by Doug Williams, Bogus Gold

The scariest thing you’ll read this week is something you’ll probably be tempted to overlook. It is this:

Carbon Emissions Linked To Global Warming In Simple Linear Relationship

Damon Matthews, a professor in Concordia University’s Department of Geography, Planning and the Environment has found a direct relationship between carbon dioxide emissions and global warming. Matthews, together with colleagues from Victoria and the U.K., used a combination of global climate models and historical climate data to show that there is a simple linear relationship between total cumulative emissions and global temperature change.

Big deal, you might say. All those already upon the Global Warming bandwagon have been acting like this was already known for a couple of decades now. That’s how we came up with the “carbon dioxide is pollution” nonsense. That’s how we got ideas floating around like “carbon taxes” and “Cap and Trade” schemes.

Well yes, but… No one is seriously proposing a flat out carbon tax simply because opposition to it is a political no-brainer. People like to vote for taxes on other people. It’s political suicide to be the politician (or the party) who wants to raise everyone’s taxes.

Which is the whole reason Cap and Trade has been the preferred route for democratic governments to go in their attempt to restrict carbon emissions. It cloaks massive new taxes under a veneer of markets and trading and capitalist enterprise. When higher prices are subsequently passed on to consumers, they never get to see a direct correlation between the defacto carbon taxes and the resulting increase in consumer prices.

But implementing Cap and Trade is not as easy as it sounds, and especially so in a litigious society like our own. The problem with the entire philosophy underlying Cap and Trade is that it has always been very, very complex to measure the true impact – and therefore the measurable value – of carbon emissions versus offsetting activities. The climate is not a linear system after all. It’s complex and chaotic. How do you set the definitions around your basic tradable commodities if there isn’t a simple, quantifiable and therefore measurable basis underlying the whole thing? You’d end up in endless and expensive legal disputes over the relative impact of carbon in one case versus another based on all kinds of potentially offsetting conditions. That has been a formidable barrier to the successful implementation of Cap and Trade from the start.

So how does this seemingly innocuous and virtually redundant study change things? I’m so glad you asked. From the same article linked above:

Until now, it has been difficult to estimate how much climate will warm in response to a given carbon dioxide emissions scenario because of the complex interactions between human emissions, carbon sinks, atmospheric concentrations and temperature change. Matthews and colleagues show that despite these uncertainties, each emission of carbon dioxide results in the same global temperature increase, regardless of when or over what period of time the emission occurs.

So there’s this incredibly complex relationship running between carbon dioxide emissions and global warming running through all sorts of complicated factors. This very complexity has previously prevented a simple basis for bundling all the different circumstances of carbon dioxide emissions together to determine their impact. But now, suddenly, through clever use of modeling against a particular set of climate data, we now have that previously elusive formula by which we can take a single variable – in this case carbon dioxide emitted – ignore every other related factor and state with certainty what its proper impact in the overall “global warming” scheme will be! Amazing!

Why, that means it will be a snap to get this Cap and Trade thing under way. We now have a reliable means allowing us to ignore all the complicated uncertainties that could otherwise derail things.

Now where have I ever heard of anything like that before? Hmmm…

Oh yeah! It reminds me of a similar great discovery in the financial sector not too long ago. Remember this?

It was a brilliant simplification of an intractable problem. And Li didn’t just radically dumb down the difficulty of working out correlations; he decided not to even bother trying to map and calculate all the nearly infinite relationships between the various loans that made up a pool. What happens when the number of pool members increases or when you mix negative correlations with positive ones? Never mind all that, he said. The only thing that matters is the final correlation number—one clean, simple, all-sufficient figure that sums up everything.

That’s from Felix Salmon’s brilliant article explaining how a single model built to simplify correlations of risk between different securities based on mortgages lead directly to the recent financial implosion. But of course, this model didn’t operate in a vaccuum. In order to allow such a simple thing to wreak maximum damage throughout all the world’s finances, one more thing was necessary.

No one knew all of this better than [the model's inventor] David X. Li: “Very few people understand the essence of the model,” he told The Wall Street Journal way back in fall 2005.

“Li can’t be blamed,” says Gilkes of CreditSights. After all, he just invented the model. Instead, we should blame the bankers who misinterpreted it. And even then, the real danger was created not because any given trader adopted it but because every trader did. In financial markets, everybody doing the same thing is the classic recipe for a bubble and inevitable bust.

So what happened to the financial markets was:

A. A model was discovered which made previously impossible correlations simple and quantifiable.

B. The model was seized upon by people who didn’t really understand it so that they could use the resulting quantification to commence buying and selling in areas previously too complex for them to attempt.

C. This model was adopted universally, meaning any flaw within it would have a universal impact.

D. When the underlying reality hit a situation the model couldn’t handle the entire house of cards collapsed.

Interesting parallel, you might be thinking. But surely these things are so unalike as to make any such comparison irrelevant. After all, what would buying and selling carbon permits and offsets have to do with buying and selling mortgages?

The answer may surprise you.

You’ve heard of credit default swaps and subprime mortgages. Are carbon default swaps and subprime offsets next? If the Waxman-Markey [that's the main Cap and Trade legislation - ed.] climate bill is signed into law, it will generate, almost as an afterthought, a new market for carbon derivatives. That market will be vast, complicated, and dauntingly difficult to monitor. And if Washington doesn’t get the rules right, it will be vulnerable to speculation and manipulation by the very same players who brought us the financial meltdown.

That article linked above is only really scratching the surface here because, while noticing the financial peril by identifying some of the same specific financial instruments as were involved in the housing crisis, it misses the larger picture: Cap and Trade requires a means to simply and universally quantify economic activity surrounding carbon dioxide in a way that translates into “warming impact.” Only once this is determined can the market mechanism underlying the concept begin to work. And the way it would work (the way it is intended to work it should be noted – this is by design, not a loophole) is to issue emissions permits and offsets which subsequently market forces could buy and sell and trade and do whatever else it wants with them.

Obviously this would require some kind of regulation. And that is already taking shape.

Cap and trade would create what Commodity Futures Trading commissioner Bart Chilton anticipates as a $2 trillion market, “the biggest of any [commodities] derivatives product in the next five years.” That derivatives market will be based on two main instruments. First, there are the carbon allowance permits that form the nuts and bolts of any cap-and-trade scheme. Under cap and trade, the government would issue permits that allow companies to emit a certain amount of greenhouse gases. Companies that emit too much can buy allowances from companies that produce less than their limit. Then there are carbon offsets, which allow companies to emit greenhouse gases in excess of a federally mandated cap if they invest in a project that cuts emissions somewhere else-usually in developing countries. Polluters can pay Brazilian villagers to not cut down trees, for instance, or Filipino farmers to trap methane in pig manure.

Let’s think about those two main instruments for a moment: carbon allowance permits and carbon offsets. They’re based on the same metric, one stated as a positive and the other as a negative. An allowance permit covers situations where carbon is emmitted – added. An offset covers situations where the warming impact of carbon is countered – subtracted. Which one is more valuable? Neither one, obviously. They are of equal value because they’re both expressions of exactly the same thing – warming impact. How is this measured? By converting carbon dioxide into a single “warming” metric.

What’s so important about that single “warming” metric is that you need it to allow any business to determine how many permits or offsets – in any combination – they would require to engage in a planned activity. That number will drive their demand. And the aggregation of that demand throughout the entire economy would create a tremendous new market for permits and offsets – which would susequently create the opportunity for incredible fortunes to be made in speculating upon their value. That is not just “kind of similar” to what happened in the mortgage market, that is exactly what happened in the mortgage market.

For the sake of clarity I’ll draw the parallel more explicitly. In the case of mortgages the complex element in need of a single quantifiable metric was “default risk.” In the Cap and Trade market, that element is “warming impact.”

In the case of mortages the complexity was overcome, not by solving for the complexity, but rather by finding a model which allowed them to ignore it entirely. In the case of cap and trade that very same kind of model is the “grand discovery” being trumpted in the article I noted at the beginning of this post.

In the case of mortgages the availability of this newly quantifiable metric spun off dizzying arrays of new financial derivatives greatly amplifying the importance and reach of all transactions based upon the certainty of their key measure – “default risk.” In the case of cap and trade – well things are shaping up exactly the same. The only difference is the metric itself is “warming impact.” And surely the model producing that could never prove prone to error.

In the case of mortgages the model achieved maximum impact throughout the financial system by its near universal adoption by those who scarcely understood the model itself. In the case of Cap and Trade that same effect is intended to be achieved by legislation mandating the adoption of such a model by implication. Think this is overstatement? Then try to think how a market would react to a wandering and arbitrary standard driven by political whim rather than predictable formula. That kind of uncertainty would kill this thing in the cradle. The only way to get this plan off the ground is to base it in the certainty of science and mutually agreed upon fact (or at least a compelling illusion of the same). That’s why this “simple linear relationship” between carbon emissions and warming cited at the top of this post is so significant. It hands legislators a tool which doesn’t require them to understand anything about the climate itself – they just need to measure one single thing. Once they have that legislated… Voilà! The market will do the rest.

Beware of conclusions that go searching for their supporting research. Double plus beware of such conclusions when trillions of dollars are on the line. And triple plus beware when the subsequently discovered supporting research relies upon speculative modeling in lieu of solid evidence. Taken together these have a collective quality of wish fulfillment. But genies belong in fairy tales and not our markets.

So whether you’re the greenest of the green, or a card carrying global warming skeptic, you have plenty of reason for alarm. Another house of cards is being built before our eyes before we’ve even recovered from the collapse of the last one.

Cross-posted at Bogus Gold. Comments welcome. Reprinted with permission.