Climate Change: Financial Innovation And The Carbon Market

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Climate ChangeFinancial Innovation And The
Carbon Market

• IMF Institute June 19 2007
• Graciela Chichilnisky
• UNESCO Professor Of Mathematics And Economics
• Director, Columbia Consortium For Risk Management
• Columbia University, New York
• www.chichilnisky.com
• gc9_at_columbia.edu

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Global Climate Risks

• Climate Change is a Catastrophic Risk 12
  trillion in losses - Stern Report, 2006 -
  Chichilnisky, ER 2000 E. of Environmentrics 2002
• Endogenous risk - Chichilnisky, RD 1995, JME
  2006
• Science is uncertain - Chichilnisky Heal JEP
  1994
• Risk has collective and individual components-
  Chichilnisky Econometrica 1994, JME 2006

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Individual Collective Risk JME 2006

• Financial Innovation decreases Individual
  Exogenous risk at the cost of increasing
  Collective Endogenous Risk
• Global Warming is a Collective Endogenous Risk
• From JME 2006 a model of financial innovation to
  provide liquidity and securitize environmental
  risks

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Risk ManagementFinancial Innovation I

• Managing global warming risk requires financial
  innovation
• First we created a new financial market the
  carbon market (KP, 1997)
• Then created a new financial instrument carbon
  credits (Clean Development Mechanism, CDM)
• Industry created Catastrophic risk insurance
  contracts

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Financial Innovation II Building On Carbon
Market And CDM

• Using carbon credits, financial innovation for
  self funded CDM projects in developing nations
  (Africa, LA)
• Insure against the risk of climate change
• Remove carbon dioxide from the atmosphere
• Secure clean abundant energy power worldwide

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Financial Innovation III

• Financial Innovation securitization - provides
  start up investment repaid from net income from
  clean power infrastructure in developing nations
  - 200 billion/year
• Using securities, access global capital markets
  to build self-funded sustainable projects

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Carbon Markets A Building Block

• Carbon Markets are a powerful building block for
• Financial Innovation
• Clean technology innovation
• Sustainable economic progress in developing
  nations (Africa, Latin America)
• Energy Security in Industrial Nations (China,
  USA)

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Carbon Markets New Financial Markets

• Carbon markets and other key environmental
  markets are financial markets
• Potentially the most important markets of the
  21st century
• Require global liquidity
• Financial innovation
• We examine why and how

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Global Marketsproblems and solutions

• Since WWII, the creation of Bretton Wood
  Institutions led to globalization and vastly
  increased resource trading
• Global environmental problems
• Market Innovation is key to their resolution

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North - South Trade Property Rights On Resources

• In developing nations resources (fossil fuels,
  forests) are common property, in industrial
  nations private property
• This led to a pattern of North - South trade
  where developing nations specialize in resources
  exports without real comparative advantage
  handicapping economic development, innovation,
  and energy security Chichilnisky (AER, 94)

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The impact of common property

• Lower prices more extraction Chichilnisky AER
  1994

Resource prices
Private property
Common property
Quantity of resources extracted
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Missing Property RightsThe Global Environment

• Over extraction of fossil fuels
• Under - pricing of fuels
• (Chichilnisky 1981, 1985, 1993, 1994)
• Undermines Innovation and
• Energy security in industrial nations

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Results

• Fossil fuels are over- consumed today 90 of
  energy used in the world is fossil
• Increasing Carbon Dioxide emissions
• Producing Climate Change

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The Carbon Market Corrects Missing Property
Rights

• Created to correct missing property rights
• Within the 1997 United Nations Kyoto Protocol
  (Chichilnisky 1993, 94, 95,96, 2000)
• It trades privately produced public goods
• CO2 concentration is uniform and stable
  around the world

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Carbon Price

• Corrects missing property rights

Private property
Fossil fuel price
Carbon price
Common Property
Fossil fuel quantity
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Our Proposal Accepted in Kyoto 97

• Industrial nations own and trade property rights
  on the use of the atmosphere emission limits for
  OECD
• Developing nations participate through the clean
  development mechanism (CDM)

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Market Performance 2007

• Carbon market traded 30 billion in 2006 (World
  Bank, May 2007)
• 8 billion in CDM projects with developing
  nations (61 China)
• CDM projects 20 of EU emissions
• Great potential for overcoming global warming
• Increasing investment clean technologies in
  developing nations

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Drawbacks

• US does not participate
• Carbon Market comprises 40 of global emissions
  (total 24 gigatonnes)
• Carbon Market and Kyoto Protocol expire in 2012

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A Price Signal ForShort And Long Run Incentives

• Long Run Transition to renewable fuels
• Short Run - Immediate Action to avert global
  warming

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Price incentives for renewable energy

• Long run transition to renewable fuels Solar can
  provide 10x increase in energy use within 2 of
  energy received
• Short run goals quite different - require
  immediate action
• In 10-20 years decrease 60 emissions (IPCC)

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Short run a new GT technology

• Solar thermal CSP PT electricity _at_ 10 cents kWh
  nearly competitive with coal
• Uses residual thermal energy to co-produce carbon
  capture and storage (fertilizers, limestone)
• Clean electrical power reduction of atmospheric
  concentration of Co2

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Short V. Long Run Costs
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Insurance Costs
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Insurance Premium and Profits

• 12 trillion losses (Stern Report 2006)
• Insurance premium 2.5 - 200 billion annually
• Compares with annual costs of GT short term
  solution
• In addition, GT plants are commercial almost
  immediately net income positive

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Long run costs coal v. solar
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Avoided v. Reduced Carbon
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How The Carbon Market Works

• The Carbon Market is a Financial Market
• Market fundamentals (1) technology and (2)
  emission limits
• Carbon market needs further Financial Innovation

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Carbon Market Equations
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Transforming Energy Into Goods
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Abatement v. Private Goods
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Two nations trade with each other
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Carbon Market Equilibrium
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Carbon Price

• Corrects missing property rights

Private property
Fossil fuel price
Carbon price
Common Property
Fossil fuel quantity
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Transition DynamicsBuilding New Power Plants

• It is possible to predict market behavior in the
  period of transition from fossils to renewable
  energy
• New power plants are built
• Expected increase in world energy use
• 5 10 times todays by this centurys end

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Adding a standard carbon plant
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Adding a Clean Carbon Plant
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Global Thermostat plant
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Transition - carbon prices drop
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Long Run Transition To The Solar Age
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The Economics Of Transition

• In the short run the GT approach provides
  insurance against Global Warming, reducing carbon
  emissions
• In the Long Run it Accelerates Transition to
  Renewable Energy sources
• CDM helps increase clean energy power in
  developing nations
• Technology transfer to developing nations
• Competitive Markets and Financial Issues are Key
• Kyoto Protocol beyond 2012

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Potential Role For International Organizations
(WB, IMF)

• Technical assistance in global negotiation of
  carbon markets beyond 2012
• Facilitate market participation by US and
  developing nations Africa and L.A.
• Ensure competitive and transparent carbon markets
• Financial Innovation for Expanded CDM
• Market stability and liquidity
• Option and forward markets, asset backed
  securities