thenextwave

Complexity and risk

Posted in climate change, environment, finance by thenextwavefutures on 2 December, 2009

In the Financial Times. columnist Tony Jackson has picked up on the Friends of the Earth report on carbon trading which I blogged about recently.FoE was mostly interested in the efficacy, or not, of carbon trading in driving down emissions, but it also warned that carbon trading could lead to derivative-type problems for the financial system. It’s this aspect which interests Jackson, as a way in to how risk managers should make these sort of assessments. His answer is by three yardsticks – simplicity, liquidity, and leverage.

As he puts it in his column:

In picking on carbon, I take no position on its merits as a way of controlling emissions. Rather, the purpose is illustrative. If I were a risk manager, what danger signs would I look for as the market develops? Let us take three yardsticks of risk: simplicity, liquidity and leverage. The more a market has of the first two and the less of the third, the safer it should be. Derivatives based on subprime mortgages ticked all the danger boxes. So far at least, carbon does not.

His assessment is that, for the moment, the financial instruments in the carbon market are relatively straightforward, relatively liquid, and there currently is not much scope for arbitraging between markets. But he’s also honest enough to admit that when he first looked at credit derivatives in 2003, he concluded that they were fairly simple. As he notes, perhaps with hindsight, “as markets develop they become more complex and risky”. Even if the FoE is wrong at the moment on the risk part of the future carbon trading market (as opposed to their efficacy), they may still be right in the future.

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