Chapter 11

Blame It on Rio

The day it arrives, it will arrive. It could be today or 50 years later. The only sure thing is that it will arrive.

—Ayrton Senna

In November 1991, the CBOT research department received a call from the United Nations Committee on Trade and Development (UNCTAD), which was planning a meeting in December at its headquarters in Geneva. UNCTAD wanted to take an active role in climate change and was interested in the CBOT's experience with SO₂ emission trading, and its implications for market-based solution to global warming. The organization wanted somebody from the exchange to explain emissions trading and describe how markets are created. Given my experience in creating markets, they thought I could contribute to their efforts.

The meeting was held in a small, spartan room at the UNCTAD headquarters. The modest location did not foretell the intellectual heft of the meeting, and I soon found myself engaged as a serious group of scholars animatedly discussed the role of markets in addressing global warming.

During the meeting, I spoke with Tom Tietenberg and Michael Grubb, who were experts in environmental economics.¹ They were especially interested in the practical process of creating the market architecture for an emissions market. I was told that there was already a broad base of scientists who believed in the imminent dangers of global warming and saw a cap-and-trade program for CO₂ as the solution. However, many did not realize that this required a market architecture that was much more complex than the one created for SO₂, which had been merely a regional pollutant. My practical experience was a useful complement to the research of the other economists at the meeting.

After a long session of meetings, the UNCTAD officer told me that the group wanted me to deliver a paper at the Earth Summit in Rio de Janeiro in June 1992. At that meeting in Geneva, I realized that there was another commodity far more important than any physical commodity or regional pollutant—the atmosphere. The atmospheric balance could be restored if only we could price the right to emit CO₂. The amount of CO₂ allowances would be capped, and the cap would also be lowered over time. This produced scarcity and price would be determined by factors such as weather, prices of competing fossil fuels, and levels of economic activity.

The United Nations Conference on Environment and Development (UNCED) was scheduled to take place from June 3 to June 14 in Rio de Janeiro, Brazil. I worked on my paper for the next six months. In fact, I was still putting the finishing touches on it as we landed in Rio. This was my first experience at a UN meeting and I didn't know what to expect.

I remember being very excited about visiting South America in general and Brazil in particular. Movies had helped me form a romantic image of the continent: Charlton Heston as a plantation owner in Peru fighting to save his land from ants after taming the Amazon, Glenn Ford as an American cattleman, and most recently, Michael Caine in a frivolous comedy about romance in Rio. My father had once told me to become a civil engineer and work in Brazil. However, the long commute on the subway to CCNY killed the dream and whatever interest I had in that profession. I began to think that there was another way I could contribute to the country, not as a civil engineer but as a financial engineer.

In fact, this was not the first time I had tried to develop new markets in Brazil. I had been invited to Rio in 1985 to give the keynote address for the opening of the first financial futures contract in Brazil. My goal was to spark the interests of Brazil's financial community and to argue that a mature financial sector, with futures markets on interest rates and stock indexes, was a necessary companion to industrial growth. I remember the local branch manager of Drexel taking Ellen and me to a yacht club for lunch. I was struck by the phonetic name of the club—Iate Club—and the never-ending small cups of espresso.

The Earth Summit became the popular name for the UNCED. The event attracted about 20,000 people—2,400 representatives from governments around the world and about 17,500 from nongovernmental organizations (NGOs) like the United Nations, not-for-profit environmental groups, businesses, academics, and students. The size and breadth of the conference was well beyond any previous UN events. I had spoken briefly with Maurice Strong, the conference undersecretary general, at an event, but did not realize how our paths would intertwine in the future. Suave and well-spoken, Maurice fit the picture of the consummate diplomat.

The weeklong meetings produced a number of important documents that would be read and reported on worldwide. These documents included the UN Convention on Biological Diversity,² the Statement of Forest Principles,³ the United Nations Framework Convention on Climate Change,⁴ Agenda 21,⁵ and the Rio Declaration on Environment and Development.⁶

In a small, tent-filled area, far from the governmental negotiations, UNCTAD was sponsoring the actual panel that been organized six months earlier in Geneva. I delivered my paper at this sideshow, one of many held by NGOs in parallel to the governmental negotiations. Multilateralism was falling out of favor in 1986 when the Secretary General of UNCTAD tried to revive it with environmentalism. I did not know it then, but my future involvement in climate change often landed me in similar sideshows, and even more rubber-chicken events.

The panel was titled “Combating Global Warming,” and discussed the challenges presented by global warming and the policy tools available to deal with them. One policy tool was emissions trading. Being the only practitioner in a sea of academics, my assignment was to discuss implementation issues and market architecture for a global CO₂ market. I used the term market architecture to denote what had to be in place for a market to be initiated. This included everything from the appropriate regulatory institutions to the salient features of the futures contract itself—like the architectural blueprint for a skyscraper.

In Search of Trees—Commoditizing CO₂

I anticipated some skepticism in the audience regarding the commoditization of CO₂ allowances. I had witnessed this in the past with interest rate and SO₂ futures and knew how to address the skeptics. While it was important to evaluate the feasibility and potential of carbon markets against the current economic and legislative climate, it was equally important to look to history and learn from its lessons. Not doing so would be tantamount to losing sight of the trees for the forest. Thus I titled my paper, “In Search of the Trees.”⁷

The conference coincided with a heightened recognition of the increasing concentration of CO₂ in the atmosphere.⁸ I am not a scientist, but the experts convinced me that climate change was anthropogenic, or manmade. Even if there was uncertainty, a student of markets knows never to bet against a ruinous outcome, regardless of the odds. I was reminded of the countless members of the CBOT and the CBOE who did very well shorting deep out-of-the-money options. It was a great short term trading strategy but bankrupted a lot of traders in the long run. This adheres to the principles of Gambler's Ruin and Pascal's Wager.⁹ There was sufficient evidence on the irreversibility of climate change, and insurance would be cheap if we could reduce GHGs at the lowest cost.

In my presentation, I traced the histories of spot and futures markets. The first active markets with specific rules and regulations made their appearance in ancient Rome under the name of fora vendalie.¹⁰ The same concept resurfaced in 1200 B.C. Egypt, China, and India in more sophisticated forms.¹¹ A series of fairs in Europe during the twelfth through the fourteenth centuries further refined the contractual elements of agreement, transfer, payment, and warranty, which implicitly define the essential features of a commodity: standard or grade, unit of trading, price basis, and delivery mechanism.

History also suggested that spot markets evolved into forward and then futures markets. Osaka rice trading in the seventeenth and eighteenth centuries, trading in highly leveraged shares in Amsterdam in the seventeenth century, and Chicago wheat trading in the nineteenth century were all evidence of this. Guided by history and my recent experience, I argued that it would be possible to create a new commodity in tradable CO₂ allowances.

The first step would be to define or standardize the commodity being traded—the CO₂ emission allowance. The Clean Air Act Amendment of 1990 set the precedent by defining SO₂ emission allowances.

Since there was some controversy regarding the status of these allowances as property rights,¹² I strongly encouraged the potential drafters of a global CO₂ treaty to thoroughly study the Clean Air Act in order to glean knowledge from its provisions and its interpretational uncertainties. I further cautioned against improvements and novelties when embarking on a transformational innovation like creating the market architecture for the CO₂ market, and advised them to adhere as closely to the CAAA 1990 so as to avoid confusing market participants.

In addition to using the CAAA 1990 as a prototype, the new CO₂ market would ideally draw on existing pools of human capital, such as the knowledge of economists, traders, scientists, and lawyers, and utilize existing information systems, operations, contract markets, and software expertise. The first step would be to draft a global warming treaty and to create a UN agency as the equivalent of the EPA in the United States to govern and enforce the treaty provisions and assign CO₂ property rights or allowances.

A bonus program similar to that in the Acid Rain Program could also be used to incentivize energy conservation.¹³ The granting of allowances would be best based on existing and future acceptable levels of national and global emissions and the baseline level should be estimated from a prior year, for example, 1990. This was to be determined with consideration to factors like fuel type, level of consumption, and age of facilities. Once the baseline year and the emission quantities were estimated, the percentage reduction target and time frame would be determined based on elements like available fuel or technology modification solution and time required for regulatory approval. Furthermore, emissions should be carefully monitored by continuous emissions monitoring (CEM) equipment, which had been successful in the Acid Rain Program.

After discussing the spot markets, I proceeded with a brief description of the set of conditions necessary for a successful futures market:¹⁴ homogeneity, existence of a spot market, competitive markets, price volatility, presence of an inefficient hedging alternative, and contract design. The CO₂ allowance market met all these criteria. What remained were CO₂ allowance contract specifications. These specifications should be borrowed from the outline used by the CBOT in tradable SO₂ allowances.

Finally, I pointed out that contract specifications should be developed by a consensus building process, involving all market participants. The audience was supportive based on the Q&A session.

Caipirinhas and Climate Change

Following the sideshow, I made another more formal presentation to the Rio de Janeiro Chamber of Commerce on the same subject. It had been an exhausting flight and the two presentations finally took their toll on me. I decided it was time to sit on the beach, eat some barbecued shrimp purchased from a man with a small Hitachi stove, and drink a caipirinha [kay-pee-ree-na]. I felt the sense of calm that came to me only after hard work and the sharing of new ideas. The guilt that accompanied me during times of idleness and inactivity was absent.

Since I had hurried to the panel and was preoccupied with my presentation, I had not had a chance to look around until now. It was a vibrant setting, and reminded me of my teaching days at Berkeley in the 1960s. There was more tie-dye there than at Grateful Dead concerts. I thought, “This is just like Berkeley in the Sixties. These young climate change activists will succeed like those in the civil rights movement, the women's movement, and the anti-Vietnam War movement.” I was only partially right.

It became clear to me at that moment that identifying the problem of global warming and delivering the bad news was only the first step. There had to be the hope of a solution, and the markets would provide the answer. Fortunately, I knew how to pioneer new markets. I had done it with interest rate futures when others thought that interest rates didn't fluctuate and there was no need to hedge. Past experiences assured me that I could weather the torrent of emotions that greeted all new ideas. Arthur Schopenhauer, the German philosopher, had made the observation centuries ago, “Every truth passes through three stages before it is recognized. In the first, it is ridiculed; in the second, it is opposed; in the third, it is regarded as self-evident.” I had witnessed these three stages firsthand and figured I was prepared for the ridicule and the opposition. But I underestimated the enormity of the task and the extent of ridicule and opposition.

Although I didn't get to attend some parts of the conference, I was interested in their outcomes. A common source of friction between countries was the benchmarking of emission reductions. Developed countries were able to reduce excess emissions at a lower cost than developing countries, which favored cheaper, higher emitting methods of energy production and transportation. The UNFCC reached a compromise by aiming to stabilize greenhouse gas emissions in 2000 to 1990 levels only among developed countries.

I was similarly interested in the negotiations of the Statement of Forestry Principles. Many developing countries felt that forest preservation could hinder their economic growth and desired funding to compensate for preserving forest reserves. This controversy continues to this day.

After the conference, I flew back to the United States and made a stop at Norman, Oklahoma, home to the University of Oklahoma. Senator David Boren had arranged for me to deliver a speech there about my experiences at Rio. The positive reception I received from the students in a conservative energy-based state bolstered my confidence, and I was convinced that there would be a futures market in CO₂ emissions at some point in the future. It was the first step of a long educational process for the academic community, and reminded me of the premarketing phase for interest rate futures.

I was only halfway through 1992, and the opportunities seemed endless. Once again, I turned to teaching to organize my ideas. The academic world, both professors and students, were always the foundation of my work in pioneering new markets.

A New Academic Field

Meyer Feldberg, a friend from Chicago, became the dean at Columbia Business School. As I meandered through the campus to the dean's office at Columbia in the spring of 1992, I thought of my grandfather, father, and brother, and how they had all attended Columbia University. I was excited about continuing the family tradition—not as a student but as a professor.

The purpose of the meeting was to brief Meyer on emissions markets, and see if he supported a course in an unheard-of area that I described as environmental finance. I told him that we were about to witness a vast change in the public attitude toward global warming, and that this was an enormous opportunity for Columbia to be on the leading edge of the most important issue of our time. To capitalize on this rare opportunity, the university should begin educating its students about the imminent changes in climate and how best to develop policy to deal with them.

I was appointed Distinguished Adjunct Professor of Finance and began teaching a course titled Environmental Finance at Columbia in the fall of 1992. A new field was born. Environmental Finance eventually became the title of a new magazine that began publication in 1999, and I was its guest columnist for the first five years of its publication. Looking back, I should have coined the term “environmental finance,” as I had already missed my previous chance to coin the term “derivatives.”

The course at Columbia covered a wide variety of topics, including the role of emissions markets in combating pollution, environmental regulations, sustainability as business strategy, project finance and the environment,¹⁵ endangered species, derivative markets, and global warming. The syllabus incorporated a mixture of academic papers, books, case studies, and articles from the popular press.

Classroom lectures were supplemented with presentations by experts in the relevant fields. The Commissioner from the Ohio Public Utility Commission spoke about regulation. He supported the markets and led the efforts to ensure a proper balance between stakeholders and stockholders for Ohio utilities. The stakeholders benefited from a reduction in acid rain and the stockholders benefited from a rapid reduction of emissions, and at a lower cost, than required and selling their excess reductions.

A representative from Allegheny Power talked about sulfur emissions and the economics of installing scrubbers. He made some very compelling points about global warming that were, unfortunately, lost in later debates. Many cap-a nd-trade advocates were concerned that although utilities could comply with the CAAA 1990 emission requirements by buying allowances at current prices for the next five years, they would only buy allowances when the price of allowances was lower than the marginal cost of the technology, and install the technology when the cost of doing so was lower than the price of buying allowances. The Allegheny Power representative argued rightly that it was the expectation of prices, and not current prices, that drove investments in pollution abatement technology. He also added that Allegheny was already installing scrubbers. To this day, some advocates of emissions trading in CO₂ still miss this simple point. Instead, they argue erroneously that prices have to be very high at the outset of emissions trading, and that the early reductions have to be drastic and achieved in a very short time in order to force firms to change their behavior.

My friend Jon Goldstein came up from Washington, DC to give a lecture on endangered species in general and the spotted owl in particular. Jon was then the chief economist of the Endangered Species Committee at the White House and had done a major study on preserving the spotted owl. He gave some great insight and a somewhat humorous take on an otherwise sober issue. Apparently, spotted owls had bad eyesight and required a lot of land to find each other for mating.

After class, Jon and I went out for a drink. He said happily, “After all my cajoling, you have finally committed to the environment!” I replied, “Jon, I feel like Patty Hearst did. I have Stockholm Syndrome. The environmentalists have captured me and I am in love with their cause.”¹⁶

Since my class attracted students from business, international studies, and environmental sciences, I thought it would be a good idea to divide the class into three sections and have each present a paper in the final class. All three were fascinating.

One group dealt with grey water—wastewater from domestic activities like dishwashing that could be recycled—and how incentives could be used to ensure that New York City's supply of fresh water would not be threatened. Another group dealt with socially responsible investing, which didn't yet exist at the time. The group accurately predicted the growth of what is now termed sustainable investing.

The final presentation was on an options market for spotted owls. In their paper, the students devised a simulation to test the feasibility of a market-based solution to the endangerment of spotted owls. In the simulation, individuals held shares that corresponded to the ownership rights of a tract of land large enough to support a spotted owl. Players were free to trade their shares according to their predictions on factors like timber market movements that pertained to the survival of the spotted owl. To influence players’ decisions, the students simulated market news loosely based on real-world events that could potentially affect timber prices. The two main goals of the project were to see if market solutions could be applied to the problem of endangered species, and determine whether it was possible for market forces to preserve a species.

Although I taught the course only once, others soon picked up where I left off. Environmental Finance became a part of the permanent curriculum of Columbia University, which became a thought leader in a field imitated by many. Environmental finance had evolved from a course into a magazine, and eventually into a graduate degree program at many universities. I was proudly reminded of Northwestern's lead in the finance curriculum when it introduced a financial futures course.

In retrospect, 1992 was a banner year. The future of emission markets seemed bright after the Earth Summit. Kidder had also brokered the first registered trade of 30-year options on SO₂ with a New England utility through which we were able to gain experience in trading, clearing, and settling SO₂ allowances trades.

In spite of these exciting developments, I began to see some threatening signs.

Early in 1992, I started to get a little uncomfortable about Kidder, Peabody, even though it had been a good year, thanks to the performance of the fixed income department. 1992 was witnessing a continuation of this trend, and I had been told that both the mortgage market and governments were being run by competent people with MBAs from prestigious universities. Nonetheless, it didn't matter how smart the individuals were or and how good their credentials were. If a market were efficient, it was very difficult to make above-average rates of return. I knew something about bonds and mortgages and thought that some above-average returns could be made on the basis of good analytics. What puzzled me was the discussion about the amount of money that can be made by basis trading and stripping—the separation of the stream of interest rate payments from the principal, that is, the amount of money received by the bondholder at maturity.

When I took over fixed income at Drexel, we had a solid business of buying Treasury bonds and selling their component parts if the parts were worth more than the whole. The opposite was done if the parts were cheaper than the whole. The margins were good but not great, and could be enhanced by using futures. When I mentioned this to a colleague on the executive committee, I was told I did not understand the potential for profits in this market—a criticism that triggered an important memory for me.

Sometime after the great bull market of 1973 and 1974, I was told a story about a trader who was the complete opposite of a stereotypical commodity trader—conservative, serious, somewhat dour, with no flash. He traded the only commodity that did not have price controls on it in World War II: rye. One day, a fellow trader came running to him exclaiming, “Tom Jones is going crazy! He just lost his entire fortune in the bean pit and he doesn't understand why it happened.”¹⁷ Peering over his half-moon glasses, the first trader said calmly, “Tommy never understood why he made his money, so why should he understand why he lost it?” There was a simple but profound lesson for me. If you didn't understand why you were making profits, it was likely that you would incur significant losses at some point in the future.

Two years later, Joseph Jett committed the largest fraud in the history of the securities industry, and Kidder went out of business.¹⁸ The fraud reflected a trend I had seen before, and one that I would see again. Just as you couldn't completely eradicate drunk driving without banning driving itself, you couldn't completely regulate human folly. You could, however, strive to have institutions in place that minimize systemic damages.

Separately, I had been working on developing catastrophe futures at the CBOT. There was a natural link between climate change and the insurance industry. It was now time to expand my interest in the commoditization of insurance.