Streetwise Professor

February 4, 2010

In Need of Therapy

No, not me–although I am sure that a few of you would disagree.  No, I refer to Senator Maria Cantwell (D-WA) and her confreres, who clearly have some deep seated neuroses and phobias when it comes to anything involving derivatives and speculation.

Cantwell actually earns a twofer today.

First, she is the co-sponsor of a new cap & trade bill.  Although cap & trade isn’t dead, it is coughing up blood; even Obama has recognized that it has no chance of passing soon.  Along with Senator Collins (R, sorta-ME), Cantwell has introduced a bill that would institute a cap & trade regime.  It is, blessedly, much simpler than the grotesquely bloated, complicated, and convoluted ACES bill that passed the House in 2009; apparently Cantwell and Collins believe that ACES is doomed, and that a simpler bill may be the only hope.  Conservation of paper is, alas, its main redeeming feature.

It isn’t really a cap & trade bill.  It’s better described as cap, definitely, trade, not so much.  And the latter feature is what lays bare Cantwell’s phobias.  To read what she and Collins have proposed is to enter bizarro world.  They impose onerous restrictions on the trade of emissions rights and derivatives on them, apparently out of a belief that (a) speculation is evil, and (b) derivatives can only be used for speculation.

There are two completely non-sensical provisions in the bill that relate to trading emissions rights, and derivatives on them.

First, the bill permits only emitters to own certificates, and to purchase them at (an annual) auction.  This means, specifically, that financial institutions cannot buy or trade certificates.  Presumably, this is intended to bar the market to those malign speculators.  But its actual effects will be to make the market extremely illiquid, and to make it unnecessarily costly for those who have more permits than they need to trade them with people who have fewer than they need; financial institutions would be the natural market makers and liquidity suppliers, and baring their participation would starve the market of liquidity.  This will hamper the efficiency of the market, and make it costlier to achieve the emissions reductions imposed by the cap feature of the bill.  Moreover, it is likely that absent such a restriction, certificates could be used as collateral and facilitate end user financing, an alternative that would be precluded under the bill, making it more costly for emitters to finance their purchases of certificates.

Second, and even more bizarrely, the bill prohibits those very end users from trading any derivative contract on emissions.

Let me repeat: the bill prohibits those very end users from trading any derivative contract on emissions.


Under a cap and trade scheme (and I mean scheme), end users are exposed to carbon price risk, and over very long time horizons.  They are natural hedgers who need derivatives to manage that risk exposure, but the Cantwell-Collins bill would preclude them from doing that.  The bill creates risk by pricing carbon, but at the same time denies those affected by this risk the ability to manage it.  That borders on cruel and unusual, and just makes it unnecessarily costly to achieve carbon reductions.  Pain with no gain.

But note the bill doesn’t ban derivatives outright, so Cantwell and Collins are apparently perfectly willing to contemplate a carbon casino where only speculators can play (though not in the certificates themselves).  But the speculators will not be allowed to provide valuable risk bearing services to hedgers.  No, it doesn’t make sense to me either.

Seldom have I seen anything so inane coming out of Congress, and that is saying something.

Separately, Cantwell came out with a call for increased regulation of commodity derivatives generally:

The US commodities market should be freed from “reckless speculation” and abusive trading practices, a leading US senator has urged, as she attempts to stop the price of everyday items like petrol and food from being impacted by financial traders.

Senator Maria Cantwell, who is separately trying to revive the Glass-Steagall reforms of the 1930s which would prevent retail and investment banks from operating under the same roof, yesterday called for increased regulation of the commodities and derivatives market.

The Democrat politician is attempting to push regulation of the commodities markets – a hot topic in the summer of 2008 when oil prices topped $140 a barrel – back to the top of the political agenda.

She is calling for stronger powers for the Commodities Futures Trading Commission (CFTC), including the potential to police the unregulated over-the-counter derivatives market, which has worth $25 trillion at the end of June 2009.

And how, pray tell, does the Senator support her case?  By calling on the vaunted expertise of megatool Michael Masters:

Backed by hedge fund manager Michael Masters, of Masters Capital Management, she called for the proposed reforms to take their place alongside wider financial regulatory reforms currently being discussed by the US Congress.

Mr Masters believes that there is a strong correlation between the credit crisis and volatile commodity costs, which have seen a rise not only in oil prices but in basic food staples in recent years.

Correlation, causation.  Whatever.

Masters and I participated in a workshop on oil markets sponsored by the Energy Information Agency back in November.   I can state categorically that he doesn’t understand the economic function of derivative markets, or of the functions that financial intermediaries play in these markets.  He says things like (I quote from memory, but this is almost verbatim) “financial markets are for allocating resources over time, but commodity markets are to get goods from producers to consumers.”  Well, yeah, but commodity markets are also crucially about allocating resources over time, because the time patterns of consumption and production don’t necessary always match exactly.  In fact, they almost never do.  (Think about a seasonal commodity, like corn or natural gas.)

So even beyond risk shifting, you need futures and forward markets to encourage the efficient allocation of commodities over time; getting stuff from producers to consumers inevitably involves intertemporal trade.  What’s more, financial intermediaries are frequently the best able to perform the function of storing and financing commodities.  After all, what they do is facilitate intertemporal resource allocation, and commodity storage and financing is just a specific example of that.  But not in Mastersworld, evidently.

Talk about the blind leading the blind–or is it the phobic leading the phobic?  Maybe group therapy is available at a discount.

After Masters made this statement at the EIA workshop, I replied along the above lines.  Only less politely.  I started by saying something like: “I can’t believe you said that.  It’s one of the dumbest things I’ve ever heard.  Commodity markets are all about allocating resources over time.”  Always trying to win friends and influence people.

I doubt either of these measures is going anywhere.  Fortunately.  But they reveal a disturbing mindset that is all too common on Capitol Hill, and among the pilot fish that swim symbiotically with the senatorial sharks.

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  1. OBAMA and Bernanke are featured in a movie– about greedy hedge funds called “Stock Shock.” Even though the movie mostly focuses on Sirius XM stock being naked short sold nearly into bankruptcy (5 cents/share), I liked it because it exposes the dark side of Wall Street and revealed some of their secrets. DVD is everywhere but cheaper at

    Comment by Streetwise Fan — February 5, 2010 @ 1:59 am

  2. Scheme indeed, its a carbon tax with pretend monetization. Great, maybe we’ll get another bi-lateral, bespoke market for these credits, like tax equity for renewable companies that can’t use their tax credits because they have no income. Our tax budgeting system is a disaster.

    The real failure of cap and trade as a market mechanism in allocating resources, from my perspective as a financial participant in power markets for a long time now, is that carbon prices will not send durable, or rather bankable price signals relative to the underlying capital investment decisions they supposedly are designed to impact.

    And they never will, because as soon as prices become large enough and liquid enough, the market will yelp at abusive profits, speculators, etc and restrict the market and scare off any long-term financiers. Thus it will always be doomed to failure as a defensible policy tool–as in, nobody will defend it when people are making a killing at the expense of poor customers. But even more critically, why do we accept that products that largely fulfill a public utility function are ever worthy of episodes of way-above average rates of return, at great expense to everyone, as the ‘efficient’ capital allocation tool, when some careful and rational planning could achieve the same function without the financial drama? I realize that right here, Professor Pirrong is shaking his head, how could anyone, let alone a former pupil believe forsaking the free market for the madness of central planning could be a reasonable proposal. I’ve just watched too much disastrous abuse and tinkering in ‘free markets’–and not episodically, really more structurally abusive by incumbants–vs. some actual decent policy evolving

    Yes, man is apt to make errors in planning, corruption exists and the free market has been (thought) to be a better capital allocator in the long haul. But it seems to me, incentivize not marginal pricing, but marginal efficiency. Short-term carbon pricing is totally inadequate to establish that ‘value’. Use sticks and carrots to achieve efficiency and let the market decide how to get there, within reason.

    If one examines the sulfur-dioxide allowance market, which worked splendidly at its outset due to available substitutes that required only modest capital investment, even when there were very large price signals over $1000/ton, it was never sufficient to go out and monetize for several years and fund the capital equipment needed to build scrubbers and reduce SOx in the free market–that decision more often than not ended up back in the regulatory purview where ratepayers paid for some long-term rate adders, and in return maybe got some discounted power or perhaps a share of above-market prices earned as a result of having a more efficient plant operating post-capex (though to be clear, almost all scrubbers cause de-rates, thus its just a theoretical expansion of headroom on margins ex-emission cost and usually pretty short-term).

    Ironically, it seems the EU policy initiatives focused on automobile carbon emissions might be the winning ticket, in terms of bang for buck. Here, the government simply sets out a forward looking, staggered, declining emission rate threshold for new auto sales, in terms of carbon/km (efficiency). The auto manufacturers all bellyached, but low and behold, they are largely complying (and certainly now competing to comply with bragging rights); the failure to comply is producing unimaginably high fines and pushing the laggards (like Porsche) off the edge to join the efficiency party. And the manufacturers with the most attractive and efficient new products–not highest domestic carbon prices!–have seen market share wins globally.

    The best trait? Clarity. Automakers can see the threshold levels ahead, can make incremental investments and improvements to adopt and manage compliance. No misallocation of credits, depressed prices pushing out investment, blah blah blah.

    No easy answers, but as usual, Professor Pirrong offers the most clarity and a voice of reason of how free markets are supposed to work when designed well. I wish I had the same faith in observation of the reality.

    Comment by MB — February 7, 2010 @ 8:56 am

  3. I have to read a lot about Michael Masters and his thoughts to even comment on his thought process. But, based on what’s written in this section, it is appearant that Mr. Masters doesn’t understand the commodity market. I totally agree than commodity market is not just a tool for passing goods from producers and consumers. The intertemporal entities do a great job of storing/stocking the commodities when the market demand is on lower side. The increased inventories of crude oil in recent months is such a great example of that. Financial derivatives serve a great tool for these intertemporal entities to hedge their own risks. So, financial and commodity derivatives are very interlinked that any tool can be used for not only risk shifting but also for timely resource allocation.

    I agree with your views professor. It was really nice to read a synopsis of the bill from an expert’s viewpoint.

    Comment by Student_Spring10_Derivatives Class — February 7, 2010 @ 1:08 pm

  4. Good post, Craig, and a good quality comment from MB, even though I disagree with him re emissions trading.

    As was said by a sceptic at a futures industry conference early on in the development of carbon markets:

    “If you want to keep a donkey healthy, you don’t regulate what comes out of it: you regulate what goes in”.

    My approach is not carbon taxation – which is at least at the right end of the donkey – but a new approach to financial products I call ‘unitisation’. Simply put, the creation of units redeemable in payment for carbon fuels, and in energy, within a partnership legal framework, rather than one using company or trust law.

    In this way it is possible to monetise the energy value of carbon, which is intrinsically valuable, rather than CO2 which is intrinsically worthless, and derives its value, as do Fed IOUs aka dollars, from political and administrative fiat. We may then raise global energy prices – particularly in those producer countries wasting energy on a cosmic scale – through a carbon levy into ‘carbon pool’ funds, which would then be deployed in direct local investments in renewable energy and energy savings. Populations would then be compensated with an energy dividend of Units, redeemable in payment for energy use. They could either choose to redeem their Units in payment for continued profligate carbon energy use, or more likely, they would invest them in energy savings, or exchange them with a willing counterparty for something else they would rather have.

    I outlined in Rotterdam recently how unitisation might work in enabling a global gas market,

    and for electricity here

    Comment by Chris Cook — February 8, 2010 @ 6:22 am

  5. […] Hey Matt: Michael Masters is a dumb, lying douchebag.  Just ask Craig Pirrong, aka the Streetwise Professor. […]

    Pingback by » Blog Archive » Taibbbbaahahahaha! — February 18, 2010 @ 7:01 pm

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