. Investment banks developed financial instruments such as indexes to allow even more investors to gain exposure to carbon, and new carbon funds (investment schemes set up to finance offset projects and/or buy carbon credits) were formed. Today, speculators do the majority of carbon trading, and they will continue to dominate as carbon markets grow. In fact, about two-thirds of carbon investment funds by volume were not established to help companies comply with carbon caps, but rather for capital gains purposes. [emphasis in original]

Some of the most visible carbon offset scandals to date have centered on international offset projects that may be simply disingenuous. Perhaps the most well-known controversies relate to offset projects designed to destroy HFC-23, a chemical byproduct of refrigerant production that is more than 11,000 times more potent than carbon dioxide. Widespread reports of companies purposely creating these very powerful greenhouse gas chemicals — just to destroy them and make money off of the credits — prompted the Kyoto Conference of the Parties to take up this issue at their December 2008 meeting in Poland.

Subprime carbon can also come from projects that use controversial methodologies to verify a project’s GHG savings. Some offset projects, such as those which seek to protect forests as a means of sequestering carbon, are by nature difficult to verify. For example, even with advances in satellite imaging, it is difficult to verify with accuracy how many tons of GHGs were sequestered by preventing a tract of land from being deforested or degraded.

So you think there was fraud in abuse in the trading of mortgages and mortgage backed securities? At least with mortgages, there are tangible assets involved, and actual buyers and sellers. Carbon credits are a purely intangible trading vehicle, invented for speculation and ripe for abuse.

Environmentalists opposed to Cap-and-Trade? The Wall Street Journal blogs picked up on it, but the rest of the mainstream press has ignored this story.

H/T Kari Scott, CRC Public Relations