The Kyoto Bubble?

It is one of the hallmark features of a capitalist economy that investors will react to changes in policy and regulation in order to make money out of new opportunities. It is one the great risks of a capitalist economy that such speculation can be unfounded. With the current re-assessment of the west's energy policy in reaction to a number of fears—global warming and energy security foremost among them—it seems that both these phenomena are occurring. A lot of people are getting very rich as a result of policy changes, but there is substantial risk that we are seeing an energy frenzy develop. Economic historians might well look back on the first decade of this century as the days of the “Kyoto Bubble.”<?xml:namespace prefix = o ns = “urn:schemas-microsoft-com:office:office” />

It is well known that Enron was a keen enthusiast for limits on carbon dioxide emissions under the aegis of a cap and trade scheme, which would enable companies to trade permits for the right to emit carbon dioxide. Enron documents released to the public reveal that executives thought such restrictions would, “do more to promote Enron's business than almost any other regulatory initiative outside of restructuring the energy and natural gas industries in Europe and the <?xml:namespace prefix = st1 ns = “urn:schemas-microsoft-com:office:smarttags” />United States.” We can now see why. In Europe, such a scheme has been introduced, and the energy companies and their advisers are very happy.

“The carbon market is going very well. We've seen tremendous growth this year,” Henrik Hasselknippe, senior analyst at Point Carbon, told Agence France Presse on February 12. “Carbon is now being used as a commodity on the same lines as other energy commodities.” According to his estimates, CO2 trading will be a $40 billion annual industry by the end of this decade. The current price for a metric ton of carbon is $31, while a year ago it was $8. Others are equally bullish. Thierry Carol of Powernext Carbon, a CO2 trading market, told the same reporter, “Things are taking off. This is just a start.”

Unfortunately, energy consumers are not quite as happy. A report last June by investment bank UBS found that “CO2 is now the key driver of electricity prices in Continental Europe,” with CO2 costs representing about 20 percent of the cost of energy. The energy companies are simply passing on the cost of the emissions permits to their customers. As the companies are allocated permits for free, this represents a significant gain to those enterprises. The World Wildlife Fund considers this an abuse of the market. UBS itself concluded that there is a significant risk of a windfall profit tax being placed on the industry. Others have suggested auctioning the permit rights rather than allocating them. For the moment, however, energy companies have been the prime beneficiaries of Kyoto and the energy consumer the prime loser.

Another Kyoto area where money is flooding in with the expectation of quick profits is renewable energy technology. As UPI Business Editor Martin Hutchinson has recently written,

The new energy sector is not short of private funding; its “cocktail party” popularity and the pressure of the Kyoto climate change agreement has produced an ever increasing devotion of resources to research, and a huge boom in speculative investment in the last couple of years. Private equity investments alone in the New Energy sector (excluding investments by existing corporations or government or fund-raising by publicly listed companies) totaled more than $1.6 billion in over 150 transactions in 2005, double the level of the previous year.As always with such explosive growth, much of the development in the sector is ill thought through. Indeed the popularity of the sector appears to be producing yet another bubble, and has undoubtedly attracted many sharp operators and indeed outright crooks. A boom/bust cycle appears to be inevitable, which is a pity because it could set back genuine progress in the field for a decade.

This is a real concern. The presence of significant economic rents in the area will attract investment like flies to flypaper. For example, President Bush's new Advanced Energy Initiative offers $148 million for solar and $44 million for wind energy research in 2007. In most economic bubbles, the expectation of high profits is driven by inflated claims of the commodity's performance. In this case, those claims are backed in part by taxpayers' money, which makes them all the more attractive to investors. That does not make the bubble any less a bubble, however.

There are currently huge amounts of money in energy attracted there primarily by the presence of Kyoto-style regulation. That money, however, is not to the benefit of the energy consumer and may well damage the development of emissions-reducing technology in the future. It would be best for government to step out and let energy provision develop naturally, in response to the pull of the market. If people are genuinely concerned about global warming, as the polls tell us they are, then that worry will affect their behavior in the market. Kyoto advocates who tell us they do not trust the market, in fact do not trust the people. When the bubble bursts, we will see how wise that choice was.