Making an asset of environmental derivatives

The tarnished reputation of derivatives (the supposedly complicated financial instruments that are held responsible by the popular press for the economic collapse of 2008) is somewhat unfair. The many different types of derivative – including futures, options, forwards and swaps – has caused considerable confusion among the general public about what they actually are, inevitably leading to mistrust.

Although there has certainly been some unscrupulous misuse of these financial instruments, derivatives can be used as a responsible investment tool. One advocate of a more conscientious approach to derivatives investing is American economist Dr Richard Sandor, a legendary figure in the formation of the asset class.

…if you don’t understand why you are making profits, it is likely that you will incur significant losses at some point in the future

Sandor has recently begun to turn his attention towards using derivative investments to help grow a greener and more environmentally focused investment market. Time dubbed him the “father of carbon trading” for his work launching the world’s first carbon trading exchange, the Chicago Climate Exchange (CCX). Sandor is eager to develop new forms of derivative investment as a means to grow green industries.

In his recent book, Good Derivatives: A Story of Financial and Environmental Innovation, Sandor outlines the history of derivative investments, which mirrors his over-four-decade career, and makes a compelling argument for a re-evaluation of their reputation. Sandors was compelled to write the book in order to restore the asset class’s reputation. He said: “I wrote it because derivatives have gotten a bad name, and unfortunately there is not enough understanding out there about the ones that work.”

Part of the problem from which derivative investments suffer is their hugely complicated composition, which often baffles the public. Sandor says derivatives are much maligned due to a lack of understanding by the general public. He said: “These are wholesale or professional products… the retail investor doesn’t really deal with these. It’s very hard for them to understand because they didn’t learn about them in school and most financial advisors don’t understand them either. Investors know what they read in the papers for the most part.”

He adds that a deeper understanding of how the market works is essential to preventing dramatic losses in the future: “if you don’t understand why you are making profits, it is likely that you will incur significant losses at some point in the future”.

Green exchanges
While derivatives traders have borne the brunt of the criticism directed at the financial markets, some believe they could be an integral part of developing a more environmentally focused investment market. Green exchanges like the one Sandor helped to launch in Chicago can help spur low-carbon investments, while also encouraging companies to off-set their emissions.

Tightly regulated exchanges, something that is argued to have been missing in the years before the crash, are also performing better. Sandor says the potential is huge: “Regulated, transparent exchanges are performing flawlessly through difficult economic times. They will continue to have an important role in helping people manage risk and sustain economic growth in places such as China, India and Latin America.”

Others in the industry echo Sandor’s opinions, but believe the carbon markets need to be significantly bigger to make a difference. Gerrit Nicholas, Goldman Sachs’s head of North American environmental commodities, said: “If you believe the science and that something needs to be done about this, the market probably needs to be big. Carbon could become an important commodity. I’m not saying it will be bigger than others, but it will be another important business for us.”

Encouraging traders to become more active in carbon markets requires a high level of liquidity, which can often seem unlikely in a highly regulated market. Sandor says traders “would rather use a market that was liquid and provided imperfect hedges than participate in a new and illiquid market”.

Ken Newcombe, founder of Washington-based carbon finance business C-Quest Capital, agrees that, although there is a need for regulation of carbon markets, excessive controls will stifle any proper growth.

Newcombe said: “The ultimate objective is economic efficiency. How can we reduce the cost of implementing important public policy? Having a pool of risk capital is absolutely vital to the smooth introduction of a cap-and-trade regime in the US… There’s legitimate concern that there may be unseemly profits or untenable risks. But a problem now is that the critical objective of stabilising the financial system could lead to an overregulation of the carbon market.”

While encouraging investors into a cap-and-trade market to develop is seen as an efficient way of fighting the increasing dangers of climate change, some argue that allowing market forces – and unscrupulous traders – to control the market is likely to have detrimental effects.

Michael Masters, founder of US-based hedge fund Masters Capital Management, was sceptical about allowing speculators enter the carbon trading market. He said: “Wall Street is going to sell it as an investment product to people that have nothing to do with carbon. Then suddenly investment managers are dominating the asset class, and nothing is related to actual supply and demand. We have seen this movie before.”

Changing behaviour
Sandor believes that derivatives can play an important role in the development of green industries, which will in turn help create new jobs and drive economic growth. He argues there are similarities with the tech industry that has come to play such an important role in world economics in recent years. He said: “I firmly believe the green sector will mimic the high-tech sector and the job creation that came with it. That road to sustainability will be led by entrepreneurs.”

Whether hedge funds can be encouraged to enter into carbon trading markets in a meaningful way will ultimately depend on cost benefits. According to Sandor, derivatives investors will fit into this new market once the price is suitably attractive: “What’s important is the price signal. It will stimulate inventive activity and cause behaviour to change.”

Getting these prices down will rely on a mix of robustness of the market, but also a suitable degree of liquidity that will enable investors to make money. The unfortunate consequence of the last five years of financial turmoil is that there is a severe lack of trust in the freedom of the stock markets to have a positive impact on the world.

However, the role they can play in helping solve the environmental crisis is something that could go a long way to restoring the reputation of the traders, and in particular those investing in derivatives. Sandor thinks the markets can be used for good, and that is what he was striving for. He said:: “My mission is to try to find a way to use the markets to achieve social and environmental objectives.”