Personal Project Blog 2 - Making Progress

Since my last personal project update, I’ve met with several contacts in finance-related job functions in order to get a better understanding of derivatives markets and market making in general.  It was my goal to apply the knowledge obtained through these meetings directly to a financial model of a carbon derivatives exchange.  However, things did not proceed exactly as I had planned and instead of helping me to move forward on my original derivatives exchange plan, these conversations helped to illustrate several obstacles within my plan that would limit its economic feasibility.  The good news is these meetings have led me in some new directions that are more feasible than my original plan.

The first person that I spoke with was a finance professor of mine, Professor Shockley. The reason that I wanted to speak with Professor Shockley was because I wanted to confirm that my hypothetical derivatives contract, of which I know of no currently existing equivalents, was mathematically sound.  I explained to Professor Shockley that even though my contract was based on an underlying asset which had no spot price, I believed that the spot price could be derived through price discovery in the futures market.  Professor Shockley confirmed that the contract made sense and recommended that I talk with the CME Group in Chicago in order to figure out why nobody else was pursing such a contract.

So that’s what I did.  During my meeting with a member of the Research and Product Development Team at the CME Group, I learned about potential methods in which I could partner with their exchange in order to launch my Carbon contract.  By working within an already established exchange, I would instantly have access to a liquid market and a credible clearing house.  In exchange for these services, I would have to pay a launch fee and I would receive only a portion of the commission generated by each trade.

After talking with the CME Group, the next person that I talked with was Michael Greenberg, the founder of the Plastics Exchange in Chicago.  The Plastics Exchange is one of a few, if not the only, truly new markets that has successfully been established in the last thirty years.  Mr. Greenberg told me that I had a clever idea but that a carbon exchange, organized in the way in which I had imagined, would be almost impossible to turn into a viable business.  The reason for this is because the commissions on futures contracts average out to be only about eight cents per contract.  This commission structure is appropriate for contracts like S&P 500 futures, which trade millions of contracts every day.  However, by launching my own exchange, even if I managed to create a market with thousands of contracts in open interest, a number which is similar to that of the Plastics Exchange, I would still be earning very little revenue in the process.  Mr. Greenberg thought that the option of working with the CME group was more realistic.

After hearing this critique, I spoke with another professor of mine in the business school, John Succo, who until recently ran his own hedge fund.  John explained that the lucrative part of making markets was the actual act of matching buyers and sellers.  In this business model, a broker earns a large fee for their match-matching efforts.  The only problem with this model is that it is much less transparent, and as a result, I do not know if such contracts/brokers currently exist.  John suggested that in order to find out, I get touch with the players who would be involved in a carbon market.

So that is the next step.  I need to get in touch with utility companies in order to find out if/how they hedge their carbon risk.

Origins of Market-Based GHG Regulation in the U.S.

Because this week’s focus on greenhouse gases (GHG) is related to my personal project (http://v515brian.blogspot.com/2011/09/personal-project.html), I thought that I would use this opportunity to blog about my findings regarding the evolution of market-based GHG regulations in the U.S. 

Prior to 1970, the federal government conducted research on air pollution but had no formal authority to issue regulations prohibiting GHG emissions.  The Clean Air Act of 1970 changed this by authorizing the development of National Ambient Air Quality Standards (NAAQS) for air pollutants.  The act provided a crucial incentive for compliance by allowing citizens the right to take legal action against any organization that violated the new standards.  The Environmental Protection Agency (EPA) was established in 1971 in order to implement the requirements included in the Clean Air Act (http://epa.gov/oar/caa/caa_history.html).

After a long period of limited amendment, the Clean Air Act was significantly revamped in 1990 due to growing environmental concerns. Two of the driving forces behind the 1990 amendments were the desires to eliminate both acid rain and ground-level ozone which were being generated by high emission levels of Sulphur Dioxide (SO₂) and Nitrogen Oxide (NO_x).  Amendments within the 1990 act were the first attempt by Congress to control pollution through market forces.  Under the program, emissions of SO_{2 l}and NO_x were capped far below 1990 emission levels.   Regional organizations were established under the act in order to achieve mutual emission reduction goals (http://www.nrel.gov/docs/fy01osti/29448.pdf).

Several trading platforms have since gained traction in order to reach these emissions targets.  The Northeast States for Coordinated Air Use Management, an association of northeast and mid-Atlantic states, has initiated a trading program for NO_x (http://www.otcair.org/).  From 2003 to 2010, the Chicago Climate Exchange (CCX) operated a Carbon Exchange.  This exchange has since been dissolved and is operated as an over-the-counter (OTC) market.   Most recently, the California government, in conjunction with the government of British Columbia, is working to establish a carbon market that would go into effect on January 1, 2012.  In the beginning, British Columbia is expected to be a net seller of carbon credits, while California will be a net buyer. (http://www.nytimes.com/2011/05/02/business/energy-environment/02iht-green02.html).

Personal Project Blog 1 - Carbon Options Exchange Concept

Originally, for my personal project, I planned to create a business plan for a web-based venture that would aim to encourage environmentally-conscious, or “green” consumption.  However, as a result of being forced to think through this concept more thoroughly within my blog posts, I have decided to slightly alter my personal project.  I have come to the conclusion that the only way consumers will purchase green products en masse is if these products are less expensive (economically) than their non-green equivalents.  The term “equivalents” is important in this sentence.  If a product is not a commodity, it will not neccessarily have a non-green equivalent, and thus it does not have to be less expensive in order for consumers to prefer it.  But, in general, I am assuming this rule holds true most of the time.

In order to make green products less expensive than their non-green equivalents, producers of non-green products must be forced to incorporate environmental costs into the prices of their products.  In the past, many countries have achieved this outcome through governmental regulation.  In the U.S., similar efforts have failed due to a lack of political will to enact such legislation.  However, I believe I can succeed where the government has failed by created a web-based derivatives exchange in which options on U.S. carbon credits can be bought and sold in a liquid market.  This market does not rely on the underlying U.S. carbon credit currently existing.  Instead, it relies on the belief by corporations and individuals that U.S. carbon credits will exist at some time in the future. 

After talking with a derivatives trader who trades NOX and S02 credits on the behalf of utilities, I have become aware that similar options on U.S. carbon credits do currently exist.  However, these options are created by banks and are traded over-the-counter.  An exchange for carbon options would provide less expensive and more transparent pricing.  As a result, utilities and other corporations would be attracted to the new exchange, and ultimately, the current “market price” of environmental destruction would begin to be incorporated into the products of producers who buy these options.   

The next step that I plan to take on this project will involve talking with the founder of The Plastics Exchange in Chicago.  This is a relatively new exchange that I imagine encountered many of the same difficulties that would be inherent to creating a carbon options market.  I’m hoping that this meeting will help me to generate the revenue and cost assumptions that will be needed to create a financial model within my business plan.

The World Without Us

I enjoyed the readings this week in Wheeler on the topic of ecological design.  I was struck by the assertion, expressed by a couple of different authors, that humanity is at war against itself.  At one point in his sermon, William McDonough explained that we have designed a “vast industrial machine, not for living in, but for dying in.”  These words echoed in my mind as I read the article, “Principles of Green Architecture,” in which the authors described the insanity of a crude system in which climate was opposed by energy, aka air conditioning.   Both articles refer to the relationship between nature and humanity as a war.

These articles and their references to our impending end as a species reminded me of a book that I read titled, “The World Without Us,” in which Alan Weisman describes what would happen to our cities in the event that humans suddenly disappeared.  You can watch a video on the author’s website which illustrates this process for the typical single family home (http://www.worldwithoutus.com/index2.html).  The book provides the reader with a fuller sense of the fragility of our civilization and the level of participation that is required by humans in order to continuously prevent our cities from reverting back to their pre-industrial states.  Weisman explains how swiftly natural processes like the freeze-thaw cycle would destroy our infrastructure and how a lack of electricity would immediately flood important systems, such as the New York City subway.  It’s as if we are all living in a leaky boat, constantly patching holes and bucketing out water as fast as we can.