Fraud-free cap and trade: What California learned from Europe

Fraud-free cap and trade: What California learned from Europe

Drawing parallels between financial markets and carbon markets is easy. Both are utilized by large corporations to execute trades of fungible products, both involve the monetization of products in a way that is difficult to understand and both have witnessed fraud and manipulation at the hands of their participants.

Experience shows that if left to their own devices, bad actors will emerge, looking for ways to “game” the system and use whatever means necessary to make money. This behavior is exemplified by the 2008 financial crash, when mortgage brokers sold mortgages to people who couldn’t pay them back. While the economy suffered tremendous losses, the brokers didn’t. They got paid regardless. 

The European Union Emissions Trading System (EU ETS) has demonstrated that this bad behavior can also extend to the carbon market, most recently in the form of tax fraud and basic theft.  

Just last month, two top Deutsche Bank executives came under investigation for allegedly selling carbon-emission certificates without paying the proper EU value-added tax (VAT) back to the government. In 2010, using a rather standard scam, thieves were able to convince unsuspecting market participants to email out login and password information, resulting in the pure theft of carbon allowances.

But there’s plenty of value in a carbon market that’s fraud-free. We know that when businesses play by the rules, they create a fair market and a level playing field in which everyone can participate with confidence. And that’s worth pursuing despite the fraud that has plagued the European market.

What can we learn from the past problems of fraud and graft in the markets? And how can new carbon markets prevent it?

What have we learned?

The answer is simple: If there is an opportunity for money to be made, whether legally or illegally, someone will try to take it. If there is a hole or feature that can be exploited, someone will try to exploit it. 

Although many thought the original version of the EU ETS was built on a foolproof foundation, it quickly became clear -- through cases of illegal market activity -- that consistent security was lacking and different registries were not coordinating. Similarly, because investors could participate in the market without having to fully prove who they were, it became possible to sell and resell stolen credits. Market criminals were acting true to form and taking advantage of regulatory gaps. The EU ETS suffered as a result.

The EU has been working to steadily plug these holes, but California, with the advantage of advanced warning, has taken the EU market’s lessons to heart. It has recognized the crucial need to tightly control -- and extensively oversee -- who can participate in the carbon market and how. With the help of the state Attorney General’s office, California has adopted more stringent rules than the EU ETS.

Closeup of business people writing by Pressmaster via Shutterstock.

Although each regulatory oversight of an otherwise “free” market may add transaction costs, the value of the oversight -- if it prevents fraud and manipulation from derailing the market -- is worth the cost. This is certainly true in the California market.

How will California be different?

Over the past five years, the California Air Resources Board (CARB) has developed a vast array of market oversight and transparency mechanisms for the state’s carbon market, resulting in an efficient and transparent market that builds upon the best practices of other allowance trading programs. These features give CARB a good chance of avoiding market manipulation or fraud.  Features that demonstrate unparalleled transparency, tight offsets control and unprecedented oversight put the program on a venerable path.

CARB has demonstrated that it has built a cap-and-trade program that is strong and worthy of emulation in the following ways:

  • Transparency: California’s program not only requires emitters to report their annual emissions in registries and hire third party auditors, but also requires that registries report spot-market prices and transfer of allowances. CARB also holds regular auctions and releases pre-determined market information, minimizing the likelihood of fraud and theft as a result of information avoidance.
  • Offsets: CARB has created an offsets program that provides an additional way for carbon emitters to meet their compliance obligation under the cap, adding flexibility as well as reducing price volatility in times of unexpectedly high demand for emission credits. However, only a small number of high-quality offset types, all using standardized protocols, are expected to be approved, virtually eliminating the possibility for fraud.
  • Oversight: CARB has extensive regulations in place to closely monitor auctions and determine who can participate. CARB also has hired expert consultants to monitor auction activity and is working with the Federal Trade Commission to watch carbon market and spot-market proceedings. In the unlikely event that criminal behavior is discovered, bad actors will be immediately recognized and appropriate enforcement actions and penalties will be sought.

All in all, it is clear that CARB has developed a high-integrity system that is reliable and accountable. By learning from the mistakes that occurred in Europe, California now has a system that can bypass the early-stage growing pains that other systems have had to suffer.

Those seeking to manipulate the California program system to their unfair advantage should be aware that California’s strict regulations won’t allow for it. Instead, the state has put in place an airtight system that is ready to reduce carbon emission in a fair, effective and transparent way – one that rewards businesses with a clear incentive to reduce their carbon use.

Read more: